Friday, February 27, 2009

Deregulation and the Economic Crisis (part1)

In case you are also getting fed up with the anti-government-intervention/anti-regulation rhetoric of the conservative free-marketer Republicans who have nothing better to offer as a remedy for the economic crisis than more of the same (tax cuts, and tax cuts and even… more tax cuts! - where does it end, no one knows...), here are a few facts and dates that show the correlation between deregulation and the current financial meltdown to throw at them :

- 1982 : The Garn-St. Germain Depository Institutions Act of 1982 : deregulated the Savings and Loan industry and allowed adjustable rate mortgages.

-1999 : the Gramm-Leach-Bliley Act eliminated the Glass-Steagall Act of 1933 which controlled speculation and separated investment and commercial banking activities, opening up competition among banks, securities companies and insurance companies (law was passed to legalize mergers like Citibank and Travelers Group, an insurance company, and in 1998)

Other restrictions which prohibited bank holding companies from owning non-financial institutions were also repealed by the same law.

-2000 : The 2000 Commodity Futures Modernization Act, “regulatory relief” provided deregulation for products offered by banking institutions. The law was partly written by Texas Sen. Phil Gramm, the free-marketer Republican chairman of the Senate Banking Committee AND lobbyists for Enron (the bill also exempted from regulation energy trading on electronic platforms - see the Enron scandal)

- 2004 : On April 28 the SEC (Securities and Exchange Commission) ruled that investment banks got rid of the Net Capital Rule which allowed "voluntary" inspection of the SEC and also meant that banks could essentially determine their own net capital. (In late September 2008, the commission decided to end the 2004 program of voluntary regulation.).

In fact, corporate self-regulation was the philosophical cornerstone of the Bush economic (and environmental) policy. But following the meltdown, even Christopher Cox, the former U.S. Securities Exchange Commission Chairman and longtime proponent of deregulation admitted lack of oversight helped cause the financial crisis.

"The last six months have made it abundantly clear that voluntary regulation does not work," Cox said in a statement, adding that the program had been shut down and authority to regulate investment banks had been transferred to the Federal Reserve. (NYTimes)

Don’t get me wrong: I’m all for capitalism (since there is no alternative anyway) and freedom but not free-market anarchism. Regulated capitalism is and has always been the right way to go and it suits our philosophy on this blog that true solutions come with moderation and that excess is often bad.

I’m always wary of incongruous and easy historical parallels but nonetheless I find it somewhat ironic than the Great Depression also followed a period of more laissez-faire economic policies in the 1920s (doing away with the regulations of the Wilsonian progressive era) during which the top tax rate was lowered to 25 percent and the stock market began its spectacular rise.

It is basically the same recipe and only the ingredients have changed a bit: too much borrowing, too much speculation with other people's money, and too little regulation.


At 19:57, Anonymous Ralph said...

Great post. The elimination of Glass-Steagall sowed the seeds of the risk culture on Wall Street and the concentration of risk amongst banks and brokerages. To learn more go to

At 23:11, Blogger Joker & Thief said...

Thank you Ralph - especially for the tip. It looks interesting and I'm going to look more into it.

At 17:23, Blogger massud said...

Um, you have not proved anything in your argument. Where is the correlation? Picking up facts conveniently to fit your argument does not prove your premises.

What in the world is regulated capitalism?
How did these deregulationary measures CAUSE the subprime mess.
What is free-market anarchism?

France and old-Europe does not grow because they embrace these very concepts which you think will spur growth.

As any economists and the reason for the subprime mess is the follwing: 1) low interest rates by the Fed (Fed needs to follow the ECB model and not twinker with interest rates in order to fight unemployment)
2) the credit mania was turbo charged by Freddie and Fannie, institutions created by the government and enjoying the socialization of credit risk; 3) community reinvestment act of 1977 which encourages lenders to lend to uncreditworthy borrowers; 4) regulation that artificially creates high barriers to entry. as a result, the credit agencies which were regulated were in cahoots with the government and the very institutions they were supposed to render credit ratings for.

