Tuesday, October 12, 2010

Pounding Away at the Deregulation Zombie

. Tuesday, October 12, 2010

My last post has generated some discussion both here and at Seeking Alpha. Nobody agrees with me, and some have seemingly misunderstood my point. Here is what I said:

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".

Here's what I did not say:

We should deregulate everything. That would make the system more stable.

In previous posts I've argued that the pre-crash U.S. banking/financial system cannot reasonably be considered as "deregulated" as it was one of the most regulated industries in the country, and was more-heavily regulated in the U.S. than in almost any other industrialized country. For example:

Reagan actually strengthened the financial regulatory structure after the Latin American debt crisis (Basel I), as did Dubya after the Enron collapse (Sarbanes-Oxley). The only major deregulation of the past three decades occurred during Clinton's second term (repeal of Glass-Steagall), and mostly what it did was allow American banks to trade on their own behalf... just as European banks had always been allowed to do.

The pushback comes along two general lines:

1. ::Fingers in ears:: NONONONONONONO! Reagan/Bush = free market fundamentalism. Therefore, they just must have deregulated everything, and this just must have caused the crisis. I will not believe anything to the contrary, ever, because I don't want to. (Extreme version at Seeking Alpha: accusing me of graduating from the "Joseph Goebbels School of Propoganda [sic]". No, seriously.)

That is not the more nuanced critique. This is:

2. There was "de facto deregulation" or a "deregulatory spirit" among regulators prior to the crash, despite the de jure tightening of regulations in some areas. This was pushed by one or two of the Seeking Alpha commenters, but mostly by Larry in comments here. The basic idea is that over the past few decades traditional banking functions (like mortgage lending) have increasingly been performed by non-depository institutions that were subject to much less oversight. At the same, banks and other financial institutions began using less-regulated or non-regulated financial instruments like derivatives, and nobody in government acted to bring these into the regulatory orbit.

There is a lot of truth to this, and it is perfectly compatible with the view I presented. I wrote that the regulatory code got stricter from 1980-2005. #2 argues that this may be, but it's only part of the story. If financial activity shifted to less-regulated institutions, then we could simultaneously say that the activities of financial institutions may have been less-regulated overall, even while the regulatory code was tightened. None of this implies, however, that it is the result of deregulation. In fact, the opposite is likely true if the "shadow banking system" grew in response to new regulations.

Did this happen? I honestly don't know. The financial industry in 1985 looked quite a lot different than it does today. True, there were no Countrywides issuing mortgages to everyone in the country, but there were a bunch of Savings and Loans doing similar things. Securitization wasn't as common in the 1980s, but securitization was done most by the GSEs operating under a public mandate and with a government guarantee, so it's a bit difficult to blame "deregulation" for that[fn1]. True, derivatives weren't as common in the 1980s and they were never required to be traded on exchanges, but does anyone really believe that that would have prevented a financial crisis when home prices fell by 40% nationwide? Remember that securitization was created to increase the liquidity in the system, just as credit default swaps were created to hedge against default risk. (It doesn't work too well as a hedging device if the counterparty can't pay up, but it's hard to base your investment strategy on the assumption that AIG is going to go bankrupt.)

Meanwhile, the bedrock of all regulatory regimes -- capital requirements and accounting standards -- were both stricter in 2007 than they were in 1980, for banks at least. If you don't trust simple counts of new regulations as evidence of this, or the enactment of the first two Basels and Sarbanes-Oxley, then you can still infer it from history. The fact that financial activity shifted away from the more-regulated banks to the less-regulated "shadow banking system" is itself evidence that the regulatory code had gotten stricter overall. Why? If regulatory arbitrage has become more profitable because the regulatory burden is heavier, then we should expect to see more of it. Which we did. Why else would a "shadow banking system" exist except to escape regulations?

The upshot is that the financial industry changed quite a lot in the past 30 years, and so did the regulatory structure. There were some deregulations, but many more new regulations (four times as many, according to Horwitz and Boettke). There were two major international regulatory agreements during that period, both of which tightened regulatory regimes. Some financial activities remained less-regulated than others, but that had always been the case. Non-regulation is not the same thing as deregulation. Blaming Summers, or Rubin, or Bush, or Reagan for not doing what nobody else had ever done is nothing more than scapegoating.

Whatever else we can conclude from this, we can say with certainty that the "30 years of deregulation by free market fundamentalists caused the financial crisis" narrative is at least too simplistic, if not outright false. We can say with certainty that financial markets, among the most-heavily regulated markets in the world, did not in any way approach laissez-faire. Anyone who is arguing either of those points (e.g. Charles Ferguson) is either ill-informed or mendacious.

