The Myth of Financial Deregulation

Government action caused the economic crisis, not the free market.

For the past nine months, Wall Street critics have painted a damning picture of the housing bubble as the product of deregulation and reduced governmental oversight. To read the Obama administration's new financial sector regulation overhaul proposal, the government didn't have anything to do with the current crisis. According to this view, our economy wouldn't be facing a recession with almost 10 percent unemployment if the government had been more involved with the market. This picture is about as historically accurate as the famous portrait Washington Crossing the Delaware.

On Wednesday, President Obama laid out his vision for changing the way Wall Street does business. From creating a council to oversee systemic risk to expanding the powers of the Federal Reserve to requiring hedge fund and private equity pools to register with the SEC for the first time, the proposal is a massive regulatory expansion.

Along with the president's speech, the White House released an 89-page "white paper" with all the nitty gritty details that make government bureaucracy so much fun. For instance, here's a real sentence from the proposal:

Last year, the IASB and FASB reiterated their objective of achieving broad convergence of IFRS and U.S. GAAP by the end of 2010, which is a necessary precondition under the SEC's proposed roadmap to adopt IFRS.

Government clarity at its finest. (See here for a breakdown and explanation of the whole proposal.)

The core problem of the regulatory proposal is its view of the causes of the crisis. Everything is built on a belief that the market failed and that deregulation created a system of excessive risk and irresponsibility. Ironically, it was government action that created incentives for financial firms to be less risk adverse, not a lack of regulation. As Washington prepares to debate regulatory overhaul this summer, it is more important than ever to wrestle the myth of deregulation to the ground.

Given all the talk of deregulation, you would expect to find dozens of deregulating laws put in place over the past few years. Surprisingly, there have only been three major deregulatory actions in the past 30 years. Ultimately, the data points to bad regulation as complicit in the creation of the financial crisis, not deregulation.

The modern era's first major Wall Street deregulation was the Depository Institutions Deregulation and Monetary Control Act of 1980. This law repealed so-called "Regulation Q ceilings" that limited the amount of interest consumers could earn from savings and checking accounts. The law also expanded the types of financial institutions that could get overnight loans from Fed discount windows.

Since letting banks pay interest to their customers encourages saving, this aspect of deregulation certainly can't be blamed. And though it could be argued that more financial institutions borrowing money partially allowed for the housing bubble, that money was being borrowed from the government—hardly deregulation. And that doesn't even begin to address the fact that there have been multiple recessions and bubbles since this law was passed.

The second major deregulation was the Garn-St. Germain Depository Institutions Act of 1982. This authorized banks to compete with money market mutual funds. (Ironically, this bill was co-sponsored by then-Rep. Charles Schumer, a key lawmaker driving the current regulatory overhaul.) Garn-St. Germain has been linked to today's crisis because it loosened restrictions on issuing mortgages, allowing for the eventual development of subprime loans.

However, it wasn't Garn-St. Germain specifically that created a subprime mortgage riddled bubble—it was the surrounding body of poorly designed, bad regulations that created perverse incentives. Garn-St. Germain should have allowed banks more freedom to compete while also clarifying the role of the FDIC. But it failed, along with other regulations, to outline the role of the government in the case of financial institution failure. As a result, the implicit government guarantee for firms "too big to fail" skewed the risk assessment process that aids market efficiency. The promise of rescue was much more damaging than loosened lending standards.

It is worth noting that the impact of Garn-St. Germain has also been blamed for causing the Savings and Loan Crisis by allowing certain financial institutions, thrifts, to gamble with taxpayer insured investments. But in this case there was an implicit government rescue guarantee for massive failure that encouraged high-risk taking.

The third deregulation blamed for causing the financial crisis is the repeal of the famed Glass-Steagall Act in 1999. This law, passed in 1933, had kept deposit-bearing banks and investment banks from competing for over six decades. After this repeal, banks were able to maximize their resources and many grew large enough to be classified too big to fail. However, they really were too entwined to fail, and the problems came with fringe regulations related to the interconnectedness of financial institutions.

Had mark-to-market regulations been more flexible banks would have had more time to raise capital and sell assets. Had Wall Street firms not seen Washington as a lender of last resort that would bail out investments gone awry, they would have managed their risk better. Had capital reserve ratios been higher banks and investment institutions would have had more liquidity when prices dropped (though some firms, like AIG, simply became insolvent and wouldn't have been saved by higher reserves). Or, if qualified special purpose entities—an off-balance sheet accounting method—had required more transparency, banks would have had to keep more risky mortgages on their books, subject to reserve requirements.

Indeed, even if these three deregulations had no caveats explaining away their supposed link to the current financial crisis, they would still hardly constitute a historical trend. In contrast, historical periods of high regulation have proven decidedly unfavorable. Financial sector regulation during the 1970s was much heavier than today, and that did not prevent stagflation, with unemployment reaching nine percent in May 1975 and inflation nearly topping 14 percent.

Similarly, Europe currently boasts some of the world's tightest financial sector regulations, and its banks have suffered just as much, if not more than American banks in this recession. European banks made the same bad bets, the same poor investments, and the same over-leveraged mistakes—despite more regulation and government oversight.

None of this is to say that there shouldn't be regulatory change. The current regulation framework creates plenty of perverse incentives that stem from outdated rules. There is much to be desired in terms of governmental transparency and clarity.

However, the answer is not increased layers of government oversight. Giving regulators increased oversight of hedge funds, forcing the standardization of derivatives, or creating a systemic risk council will cause more harm than any good. Neither will expanding the Fed's powers ex post facto. Richard Fisher, President of the Federal Reserve Bank of Dallas, told the Wall Street Journal last month that regulators had enough authority to prevent a crisis. They simply failed to do so.

A far more prudential regulatory response is to fix broken rules—like the government has done with mark-to-market—and to have regulating agencies do a better job of oversight for 21st Century financial products. In a world of continually innovative investment strategies, flexible regulation from a loose government hand will prove most beneficial to a sustainable economy. The worst thing Washington could do is buy into the false history of phony deregulation and create more oppressive rules and stifling agencies that extend our economic struggles.

Anthony Randazzo is a policy analyst for Reason Foundation. Read his Reason archive here.