The Magazine

Another Fine Mess

The economic costs of ignorance

Feb 20, 2012, Vol. 17, No. 22 • By MATTHEW CONTINETTI
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It was such ignorance about the future that led regulators in 1988 and 2005 to impose international banking standards which required banks to hold more capital for commercial loans than mortgages; the 2001 Recourse Rule that led banks to load their balance sheets with AA- and AAA-rated mortgage-backed securities; the 1975 rule that securities could receive ratings from only Moody’s, S&P, or Fitch; and the 1993 “fair-value” accounting standard that spread panic when the ratings oligopoly turned out to be mistaken and the banks became saddled with bad debt. No one possibly could have known how these various laws would interact, first encouraging the housing bubble and later pressuring it to pop. Nor does anyone have the faintest clue about the other time bombs lurking in the 150,000-page Code of Federal Regulations and three-million-page Federal Register.

Friedman and Kraus’s examination of the 2008 financial crisis ends with a broader critique of economic policy in the administrative state. The role of government in the early 21st century is to acknowledge and “solve” the problems identified by public opinion and mass media. But since the world is infinitely complex, the people and their representatives delegate authority to experts in the civil service, whose business at places like the Federal Reserve, Commodity Futures Trading Commission, Office of the Comptroller of the Currency, Environmental Protection Agency, and elsewhere is to simplify problems and implement rules. In the final analysis, however, the experts are just as ignorant of the future as the rest of us, and each new rule has unintended consequences that may interact with the other rules in dangerous and unknown ways.

Most of us never look at the role ignorance and regulation play in financial panics because we hold capitalism to a standard of utter perfection. Every deviation from this standard becomes a reason for further policies that set into motion the cycle of rule-making and unintended consequences. And so the latest round of Basel Accords encourages purchases of sovereign debt—look how that’s working out—and the Dodd-Frank finance bill instructs regulators to write 70 studies and make 240 rules. Meanwhile, President Obama circumvented the Senate and the Constitution so that the former attorney general of Ohio can muck around in the consumer financial product sector. Despite all this, I believe I can safely predict that, when the next panic arrives, it will be blamed on unregulated markets and rapacious capitalism.

Engineering the Financial Crisis is not an easy read. It is technical and contains too many acronyms and italicized words. But it is also the most important book on the 2008 crisis that I have encountered. Has any other title proposed such an original and compelling interpretation of the events of 2007 and 2008? Is there any other book that courageously raises the problem of human ignorance for democratic policymaking?

As the oracle might say, “There is none.”

Matthew Continetti is a contributing editor to The Weekly Standard and editor in chief of the Washington Free Beacon.