[fn1] And, contrary to CW, W. Bush tried repeatedly to regulate the GSEs more tightly and was rebuffed by Congress. Many Republicans were part of that effort, but the biggest obstacles were noted laissez-faire fundamentalists Chris Dodd and Barney Frank. Larry Summers, for the record, wanted to regulate the GSEs more strictly in 1999, as did Alan Greenspan by at least 2004. It is true of course that both pushed hard against regulating derivatives. As with everything else, it's just not as simple as Summers/Greenspan = deregulation. It depends on the case.


Anonymous said...

Since we're doing blame, we want to get biblical on this, "So whoever knows the right thing to do and fails to do it, for him it is sin." James 4:17(ESV). But maybe sometimes they knew not what they were doing so deserve our forgiveness.

But simon johnson, in his piece for the atlantic, identifies 6 sins of commission which I think you need to address (these are his views, not necessarily mine) i) insisting on free capital movement; ii) glass-steagull repeal; iii) congress banning regulation of CDS; (iv) leverage constraint lifted by SEC; (v) light touch SEC regulatory enforcement; vi) Basel being hijacked to allow self-assessment of risk.

We can add inaction on derivatives and the Brooksley Born story and some other things. He also makes the general point about regulation not keeping up with changing market conditions, and notes the outsized campaign contributions from finance to congress. Even if you don't want to say "deregulation" can you agree to "bad regulation", perhaps influenced by an overly powerful interest group?

Anonymous said...

Also, can you address the Greenspan quote:

"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."

How are we supposed to interpret this, except as, I should have regulated banks more?

Kindred Winecoff said...

Larry -

As you say, there are sins of omission and sins of commission. Charles Ferguson (and his ilk) are claiming the sin is one of commission: a history of deregulation. You are claiming the sin is one of omission: a history of "un"regulation.

Ferguson is wrong. Whether you are right or not is up for you to prove, not me. (FWIW, I think you probably are right, but I also think that there is basically nothing that could have be done on the regulatory side -- within reasonable parameters -- to prevent this crisis.)

It's been awhile since I read Johnson's Atlantic piece, so I don't remember the specifics. I'll try to re-read it sometime, maybe tomorrow. But in general I think Johnson almost always overstates his case. Here's how I'd respond in brief:

1. Ironic that the former head of the IMF during the Asian financial crises is critical of free capital movement. In any case, is there any evidence that this caused the crash? Or even had anything to do with it? 2008 was not 1997. This wasn't a "hot money" crisis.

2. Glass-Steagall is the thing that always gets tossed around, but never with any causal mechanism attached. How did G-S repeal cause the crisis? Why was the event touched off by Bear and Lehman (and Fannie/Freddie), which were not mixed firms? Why did JP Morgan Chase -- a mixed firm -- perform the best during the crisis? Remember that Morgan Stanley and Goldman were saved only by *becoming* mixed firms. WaMu and Wachovia, more traditional commercial banks, didn't make it. None of these are explainable from the viewpoint that G-S repeal caused the crisis.

3. What CDS regulation, specifically, would have prevented the crash? (More on this below)

4. There might be some "there" here, but I view the crash being caused by a liquidity crunch that triggered a run on less-liquid banks and their counterparties. Leverage is related to that, but the same could have happened if banks hadn't levered-up 30 to 1.

5. I fail to see how the observation that regulators performed badly supports the argument that we should give them much more authority. This also applies to #4, if you like.

6. Self-assessment of risk came about because no gov't agency was/is qualified to do it. It was a pragmatic decision, not an ideological one. Anyway, I think it's wrong to phrase Basel in those terms. For more of what I think about Basel search for "Basel" on the blog. Basel is about politics.

Inaction on derivatives is probably the elephant in the room, but that's a sin of omission, not commission. It's not like derivatives were regulated by Jimmy Carter and then Reagan reversed it. They were never regulated, so they couldn't've been deregulated.

Furthermore, I always hear people say "we should have regulated derivatives" but I never hear them say *how* we should have done so. Isn't that the important part? Born wanted to put them on exchanges. A good idea, I think, and I'm glad FinReg does it. But does anyone really think that would have prevented the crisis? I've never seen anyone make a remotely persuasive case.

More importantly, none of these challenges my central claim, which is that the regulatory structure was strengthened during the Reagan-Bush-Clinton-Bush years. Perhaps it wasn't strengthened enough, as Greenspan acknowledges, but that's a separate argument. And those who make it need to say what should have been done, *and* how that would have fixed the problem.

