You can’t explain a change with a constant.
This posting is by D&S Associate Arthur MacEwan.
Various people explain the current financial crisis as a result of “greed.” There is, however, no indication of a change in the degree or extent of greed on Wall Street (or anywhere else) in the last several years. Greed is a constant. If greed were the cause of the financial crisis, we would be in financial crisis pretty much all the time.
But the financial markets have not been in perpetual crisis. Nothing close to the current crisis has taken place since 1929. Yes, there was 1987 and the savings-and-loan debacle of that era. The current crisis is already more dramatic—and threatens to get a good deal worse. This crisis emerged over the last decade and appeared full-blown only at the beginning of 2008 (though, if you were looking, it was moving up on the horizon a year or two earlier). The current mess, therefore, is a change, a departure from the normal course of financial markets. So something has to have changed to have brought it about. The constant of greed cannot be the explanation.
So what changed? The answer is relatively simple: the extent of regulation changed.
As a formal matter, the change in regulation is most clearly marked by the Gramm-Leach-Bliley Act of 1999, passed by the Republican-dominated Congress and signed into law by Bill Clinton. This 1999 act in large part repealed the Glass-Steagall Act of 1933, which had imposed various regulations on the financial industry after the debacle of 1929. Among other things, Glass-Steagall prohibited a firm from being engaged in different sorts of financial services. One firm could not be both an investment bank (organizing the funding of firms’ investment activities) and a commercial bank (handling the checking and savings accounts of individuals and firms and making loans); nor could it be one of these types of banks and an insurance firm.
However, the replacement of Glass-Steagall by Gramm-Leach-Bliley was only the formal part of the change that took place in recent decades. Informally, the relation between the government and the financial sector has increasingly become one of reduced regulation. In particular, as the financial sector evolved new forms of operation—hedge funds and private equity funds, for example—there was no attempt on the part of Washington to develop regulations for these activities. Also, even where regulations existed, the regulators became increasing lax in enforcement.
The movement away from regulation might be seen as a consequence of “free market” ideology, the belief as propounded by its advocates that government should leave the private sector alone. But to see the problem simply as ideology run amok is to ignore the question of where the ideology comes from. Put simply, the ideology is generated by firms themselves because they want to be as free as possible to pursue profit-making activity. So they push the idea of the “free market” and deregulation any way they can. But let me leave aside for now the ways in which ideas come to dominate Washington and the society in general; enough to recognize that deregulation became increasingly the dominant idea from the early 1980s onward. (But, given the current presidential campaign, one cannot refrain from noting that one way the firms get their ideas to dominate is through the money they lavish on candidates.)
When financial firms are not regulated, they tend to take on more and more risky activities. When markets are rising, risk does not seem to be very much of a problem; all—or virtually all—investments seem to be making money. So why not take some chances? Furthermore, if one firm doesn’t take a particular risk—put money into a chancy operation—then one of its competitors will. So competition pushes them into more and more risky operations.
The danger of risk is not simply that one investment—one loan, for example—made by a financial firm will turn out badly, or even that a group of loans will turn out badly. The danger arises in the relation between its loans (obligations to the firm), the money it borrows form others (the firm’s obligations to its creditors) and its capital (the funds put in by investors, the stockholders). If some of the loans it has made go bad (i.e., if the debtors default), it can still meet its obligations to its creditors with its capital. But if the firm is unregulated, it will tend to make more and more loans and take on more and more debt. The ratio of debt to capital can become very high, and, then, if trouble with the loans develops, the bank cannot meet its obligations with its capital.
In the current crisis, the deflation of the housing bubble was the catalyst to the generally crumbling of financial structures. The housing bubble was in large part a product of the Federal Reserve Bank’s policies under the guidance of the much-heralded Alan Greenspan, but let’s leave that issue aside for now.
When the housing bubble burst, many financial institutions found themselves in trouble. They had taken on too much risk in relation to their capital. The lack of regulation had allowed them to get in this trouble.
But the trouble is much worse than it might have been because of the repeal of the provisions of Glass-Steagall that prevented the merging of investment banks, commercial banks, and insurance companies. Under the current circumstances, when trouble develops in one part of a firm’s operations, it is immediately transmitted throughout the other segments of that firm. And from there, the trouble spreads to all the other entities to which it is connected—through credits, insurance deals, deposits, and a myriad set of complicated (unregulated) financial arrangements.
AIG is the example par excellence. Ostensibly an insurance company, AIG has morphed into a multi-faceted financial institution, doing everything from selling life insurance in rural India to speculating in various esoteric types of investments on Wall Street. Its huge size, combined with the extent of its intertwining with other financial firms, meant that its failure would have had very large impacts around the world.
The efforts of the U.S. government may or may not be able to contain the current financial crisis. Success would not breathe life back into the Lehman Brothers, Bear Stearns, and who knows how many other major operators are on their deathbeds. But it would prevent the financial crisis from precipitating a severe general depression; it would prevent a movement from 1929 to 1932.
The real issue, however, is what is learned from the current financial mess. One thing should be evident, namely that greed did not cause the crisis. The cause was a change in the way markets have been allowed to operate, a change brought on by the rise of deregulation. Markets, especially financial markets, are never very stable when left to themselves. It turns out that the “invisible hand” does some very nasty, messy things when there is no visible hand of regulation affecting the process.
The problem is that maintaining some form of regulation is a very difficult business. As I have said, the firms themselves do not want to be regulated. The current moment may allow some re-imposition of financial regulation. But as soon as we turn our backs, the pressure will be on again to let the firms operate according to the “free market.” Let’s not forget where that leads.
Arthur MacEwan is professor emeritus of economics at UMass-Boston and is a Dollars & Sense Associate.