As shown in the chart below, the U.S. economy had a few reasonably good quarters of recovery after the crisis, particularly the third and fourth quarters of 2009 and the first quarter of 2010. These were not of Reagan quality, of course, but they suggested that the economy was beginning to heal.
On June 30, 2010, however, the Democrat-controlled House voted along party lines to adopt the House version of Dodd-Frank. That was expected, of course, but two weeks later two Republican Senators—Scott Brown of Massachusetts and Olympia Snowe of Maine—announced they would vote for cloture in the Senate. These two votes virtually assured that the bill would pass the Senate and eventually become law. Almost immediately, GDP growth in the third quarter of 2010 began to slow. It has never recovered.
The effects of Dodd-Frank went well beyond GDP. Because it was such a comprehensive piece of legislation, it also had adverse consequences in virtually every major industry. Below are charts showing a nearly identical pattern in the housing market…
And in factory production:
Although event studies like this are always subject to question, the fact that the same patterns are seen in overall GDP and in two major sectors of the economy lends support to the idea that they had the same cause. Moreover, no other event at the outset of the third quarter of 2010 can explain the two-year persistence of the decline that followed.
The question is why—why did this act have such a dramatic effect on the U.S. economy, essentially stifling the modest recovery that had begun almost a year earlier? The most likely explanation is uncertainty. The Dodd-Frank Act was such a comprehensive piece of legislation—and required so many new regulations before its effects could be fully evaluated—that many financial institutions and firms simply decided to wait for regulatory developments before expanding, hiring new workers, or rehiring workers who had previously been laid off.
For a law with dozens of complex, radical, and occasionally contradictory provisions, adopting it so quickly and with so little real understanding of its effects verged on dereliction of duty.The act also had very substantial unintended consequences. In part, this was the result of the short shrift that the relevant congressional committees gave to specific provisions before adopting the law. Following the precept of the president’s then-chief of staff Rahm Emanuel that “You never want a serious crisis to go to waste,” the law was rushed through Congress only 18 months after the Obama administration took office and 13 months after the first draft of the law was available to Congress and the public. This would have been warp speed for any one of the major provisions in the act. For a law with dozens of complex, radical, and occasionally contradictory provisions, adopting it so quickly and with so little real understanding of its effects verged on dereliction of duty.
Once business firms got a look at the language, they realized that they would have to change their financing arrangements in significant ways, and the costs were largely unknown. For example, the Volcker Rule, in Title VI of the act, prohibits banks from engaging in “proprietary trading.” This idea, which was generally described as prohibiting banks from selling securities for their own account, was never adequately thought through. For example, when companies sell commercial paper through bank dealers, the dealers will typically provide the issuer with the full principal amount of the funds the firm intended to raise, but may hold back a portion from the market until conditions improve. When they sell that withheld amount, is that a trade for their own account? No one knows the answer, yet billions of dollars in financing are done every day in which this would be a significant question. As a result, firms have had to consider new and more costly ways of financing their short-term needs.
For financial firms, the act was even more unsettling. Rather than a set of rules to follow, it was much closer to a collection of general directions—introducing new concepts and terms with no readily discernible meaning—that the regulators had to turn into something that could be followed by the regulated industry. It was impossible to know what effect specific provisions would really have until the implementing regulations had been promulgated. But in many cases, this required several regulatory agencies to work together, resulting in further delays because of turf fighting and differing interpretations of the statutory language.
For example, in the Title IX provisions on housing finance reform, two completely new and important concepts were introduced that had no clear meaning—the “Qualified Residential Mortgage” (QRM) and the “Qualified Mortgage” (QM). The former was supposed to be a high quality mortgage, but what did that mean? The regulators’ first try was a mortgage with a 20 percent downpayment; this provoked a huge outcry in the housing finance industry, and even from members of Congress who had voted for the bill. The regulators went back to the drawing board, and now—almost two years after the act was signed into law—there is still no regulation that defines this key term. No responsible private firm could possibly invest in starting a business in residential finance, or expanding it with new hires, without knowing what the act meant by the term “Qualified Residential Mortgage.”
The act also had very substantial unintended consequences.Similarly, the Consumer Financial Protection Bureau (CFPB), another creation of the act, recently put off promulgating its definition of the QM until the end of 2012, conveniently after the election. This provision allows a delinquent mortgage borrower to defend against foreclosure by claiming that the lender should have known he could not afford the mortgage in the first place. Only the most confident and aggressive souls will be entering the housing finance business until the definition of the QM and how it will be implemented are also fully resolved.
The same problems have arisen with Title VII, covering derivatives. Companies that have always used derivatives to limit their risks have found that they can no longer do so, or can do so only at much higher cost. Title X, the authorization for the CFPB, would have been major legislation if adopted on its own. Instead, it received almost no serious vetting before it was incorporated in the act and signed into law. This agency is perhaps the most powerful regulatory agency ever established. It can regulate every financial relationship with consumers, whether by the biggest banks or the smallest check cashing store on Main Street. Businesses are smart to be wary about the yet-unknown cost of interpreting and complying with the regulations that this agency is certain to develop.
These are only a few examples of the uncertainties created by the Dodd-Frank Act. There are many—perhaps hundreds—more.
The economy’s slow recovery from the financial crisis has been the story of the 2012 election. If President Obama loses in November, he will have his own administration—and a wholly compliant Democratic Congress—to thank.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the .