The CMFA’s George Selgin, Thaya Brook Knight, and Mark Calabria (now Chief Economist to VP Pence) contributed chapters, writing on monetary policy, securities regulation, and financial regulation, respectively. You can find all three chapters here. A synopsis of their recommendations follows.
Monetary Policy
Selgin proposes a series of legislative reforms to the Fed’s operating framework that would improve financial stability and the efficient allocation of credit. He recommends that Congress replace the Fed’s dual mandate with a single, stable-spending mandate. The dual mandate, by containing two potentially contradictory goals, price stability and full employment, often serves as a cover for the Fed to justify any policy it chooses. A single mandate would define a clear goal for the Fed and allow Congress and other overseers to easily discern whether a given Fed policy is furthering that goal. A stable-spending mandate would have the Fed conduct monetary policy in a way that would avoid both liquidity shortages and unsustainable booms. To make the Fed’s commitment to a single stable-spending mandate credible, Selgin recommends that Congress require the Fed to follow an explicit, straightforward, monetary rule.
Selgin also recommends a more efficient process for the Fed to use in distributing newly created liquidity in both ordinary times and times of financial market stress, a reform he calls a “flexible open market” framework, or Flexible OMOs for short. This new framework replaces the Fed’s primary dealer system with auctions open to almost all financial firms. It also broadens the range of securities eligible to serve as collateral in a fashion similar to the “product-mix” auctions the Bank of England uses.[1] Increasing the assets eligible for purchase and the firms able to participate would ensure that new credit created by the Fed is put to its most efficient use — while also limiting the Fed’s footprint on allocating credit. Moreover, Flexible OMOs would rid the Fed of any need or justification to engage in direct lending, as any solvent financial institution could purchase the credit it needs during a liquidity crunch. So long as the Fed follows its proposed stable-spending mandate, it would automatically create the credit needed to meet emergency liquidity needs.
Securities Regulation
Overly restrictive securities regulation deters innovation, economic dynamism, and investment opportunities for ordinary people. Thaya Brook Knight provides policymakers with concrete steps towards more robust and fairer capital markets. To reduce burdens on firms pursuing an initial public offering (IPO), Congress should extend the 2012 JOBS Act IPO on-ramp to all firms pursuing an IPO, not just those with less than $1 billion in annual revenues. The IPO on-ramp provides five years of forbearance from certain reporting requirements, the ability to advertise to institutional investors before filing SEC paperwork, and relief from some Dodd-Frank and Sarbanes-Oxley rules. Knight also proposes that Congress revise Sarbanes-Oxley’s Section 404, which requires companies to report on the adequacy of internal controls and accuracy of financial information. Due to the costly nature of satisfying Section 404 requirements, Knight suggests that these requirements only apply to companies that have histories of internal control or accounting problems.
While easing public market restrictions will go a long way towards improving investment opportunities, Congress should go further and toss out the rules that restrict private offerings only to the rich. In 1982, the SEC promulgated Regulation D, which exempts private placements from state level regulations if the offerings meet certain requirements. Most private placements today are offered under Rule 506 of Regulation D, which essentially restricts individual investment in these offerings to people who earn more than $200,000 annually or have assets, excluding primary residence, valued in excess of $1 million. As fast growing young companies are staying private for longer, these restrictions are steadily becoming more pernicious. Congress should recognize that wealth-based investment restrictions are at odds with a liberal democratic society, and are a driver of income inequality. If lawmakers are hesitant to allow all people to purchase securities without the the full set of regulations imposed on public offerings, then at the very least the legal criterion for financial competence should be updated and based on something more objective than wealth.
Financial Regulation
Mark Calabria identifies a cycle at the heart of the longstanding relative instability in the American financial system. Restrictions on entry and competition artificially weaken the financial sector, as they limit firms’ ability to diversify their assets and reduce the market incentives for prudent risk management. Weakness resulting from these restrictions serves as an impetus for prudential regulation by government, like FDIC deposit insurance, risk-based capital requirements, and the Federal Reserve’s emergency lending safety net. Prudential regulation is inferior to market discipline because it relies on knowledge regulators do not and cannot have in real-time, making the system more prone to crisis.
To fix this cycle, Calabria recommends policymakers reduce the bank safety net and remove regulations that distort risk-taking incentives and erode market discipline. The best first step would be repealing Dodd-Frank. If Congress cannot achieve a full repeal, Calabria suggests at a minimum doing away with Titles I,II, and X. Title I established the Financial Stability Oversight Council, the regulatory super council that is tasked with designating firms as systemically important, or in others words, codifying too-big-to-fail. Title II gave the FDIC orderly liquidation authority (OLA) to resolve failing banks and non-bank financial firms at its discretion, which essentially institutionalizes government bailouts. Title X established the Consumer Financial Protection Bureau, which imposes non-economic lending standards on financial companies while taking a paternalistic view of consumers and regulating financial products it deems dangerous for them out of existence — despite consumers demonstrated demand for those products.
In addition to Dodd-Frank, Calabria points to mortgage finance, deposit insurance, and community lending as areas where public policy has made the financial system less stable and efficient. Given the role Fannie Mae and Freddie Mac played in the financial crisis and the dangers they continue to pose to the stability of the financial system, they should be briskly wound down, in no more than six years. Calabria outlines the legal methods to accomplish this. Congress also should tackle the distortions caused by Federal Housing Administration (FHA) subsidies. In the long run, Congress should abolish the FHA, but interim fixes include higher down-payments, lower debt-to-income ratios, and credit rating requirements for borrowers taking out FHA loans. Regarding deposit insurance, Calabria points out that it is extensively documented in academic literature that public insurance reduces the vigilance of bank creditors, encourages risk taking, and leads to more failure. Calabria suggests reducing the FDIC per account cap from $250,000 to its pre-savings and loan crisis level of $40,000, at the very least. A $40,000 cap would still leave most American households covered — since on average households keep well below this amount in insured accounts. Lastly, Calabria suggests Congress repeal the Community Reinvestment Act, which forces banks into making economically unsound loans and opens avenues for costly litigation.
Read More…
To delve further into the policy recommendations made by Selgin, Knight, and Calabria, read all three CMFA chapters from the Cato Handbook for Policy Makers here. Or browse the entire Handbook here.
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[1] Selgin specifically proposes that all firms that currently have access to the discount window be allowed to participate in these auctions, and that all marketable securities accepted as collateral at the discount window stand ready for purchase.
