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.

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  1. I don’t care. I just got another degree and I’m’a get shitfaced now.

  2. In the strongest message yet from the U.S. government, the House voted 405-1 Friday to condemn Tehran’s crackdown on demonstrators and the government’s interference with Internet and cell phone communications,” the Associated Press voted from Washington. The only “no” vote, unsurprisingly, came from Republican Ron Paul

  3. I just got another degree and I’m’a get shitfaced now.

    Shit, i ain’t need a degree to do that.

  4. congrats warty. Have a truly excellant weekend!

  5. Yeah, they want to give the fed even more power, the fed already prints money anytime the see fit. The fed has pretty much caused nothing but wars, the depression, a blue million resessions, and the inflation and mere destroction of our dollar.

  6. Rick’s Custom Squirrels: Serving all of your gun-toting, mounted-squirrel needs:,0,3755585.story


    Call it Mises’ Law: People of the most widely divergent views nonetheless always converge in condemning “free market” capitalism for whatever they believe wrong. Particularly relevant is its derivation, Loberfeld’s Law: In a mixed economy, it’s the market element that takes the blame. (See BAILOUT.) Statism is eternally innocent.


  8. I agree but this article should cover the Commodity Futures Modernization Act of 2000 and Credit Default Swaps. I believe that anyone who does blame deregulation will dismiss this article immediately because this is not mentioned.

  9. Barry Loberfeld,

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  10. I asked my congressman about the squirrel site and posted his response to youtube.

  11. Tom – The Commodity Futures Modernization Act of 2000 was absolutely as important to all of this as the Community Reinvestment Act and all the others… The problem is, neither is a root cause.

    What I think people really need to realize here, is that when Greenspan pushed interest rates to the widely touted “Historic Lows” ™ that they were in 2001-2002 and pumped some billions of dollars into the economy to compensate for the tech bubble’s bursting (another Fed-created boom period of course), then the form that the subsequent bubble took was queued up by what regulations and political pressures were in place to channel that new money.

    The government wanted everyone to have a home, they made some sweet deals for some of the biggest investment firms in the US, they backed everyone’s malinvestment with Fannie & Freddie and the FDIC… then they handed these guys billions of dollars in cash created out of Greenspan’s ass.

    So guess what – it funneled its way into the hands of building developers and the financiers that were “paying” for it.

    Now, my guess is as much of the new money as possible is going to go right into a green-tech bubble… Though there’s soooo much money being pumped in this time, I have to wonder if we won’t be experiencing two or three bubbles simultaneously over the next several years.

  12. The green bubble bursting is a forgone conclusion. What I’m waiting for is the Obama bubble to burst.

  13. It still pisses me off that the Republicans nominated that economic illiterate McCain last cycle so that there was no one on that debate stage (a Libertarian not being there was business as usual) when Obama first blamed the economic problems on deregulation to laugh in his face and school him. Instead, we had McCain standing there without a clue and the media ran with the deregulation meme and now it’s one of those things “everybody knows”, making it that much harder to fight the inevitable flood of new and useless regulation.

  14. Well Ron Paul blew his big chance on that one. He could have at least injected the right line of logic into the debate. Instead he had to go spend his moment in the lime light blabbering about “we’ve got to go back to a GOLD standard dammit!”.

    (a Libertarian not being there was business as usual)

    And as usual, Libertarians were at least half to blame for that fact.

    When Paul started talking fiscally responsible policy, he had heads turning. When he started blabbering “gold standard”, they turned away.

    I’m not a politician by any means, but even I’m smart enough to know that bringing the gold standard out in your opening shot is political suicide.

  15. The article has some great points, but it fails to see the obvious: other countries’ money (OCM) was a major cause of the financial bubble. More on OCM after the jump:

  16. Don’t confuse me with the facts. I want to regulate the shit, okay? Regulate, regulate, regulate…because regulators never have venal motives like the capitalists do. They do what they do for love of process and country. They are pristine and above it all.

    Get me some new regs, goddamnit.

