John Cochrane on Dodd-Frank

From an interview in the Federal Reserve Bank of Richmond’s Econ Focus:†

EF: Does the 2010 Dodd-Frank regulatory reform act meaningfully address runs on shadow banking?

Cochrane: It tries, but I don’t think it actually does much about runs. I think Dodd-Frank repeats the same things we've been trying over and over again that have failed, in bigger and bigger ways. The core idea is to stop runs by guaranteeing debts. But when we guarantee debts, we give banks and other institutions an incentive to take risks. In response, we unleash an army of regulators to stop them from taking risks. Banks get around the regulators, there is a new run, we guarantee more debts, and so on.

The deeper problem is the idea that we just need more regulation — as if regulation is something you pour into a glass like water — not smarter and better designed regulation. Dodd-Frank is pretty bad in that department. It is a long and vague law that spawns a mountain of vague rules, which give regulators huge discretion to tell banks what to do. It’s a recipe for cronyism and for banks to game the system to limit competition.

Runs are a feature of how banks get their money, not really where they invest their money. So a better approach, in my view, would be to purge the system of run-prone financial contracts — that is, fixed-value promises that are payable on demand and cause bankruptcy if not honored, like bank deposits and overnight debt. Instead, we subsidize short-term debt via government guarantees, tax deductibility, and favorable regulation, and then we try to regulate financial institutions not to overuse that which we subsidize.

One of the points in my “Why Is Macroeconomics So Hard?” lectures is that most of what passes for government policy is a rehash of policies tried before. “They’ve always done it this way” is a useful lens for students to use to figure out why government does what it does. Cochrane is saying that Dodd-Frank is a prime example.

I found the point in the third paragraph both brand new, yet blindingly obvious … and I’ve been thinking about this stuff for 30 years. We’re most worried about runs, but runs occur because of only half the business that financial institutions do, and we mostly regulate the other half. That’s goofy if you think about it. An insight like that makes me think that regulators have other motives.

* John Cochrane is a macroeconomist working on the borderline of macro and finance (sort of like me, except he’s a superstar). He has been on the faculty at the University of Chicago for close to 30 years, wrote one of the top graduate finance texts, and may win a Nobel Prize in the next 20 years or so. When he talks, you should listen.

† Each Federal Reserve Bank publishes free several things, weekly to annually, that cover macroeconomics and finance at a level that undergraduates can understand. If you’re curious, start looking.