Many observers have been shocked by the level of government involvement in the U.S. economy in recent days. Among other things, the government has (1) bailed out an insurance company that got “too big to fail,” (2) decided to spend up to $700 billion buying the distressed assets of financial firms (and apparently directly investing in those firms), and (3) banned investors from short-selling the securities of a number of firms. Seems like a pretty massive governmental response, no?

No, says Judge Posner. This is really a “private sector” response. He explains:

But here is a remarkable thing about these responses. To a great extent they are not responses by government, really, but by the private sector. Bernanke and Paulson are neither politicians nor civil servants; Bernanke is an economics professor and Paulson is an investment banker. Their principal advisers are investment bankers rather than Fed and Treasury employees. Even the prohibition on short-selling, which seems like a product of the kind of mindless hostility to speculation that one expects from politicians, has been strongly urged by Wall Streeters, including the CEO of Morgan Stanley. The White House, the Congress, and even the SEC have been only bit players in the response to the crisis.

Posner’s position seems to be that because individuals from the private sector proposed these initiatives, the initiatives are ultimately private sector actions. That’s ridiculous (and remarkably naive for a thinker as astute as Posner). Because practically every governmental action creates some “winners” in the private sector, private actors spend gobs of time and effort advocating for government initiatives (regulations, etc.) that will benefit them. Via their various lobbying activities, they have a tremendous amount of input into the substance of various rules and initiatives. But that in no way implies that the actions at issue are private actions. Rather, the private actors just managed to convince politicians to undertake the public actions that those private actors preferred.

To determine whether an action is a private action or a government action, one should not merely ask whose idea the action was (i.e., was it an elected representative’s or a private citizen’s?), for private citizens routinely initiate and recommend state action. Instead, one should ask whether the action was accomplished by a threat to use force legitimately. Because the state has a monopoly on the legitimate use of force (at least outside the realm of self-defense), the key question is whether the action required the threat of such force.

For example, a vulture fund’s purchase of distressed assets is private action because no one was coerced by threat of force into tendering his or her money to accomplish that transaction. On the other hand, when the U.S. government uses tax dollars to buy up troubled assets, the threat of legitimate force is a necessary part of the deal: citizens who refuse to contribute taxes to the purchase fund may legitimately be thrown into jail. Similarly, if the owners of a private market voluntarily adopt a rule that sellers at the market may not sell borrowed stuff that they do not actually own, the effective ban on short-selling amounts to private action. By contrast, if traders’ agreements not to engage in short-selling are procured by public officials’ threats to use force (legitimately), the short-selling ban is government action. And that is true even if some private actors, who stood to benefit from a short-selling ban, lobbied the government to threaten the use of force.

So is this all just semantics? I think not. Private action, induced without any threat to use force, is voluntary. That being so, we can be pretty sure that the parties engaging in the action perceive it to leave them better off. Assuming the action involves no negative third-party effects (negative externalities), the action is likely welfare-enhancing. In addition, permitting it respects the actor’s autonomy. When action is instead induced by the threat of force — even legitimate force — we can’t be confident that it leaves the actor better off. The action is thus more likely to reduce wealth and to infringe upon the autonomy of the coerced actor.

The upshot is that government action, unlike private action (other than that involving negative third-party effects), generally needs a justification. If we follow Judge Posner’s approach of defining government action as only those activities that are proposed by public officials acting in their official capacity and without any input from private actors, we may let our public officials get by with way too much.

From Peter Klein:

Over and over during the last week we’ve been told that unless Congress, the Treasury, and the Fed “take”bold action,” credit markets will freeze, equity values will plummet, small businesses and homeowners will be wiped out, and, ultimately, the entire economy will crash. Such pronouncements are issued boldly, with a sort of Gnostic certainty, a little sadness for dramatic effect, and only minor caveats and qualifications.

And yet, details are never provided. The analysis is conducted entirely at a superficial, almost literary, level. “If the government doesn’t act then banks will be afraid to lend, and people can’t get credit to buy a house or expand their business, and the economy will tank.” Unless we rescue these particular financial institution, in other words, a massive contagion effect will swamp the entire economy. But how do we know this? We don’t. First, we don’t even know if there is a “credit crunch.” Nobody has bothered to provide any empirical evidence. Second, even if credit markets are tight, how much does it matter? Any predictions about the long-term effects are, of course, purely speculative. Sure, borrowers like cheap and easy credit and tighter credit markets will leave some borrowers worse off. But what are the magnitudes? What are the likely aggregate effects? What are the possible scenarios, what is the likelihood of each, and how large are the expected effects? Where is the cost-benefit analysis? After all, the seizure of Fannie and Freddie, the takeovers of AIG and WaMu, the modified Paulson plan — the effective nationalization of the US financial sector, in other words — ain’t exactly costless. There are direct costs, of course, to be borne by taxpayers, but the possible long-term effects brought about by increased moral hazard, regime and policy uncertainty, and the like are enormous. Even on purely utilitarian grounds, the arguments offered so far are tissue-paper thin.

Today, Treasury Secretary Henry Paulson is set to present some comments about the Treasury’s Blueprint for Financial Regulatory Reform, released on Saturday.  (A summary of the proposal is here.) 

The summary of the proposal report provides:  “In this report, Treasury presents a series of “short-term” and “intermediate-term” recommendations that could immediately improve and reform the U.S. regulatory structure. The short-term recommendations focus on taking action now to improve regulatory coordination and oversight in the wake of recent events in the credit and mortgage markets. The intermediate recommendations focus on eliminating some of the duplication of the U.S. regulatory system, but more importantly try to modernize the regulatory structure applicable to certain sectors in the financial services industry (banking, insurance, securities, and futures) within the current framework.” 

