We Didn’t Deregulate

When Barack Obama was running for president, he made no secret of his plan to “restore commonsense regulation” by closing up regulatory “loopholes” he blamed Republicans for opening. Deregulation of the financial industry, he argued, was a main cause of the financial crisis.

Much like Franklin Delano Roosevelt during the Great Depression, President Obama offered a sweeping, ambitious regulatory agenda: a total revamp of the financial industry, including reform of the process by which loans are converted into securities; more robust federal regulation of credit-rating agencies; the creation of a systemic-risk regulator; stricter government oversight of the hedge-fund industry; new regulation of credit-default swaps; and the consolidation of several financial regulatory agencies.

But unlike FDR, Obama won’t have to create a new regulatory system from scratch: For all the lamentation of our allegedly scanty policing of Wall Street, the financial industry already answers to a host of regulators, including the Federal Housing Finance Agency, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Federal Reserve, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and, not least, the Securities and Exchange Commission.

In fact, as Peter J. Wallison of the American Enterprise Institute explained in 2008, “almost all financial legislation, such as the Federal Deposit Insurance Corp. Improvement Act of 1991, adopted after the savings and loan collapse in the late 1980s, significantly tightened the regulation of banks.” In other words, we’ve had regulation, not deregulation.

The great villain in the deregulation myth is the Gramm-Leach-Bliley Act, signed into law by Bill Clinton in 1999, which repealed some restrictions of the Depression-era Glass-Steagall Act, namely those preventing bank holding companies from owning other kinds of financial firms. Critics charge that Gramm-Leach-Bliley broke down the walls between banks and other kinds of financial institutions, thereby allowing enormous systemic risk to percolate through the financial world. This critique is the keystone of the “blame deregulation” case, but it doesn’t hold up: While Gramm-Leach-Bliley did facilitate a number of mergers and the general consolidation of the financial-services industry, it did not eliminate restrictions on traditional depository banks’ securities activities. In any case, it was investment banks, such as Lehman Brothers, that were at the center of the crisis, and they would have been able to make the same bad investments if Gramm-Leach-Bliley had never been passed.

Another common claim, that credit-default swaps and other derivatives left unregulated by the Commodity Futures Modernization Act of 2000 were a cause of the financial crisis, doesn’t stand up to scrutiny, either. Research by Houman Shadab of the Mercatus Center has shown that this argument is undermined by its failure to distinguish between credit-default swaps, which are simply insurance against loan defaults, and the actual bad loans and mortgage-backed securities at the root of the crisis. Stricter regulation of credit-default swaps wasn’t going to make those subprime mortgages any less likely to go bad.

And it’s not as though our regulators have been hamstrung by a lack of resources. Government budget figures show that inflation-adjusted spending on finance-and-banking regulation has gone up significantly over the last 50 years, from $190 million in 1960 to $2.3 billion in fiscal 2010. Total real expenditures for finance-and-banking regulation rose 45.5 percent from 1990 to 2010, with a 20 percent increase in the last ten years. That spending rose by 26 percent during the Bush years, and by 7.1 percent in 2009. While these data do not say anything about the regulators’ effectiveness, it is reasonable to assume that a dramatic increase in their budgets is not a sign of radical deregulation.

To be sure, there has been a great deal of deregulation in some sectors of our economy over the last 30 years or so — the airlines, telecom, and trucking, just to name a few — but practically none of it has been in the financial sector or has had anything to do with the current crisis. Which is to say, the Obama administration’s regulatory proposals rest on imaginary foundations. And while the president’s populist criticism of greedy executives and unbridled capitalism may make for good headlines, it has nothing to do with the actual problem. This was that the FDIC, the Treasury Department, and the Federal Reserve created a housing bubble by encouraging a decade of careless lending. When the federal government guarantees bank loans or assets, banks have a weaker incentive to evaluate loan applicants thoroughly, and a stronger one to engage in risky behavior. When things are good, they make high profits; in the case of a catastrophic downturn, it is the taxpayers, not the banks, who foot the bill.

The financial-reform legislation currently under consideration in Congress does nothing to address the Fed’s cheap-money policy or the unsustainable subsidies that government still provides to homeowners and mortgage lenders — the main causes of the housing bubble. Instead, our would-be reformers assume that increased federal control of the economy, the appointment of a new federal czar with the power to curtail the pay of executives in businesses the government now controls, or the creation of a Bureau of Consumer Protection (the zombie version of Senator Dodd’s Consumer Financial Protection Agency) will set things right. The proposed regulations don’t attack the problem of excessive leverage. They don’t reform Fannie Mae and Freddie Mac. They don’t guarantee that taxpayers won’t have to pay for the future errors of bank executives who, cheered on by their government enablers, take on excessive risk. The “reformers” simply wish away the root causes of this crisis: the “too big to fail” mentality and crony capitalism.

Crony capitalism means that not everybody plays by the same rules. Allowing financial institutions such as Freddie Mac, Fannie Mae, and investment banks to maintain significantly smaller capital reserves than commercial banks, while implicitly guaranteeing their obligations, was a critical part of the financial problem. Capital-ratio rules require that firms value all their tradable assets at market prices and maintain a cash balance equal to a certain percentage of that price, weighted for the risk of each asset. In 2004, the SEC decided to allow five firms — Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley — to reduce their capital ratios, letting them keep more assets on their balance sheets while subjecting them to less-stringent reporting requirements. Special favors like that — favors from the regulators themselves — are representative of the unhealthy marriage between government and its friends on Wall Street.

And nowhere has that relationship been more toxic than in the case of Fannie Mae and Freddie Mac. The only reason those government-sponsored enterprises were able to guarantee nearly $5 trillion in home loans with a mere $100 billion in net equity was that both their management and other market operators knew that the government would step in if things took a turn for the worse.

Rather than ending the explicit and implicit guarantees, the administration is calling for limits on the size of financial institutions. Under the Treasury Department’s proposal, no one firm’s holdings could amount to more than 10 percent of the entire financial industry’s liabilities. While those limits would likely reduce the system-wide repercussions of bank failures, they would do nothing to curtail the bad lending at the heart of the problem. Similarly, the administration’s proposal to prohibit commercial banks from carrying out some kinds of “high risk” trades is another sign of how little has been learned from this crisis. The perverse incentives in the financial industry will remain, as will the political manipulation of housing prices and lending standards.

Not only will these regulatory initiatives not address our biggest problems, they threaten to make things worse. The massive government intervention in the economy in the 1930s made the Depression an even bigger disaster than it had to be and significantly delayed the eventual recovery. President Obama’s invasive agenda — and the great uncertainty it has injected into the system — probably has already had a similar effect, distorting the market mechanisms that otherwise would allow investors to price securities accurately and help get us out of this crisis quickly and efficiently.

With all that in mind, it is hard to argue that deregulation of the financial-services industry was the problem, and that more regulation is the answer. Yet, like Don Quixote and Sancho Panza, the Obama administration insists on fighting imaginary enemies. The president’s war on Wall Street windmills will come at a tremendous cost to taxpayers — and to everyone in the private sector who will remain unemployed or financially insecure while the recovery is delayed.

– Veronique de Rugy is an economist at the Mercatus Center at George Mason University. This article first appeared in the April 5, 2010, issue of National Review.

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