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Did Deregulation Cause the Recession?

Originally Published in the Herald-Mail

Economic & Fiscal Policy

by Thomas A. Firey

OP-EDS

In the summer of 2007, house prices in the United States began falling, ending a 15-year-long climb.[1] Prices fell 5 percent by the end of the year and 15 percent by the summer of 2010. That decline continues today; this spring, house prices fell to 20 percent below their 2007 peak. Millions of Americans who once believed “there’s no better investment than owning your home” now owe more on their mortgages than what their houses are worth.

The collapse was a calamity for homeowners. It was also a disaster for the financial world. Mortgage lenders, of course, took a beating when households stopped making payments. But the effect on the broader financial world was unexpected. Until the collapse, large bundles of mortgage agreements were considered by business and financial regulators to be so safe that they were used as collateral for other loans. Business runs on short-term credit as companies borrow money to buy supplies and make payroll while they wait for payments from customers. When mortgage agreements lost their value as collateral and snake-bit lenders became squeamish, businesses found it difficult to borrow. At the same time, struggling consumers cut back on spending. The result: a financial crisis, recession and massive unemployment.

Ever since, people have searched for a scapegoat to blame for the recession. Some on the political left have settled on “financial deregulation”: a series of banking reforms in the 1980s and 1990s that culminated in the 1999 Gramm-Leach-Bliley Act. The problem is, Gramm-Leach-Bliley and the other reforms had nothing to do with the financial crisis.

Gramm-Leach-Bliley repealed parts of a 1933 law known as the Glass-Steagall Act. Before Glass-Steagall, a bank could provide many different financial services: handle deposits, provide insurance, and underwrite, buy and sell stocks and bonds for its customers. In the 1930s, many people blamed this “universal banking” for the Great Depression. They believed universal banks had misled customers about the riskiness of securities, endangering both customers’ wealth and the banks’ own stability.[2] Glass-Steagall ended this supposed conflict of interest by dividing banking into two sectors: deposit banks that couldn’t offer financial services and investment banks that couldn’t offer deposit services.

Today we know the reasoning for Glass-Steagall was ill-conceived. Universal banks’ investment practices differed little from other institutions,[3] and universal banks proved more stable during the Depression than banks that didn’t handle securities.[4] So instead of correcting problems, Glass-Steagall created new ones: constraining banks’ ability to contend with the high inflation of the 1970s, planting the seeds for the savings-and-loan crisis of the late 1980s, and handicapping American banks in their competition with international banks whose home countries allow universal banking. Those problems resulted in a bipartisan consensus in Washington on the need for banking reform.

Interestingly, at the time of the 2007 financial crisis, the banking world had changed little as a result of Gramm-Leach-Bliley.[5] Though banks were no longer legally required to be investment banks or deposit banks, most continued in the same line of work they had done for decades. Consider that the banks at the heart of the financial crisis were either investment banks (Bear Stearns, Lehman Brothers, Merrill Lynch) or deposit banks (Washington Mutual). Glass-Steagall permitted both investment and deposit banks to deal in mortgages, and federal policy had encouraged them to do so for decades.

So, if banking reform is not to blame, what did cause the financial crisis? Go back to the quote in the first paragraph. The belief in the soundness of homebuying was ingrained in American business practices, financial regulation and government policy. Economic history is littered with financial crises that resulted from the collapse of consumer-anointed, investor-supported, and government-approved “sound investments.” In those cases, financiers weren’t “gambling” with other people’s money; they were investing in what “everyone knew” was safe. The problem is, what “everyone knew” was wrong. The way to avoid such crises in the future isn’t to adopt gimmicks like Glass-Steagall, but to develop a financial system that can better withstand the shock of the collapse of an asset that “everyone knew” was safe.