America’s Shampoo Economy

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I recently gave an update on America’s economic policy, such as it is, to a group of bankers. I expected a great deal of interest in the Republican tax plan, but instead, they wanted to talk about how costly it was for them to comply with the rules introduced by the Dodd-Frank reform bill.

While sympathizing with their plight — the cost of regulatory compliance has clearly risen over the last decade — I asked them to recall the last financial crisis, a set of catastrophic, deep-recession-inducing events that motivated the creation of Dodd-Frank in the first place.

A few heads nodded. There was some mumbling about irresponsible home buyers.

Add to this anecdote the Trump administration’s attempt to undermine the consumer protection agency created by Dodd-Frank, along with similar congressional actions I suspect you haven’t heard about (I’ll fix that in a moment), and the person this brings to mind is the economist Hyman Minsky.

Perhaps because Minsky, who died in 1996, was both an economics professor and a banker, he understood something other economists assumed away: recurring cycles of financial instability. After a crisis, like the bursting of the housing bubble and its ensuing damage to all the banks involved in mortgage lending (or derivatives of such loans, or insurers of such derivatives — Minsky thought about all this), the financial sector and policymakers are duly chastened. They recognize that risk was systemically underpriced, and they’re even willing to countenance some guardrails against reckless banking and damaging speculation.

Then, a few years into the next expansion, as the memory of the crisis fades, lenders start getting their risk back on. As Minsky observed, this phase is characterized by increasingly exotic and complicated financial tools that disguise the extent of leverage being doled out to borrowers who are far from creditworthy. The next thing you know, you’re inflating the next bubble, which feeds itself until it suddenly pops — a point known as the Minsky moment, when risk-seeking flips to risk-aversion.

My own term for the Minsky cycle is the “shampoo economy”: bubble, bust, repeat. Before the housing bubble, there was the dot-com bubble, and before that, another real estate bubble. Scholars have documented centuries of this cycle in action.

The only way to block the cycle is to regulate the sector, dialing up the oversight when amnesia sets in. Yet, largely behind the scenes, President Trump and the Republican majority are busily dismantling many of our newest guardrails. As Stephen Hall of the financial watchdog group Better Markets recently put it: “We are in the early stages of a major wave of financial deregulation that will, without question, increase the likelihood and severity of another financial crisis and once again inflict devastating losses on millions of everyday Americans.”

The most visible attack on the financial regulatory system is the administration’s attempt to take down the Consumer Financial Protection Bureau, an agency that has returned about $12 billion to 29 million people ripped off by the abusive practices of consumer lenders (for example, the bureau fined Wells Fargo $100 million for setting up millions of phony accounts at depositors’ expense).

Less visible efforts include a recently introduced bill, one with some bipartisan support (Democrats are not immune to the Minsky cycle), that draws a much smaller corral around lenders deemed to pose systemic risk to the system. A potentially fatal error here is mistaking the size of a bank’s holdings instead of its interconnectedness as the determining factor for regulatory scrutiny (Lehman Brothers, whose collapse helped set off the 2008 meltdown, was never the biggest bank on the street).

Then there’s the Choice Act, passed by the House last June, which rolls back much of Dodd-Frank, including the Volcker rule, which prevents government bailouts of banks whose liabilities are insured by taxpayers, and the ability of regulators to safely liquidate failed banks that pose systemic threats. Even further behind the scenes, the Trump administration is engaged in broad-based deregulation at the regulatory agencies, installing industry-friendly appointees and dismantling Obama-era rules.

In a revealing development that moves from Minsky to Orwell, Mr. Trump’s Treasury Department recently argued that the term “shadow banking,” which refers to financial firms outside the regulatory boundaries, should be replaced by “market-based finance.”

The finance-market amnesiacs are not just attacking the prevention side of the Minsky equation. They’re also going after the ability of the government to intervene after the next crisis. The House Financial Services Committee just approved two bills that restrict the Federal Reserve’s ability to provide emergency liquidity in a credit freeze (the Fed would need congressional approval, politicizing what should be an independent judgment by the central bank), and to buy any securities other than Treasury bonds (had this been in place, the Fed would not have been able to provide essential credit to the housing market after that bubble burst).

At the same time, fiscal space to support the economy during the next downturn has been diminished by the deficit-financed tax cut. Moreover, President Trump has announced that one of his administration’s next priorities is “welfare reform,” code for hacking away at the safety net, Social Security and Medicare.

Simply put, the Republicans’ agenda is to deregulate, transfer tax revenues from the Treasury to their donors and shrink government. In year nine of our aging economic expansion, the timing of this agenda is coinciding with the point in the Minsky cycle where risk aversion has flipped to underpriced risk taking amid an aggressive attack on the measures put in place after the last crisis to meet just this moment.

Unless we quickly regain our memories of what happened at the last Minsky moment, this can only end badly.