I have a few comments on the proposals:

1.  The report contemplates consolidation of market regulators for the securities markets and the commodities markets.  This is a difficult issue.  Intuitively, I like the notion of consolidating regulation, as the regulatory authority dealing with commodities (the CFTC) and regulators of the general securities markets (SEC) both regulate the markets for securities.  That said, commodities regulation is (a) incrementally more sophisticated than the regulation of the generic securities markets due to the increased complexity in products, their evolution, and their likely economic/market impact and (b) different in sort than the regulation of plain vanilla securities.  Moreover, my impression – based on my experience working at the SEC and my experience as a corporate/securities/business scholar – is that the CFTC does a bit of a better job than the SEC in avoiding political pressure.  (Think about it – while we can easily recall a series of SEC Chairmen resigning under pressure, can we easily recall a series of CFTC Chairmen resigning under pressure?)  Is it sensible to combine agencies and lose that market niche insulation?

2.  The motivation for Treasury’s proposals strikes me as questionable.  The report summary says:  “Market conditions today provide a pertinent backdrop for this report’s release, reinforcing the direct relationship between strong consumer protection and market stability on the one hand and capital markets competitiveness on the other and highlighting the need for examining the U.S. regulatory structure.”  Indeed, the argument was made in connection with last spring’s Paulson report that the US capital markets are becoming less competitive, in part due to mis-regulation (and overregulation).

 But the argument that the US capital markets are becoming less competitive continues to be the subject of robust academic debate.  (For example, Howell Jackson, Jack Coffe, Kate Litvak, and Don Langevoort, all very credible scholars, expressed differing views on the issue at the AALS annual meeting this past year.)  I, for one, do not believe that the US capital markets are becoming less competitive.  Instead, I believe that the overseas markets are becoming *more* competitive.  That is not a bad thing, nor is it reason to overhaul US market regulation.  In reality, maybe the increasing competitiveness of overseas capital markets counsels in favor of our holding the status quo, to see how things shake out with the fundamentals that make the overseas markets increasingly competitive in the short term.

To that end, the report summary says “[g]lobalization of the capital markets is a significant development. Foreign economies are maturing into market-based economies, contributing to global economic growth and stability and providing a deep and liquid source of capital outside the United States. Unlike the United States, these markets often benefit from recently created or newly developing regulatory structures, more adaptive to the complexity and increasing pace of innovation.”  Until we know how these more newly developed regulatory structures fare in the long term, is seems unwise to jump to action to keep up with them.    Moreover, the summary of Saturday’s report indicates that its authors looked closely at the UK, Australia, and Netherlands financial markets regulatory regimes in designing the proposals in the report.  Basing reform of the US capital markets on regulation in the UK, Australia, and the Netherlands, however, does not strike me as sound.  If we are entertaining notions of wholesale reform, why not instead pin down what the conceptual optimal model would look like, as opposed to mining for inspiration from other regulators?  That said, the report purports to so do, to a degree, as discussed below in point three. 

3.  The report touts a new “objectives based regulatory approach.”  This approach, however, while radically different from the current US capital markets regulatory structure in terms of how it is implemented, is nothing new in terms of goals.  (Indeed, the summary says the new structure is motivated in part by “the convergence of financial services providers and financial products has increased over the past decade.  Financial intermediaries and trading platforms are converging.   Financial products may have insurance, banking, securities, and futures components.”  But wasn’t this dealt with in the Gramm- Leach-Bliley Act?  Why now do we need to revisit what appears to have been sensible reform less than a decade ago?)

The report summary says “[l]argely incompatible with these market developments is the current system of functional regulation, which maintains separate regulatory agencies across segregated functional lines of financial services, such as banking, insurance, securities, and futures,” and the report instead argues for an objectives based regulatory scheme, based on the objectives of “[m]arket stability regulation…, [p] rudential financial regulation…, and [b]usiness conduct regulation.”  But our current functional regulatory scheme operates with a focus on these exact objectives.  A consolidation of power into one regulatory authority for each objective seems to do nothing other than allow for (a) tunnel vision by a given objective’s regulator and (b) decreased input in terms of how to regulate to the goal of meeting these objectives.  With respect to point “b,” I believe that it is useful to have the leaders at the SEC, the CFTC, and the Federal Reserve all making calls to each other, giving input to the President and Congress, and agitating for ways to secure better regulation.  Yes, there is tension and a bit of repetitive regulation, but it seems to me that that is healthy when dealing with a matter as important as the United States capital markets.

4.  I have not worked through exactly how Saturday’s report proposes, if at all, to restructure the actual Board of Governors of the Federal Reserve System.  I will note, however, that I am generally leery of restructuring the Federal Reserve, both in terms of authority and operation.  Part of what makes the Federal Rserve work is the fact that the Governors serve for 14 year terms, allowing for insulation from political pressure (to a degree) and a link between immediate decision-making and longer-term implications.  (Contrariwise, the SEC Commissioners are usually long gone before the fall-out from their decisions becomes manifest.)  The Federal Reserve System has worked well for almost 100 years.  Does it really make sense to tamper with it?   

5.  To paraphrase, “regulate in haste and repent in leisure.”  I am never thrilled to see a massive proposal for overhaul and reform on the heels some major business or economic event.  Did the aftermath of the Sarbanes-Oxley Act (which is an act that I support, by the way) teach us nothing?

David Zaring and Gordon Smith have some interesting comments over on the ‘Glom, as does Larry Ribstein on his blog.