If the Obama administration had set out with the purpose of creating a permanently sluggish economy, it could not have done better than it has.
Entrepreneurs have to take risks to launch ventures that, if successful, create new jobs, but government rules and regulations discourage risk-taking. When risk-taking declines, we end up with a historically weak recovery and fewer new jobs than would otherwise have been created.
Peter J. Wallison of the American Enterprise Institute attributes a lot of this refusal to take risks to Dodd-Frank but argues that yet another proposed Dodd-Frank-type regulation is going to repress entrepreneurship even more. Wallison explains:
The new rules impose limits on incentive pay such as bonuses, and require that 60% of any incentive compensation be deferred for at least four years. Bonuses would also be subject to “claw back” by financial firms for up to seven years after being paid in the event of losses attributable to poor judgment or undue risk-taking by the recipient.
The best way to understand the effect of these proposals is to consider them in the context of the legal principle known as the “business judgment rule.” This rule holds that corporate boards of directors cannot be sued for a decision made with the best information available and in the good-faith belief that it was in the best interests of the corporation.
This is a judge-made rule long embodied in the common law and upheld by courts over many years. The underlying policy for the rule is clear: If directors are liable for suit any time they approve a corporate action, it will be difficult to get them to approve anything, and corporate risk-taking—as in mergers or other major transactions—will grind to a halt. To gain the protection of the rule, boards go to extraordinary lengths to be sure their decisions are adequately documented with approvals by independent experts.
The financial compensation rules now under consideration raise the same questions about risk-taking. For example, assume a bank officer is presented with a company’s application for a substantial loan for the construction of a new plant. The corporation is solvent, but the plant will be making a product that hasn’t been tested in the market. If the plant is built but the product fails to make the grade with consumers, the company could be in financial jeopardy.
Under the new rule, banks would probably turn down loans that could have created businesses and jobs. Just for the record, and this should not need to be said: We're not advocating that banks make shaky loans. But if bankers are afraid to make loans that incur risk, we are going to see entrepreneurial ventures becoming increasingly difficult to get off the ground. A certain level of risk taking is necessary for a capitalist society to flourish and create prosperity. Wallison explains how the current situation came about:
How did we get here? The answer is the widely adopted explanation for the 2008 financial crisis. Although there is a great deal of evidence that the government’s housing policies were at the root of the crisis, the 2008 subprime mortgage meltdown and ensuing recession were blamed on “excessive risk-taking” on Wall Street. This gave rise to Dodd-Frank and the notion—popular among academics and regulators—that compensation in American finance had contributed to the problem.
This theory of the housing bubble, argues Wallison, fails to take note of loan standards that deteriorated after the Department of Housing and Urban Development’s decreed “affordable housing” goals that led to granting loans to people who would have been denied loans under previous standards.
Loans that were clearly too risky were made–or maybe we should say that rather than being risky they were actually doomed to fail. But these loans were made so banks could be in compliance with HUD aspirations for home ownership, even if the facts on loan applications would have warned banks off if the government hadn't stepped in and thrown its weight around. Now the government is busy again. These new rules could mean that bankers might be unwilling to take even good risks, and that is a recipe for further economic stagnation.