Lately I have heard many claims that the current economic crisis is the result of lack of regulation. I am trying to understand this argument but most articles I have read merely proclaim and forget to explain. The only explanation I have seen put forth is that brokerage firms invested in risky mortgages and then sold these to unwary investors. The regulators weren’t there to stop this and voila: financial crisis.
My question is:
How does lack of regulation lead to financial meltdown (according to proponents of this argument)?
Thanks to those who take the time to answer yet another question form mitcjm.
It’s not the result of a lack of regulation. It is the result of regulation.
This will be tough to get the answer you are looking for, because only misguided or uninformed people take the position that this was exclusively big bad business operating in a regulatory vacuum.
If the interest rate was not regulated, and the regulated money supply not inflated, and numerous initiatives from regulatory bodies encouraging home ownership at all costs, this likely would not have happened.
My advice to you personally, is to start reading Lew Rockwell daily if you do not already. Also the Mises Daily articles. They will get you up to speed quickly on current events and libertarian/austrian perspectives on those events.
Anyways the answer to the question is simple -The Glass-Stegall Act was repealed. This allowed the bad incentives generated by all the other regulations to take effect. Very similar to the “failure of privatization” in california, S&L, and the late soviet union.
I think a lot of it stems from the fact that a lot of bank “de-regulation” was done under a Republican controlled congress in the 1990s, so Democrats have jumped on that as a campaign theme this election cycle.
I think that’s it, too. They say “deregulation, then crisis” but they never specify the nature of that (supposed) cause and effect relationship. The only argument I’ve heard is that risky investment was allowed and this had bad results. Obviously this assumes that the government needs to be there to watch over us and make sure that nobody makes bad decisions. It is scary that this assumption seems to be widespread.
Wasn’t Glass Steagall the one that prevented deposit banks from becoming investment banks? Yes, I often hear people state that as proof of “deregulation” (of course, there are many other regulations, most of them bad, some of them neutral and few of them good… but let’s just totally ignore those), but I have never heard an actual economic explanation on why that would be the cause of this financial mess. “Greed” is another popular explanation for this crisis, and that’s a pathetic platitude. When the hell are people not greedy? I suppose they were extra-greedy this time.
The problem with thinking that deregulation was the cause of this mess, is that one then gets the foolish idea that regulation is the solution. People just say “regulate it” as if it were that simple. Why don’t we regulate everything and then we’ll just live in a perfect world? Who do people think write these regulations and enforce them anyway, beautiful altruistic little angels or something? People will whine and bitch about the Bush administration failing to even enforce regulations already on the books as if it were a partisan issue, never even thinking that perhaps it could be bureaucratic failure. Anyhow, I’ve said piece.
Ultimately the reason lots of banks etc. lost lots of money is because it wasn’t their money so they didn’t have much motivation to limit the risks they took. When they made money they took a cut, when they lost it someone else footed the bill.
You have two phenomena.
One is people walking into banks and depositing money (savers) with the rather misguided belief that a bank is a safe place to put money… and if banks were merely deposit institutions (100% reserve institutions) then this might be more or less true.
The other is that banks aren’t merely deposit institutions. They extend loans on the basis of less than 100% reserves, which enables them to multiply their profits. This means that implicitly they are “investing” money on behalf of all of the depositors (savers) that are their customers. The bank, of course, takes the lion share of the rewards.
When things go bad, however, in the first instance, the depositor could foot the bill - effectively being punished for the rather risky behavior of their banks even though their own intention was quite to the contrary (keeping savings in a bank being a pretty conservative “investment” by most people’s standards). The government, seeing this disconnect between the intention of conservative savers and the actions of risk taking bankers seems to think their role is to force the bankers to take less risk by somehow installing some board like the “securities exchange commission” with rules that the banks must follow to make sure that it doesn’t happen again.
If banks are in fact investment institutions then depositors should be aware of this. They should either demand a higher rate of interest to cover that risk, or simply not keep their money in banks (which are investment institutions as well) but instead keep their money somewhere genuinely safe (like a money warehouse - i.e. an institution that operates on 100% reserves). If the banks were allowed to fail and people were allowed to come to the realization that banks are NOT safe places to put your money, the market would work out an adequate solution where people who were willing to take risks and acknowledged that they were doing so when depositing their money with risky institutions like UBS or HSBC could do so and could earn interest on that “investment”. People who were not willing to take those risks would keep their money in money warehouses that operated on 100% reserves.
However, to frustrate that market result from ever happening, the central bank currently has the power (and it should not have) to act as the lender of last resort, to bail out those investment banks that go bust in order to “protect the depositor”. It is primarily this single piece of legislation that is responsible for the entire financial catastrophe at present. Had the banks known from the start that no lender of last resort existed and had depositors also known this (and been aware that there was no FDIC insurance either) then I’m quite sure people would have behaved very differently and made very different decisions about where to put their money over the course of the last 75 to 80 years. The emergence of 100% money warehouses would almost certainly occurred. The incompetent banking institutions that are currently failing most likely never would have come into existence or, even had they done so, certainly wouldn’t have had control of the capital that they currently control. The fear of bank runs alone would have forced these banks to keep much tigher control of their reserves and keep a much tighter check on the degree to which they inflated (by creating credit based on their reserves). For the most part, these banks would have been controlled not by depositors but by other banks - a bank that didn’t keep very ample reserves would be unable to borrow money from other banks that did not trust their ability to pay back loans in the event of a bank run.
What is usually called “deregulation” is at best, a partial deregulation, and often simply re-regulation on different terms. Thus, people see various “deregulation policies” that government has enacted, and the resulting consequences, and assume that deregulation hasn’t worked, without going to the effort of understanding what the “deregulation” policies actually did.