Was deregulation the cause of the financial crisis?

Issue No. 231/232 (Nov/Dec 2009)

Much of the debate on the causes of the current economic crisis has focused on the absence of regulation of the US financial system. Humberto Campodonico argues that the drive to deregulate was inherent in an economy dominated by finance, and the key problem facing the US economy was the persistent weakness of demand and its tendency to stagnate. It was the desperate attempt to stimulate such an economy by means of 'bubblenomics' that triggered off the crisis.

'The truth is that there is plenty of blame to go around. Many Americans took out loans that they could not afford. Others were enticed into loans they did not understand by lenders trying to make a quick profit. Investment banks bought and packaged these questionable mortgages into securities, arguing that by pooling the mortgages, the risks had been reduced. Credit agencies stamped these securities with their safest rating when they should have been labeled "Buyer Beware." And as the bubble grew, there was almost no accountability or oversight from anyone in Washington.' - Barack Obama, Fortune, 17 April 2009

After the stock market crash of 1929, the banking crisis started in 1933, leading the sector to a financial crash. A majority of analysts said that the cause of this crisis was the fact that the banks had overstepped their traditional role as financial intermediaries, which means that they were supposed to receive money from depositors and then lend it to entrepreneurs and other agents that need capital for different business purposes.

Effectively, banks had gone into the capital markets and were issuing bonds, were investing in the stock market and were also financing mergers and acquisitions. As is well known, these activities are risky and involve a great amount of speculation.

In order to remedy this situation, the Glass-Steagall Act was passed in 1933 in the US. The law was intended to create a wall between operations and activities that could be carried out by the commercial banks, and the activities of the 'investment banks' (as they are known today). The Glass-Steagall Act also created the Federal Deposit Insurance Corporation (FDIC), which protects the savings of the public in the commercial banking sector (not in the investment banks) up to a certain amount ($250,000 in 2008).

Deregulatory push

This Act worked fairly well for some 50 years. But late in the 1980s, with the deregulation of the financial system (that started in London in 1986 with the so-called Big Bang), commercial banks began using legal loopholes in order to penetrate the investment banking sector. They did this because profit opportunities in capital markets were much more lucrative than in their traditional activities of lending to manufacturing, trade and service industries (see graph on p.63).

Under Ronald Reagan's presidency, US Federal Reserve Board (Fed) executives started to 'reinterpret' the Glass-Steagall Act in order to give banks some kind of access to capital market activities - although still very restricted. In 1990, new Federal Reserve chief Alan Greenspan (who came from JP Morgan) gave permission to a commercial bank to issue financial notes. That bank was JP Morgan.

In 1996, Greenspan issued a Fed order that permitted commercial bank subsidiaries to participate in investment businesses up to an extent of 25% of their capital. The deregulatory offensive in the 1990s was led by Sandy Weill, the CEO of Travelers (which owned the investment house Salomon Smith Barney), and John Reed, CEO of Citicorp (the parent of Citibank), who wanted to remove any regulatory hurdles to a merger of their companies that would create the financial services giant Citigroup. Finally, in 1999 President Bill Clinton signed the repeal of the Glass-Steagall Act.

After the repeal came the 'consolidation' of the financial industry, which is a euphemism for the enormous oligopolistic financial concentration that was taking place. Commercial banks entered foreign exchange markets, issued bonds, invested in commodities markets and stock exchanges, and financed mergers and acquisitions.

The cherry on the cake came with the advent of securitisation, which permitted Wall Street banks to purchase mortgage loans, especially subprime loans, and package them into securities for sale to global investors. All this with the blessing of major rating agencies (Moody's, Fitch and Standard & Poor's) that gave AAA rating to these junk loans.

From the Fed, Greenspan decisively encouraged the speculative bubble, lowering the interest rate to 1% and maintaining it for three years (2002 to 2005). The bubble burst last year, sparking a financial crisis that has turned into a systemic crisis. In October 2008, Greenspan said: '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' (Wall Street Journal, 25 October 2008).

Was it a mistake?

Most mainstream economic analysts and, most notably, the Obama administration say that the lack of financial regulation was the cause of the crisis. Therefore, they say, the solution consists in the implementation of new and strong financial regulation.

But this is not what other economists are saying. We take here the views of Professor Robert Brenner, from the University of California, Los Angeles (UCLA). Brenner argues that the basic source of the crisis is the declining vitality of the advanced economies since 1973, especially since 2000. Economic performance in the US, Europe and Japan has steadily deteriorated, business cycle by business cycle, in terms of every standard macroeconomic indicator - GDP, investment, employment and real wages (see Robert Brenner, 'From budget-cutting to "bubblenomics"', TWR, No. 217-218, Sept-Oct 2008).

Brenner says that in view of the persistent weakness of aggregate demand, the governments of the industrialised countries used different economic policies to try to 'revitalise' it. In the 1980s they applied Keynesian economic policies to stimulate the economy, producing enormous fiscal deficits. But these policies did not work, because economic growth was not significant.