Note that it was not private equity or hedge funds that posed a systematic risk to the market as the Federal Reserve assumed but the too big to fail institutions which became too big because of regulatory capture.

time to save capitalism from the capitalists and continue to cut taxes and deregulate.

At 08:18, Blogger massud said...

interesting how you mention about the repealing of the glass and steagal act and blame it on the current problems. on the one hand you mention that it allows companies to grow and become too big. well, if there was competition in the investment banking sector, the discipline ensued from competitive forces would allow things to be put in check. companies are merging to become too big so that they dont fail because government is handing out free money. you see they are gaming the system. in that scenario, you would have endless number of regulations. the problem is with the government. it should not tax its citizens and throw cash at the financial industry. you are confusing symptoms with causes.

on the other hand, when the treasury steps in an orchestrates a deal (between a commercial bank and the investment bank) you dont apply the same logic.

cant have your cake and eat it also. governments cannot be above the law - in france maybe that can be afforded but not by the US because when the US sneezes, the world catches a cold.

there is no better form of regulation than competition. the too big to fail companies which are receiving financial aid GREW because of artificial high barriers to entry created by the government. wikipedia - "regulatory capture". these ideas fall under the domain of public choice economics.

At 08:18, Blogger massud said...

This comment has been removed by the author.

At 11:57, Blogger Jerome said...

How did these deregulationary measures CAUSE the subprime mess?
Well, before deregulation banks were restricted to certain businesses and could not for instance enter into the insurance or brokerage business. Regulation also obliged banks to evaluate risk and the creditworthiness of borrowers (loans could not be sold to the secondary bond). So banks could not package the subprime loans into complex financial instruments.
Not only did deregulation eliminate all the firewalls between commercial banks, investment banks, insurance companies, and securities firms but it also resulted in dangerous mergers.
What is free-market anarchism?
The replacement of government held institutions with a competitive market of private institutions.
France and old-Europe does not grow because they embrace these very concepts which you think will spur growth.
Growth based on greed and unchecked risks is not worth it. I’d rather have more limited but sustainable growth. Besides the whole idea of growth at any cost has the seed of its own demise.
As far as the other points you suggested :
1) Yes, the Fed and Alan Greenspan are also partly responsible for the subprime mess. (he has been, by the way, a proponent of Ayn Rand’s political philosophy of “Objectivism”).
2) The main problem with Freddie and Fannie was that profits were privatized but the risks were socialized. It is the need for more profits p(and the pressure of shareholders) that caused them to push for unreasonable measures. The Clinton administration is also partly guilty as they pushed for more mortgages for poor(er) people. The intention may have been good but the consequences, not so much.
However, it is in 2004 that the problem got worse and got us into this mess. The US Department of Housing and Urban Development helped fuel more of the risky lending. In other words, HUD did not play its regulatory role over Fannie and Freddie. So there you have it again.
3) The idea that the 2007 mortgage crisis was the result of a 1977 law is ludicrous. Besides, most subprime loans were made by firms that aren’t subject to the CRA (which is not surprising since the CRA program required higher supervision)
4) As to your 4th point: since all the laws passed under the Bush administration has been towards more deregulation, I am curious to see how you explain the current mess by “too much regulation”. Your argument makes no sense.
At the core of our philosophical differences, lies this idea, that “the discipline ensued from competitive forces would allow things to be put in check” because for competition to put things in check, you need fairness. The problem with companies becoming too big (as I mentioned) is that they disrupt the market. Hence the need for anti-trust laws (the same thing happened in the late 19th cent. and in the 1920s).
Human nature is such that without restraints, only the strong and the bullies run the show, at the expense of the community. You may want to go back to this feudal tribal society, I don’t. I believe in freedom but with freedom, comes responsibility and when companies are too big, the risk they take has ripple effect onto the community at large, and they know it (they become indeed “too big to fail”).

At 17:36, Blogger massud said...

Your comment, "Human nature is such that without restraints, only the strong and the bullies run the show, at the expense of the community." runs counter to the fundamental philosophy of Austrian School of Economics. Perhaps check with them to strengthen your argument. Not sure if we are ready to discard their ideas as it has withstood the test of time.


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