The financial crisis: why the conventional wisdom has it all wrong.

• Author: Kovacevich, Richard
• Position: Column

Like many of you, I am appalled at the political environment and gridlock that continues to exist in this town. I simply cannot understand nor do I accept why our elected officials continue to concentrate on party politics and the next election above doing what's right for America, especially as we endure the past five years of economic stagnation and high unemployment. Nothing is more debilitating and unfair than a head of household willing to work but who cannot find a job. Why hasn't job creation been the number-one focus of our government during this economic crisis?

Don't believe for a moment those economic theorists who tell us the reason for our slow growth, economic malaise, and continued high unemployment is due to the uniqueness of a financially led economic recession. Rather, it is due to the failure of the leaders in this town to adopt those monetary, regulatory, and fiscal policies that have successfully worked in the past while, alternatively, focusing on a political agenda that did not put economic growth and jobs at the top of the list. In my opinion, the early 1980s' economic recession--with its exceptionally high 10 percent inflation, 20 percent interest rates, and 12 percent unemployment--was far more difficult to correct and resolve. Yet our economy bounced back in 18 months with GDP growth of over 7.5 percent the next year. In the 1980 recovery, GDP growth averaged 4.9 percent, and for all recoveries since the Second World War, the average was 4.1 percent. The current recovery has been a paltry 2.2 percent.

With the appropriate monetary, regulatory, and fiscal policies our economy should be growing at 3 percent or even higher, which is what is needed to bring employment, our budget deficits, and the labor participation rate to acceptable levels.

One of the many reasons our economy is growing at historically low rates is the extraordinary and unprecedented increase in regulations facing job creators--the most by any administration ever. For example, small businesses have always been the major source of new jobs in our country as compared to large companies. Not this time, however. Why? According to small business polls over the past five years, the job malaise is due to excessive regulation, higher taxes, and increased health care and other costs--the exact opposite of job creation policies that have worked well in the past.

My focus today will be on financial regulation, but similar regulatory burdens are impacting all industries. For example, the Kauffman Foundation, a think tank, reveals in a survey that small businesses, the primary job creators forever, feel more over-regulated than even overtaxed. The Competitive Enterprise Institute estimates that the total cost of complying with America's federal regulations in 2013 was $1.86 trillion, about $15,000 per household. I will also address why I think the conventional wisdom has it all wrong as to what and who caused the 2008 financial crisis and why the response to it was irresponsibly implemented and can be summarized as "senseless panic." I will posit that recent financial regulation would not have prevented the last financial crisis nor prevent the next one. I believe that because of the Dodd-Frank legislation, and the current monetary policies of the Federal Reserve, the bottom 25 percent of Americans on the economic ladder will have restricted access to mortgage and personal loans and will incur much higher fees for banking services, all of which is inhibiting economic growth and significantly widening the income inequality gap.

Origins of the Financial Crisis: TARP, a Massive Government Failure

So how did we get into this mess? The last time I was in Washington was in October 2008, for the infamous TARP (Troubled Asset Relief Program) meeting between the Treasury Department, regulators, and large bank CEOs. I believed at that time, said so at the meeting, and I still believe today that forcing all banks to take TARP funds, even if they didn't want or need the funds, was one of the worst economic decisions in the history of the United States. What should have happened is that only those financial institutions who were still solvent but had liquidity challenges, and who needed the funds temporarily, should have been given that choice. You can't fool the markets as Treasury officials and regulators believed you could. The market knew which financial institutions were in trouble as evidenced by stock prices and credit default swap rates that existed at that time. Forcing TARP funds on all banks did not restore confidence in the industry. It destroyed confidence as the market concluded that all banks must now be in trouble because all banks were receiving funding and presumed to have needed and wanted it.

You may have forgotten that prior to TARP, and even a month after the Lehman bankruptcy, markets had declined but were still behaving reasonably well, except for those financial institutions that were having liquidity issues. With the announcement of TARP, isolated liquidity issues turned into a tsunami impacting all banks and all industries. It precipitated a dramatic drop in the stock market, froze trading and the capital markets, magnified and extended the market collapse, damaged the reputations of many financial institutions who did no wrong, increased moral hazard, institutionalized "too big to fail," angered and outraged the general public, and provided Congress an excuse to burden the banking industry with a massive 25,000 pages of new regulations--the largest increase in bank regulations in history. Even four years after its passage, regulators have still completed only 52 percent of its 398 rules according to law firm David Polk and Wardwell. These Dodd-Frank regulations were authored not by considered judgment, but rather as anger and punishment for the TARP bailouts. Without TARP, the Dodd-Frank bill would unlikely have been passed or at least not in the form that now exists. It was TARP that started this whole mess.

Conventional wisdom, on the other hand, especially inside the Beltway, suggests TARP was a great success in restoring confidence in the financial industry. The facts suggest it was an unmitigated disaster and TARP should never be repeated. The spin never stops in Washington. No surprise, as all the authors of TARP were Washington insiders focused on protecting their reputations and deflecting blame for their failure to do their jobs of properly monitoring and reducing excessive risks being taken by some financial institutions.

TARP contributed to an unnecessary panic in the marketplace and required an unprecedented $29 trillion dollars of market intervention by the Fed and the Treasury, over twice the annual GDP of the United States, to restore the very markets that they, themselves, helped to collapse. I warned at that meeting that politicians, especially those from the rust belt, wouldn't stand for giving banks money but not to struggling automobile and other companies. I also argued that by giving capital to all banks, even the sound ones who didn't need it, the market would likely decide that even the healthy banks were in trouble and confidence levels in the industry would actually decline, not improve.

So what actually did happen? Why was TARP clearly a mistake? Within two months of giving all banks money, the Dow Jones Industrial Average fell by 40 percent and financial stocks fell by 80 percent. How can anyone claim that an 80 percent drop in the stocks of financial companies, reaching their all-time lows, is a show of confidence? In fact, it was an unmitigated disaster. Now giving some banks money, who were having liquidity issues, may make sense if those banks were not insolvent but are just facing liquidity pressure. Giving all banks funds should never occur-never ever again. Because of TARP, Congress and the administration demonized and vilified all financial companies...