Financial Deregulation and Origin of the Financial Crisis of 2008

Many neoliberals, New Classical economists and other defenders of free market economics argue that financial deregulation was not a fundamental cause of the crisis of 2008.

One recent aspect of the debate has been the assertion of Eugene Fama, who is from the University of Chicago and father of the “efficient market hypothesis,” that financial deregulation and international capital flows led to “a period of extraordinary growth” from the early 1980s in the developed world and some parts of the developing world.

Paul Krugman has demonstrated how utterly false this idea is in his New York Times blog.

Financial deregulation is not correlated with better or faster growth. In fact, in the wake of financial deregulation in the 1980s, average GDP growth rates in the Western world fell sharply, as compared with the extraordinary period of post-WWII prosperity now known as the Golden Age of capitalism (1945–1973). This period was the Bretton Woods era of Keynesianism, social democracy, and financial regulation.

Angus Maddison, Emeritus Professor at the Faculty of Economics at the University of Groningen, is widely recognized as a leading scholar on the history of rates of economic growth. In 1995, Maddison published a study called Monitoring the World Economy 1820–1992 (OECD Development Centre, Paris, 1995), the first authoritative study on the effects of globalization and neoliberalism on growth rates in the developing and developed world, as compared with the Bretton Woods era. He compared growth rates both in GDP and per capita GDP in seven major regions of the world from 1950 to 1973 with those in the early era of globalization (1974-1992). He found that there were significant declines in the average annual growth rates in six of the seven areas: in fact the average annual rate of growth of world GDP was only half of what it had been under Bretton Woods. That is, world economic growth was about 50% lower than in the Bretton Woods era.

The only region that showed an increase was East Asia, precisely the region dominated by the protectionist state-led model of industrialization, led by Japan, South Korea, Taiwan, and (from the early 1990s) China.

Maddison’s study was updated by the Centre for Economic Policy Research (CEPR) in 2001 in the Scorecard on Globalization 1980–2000: 20 Years of Diminished Progress (July 2001).

Since the full effects of the collapse of Bretton Woods were not really felt until after 1979, their updated version which studies economic growth rates from 1980 to 2000 gives us a much more accurate measure of the consequences of orthodox neoliberalism or globalization on the world economy. The era of globalization was a disaster for much of the Third World. In Latin America (where the adoption of neoliberalism was somewhat later than in the West), real capita GDP grew by 82 percent from 1960–1980. But from 1980–2000, per capita GDP grew by only 9 percent.

However, it is correct that global poverty has fallen over the last 20 years: but the overwhelming number of such people are in China and India, where governments largely reject the policy prescriptions of globalization/neoliberalism. In India and China, for instance, there are still capital controls that prevent “hot money” from flowing in and out and destabilizing the economy.

But the devastating proof of the failure of globalization is the fact that those countries that have followed the rules – in Africa, the Caribbean, Latin America, and the former Soviet Union – have seen growth rates collapse to a level lower than the Bretton Woods era, and in some areas poverty rates have got worse.

The era of globalisation between about 1980 and the early 2000s was characterized by extreme financial liberalization in comparison with the 1945–1980 period of tight and effective financial regulation.

One simply cannot deny that in comparison with the 1945-1980 period, the last 20 years have characterized by a major trend towards deregulation.

For instance, from about the 1930s to the 1980s, many countries had policies of financial regulation that included many of the following:

1. Interest rate ceilings
2. Liquidity ratio requirements
3. Higher bank reserve requirements
4. Capital Controls (that is, restrictions on capital account transactions)
5. Restrictions on market entry into the financial sector
6. Credit ceilings or restrictions on the directions of credit allocation
7. Separation of commercial from investment (“speculative”) banks
8. Government ownership or domination of the banks.
(Ito 2009: 431–433).

These were abolished as financial liberalization and capital account liberalization became widely adopted in the 1980s and 1990s.