Anonymous said...

johnson was *chief economist* at the IMF 2007-2008...a long long time after the summers v stiglitz asian crisis days...(stan fischer was first deputy man dir at IMF then)

the point about the transparency of clearinghouses is that people understand where the risks in the system are. the crisis is not only about housing, but about the mechanisms which allowed amplification of a subprime into credit and (global) financial crisis. and derivatives and leverage are intimately related to amplification.

i really find it odd where you think the burden of proof is here. regulation should always be thought of relative to the technology and rest of the institutional setting. I can't assess something like "there was `more' regulation". Regulation shouldn't be about more or less, and maybe that is where the people you criticise go wrong. answering this question properly requires a careful study of the legislative history (related to HMDA, gramm-leach-bliley, Commodities futures modernization, BAPCPA, even things like the new jersey and georgia predatory lending statutes etc etc) and looking at the role of lobbying. It's plausible that regulations (and enforcement) were less stringent than they would have been but for `faith in the markets' rhetoric (we had defeated communism after all) from favored campaign donors. Isn't that where the political economy is?

When you ask: What should the regulation have looked like? Well, we have a better idea now. But, maybe we didn't even need more - maybe a Fed, a (well-funded) SEC and CFTC that believed in regulation would have been enough. (and not letting systemically important firms pick their regulator would have helped).

and maybe politically it takes a big crisis to get regulatory changes /changes in enforcement which ex post are sensible. but greenspan appears to think that too much was left to financial institutions to develop their own self-regulatory frameworks and that maybe he could/should have done more. Seems sensible to start with that prior rather than the reverse.

Kindred Winecoff said...

Mea culpa on Johnson's IMF record. Not sure why I thought that, but it guess it serves me right for making an unnecessary passing swipe.

Clearinghouses: In theory that's right, but no one is really sure how clearinghouses will work, or would have worked. Was the problem about transparency? In Sept. 2008 it was, at least in part. In 2004-06 it was not. By the time increased transparency could have helped it was likely too late.

In any case, increased transparency could have made things much worse by exacerbating runs on the weak firms. Remember when the Fed made *every* major bank take TARP funds to hide which were on the brink of insolvency in order to protect them from runs? (I thought I'd blogged that at the time, but can't find it now.) If investors (including other firms) know which firms are weak they'll kill them, and since all of these big firms are inter-connected that could still lead to a system-wide run that would sink even healthy banks. Increased transparency could conceivably be worse than opacity in a bank run.

The point is that we don't know whether exchanges would have helped, or how much. I tend to think they are a good idea, but I also don't believe that they would have been enough to halt "amplification". In an asset bubble it seems doubtful that creating a bigger market for the bubbled asset would deflate the bubble. I don't know that is true of course, but I think it's the most likely case. Counterfactuals are very hard in this case, which is why I tend to take the view that scapegoating and demagogy aren't productive.

Regarding the burden of proof... It seems clear enough to me. There is a simple, empirical question: Did the U.S. deregulate from 1980-2008? The answer is: No, on balance it did not. The regulatory structure shifted in several ways, but in general regulations concerning capital, accounting, and disclosure were made stronger over that period. So it's quite easy to assess a claim like "there was 'more' regulation". There was.

Was that regulation as effective as in previous periods? Well, that's a completely different question. From 1982-2000 we had about seven different financial crises in the U.S., or one every 2.5 years or so. Some worse than others, and none as bad as the subprime crisis, but crises nonetheless. From 2000-2008 we had none, then the big one. It's not at all obvious from the historical record what regulatory structure is best.


And that's just in the US. Globally, financial crises have hit countries with all sorts of regulatory structures over the past 3 decades. So it's hard for me to have much confidence in any particular regulatory regime.


Kindred Winecoff said...


Ultimately the subprime crisis was so bad because the bubble was so big. In my opinion there are about 20,000 different reasons for why the bubble was so big, and so why the crisis was so deep. Lax regulations was probably one of them, but regulatory arbitrage was another. Eliminating the "Recourse Rule", for example, might have had a much bigger prudential effect than trading derivatives on exchanges. Hell, not forcing banks to mark to market might have prevented some of the stampede that sank Lehman.

You're right that the political economy angle is about competition, power, and interest groups, and that that is the interesting stuff. That's what my dissertation is focused on, albeit in the early stages. A brief discussion of part of that is here:


But to me, Johnson's "13 bankers stole the country" narrative is way too simplistic, as is the "neoliberals deregulated everything and then it went boom" narrative, and the "government caused it by encouraging lending to poor people" narrative, etc. Knocking down those straw men is necessary to get at the real meat.

So my prior is that all simplistic narratives are wrong, and all regulatory regimes are prone to failure. My prior is that the causes of crises (and regulations) are political, but no politician from any party wants to destabilize the financial system, so we need to deeper causes. My prior is that U.S. regulators operate within an international context that is meaningful for understanding outcomes.

And I don't really care what Greenspan thinks. If he didn't know what he was talking about before why should I assume that he does now? He's a smart guy, but he's always had a too-high a view of his capabilities. He thinks he could have prevented the crisis. I don't.

Pounding Away at the Deregulation Zombie
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