Because of this, in the 1990s there was a radical change of policy, the governments opting for fiscal equilibrium. In the early 1990s, therefore, in both Europe and the US, led by Clinton, Treasury  Secretary Robert Rubin and Greenspan, governments moving to the right and guided by neoliberal thinking (privatisation and slashing of social programmes) sought to overcome stagnation by attempting to move to balanced budgets. But, says Brenner, because profitability had still failed to recover, the deficit reductions brought about by budget balancing resulted in a huge hit to aggregate demand. As a result, during the first half of the 1990s, both Europe and Japan experienced devastating recessions, the worst of the postwar period, and the US economy experienced the so-called jobless recovery.

Since the mid-1990s, the US has consequently been obliged to resort to more powerful and risky forms of stimulus to counter the tendency to stagnation. In particular, it replaced the public deficits with private deficits and asset price inflation. This can be called 'asset price Keynesianism, or simply bubblenomics' (Brenner, 'From budget-cutting to "bubblenomics"').

This bubblenomics permitted the increase of credit that backed the strong expansion of investment and consumption, despite the fact that real wages had been falling (or stagnant) since the 1990s. But these bubbles and the financial repression did not increase the rate of profit because of the overcapacity in the manufacturing and also in the information technology sectors. Says Brenner: 'The so-called New Economy boom was the direct expression of the historic equity price bubble of the years 1995-2000.'

 This overcapacity resulted in the bursting of the Internet bubble in 2001, which led to a recession. But the problem was aggravated because the Fed, led by Greenspan, decided to fight the recession by reducing the interest rate, which was zero in real terms for three years. Thus, a new bubble was created. From 2003 to 2007 there was an unprecedented increase in housing credit, which triggered a rise in house prices and also in household wealth, although this was purely illusory.

Says Brenner: 'It made possible a steady rise in consumer spending and residential investment, which together drove the expansion. Personal consumption plus housing construction accounted for 90-100% of the growth of US GDP in the first five years of the current business cycle (2002-2006). During the same interval, the housing sector alone, according to Moody's Economy.com, was responsible for raising the growth of GDP by almost 50% above what it would otherwise have been - 2.3% rather than 1.6.'

The heart of the matter is that these two bubbles were not able to reverse the generalised weakness of the real economy: profitability, total investment, exports and even private consumption. Rather, they amounted to sweeping under the carpet the real economic problems: 'Most telling, the business cycle that just ended, from 2001 through 2007, was - by far - the weakest of the postwar period, and this despite the greatest government-sponsored economic stimulus in US peacetime history.'

It was not a mistake 

What comes out of the analysis is that economic policies during the last 20 years have been applied ad hoc, tailored to the functioning of the capitalist system. This means that regulatory policies that could have avoided the creation of bubbles, at least for some time, would not have permitted the functioning of this type of capitalism.

This tells us that the lack of regulation did not arise from a 'lack of attention' or an oversight. It was a deliberate policy followed by Alan Greenspan in order 'to keep the system working'. As the economist Joseph Stiglitz says: 'During his reign as head of the Federal Reserve in which this mortgage and financial bubble grew, Alan Greenspan had plenty of instruments to use to curb it, but failed. He was chosen by Ronald Reagan, after all, because of his anti-regulation attitudes. Paul Volcker, the previous Fed Chairman known for keeping inflation under control, was fired because the Reagan administration didn't believe he was an adequate de-regulator.' (Interview with Nathan Gardels, http://www.huffingtonpost.com/nathan-gardels/stiglitz-the-fall-of-wall_b_126911.html)

Immanuel Wallerstein, a world systems theorist who views the current crisis from the perspective of 50-year Kondratieff cycles, has also drawn attention to the role played by financial bubbles in the crisis: 'As for the speculative bubbles, some people always make a lot of money in them.  But speculative bubbles always burst, sooner or later.  If one asks why this Kondratieff B-phase has lasted so long, it is because the powers that be - the US Treasury and Federal Reserve Bank, the International Monetary Fund, and their collaborators in western Europe and Japan - have intervened in the market regularly and importantly - 1987 (stock market plunge), 1989 (savings-and-loan collapse), 1997 (East Asian financial fall), 1998 (Long Term Capital Management mismanagement), 2001-2002 (Enron) - to shore up the world economy.  They learned the lessons of previous Kondratieff B-phases, and the powers that be thought they could beat the system. But there are intrinsic limits to doing this.  And we have now reached them.' ('The Depression: A Long-Term View', http://www.monthlyreview.org/mrzine/wallerstein161008.html)

Thus, while a proper regulatory structure is crucial in economic management, regulation (or lack thereof) was not the fundamental cause of the present crisis. Indeed, unless the underlying problems in the economic system are addressed, more such crises may well be on the cards.    

Humberto Campodonico is a senior researcher at the Peruvian NGO DESCO and Professor at the Economics Faculty of San Marcos National University in Lima. A consultant to the United Nations Conference on Trade and Development (UNCTAD) and the Andean Community of Nations, he is also an economics columnist with the Peruvian daily La Republica.

*Third World Resurgence No. 231/232, November-December 2009, pp 61-63