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The Dodd-Frank Wall Street Reform and Consumer Protection Act: The Triumph of Crony Capitalism, Part 1


The revolving door between Washington and Wall Street allows people attracted to power and skeptical of free markets to dominate economic policy for their benefit.


The "Failure of Capitalism"

The Act assumes that the economic bust was caused by a failure of capitalism and a failure of government to properly regulate the economy.

Upon signing the Act, President Obama said:

"For years, our financial sector was governed by antiquated and poorly enforced rules that allowed some to game the system and take risks that endangered the entire economy," Mr. Obama said.

The new law, he said, would better protect consumers, empower investors and bring transparency to dark corners of the financial markets.

"The American people will never again be asked to foot the bill for Wall Street's mistakes," Mr. Obama said. "There will be no more taxpayer-funded bailouts. Period."

The President and most politicians, Republicans and Democrats, blame the crisis on capitalism itself, and, rather incredibly, on what they view as unregulated "laissez-faire" capitalism. They ignore the fact that the financial industry is one of the most regulated sectors of our economy. When they say "laissez-faire," what they really mean is that they want to completely control the financial sector.

The President views Wall Street and free enterprise with disdain, repulsed by what he sees as just the latest failure of capitalism and the "old ways and failed policies of yesterday." He believes, as the benevolent legislator-in-chief, he must step in and protect us from evil predations of Wall Street like a shepherd guarding his flock: Only the guiding hand of government can make capitalism safe for society.

The President, like most politicians, lawyers, and economists, believes that the economic bust was caused by greed, excessive compensation, fraud, speculation, complex securities that no one understood, predatory Wall Street practices, and a lack of sufficient regulatory powers. These factors, they say, allowed financial institutions such as Wells Fargo (WFC), JPMorgan (JPM), and Goldman Sachs (GS) to take unnecessary risks which jeopardized the world's financial system and almost brought it down.

The problem is that their beliefs are wrong, and they make up data to fit their beliefs. Their conventional wisdom fails to satisfactorily explain the actual underlying causes of this boom-bust cycle and the new law will do nothing to prevent another cycle. The factors they blame for the crash always exist in financial markets, and yet, for reasons they don't explain, actors on the financial stage suddenly explode into an orgy of greed directed at the housing market.

There are two questions you should consider while evaluating the Act's impact and scope that help explain this boom-bust cycle:

1. Why did the housing market become a bubble?

2. Why would any lender lend money to a home buyer who (i) had a credit score of 500, (ii) made a down payment of 5% or less, and (iii) didn't have to prove his or her ability to repay?

I would answer these questions by saying:

1. Only cheap money drives bubbles and there's only one entity that creates cheap money and that's the Federal Reserve. From 2000 to 2004, the fed funds rate went from 6.5% to 1.0% wildly distorting entrepreneurial behavior. This was the cause of this boom-bust cycle.

2. No one would lend so carelessly unless they didn't care. They didn't care because someone else, in this case the government (Fannie, Freddie, and the FHA), would guarantee repayment.

Everything stems from these two factors yet there's nothing in the Act that prevents the Fed from starting a new cycle or that prevents Fannie or Freddie from again distorting the economics of the housing market. The purpose of this article isn't to go into the ultimate causes of the bust as I've discussed them at length in other articles, but these factors highlight the foundational fallacies of the Act.

No positions in stocks mentioned.

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