  17. But do regulators have incentives to do their jobs? No. Actually, it makes more sense for them to not do their jobs. That way, if something goes wrong, they get more power. It’s called job protection. Also, regulators are not the wise, god-like beings they’re made out to be. They are just as susceptible to making mistakes and being as corrupt as everyone else. Proponents of regulation chide proponents of free markets about having too much faith in market forces, but don’t those in favor of regulation have too much faith in it? Who’s going to ensure that regulators do their jobs? Should we regulate the regulators?

  18. Fact is, regulators generally don’t understand the industries they’re regulating. They had too much power before this all happened, which, without them doing anything, contributed in some part to the whole mess. See, because financial services was heavily regulated, people figured that nothing too awful could happen, and what disasters did occur would be covered by the Treasury.

    The idea that we had any kind of deregulation in the era of USA Patriot, FACTA, “predatory lending” legislation, Sarbanes-Oxley, etc. is not a myth. It’s a lie.

  19. I’d go even further and suggest this whole business is the fault of doom and gloomers jumping on the badwagon at election time for political purposes, which then becoming self fulfilling.

    Let’s think back to TARP 1 when if it wasn’t passed within days the country would go belly up, the days passed, nothing happened, McCain (to his credit) said economy was fundamentally sound, Obama screeched he was crazy, that the sky was falling and the media parroted it as they do. We kept hearing about how there was no credit despite the fact that as usual everyone was still trying their damnest to give people credit. TARP was passed, softened by the promises that it would be mostly paid back, but the negativity had infected the markets too soon. People started to tighten their belts. They cut back on $4 starbucks, and the little things, recession was coming. Bracing for the impending depression, companies shed workers to make themselves leaner. People don’t wait for the recession to take action no more than you wait for the hurricane to arrive before you shutter the windows. You prepare for it before hand. Again, the government trotted out the lines that credit was drying up, giving figures that shows lower credit borrowing as evidence. Of course the real problem was that nobody wanted to take on more credit with bad times around the corner. So unemployment increases, credit falters, unemployment increases foreclosures, and the government takes this domino effect as a crisis to be made use of. The economists who as a whole have lousy prediction ratings are more concerned with being on the right track as opposed to being correct. Being so close to the election there’s still plenty of time to blame it all on the last administration despite the fact that it was the Democrats who had their grubby paws all over Fannie and Freddie, and under Bush we enjoyed the bubble of high housing, low unemployment, and growth that we haven’t seen in decades. Of course this comes at the price of a correction, and the chosen time for it is when a socialist style democrat with desires to remake the country to his own liking is on the verge of being elected.

    As for blaming McCain, you have a point, but perhaps the blame should lie with the independents that bought the rhetoric against McCain and the propaganda pushed by Obama and the propagandists that pushed it. The media doesn’t donate to Democrats 95% of the time because they are unbiased.

  20. It must be nice to be a Libertarian. Since, in your minds, there’s no free market, you can blame any problem on regulation.

    I know: the regulation that required bad loans to be made. And the other one that required rating services to lie. And still another one that required Congress to bail out the millionaires. Yeah.

    Are you people aware that another work for regulation is “law”? So…no laws then? Is that really what you want? To make theft and deceit fully legal with no consequences?

  21. Andy,
    Don’t be a moron. Both candidates, Congress and the sitting President all approved and supported TARP 1. The Blame Game is a little hollow, don’t you think?

  22. To show that certain forms of deregulation did not cause the crisis is not the same as showing that these were benign, nor that other sorts of regulation might now be appropriate, e.g., increased capital requirements for institutions and greater transparency for tradable instruments. And, as Mr. Butler points out, severe disincentives for lying (about risk and reward, for instance) would also seem to be a very good policy innovation.

  23. Regulation solves everything. Just with a wave of its magical wand. I picture the people who carry it out are super-human or meta-human essences, just pure emanations of spirit. What I can’t imagine is “that regulators had enough authority to prevent a crisis. They simply failed to do so.” I mean, regulation isn’t like other things, where mere mortals, flawed as they are, make mistakes or do anything wrong. Regulation is above all that, unsullied and utterly perfect.