In the case of the US, we can point to a number of important acts of financial deregulation that were the direct causes of the crisis:

(1) Repeal of the Glass-Steagall Act (1999)
In the US, the Glass-Steagall Act, initially created in the wake of the Stock Market Crash of 1929, prohibited banks from both accepting deposits and underwriting securities. This led to segregation of investment banks from commercial banks. Glass-Steagall was effectively repealed for many large financial institutions by the Gramm-Leach-Bliley Act in 1999.
Joseph Stigliz has argued that

“The most important consequence of the repeal of Glass-Steagall was indirect—it lay in the way repeal changed an entire culture. Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively. It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money—people who can take bigger risks in order to get bigger returns” (Stiglitz 2009).

Deposit insurance does make sense when it protects a commercial banking sector prevented from making highly speculative and risky investments.

(2) Hiding Liabilities on Off-Balance Sheet Accounting
Banks used off-balance sheet operations called special purpose entities (SPEs) or special purpose vehicles (SPVs) to take on toxic asset-backed securities. This allowed banks to escape even the weak regulation of Basel I and II. It is estimated that the top 4 U.S. depository banks put around $5.2 trillion into SIVs.

(3) Commodities Futures Modernization Act (CFMA), 2000
This exempted financial derivatives, including credit default swaps, from regulation.

(4) The SEC’s Voluntary Regulation Regime for Investment Banks, 2004-2008
The SEC's Consolidated Supervised Entity (CSE) regime was introduced in 2004. It allowed investment banks to engage in their own net capital requirements in accordance with the standards of the Basel Committee on Banking Supervision. It was voluntarily administered, and the result was that investment banks pushed borrowing ratios to as high as 40 to 1, as in the case of Merrill Lynch.

One major confirmation of the effectiveness of financial regulation is the state of Canada’s banking system. In 2008, the World Economic Forum ranked Canada's banking system as the soundest in the world. The US system was ranked at number 40, and Germany and Britain ranked 39 and 44. Canada’s banks required no direct government bailouts.

Some commentators blame Basel I and II as a major cause of the financial collapse.
But if Basel I and II led inevitably to asset bubbles and financial collapse, then why has this not occurred in Canada?

The answer is fairly simple: Canada, unlike many other Western countries, still has tight and effective banking regulation.

That the role of Basel I and II in the present crisis is exaggerated is suggested by the fact that

“Canadian banks were the first in the world to adopt risk-management approaches under the new international Basel II capital framework, which sets out rigorous requirements to ensure a bank holds adequate capital reserves appropriate to the risk it is exposed to through its lending and investment practices. Canada's banks offer haven in turbulent sea, Vancouver Sun, Saturday, September 27, 2008

Furthermore, neither investment banks nor hedge funds (essentially the shadow banking sector) were really subject to Basel rules, yet these were the sectors of the financial system where the crisis originated: thus it was the investment banks Bear Stearns and Lehman Brothers that first collapsed in 2008. Furthermore, even commercial banks could evade Basel by creating SIVs, which were not subject to Basel I and II capital regulations.

All in all, this crisis was clearly caused by a spectacular failure of regulation.

Bill Mitchell of Billy Blog, a neochartalist economist in the post Keynesian tradition, has proposed set of new financial regulations that command respect. He proposes the following:

– commercial banks should only lend directly to borrowers: all loans would have to be shown and kept on their balance sheets
– an end to third-party commission deals which might involve banks acting as “brokers” and on-selling loans or other financial assets for profit
– banks should not be allowed to accept any financial asset as collateral to support loans. The collateral should be the estimated value of the income stream on the asset for which the loan is being advanced
– banks should be banned from having “off-balance sheet” assets
– banks should be banned from trading in credit default insurance.

Billy Blog, Asset Bubbles and the Conduct of Banks, 2 October, 2009

These policies should be the starting point of any sensible response to the financial crisis of 2008.


BIBLIOGRAPHY
Ito, H. 2009. “Financial Repression,” in K. A. Reinert, R. S. Rajan et al. (eds), Princeton Encyclopedia of the World Economy, Princeton University Press, Oxford and Princeton, N.J.

