Monday, October 11, 2010

Just How Laissez-Faire Was the Financial Sector?

. Monday, October 11, 2010

I just want to tie up some loose ends on Charles Ferguson and the argument that the recent financial crisis was the end product of several decades of financial deregulation. I've already pushed back against this here and here, now Will Wilkinson piles on:

As economists Peter Boettke and Steven Horwitz have pointed out in a lucid short paper on the causes of the "Great Recession", between 1980 and 2009, four new regulatory policies were imposed on the financial sector for each regulatory policy lifted. It's simply inaccurate to describe this period as an era of deregulation. It was, on the whole, a period of decidedly increasing regulation.

Boettke and Horwitz's paper is here (pdf). As actual laissez-faire Austrian economists, unlike Summers and other neo-Keynesians that Ferguson goes after, they point out that:

We do not live in a free market. We live in a mixed economy. The mixture varies by industry. Technology is primarily free. Financial Services is primarily government. It is not surprising that the most government regulated and controlled segment of the economy, financial services, experienced the biggest problems.

Jeffrey Friedman has made similar points (pdf). This is more or less true. Even the biggest deregulation over this period -- the repeal of Glass-Steagall -- simply allowed U.S. banks to act more like Continental European banks always had. Is it really Ferguson's position that the financial crisis occurred because the U.S. moved towards a more European system?

I don't think it's true that the financial system would be more stable absent all (or almost all) regulation, as Boettke and Horwitz argue. But to acknowledge that is not to imply that the system we have had at all resembles a deregulated system, nor that failures can't occur despite a heavy regulatory structure. The recent financial crisis spread throughout all kinds of countries: some heavily-regulated states had crises, while others didn't. We need to acknowledge that it's not as simple as "regulation safe, deregulation risky".


sbd said...

Right, and it's also not as simple as "if a regulated sector is unstable while an unregulated sector is stable, regulation is risky." Selection effects anyone?

Kindred Winecoff said...

Definitely. I tend to think that in finance, there is no such thing as "stable". Not over any decent time horizon at least. We've seen so many collapses under so many types of systems that it's difficult to proselytize for much of anything.

India and Canada had fairly strict regulatory structures, although very different, and they performed quite well during the crisis.

Anonymous said...

Sorry if I'm repeating ground you've covered, but I think the argument is usually that regulation did not keep pace with changes in banking i.e. the development of this massive unregulated shadow banking system. Certain prominent, powerful individuals, most notably greenspan thought this was ok - we didn't need regulation because the market would price risk appropriately. People normally talk about the failure to put derivatives on an exchange, financial institutions being able to choose their regulator, changes in the bankruptcy regime (e.g. the derivatives exemption from automatic stay), the leverage constraint repeal by the SEC, and the general failure of the regulators to enforce existing regulations. I think it's fair to say, this was at least informed by a deregulatory spirit, such as characterized the post Reagan/Thatcher era.

Kindred Winecoff said...


That is certainly one argument that people have made. That is not, however, the argument that Ferguson was actually making. His claim was that the financial sector was less regulated in the 2000s than it was in, say, 1980. As a factual matter that just isn't right.

(Ferguson isn't alone in this... many others have made the same claims. Krugman is a notable one but there are plenty of others.)

As to a "regulatory spirit"... I don't know how to assess that and I'm not sure you could. There clearly was no interest in regulating derivatives, as you say, but the problem was that there was a massive depreciation in home values that led to a run on banks. I'm not sure how putting derivatives on exchanges would have prevented that.

On the other hand, there was a very strong importance placed on maintaining high capital ratios, and the U.S. had stricter capital standards than almost any other developed country. Less emphasis placed on liquidity and leverage, true, but that was at least partially because securitization was was intended to boost liquidity and CDS would allow hedging against over-leveraging.

That was the idea anyway. Apparently no one bothered to worry about what would happen if the CDS underwriters couldn't pay up.

So I suppose I'd say the record is mixed: certainly U.S. regulators emphasized some regulations more than others, but I'm not sure you conclude from that that there was a "deregulatory spirit". That is probably more true of the U.K. from the "Big Bang" to "light touch".

Anonymous said...

I want to explore this a bit more - "that the financial sector was less regulated in the 2000s than it was in, say, 1980." In 1980 "banking" (lending long, borrowing short) was done by clearly regulated depository institutions; in the 2000s, the same function was being done off balance sheet by unregulated (or lightly regulated) 'shadow' institutions. Financial holding companies were global, very large in assets under management, and had an implicit state guarantees. Doesn't this makes the system as a whole less regulated, in some sense?

Kindred Winecoff said...


I can see what you're saying. I think banks were still performing many traditional banking functions, but some (e.g. mortgage lending) were also being done by other institutions. So even if banking regulations were stricter, if more financial activity was conducted by non-banks, then the amount of less-regulated financial activity could have increased even if banks were regulated more strictly. Is that what you're driving at?

If so, you might be right, although I haven't examined the question empirically and don't know of anyone who has. I'm not sure what effect the shift from the S&Ls (also less-regulated) to the Countrywides as mortgage lender had on the incidence of regulation. I do know that securitization was driven in large part by the GSEs operating under a public mandate, so I'm not sure it's fair to include them in the "less-regulated" column.

But if the dynamic you're suggesting exists, and I suspect it does to some extent, it would be fairly easy to make the case that it was encouraged by the increases in banking regulations during the same period. The regulatory code favored securitization (esp of mortgages; this is Jeffrey Friedman's point) as did the GSEs, so banks were happy to shift in that direction.

Both things can be true: the increase in regulations incentivized a shift in financial activity to less-regulated sectors. That doesn't mean that the industry was deregulated. To the contrary, it means the return to regulatory arbitrage increased, which is further evidence that the regulations got stricter, in the banking sector at least.

Anonymous said...

Sure, we're playing with narrative here. It is common cause that the regulation was poorly designed and it allowed a massive transfer of wealth away from the taxpayer. But the central claim that government regulatory failures (their suboptimal *inaction* in the face of visible institutional and technological change) were a result of interest group and ideological (deregulatory) capture, may well be true. Recall Greenspan's admission, "I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms."

Kindred Winecoff said...


Sorry for neglecting this. I'd argue that "non-regulation" is not at all the same as "deregulation". I expand in a new post here:

I'd be interested in your thoughts, if you have more.

Just How Laissez-Faire Was the Financial Sector?
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