Markets Scream through Dodd's Stifling Embrace

It wasn't a coincidence that equity markets posted their biggest drop in more than a year the day the U.S. Senate passed its sweeping financial reform bill. Yes, fears about the spread of Greece's financial crisis are hurting markets worldwide, but in the U.S. on May 20, the big news was passage of Senator Christopher Dodd's financial-reform legislation.

Congressional leaders have no idea what caused the financial crisis, but that has not stopped them from crafting a massive new set of intrusive rules.

Our feckless leaders, the modern-day gang that couldn't shoot straight, targeted their policy weapons at Wall Street but hit Main Street. Big financial firms such as JPMorgan Chase & Co. (down 3.9 percent) and Goldman Sachs Group Inc. (down 2.9 percent) fell roughly in proportion with the overall Dow Jones Industrial Average, which declined 3.6 percent on Dodd's big day. By contrast, some companies that actually sell things to people plummeted: Ford Motor Co., down 6.5 percent; Timberland Co., down 8.8 percent; Sears Holdings Corp., down 11 percent.

How could passage of so-called financial reform contribute to such a broad collapse? There are three key reasons.

The first and most important is that private industry can no longer predict where the massive government intrusion will end. There was some hope that the public uproar over the health- care debacle would slow the legislative fervor of the Democrats. The opposite seems to be the case.

The U.S. government, fresh off nationalizing its largest automaker, then legislating the takeover of health care, is now enveloping financial services in its stifling embrace. The bill gives the Federal Reserve dictatorial power over firms that are viewed to be "systemically important." The distance between such a rule and outright government control would fit on the head of the pin.

60-40 Split

With financial services and health care joining its direct programs on the state and federal levels, the government now controls 60 percent of the U.S. economy. Is it any wonder that the 40 percent is getting nervous?

The second cause of market pessimism is the likely impact of Democrats' financial reform on the cost of doing business for nonfinancial firms. As I wrote previously, the new rules will surely concentrate the financial industry into a few very large firms with significant market power. That will be good for the bottom lines of these firms while likely increasing the cost of financial services for everyone else.

The firms that are too big to fail will be able to hold borrowers hostage with high rates. This will make it harder for firms to borrow to invest in new plants and equipment--the equivalent of a big interest-rate rise targeted at nonfinancial firms. Such an increase would never be considered by monetary policy makers at this tenuous stage of the economic recovery, but it just got through the U.S. Senate.

Just a Placebo

The third force driving markets south has been the realization that the medicine will do nothing to make financial services any safer. The bill is the economic equivalent of a placebo treatment for a patient with terminal cancer.

Starting with the 2008 election, Democrats have peddled a conveniently narrow explanation of the financial crisis. It holds that greedy bankers tricked borrowers into taking loans with low teaser rates they didn't understand. These innocent victims were unable to make the monthly payments when their interest rates adjusted upward. This led to the collapse of the housing market.

The truth is much more complicated.

Fortunate Borrowers

Lenders were able to print money because they could pawn off any loans they made to Fannie Mae and Freddie Mac at a healthy profit. There was no need to inspect the ability of the borrower to repay the loan, because repayment was Fannie and Freddie's problem, not the lender's. Many borrowers, far from being confused, couldn't believe their good fortune. They were given essentially a free option on a new home. If the price went up, they stood to make a healthy profit. If the price went down, they could walk.

The financial-reform bill reveals that the Democrats believe their own screwball rhetoric. How else to explain the proposed new Consumer Financial Protection Agency, which would make sure that borrowers aren't tricked again. It would presumably accomplish this by establishing lending rules and using its authority to delve into bank operations.

The result is legislation that increases the likelihood of another housing bubble--only ext time, we won't be able to say that borrowers were tricked into accepting something too good to be true. The bill leaves Fannie and Freddie standing, without addressing the fact that they are still subsidizing loans to those who can't repay the principal. The inevitable outcome will be a replay of the entire real estate fiasco.

Congressional leaders have no idea what caused the financial crisis, but that has not stopped them from crafting a massive new set of intrusive rules. The only sure thing is that the cost of doing business in the U.S. just increased enormously, as did the odds of a double-dip recession.

America has become the land of high taxes, big government, complex regulations and indignant politicians. The future of such a place is not bright. The markets understand that.

Kevin Hassett is a senior fellow and the director of economic policy studies at AEI.

Photo Credit: iStockphoto/Lyle Koehnlein

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