Wade, R., 2008, “Financial Regime Change?” New Left Review 53 (September-October), http://www.newleftreview.org/?page=article&view=2739

Stiglitz, J. E., 2009, “Capitalist Fools,” Vanity Fair (January)
http://www.vanityfair.com/magazine/2009/01/stiglitz200901

Weissman, R., 2009, “Reflections on Glass-Steagall and Maniacal Deregulation” (November 13), http://www.zmag.org/zspace/commentaries/4042

Capital Controls, Financial Regulation and the Global Economic Crisis of 2008–2009

In 2008–2009, the world has seen the worst financial crisis since the Great Depression.

In 2002–2004, large amounts of money flowed into the US from East Asia and oil-producing countries at a time when the US Federal Reserve had an easy money policy of low interest rates.

The blogger Cynicus Economicus has argued that

This massive wall of money invested into consumer borrowing created a fundamental problem. In simple terms, the first tranche of money invested ought to find the cream of the investment opportunities. However, as more money enters the system, good opportunities become scarcer – but it must still ‘go’ somewhere. In such circumstances, the capital is allocated to ever riskier investments, which explains the rise in popularity of collateralised debt obligations (CDOs) and other, similar financial instruments. These practices were simply a method of burying bad investments, while creating an illusion of continued low risk … In such a situation, we can see the roots of the house-price boom in the US, UK, Spain and Ireland (among other places) – a classic asset-price bubble in which there was a massive increase in the supply of money and the money simply chased an asset-base that could not expand as fast as the supply of money. A boom in land and property prices was inevitable …

Thus Cynicus Economicus contends that the flood of money from the East to the West with insufficient investment opportunities to “soak up” the money was the underlying and real cause of the crisis. Furthermore, it is claimed that nobody can show how “any regime might have coped with the influx of money from the East” since the “the money coming from the East created a circumstance that was entirely novel in the West.” Thus “the money would have arrived in the economy, and bubbles would [have appeared].” (see note 1 below).

This thesis, I believe, is false. The situation was not novel, and there were clearly ways in which the West could have prevented the asset bubbles.

Was There No Way to Prevent Asset Bubbles in the West?
First, it is simply not true that the flood of money flowing into the West from 2000 to 2006 was unprecedented or novel. There is an obvious historical parallel: the petrodollars that started flooding into London and New York banks in 1973–1974 and 1979 after the “oil shock” price surge. In 1974, the Arab oil-producing countries had a current account surplus of $68 billion US, which they mostly invested in the West (in 2007 inflation-adjusted US dollars that would be the equivalent of $285 billion entering the US economy). In 1975, these countries had a surplus of US $92 billion, an even greater amount.

And yet the Western financial system was not destroyed by large destructive asset bubbles in these years. Why?

The reason is that we had effective financial regulation that still existed before the onslaught of deregulation in the 1980s and 1990s.

Secondly, controls on capital inflows were actually a regular part of capital controls in the Bretton Woods era and in some countries well into the 1980s (Goodman and Pauly 1993: 282).

The dangers of large destabilizing capital inflows into an economy are well known. They can result in:

(1) damaging appreciation of a nation’s exchange rate that harms its exports and trade;

(2) short-term capital or “hot money” that causes financial instability and rapid outflows due to irrational herd behaviour and in turn balance of payments crises, and

(3) asset price bubbles, if there are very large inflows (Magud and Reinhart 2007: 647).

There are effective ways to prevent all these things. For instance, in Europe, which experienced large petrodollar inflows in the 1970s,

“capital controls and domestic bank regulations … separated Eurocurrency markets from the corresponding national markets … [For instance, there were] controls on capital inflows designed to keep a strong currency from becoming stronger … [in the 1970s] the German authorities attempted to discourage capital inflows through a variety of means, including a 60% marginal reserve requirement on bank liabilities to foreigners and a 50% cash deposit ratio on foreign borrowing (Herring and Litan 1995: 33–34).