  24. Ray Butler, you seem to be confusing active regulation and the negative protections inherent in the rule of law. So, in other words, stealing is illegal, because it violates a negative protection put in place that says it’s not OK to take someone else’s property, but regulation that says, e.g., “you can’t sell that shit until you say how much it is worth right now, even if the other party is OK with your terms” is overly stifling and has nothing to do with theft or fraud.

    As for your misreading of the criticism of McCain’s economic ineptitude, the point was (as I see it) that the dumb fat-ass elephants put a decrepit economically-illiterate dick head up there on the podium, and he just twiddled thumbs and sweated and tried to deflect talk about the economy and the “failure of the free market” instead of calling Chairman Obama out on his bullshit rhetoric.

  25. Regulation is not perfect. It does have flaws. Most regulatory laws address problems that have already happened. They do not address problems that pop up several years later. Also, regulations have unintended consequences. For instance, raising capital requirements on banks hurts borrowers since a decrease in the amount of money available to loan out increases the interest rate at which they must pay back the loan. Potential borrowers who could pay off the lower rate may not be able to pay off the higher the one. This decreases wealth creation since some of those borrowers can now not open or expand businesses, which both they and their investors can profit from. In the end, this hurts every one since those goods and services, some of which may have been technological breakthroughs, are not available for consumers.

  26. I agree with Ray above. Libertarians just dismiss the problem. If reality does not agree with your theory, too bad for reality. The article says it’s government’s fault but does not explain this very clearly. It is not the government that made the market collapse but bankers gone berserk, avid to make quick profit. Can one regulate this? I agree regulation has its problems as Shawn says but I see no other solution. The market, just simply can not solve all the problems. Society has to step in now and then to avoid excess.
    And this, now, is exactly the point where society steps in.

  27. Wow. The only thing more ignorant than the article it the comments. Apparently this society is in so much trouble is because of our collective stupidity.

    This article is just another bitch session. It’s absolutely not even anti-regulatory. Nothing cited, no stats, no nothing. The blue sky causes people to fart because I said so. There. I just matched this article.

    Regulations are what the rest of call LAWS. Let’s do away with all bothersome traffic lights. They slow down traffic and afterall the driver knows whats best right? He wouldn’t do anything to damage his own car right? Nonsense. When your behavior starts to harm others it’s typically a violation of the law. Only not on Wall Street. Its a cause for huge bonuses.

    The “regulations” now in place, or taken away, over the last few years were specifically done at the behest of Wall Street. To blame our so-called Government is like blaming your bung hole for getting butt raped. Our current environment was designed, letter by letter, by the very same Wall Street now getting bailed out, to allow a small fraction of our population to steal from everyone else and escape prosecution. Government didn’t design the asinine mortgage lending laws, the Lenders themselves designed those laws and their well paid minions on the hill voted them into being.

  28. Settle down Jesus. You’ll actually find that libertarians agree with some of what you said. “When your behavior starts to harm others it’s typically a violation of the law.” Exactly! Libertarians are huge proponents of property rights. When person A harms or steals person B’s property (one’s body and life is considered one’s property), person B is entitled to receive compensation from person A (or the return of the property to its rightful state of ownership).
    As for businesses writing the laws, you’ll find that this is very un-libertarian. We agree that government and business should not be writing laws and regulations together. Favoring a group of businesses in a particular industry often hurts others that don’t get that special treatment. This often leads to the creation of oligopolies, which tends to hurt consumers since they have fewer, more expensive choices. Such policies are more like corporatist economics, not laissez-faire economics, which libertarians favor.
    However, this doesn’t mean we should regulate the economy like traffic. We already do this and it’s not working so well. We have a traffic light cop in the form of the Federal Reserve. Low interest rates are green lights and high interest rates are red lights. The fed’s monetary policy over the last several years, encouraged people to step on the gas. This, known as the Austrian Business Cycle Theory, is what helped create the bubble and the bust. If you want to read more about the Austrian perspective, I suggest you read the articles found here

