The American Action Forum has released a study claiming that the Dodd-Frank Act will reduce total U.S. economic output by $895 billion between 2016 and 2025.1 But the study has multiple significant flaws. These include:
- A failure to incorporate any of the benefits of improved financial sector regulation. Extensive economic research shows that the benefits of greater financial sector stability alone will exceed the costs claimed by the AAF. As explained below, if Dodd-Frank cuts the annual probability of a financial crisis in half, it will create $2.9 trillion in economic benefits over the next decade. This figure alone is more than triple the costs claimed in the AAF study, and does not even count the substantial benefits that will accrue from improvements in consumer protection and economic fairness.
- Exaggerating the growth impacts of regulation. The AAF study exaggerates the cost of regulation in several ways. The study assumes that all regulatory costs will be subtracted from capital investment, even though some regulatory costs themselves involve capital investment and some compliance costs will be funded by spending reductions (e.g. cuts in top executive compensation) at financial institutions. The study also appears to assume that temporary transitional regulatory costs extend permanently. Finally, the study assumes that increases in bank capital (higher equity vs. debt in bank funding) are identical to a tax on investment, which is highly questionable.
In sum, the AAF study both exaggerates the growth costs of regulation and fails to include benefits from regulation that would substantially exceed even these exaggerated costs.
Dodd-Frank Act: The Benefits of Financial Regulation
Studies have found that the 2007-2009 financial crisis created over $10 trillion in economic costs to the U.S. economy.2 In their consideration of new capital rules, global regulators at the Basel Committee also performed an extensive analysis of the costs of financial crises and the benefits of reduced financial instability.3 The analysis was based on a complete literature review on the impact of financial and banking crises in advanced economies since WWII. It found that4:
- Banking crises occur roughly once every 20 to 25 years, implying that each year there is a 4 to 5 percent chance of a crisis.
- The median or average estimated economic cost of a financial crisis is roughly 63 percent of economic output. This includes both the initial impact and the discounted cost from the loss of future growth over many years.
- Reducing the annual probability of a financial crisis by just one percentage point (i.e. from 4-5 percent to 3-4 percent per year) would lead to annual benefits of .63 percent of economic output. Reducing the probability of crisis by two percentage points would lead to annual benefits of 1.26 percent of economic output per year.
These figures imply that if the Dodd-Frank Act and associated regulatory changes reduced the annual probability of financial crisis by just one percentage point, this would create $1.46 trillion in increased economic output over the next decade (2016-2025). A two percentage point decline would create $2.9 trillion in economic benefits.5
It is important to understand that these estimates do not require that the Dodd-Frank Act completely eliminate the probability of financial crisis. A one percentage point decline in the probability of financial crisis corresponds to cutting the chance of a financial crisis by 20-25 percent (from 4-5 percent each year to 3-4 percent each year). A two percentage point decline in the probability of financial crisis corresponds to cutting the chance of a financial crisis roughly in half (from 4-5 percent each year to 2-3 percent each year).
The benefits from either scenario substantially exceed the costs estimated in the AAF study. For example, the benefits of a 20-25 percent reduction in financial crisis probability would create economic benefits that exceed the costs estimated by AAF by over 60 percent. If Dodd-Frank cuts the probability of financial crises in half, then it will create economic benefits more than triple the costs estimated by the AAF.
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