International financial centres at Paris and Frankfort remained heavily regulated until the 1980s (Jones 1996: 188). As late as the 1970s, both Switzerland and Germany imposed controls on capital inflows to prevent currency appreciation and too rapid an expansion of their domestic money supplies from foreign inflows (Quirk 1995: 9). Germany, in particular, did so during 1971–1975 and from 1977–1981, precisely the time when petrodollars were flooding into Europe through Eurodollar markets. It is no surprise that, despite the massive flood of money in the 1970s, there were no destructive asset bubbles in the West.

Charles Kindleberger in the classic Manias, Panics, and Crashes: A History of Financial Crises (5th edn, John Wiley and Sons, 2005) shows that financial crises are a perennial characteristic of unregulated financial systems: from 1725 to 1929 destructive bubbles have occurred roughly every eight and half years in the West. But they largely disappeared in the Bretton Woods era (1945–1973).

Capital account liberalization and deregulation of financial markets started in the 1970s and intensified in the 1980s and 1990s. The results have been predictable: a massive rise in financial crises and destructive asset price inflation.

Quite simply, an important real cause of the crisis and the asset bubbles was capital account and financial liberalization. It is utterly false to say that real estate and stock market bubbles are inevitable.


Note 1
The views of Cynicus Economicus are presented in these articles:

“Five minutes to midnight,” Trade and Forfaiting Review 12.5 (23 March, 2009)
http://www.tfreview.com/xq/asp/sid.05DADC19-2C24-4FA1-9CC6-68BA35A5344F/articleid.5E87BC0A-16E2-497B-BDEB-E0F8BD765EF1/eTitle.Five_minutes_to_midnight/qx/display.htm

“Underlying Economic Crisis Caused Financial Crisis,” Huliq.com
http://www.huliq.com/1/82005/underlying-economic-crisis-caused-financial-crisis

BIBLIOGRAPHY

Calvo, G. A., Leiderman, L. and C. M. Reinhart, 1994, “The Capital Inflows Problem: Concepts and Issues,” Contemporary Economic Policy 12 (1994), 54–66.

Goodman, J. and L. Pauly, 1993, “The Obsolescence of Capital Controls? Economic Management in an Age of Global Markets,” in J. A. Frieden and D. A. Lake, International Political Economy: Perspectives on Global Power and Wealth, St. Martin's Press, New York, 1991. 280–298.

Herring R. J. and R. E. Litan, 1995, Financial Regulation in the Global Economy, Brookings Institution, Washington, D.C.

Jones, G., 1996, The Evolution of International Business: An Introduction, Routledge, London and New York.

Magud, N. and C. M. Reinhart, 2007, “Capital Controls: An Evaluation,” in S. Edwards (ed.), 2007, Capital Controls and Capital Flows in Emerging Economies: Policies, Practices, and Consequences, University of Chicago Press, Chicago and London. 645–674.

Quirk, P. J., Evans, O., Gajdeczka, P. et al., 1995, Capital Account Convertibility: Review of Experience and Implications for IMF Policies, International Monetary Fund, Washington, DC.

Rajan, R. S., and I. Noy, 2008, “Capital Controls” in K. A. Reinert, R. S. Rajan et al. (eds), The Princeton Encyclopedia of the World Economy, Princeton University Press, Princeton, 2009. 152–156.


Appendix 1: Capital Controls in the West

You can see here when capital controls were abolished in most Western countries. It is clear that throughout the 1970s Western countries were protected from damaging capital inflows.

UK – 1979, capital controls abolished.

Japan – 1980, capital controls abolished.

Germany – 1958, abolition of control on capital outflows; severe restrictions on inflows until 1969, then again from 1971–1975 and 1977–1981; final abolition of remaining controls in 1981.

Australia – 1983.

New Zealand – 1984.

Netherlands – 1986.

France – 1989, remaining controls abolished.