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Wednesday, March 31, 2010

What about Financial Reform?

ObamaCare applied to the financial system?

With “health care reform” signed into law, the Usual Suspects demand “financial reform,” which means we can expect a new wave of sophistry about finance to replace the old wave of sophistry on medicine. In other words, we are now on Page Two of “Change.”

Unfortunately, people don’t understand what happened in the financial sector. The official political narrative is this: About 30 years ago laissez-faire ideologues took a near-perfect financial system and created a free-market mess that ultimately collapsed.

Thus, people conclude, the problem is free markets. The solution? Just reregulate and populate regulatory agencies with people, according to Paul Krugman, who are “smart and well-intentioned.”

The dominant narrative is a caricature of the truth and rests on the false picture of markets. There are two problems with such a portrayal: The first is that the financial history of the past 30 years differs from the media-presented picture; second, “deregulation” did not equate to “free markets.”

Krugman writes:

[W]e used to have a workable system for avoiding financial crises, resting on a combination of government guarantees and regulation. On one side, bank deposits were insured, preventing a recurrence of the immense bank runs that were a central cause of the Great Depression. On the other side, banks were tightly regulated, so that they didn’t take advantage of government guarantees by running excessive risks.

However, this nirvana was undermined:

From 1980 or so onward, however, that system gradually broke down, partly because of bank deregulation, but mainly because of the rise of “shadow banking”: institutions and practices — like financing long-term investments with overnight borrowing — that recreated the risks of old-fashioned banking but weren’t covered either by guarantees or by regulation. The result, by 2007, was a financial system as vulnerable to severe crisis as the system of 1930. And the crisis came.

Krugman claims deregulation came about because of “Reaganite ideology,” but Reagan was not president when deregulation initiatives were being pushed by President Jimmy Carter and congressional Democrats in 1980. It was not ideology that led Congress to change the bank rules, but the hard fact that people no longer wanted to keep their inflation-ravaged dollars in regulated accounts with interest-rate ceilings.

Investors and depositors, instead, went outside the banking system and helped finance many new investments that came through what Krugman calls the “shadow” system. Ironically, Krugman complains about the very system that gave us most of the major investment initiatives of the 1980s, and if it had been under the same kind of regulation that governed banks, the investments that fueled the 1980s economic recovery never would have happened.

This sector Krugman criticizes did not come from “Reaganite” ideology (indeed, the best-known investment banker of that sector was Michael Milken, who was a liberal Democrat), but rather from the fact that investors wanted to finance entrepreneurs. Unfortunately, banking regulations of that time often prevented such unions.

The meltdown did not occur for lack of regulation, but because of moral hazard. When the government agreed both tacitly and openly to backstop Wall Street losses, and when huge pyramids of “investments” were piled on mortgage securities (also tacitly backed by the government) that turned bad, a meltdown was inevitable.

The meltdown did not occur in a “free market orgy.” Indeed, the market exposed the foolishness on Wall Street, which long ago had jumped into bed with the politicians.(Wall Street has been a major campaign contributor, and politicians don’t want to lose their cash cow.) Furthermore, the bailouts have not prevented us from going into a depression; they only have prolonged the financial agony.

Only one kind of “regulation” will work in finance: the freedom of financial institutions to invest make profits. However, should they incur losses, they must face the consequences on their own and not have taxpayers cover their losses. Indeed, I believe that had Congress said no to Wall Street in September 2008, markets temporarily would have crashed, but the system would have recovered and would be much stronger today than it is.

  • Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Economics from Auburn University. He is a member of the FEE Faculty Network.