  29. My only point is that if you take the Bible straight, as I’m sure many of Reasons readers do, you will see a lot of the Old Testament stuff as absolutely insane. Even some cursory knowledge of Hebrew and doing some mathematics and logic will tell you that you really won’t get the full deal by just doing regular skill english reading for those books. In other words, there’s more to the books of the Bible than most will ever grasp. I’m not concerned that Mr. Crumb will go to hell or anything crazy like that! It’s just that he, like many types of religionists, seems to take it literally, take it straight…the Bible’s books were not written by straight laced divinity students in 3 piece suits who white wash religious beliefs as if God made them with clothes on…the Bible’s books were written by people with very different mindsets…in order to really get the Books of the Bible, you have to cultivate such a mindset, it’s literally a labyrinth, that’s no joke

  30. My only point is that if you take the Bible straight, as I’m sure many of Reasons readers do, you will see a lot of the Old Testament stuff as absolutely insane. Even some cursory knowledge of Hebrew and doing some mathematics and logic will tell you that you really won’t get the full deal by just doing regular skill english reading for those books. In other words, there’s more to the books of the Bible than most will ever grasp. I’m not concerned that Mr. Crumb will go to hell or anything crazy like that! It’s just that he, like many types of religionists, seems to take it literally, take it straight…the Bible’s books were not written by straight laced divinity students in 3 piece suits who white wash religious beliefs as if God made them with clothes on…the Bible’s books were written by people with very different mindsets…in order to really get the Books of the Bible, you have to cultivate such a mindset, it’s literally a labyrinth, that’s no jokeWow. The only thing more ignorant than the article it the comments. Apparently this society is in so much trouble is because of our collective stupidity.

  31. Libertarian and conservative institutions and publications like Reason and Cato need to quit ignoring the facts- BOTH gov’t and Wall St. were to balme for the crisis. Why does it always have to be either/or? I mean, I actually wrote a brief paper on the causes of the crisis, and it’s not as clear cut as saying “The market failed” or “Gov’t did it all.” BOTH did bad things that contributed to it. Yes, there were some big deregulations and Wall Street excesses that contributed. However, things like Fannie and Freddie and the Fed lowering interest rates to ridiculously-low levels ALSO were to blame.

    But I’ll tell you what’s NOT to blame: the CRA. Also, there are plenty of INDEPENDENT economists who’ve published studies that show that deregulation did play a hand in this as well. It’s only the economists who are libertarian-leaning, esp. those affiliated with openly-libertarian or conservative groups like Reason or Cato, who say crap like “Government caused it all.” That’s nonsense. Besides, it fucking passes the buck. So Wall St. is ZERO percent to blame for screwing up? Come on, guys. We sound like a bunch of pro-business shills, no better than Republican troglodytes, when we parrot bullshit like that.

    What about derivatives and CDOs?? Those things had practically ZERO value to the economy and were just investors and bank executives basically gambling with other peoples’ money in their respective financial institutions, among other reckless actions. Even the Congressional Research Service recently did a study that found 26 main causes of the crisis (or 23, either one), many of which included GOV’T and BUSINESS failures. We don’t have to stay within this stupid dichotomy.

    Let’s admit the truth but still be libertarians, for the most part, and tell Congress and the president to focus on the RIGHT actions and stay away from the wrong. Admitting our ideology kind of failed is not weakness. Refusing to admit the failure is market fundamentalism.

  32. It seems to me that too many of those on the Right end of the spectrum are afraid to admit that Wall Street fucked up because they don’t wanna admit their “free market” system is imperfect. Or that it IS prone to failures from time to time. But why?? What’s wrong with admitting when we’re wrong? NOT admitting it and just ignoring our faults only makes things worse.

    This article is terrible and doesn’t even get close to explaining the causes.

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