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Reformed Regulation Boosts Competence

Calamities are coming fast and furious. The collapse of Bank of New England over the weekend was followed Monday by the cancellation of the A-12 Navy fighter program--the largest termination of a defense contract--and on Tuesday by the bankruptcy filing of Pan Am, the venerable but ailing airline.

None of the events came as a complete surprise; bank, plane contract and airline were all known to be in trouble. Yet each came as a shock to the system, a warning of chaos in a difficult time for the economy and a tense time for the world.

In reaction, there are growing calls for renewed regulation--in banking, where 200 to 300 banks could fail this year; in defense contracting, where the Pentagon is trying to recover $1.9 billion paid to contractors, and in airlines, where three U.S. carriers are operating in bankruptcy a dozen years after deregulation.

But regulation isn’t easy. And it is important to get it right, because regulation gone bad can be costly to the whole economy, as we are discovering in this week’s misfortunes. Each is a case of government and industry incompetence distorting business and hurting the economy.

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Maybe if we can understand how they all happened, we can think about intelligent solutions and what reforms are needed.

At Bank of New England, the $22-billion asset bank that is being rescued by the Federal Deposit Insurance Corp., depositors were protected from loss.

But the banking system and the economy at large were not protected from the massive bad loans that BNE’s former Chairman, Walter Connolly, made to real estate developers. Connolly was not the first banker to go haywire with insured deposits. It has happened repeatedly in the past decade or so--in loans to developing countries and in the savings and loan industry.

The problem is that a business in which bankers made easy profits from the spread between government-controlled interest rates paid on deposits and government-influenced interest rates earned on loans has been transformed since the 1970s. The banking system was presented with competition for depositors and borrowers--and lost on both counts.

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From garnering 60% of the nation’s deposits after World War II, banks’ share has fallen to 30%. From lenders to all business, the inefficient banks have lost corporate customers to the commercial paper markets and to commercial lenders, such as GE Capital and Transamerica.

The result is that unintended consequences are at work in banking. Insured deposits, devised in 1933 to keep banks solvent so they could serve the community, are being allocated to less credit-worthy borrowers, who pay loan rates high enough that inefficient banks can make a profit. Not surprisingly, loans to such borrowers frequently go bad.

And that will cost the economy heavily. In the wake of BNE’s fall, banks everywhere probably will tighten still further and cut off loans to small business. The result could be widespread small-business failures, deepening the recession. As a stopgap, the government may have to encourage lending--by guaranteeing loans, or even by setting up a modern equivalent of the Reconstruction Finance Corp. of the 1930s.

For the longer term, the U.S. Treasury is scheduled to introduce ideas for reform of the banking system next week. It should be clear what it needs to achieve: reassurance for depositors--who lined up to withdraw their money in New England, even though they were insured--and credit at reasonable rates for small business.

The A-12 contract also suffered from distortions--the sham of government and industry working together to fool the public. The contract was put out on a fixed-price basis, $4.8 billion for development of the initial planes in what was to have been a $57-billion total production run of fighter planes.

But the contract was a sham; the fixed price was a public relations attempt to demonstrate cost-consciousness by former Defense Secretary Caspar Weinberger’s Pentagon. The contractors, General Dynamics and McDonnell Douglas, went along with the sham, bid a price for the initial planes, hoping to make up any losses on subsequent phases of the A-12 project. That’s the way Pentagon contracting has been done for decades, with a nod and a wink.

But budgets are tight now, and Defense Secretary Dick Cheney didn’t nod or wink. He canceled the contract. And what we have is a kind of chaos, contractors asking the Pentagon for $1.6 billion in payments due, and the Pentagon asking the contractors for $1.9 billion in refunds for work not delivered.

The dispute threatens to drag on for years before the Armed Services Board of Contract Review and ultimately before the courts, says Wolfgang Demisch, a defense analyst for Union Bank of Switzerland. Meanwhile, employees are being laid off, billions of dollars have been wasted and the Navy is no closer to having a new plane--at a time the Persian Gulf crisis demonstrates that the Navy will need attack planes in the decades to come.

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A better solution than contract review and courtrooms would be a settlement, imposed either by Cheney or President Bush, followed by an attempt to produce a plane, under accurate cost estimates and as efficiently as possible.

Finally, Pan Am’s bankruptcy comes decades after an earlier failure of regulation. As an international carrier, Pan Am was long prohibited from having domestic routes. Ultimately, it fell victim to poor management, union troubles, a long decline. Its threatened passing reduces the number of airlines and increases worries that other U.S. lines will fail. The solution is to open the market. Let foreign airlines invest in U.S. lines but open the foreign markets to U.S. carriers. Then customers everywhere will benefit, which is what regulation should accomplish.

The point is not to argue about regulation and free markets. But to see how reform can encourage competence in government and in industry. They should go together.


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