NEW YORK – Market “failures” seen during the financial crisis resulted from “poorly conceived regulations,” that created “distorted incentives,” said Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser.
“The financial crisis was not a failure of our capitalist system. Nor was it largely the result of a lot of greedy evildoers whom we could just put in jail to solve the problem,” Plosser told the Union League of Philadelphia, according to prepared text of his remarks, which were released by the Fed. “Rather, it largely reflected a collection of incentives, some arising in private markets and some created by the government that motivated individuals to act in ways that proved damaging to the nation’s overall economy.”
Market failures occur, and sometimes the government must step in, but it is important “to cure the disease and not just treat the symptoms.”
He noted, “good regulation works to align incentives so that market discipline is strengthened. It encourages self-interested financial firms to act in ways that further our societal goal of a financial system that is less prone to crises while facilitating economic growth.”
But, he said, too often “well-intentioned government policies and regulations distorted incentives rather than aligned them with overall economic well-being. For example, excessive leverage in many financial institutions exacerbated the financial crisis. Yet, our tax code encourages reliance on debt financing over equity financing by making interest payments tax deductible for the firm while dividend payments are not. Similarly, many observers lament the fact that American consumers have been living beyond their means with too much debt and not enough savings. However, our tax code has encouraged such behavior by allowing interest payments to be deducted while taxing capital gains and double taxing dividends, all of which discourage saving and investment and promote debt-financed consumption. Moreover, the tax deduction for mortgage interest skews the decision between being a homeowner and a renter.”
Government safety nets, set up “in the decades leading up to the financial crisis and during the crisis itself,” offered firms guarantees, “like those given to the creditors of firms deemed too big to fail and to Fannie Mae and Freddie Mac,” that “undermine the natural forces of the market to limit excessive risk-taking.”
With the promise of a federal bail-out there is no incentive to avoid risk, Plosser said. The U.S. rewards “entrepreneurs and businesses that take risks by creating innovative products and services,” but if the products aren’t wanted, the producers lose money and may fail. “For a market economy to function effectively, individuals and businesses must not only have the freedom to reap the rewards of their success, they must also have the freedom to fail.”
Plosser said to restore market discipline a credible resolution mechanism for large institutions must be created. “It needs to impose losses on creditors as well as shareholders and to do it in a consistent manner so that they have the incentive to take adequate precautions against failure.”
In the recent crisis, Plosser said, “government’s policies toward housing, however well-intentioned,” created problems. By pushing homeownership through GSEs (including Fannie Mae and Freddie Mac), there was an implicit government guarantee, so market discipline was low, and the institutions were not heavily regulated. “So neither market forces nor government oversight imposed adequate controls and the institutions were not forced to bear the cost of the risks they took on,” he said. “Because they were allowed to be thinly capitalized and highly leveraged, it became very profitable for them to grow their portfolios – they became so large that the market believed they were too big to fail, which turned out to be true.”
The solution? Plosser said is “better-designed regulation that recognizes incentives and tries to address moral hazard so that market discipline can work.” He said safety net subsidies must be scaled back and a process must be instituted to “resolve insolvent institutions without endangering the stability of the financial system.”
