Financial Deregulation

In 1999, Congress repealed the Glass-Steagall Act. The historic maneuver removed a set of controls implemented since the Great Depression era of 1933 in an effort to control the banking system. The Act itself had previously limited the ability of banks to operate in multiple sectors where they had the right to only act within the capacity of a commercial bank, an investment bank, or an insurance company. After 1999, they were legally permitted to sell securities, trade foreign currencies, offer savings and loan service, and assist firms in mergers all under the same name and organizations. The decision shaped the banking world by allowing banks to take more risks as they enjoyed larger and more diversified assets. With greater size, however, came even greater liability in the case of failure.

When, in 2008, the American economy underwent its historic financial crisis, analysts and critics were quick to examine the causes culminating in such a disastrous situation. Some blamed movements directed towards deregulation as in the removal of the Glass-Steagall Act. Because of such aggressive and successful short-term decision-making, banks grew to serve as mainstays within a matter of years—pillars of the American economy. Their demise would not potentially represent an unfortunate casualty of the capitalist system; rather, their fall would topple the entire system. As the largest banks such as JP Morgan Chase and Bank of America amassed assets amounting into the trillions of dollars, their potential failure placed a menacing specter over society. Financial deregulation, however, began long before the late 1990s. In this essay, I will examine movements towards financial deregulation from the late 1970s until 2008 and conclude with a summary of how it led to the momentous 2008 financial crisis.

Floating currencies lie at the root of deregulation movements. As a costly war in Vietnam impeded on the American economy, President Richard Nixon sought to suspend the ability to convert the dollar into gold, thereby creating an economic situation where exchange rates could shift (Coggan 1). This generated a futures commodities market based on exchange rates and allowed world economies to more easily connect (1). In domestic matters, the court case of Marquette v. First of Omaha contributed the first blow against regulation. As a result of this decision, banks received the ability to apply the usury laws across the nation (Sherman 1). As bank policies began to undercut the policies of banks in other states, a correction of the market occurred where banks were forced to pit their interest rates in the face of greater competition.

By 1980, Congress enacted the Depository Institutions Deregulation and Monetary Control Act in an effort to generate consumer confidence. In effect, the Federal Deposit Insurance Corporation (FDIC) raised coverage from $40,000 to $100,000 and interest-rate ceilings on deposit accounts were removed (1). The policy decisions of President Nixon, the Supreme Court, and Congress culminated in a three-branch movement of Federal government policies contributing to the removal of financial borders at home and abroad. In addition, the encouraging government support of increasing deposit insurance supplied the investor with a policy of confidence for investing in the system.

The election of President Ronald Reagan in 1981 came with substantive policy directives aimed at financial deregulation. The changes were based on a belief that the consumer-driven market would empower property owners to more easily obtain mortgages as credit controls were removed and more lenders entered the market (Coggan 2). As capital controls were removed and floating exchange rates took a more prominent role in marketplace dealings, the value of the dollar increased to a point significant enough to make exports more difficult for American companies and worsen the economic recession of the early 1980s (2). However, an additional result created the ability to move money between borders at increased liquidation. Within American borders, Reagan engendered bi-partisan support of the 1982 Garn-St. Germain Depository Institutions Act. This action removed controls on thrifts, allowing them to operate commercially alongside "a new account to compete with money market mutual funds" (Sherman 1). With greater freedoms came difficult short-term fluctuations that succeeded in opening the market up to more and more lenders in the interest of consumer benefits.

Reaganomics shaped policy decisions of the 1980s and played an important role, albeit controversial, in economic development. Under the policies espoused by President Reagan, 20 million new jobs were created, inflation dropped from 13.5% in 1980 to 4.1% by 1988, unemployment fell from 7.6% to 5.5%, net worth of families earning between $20,000 and $50,000 annually grew by 27%, real gross national product rose 26%, [and] the prime interest rate was slashed by more than half, from an unprecedented 21.5% in January 1981 to 10% in August 1988 (Heubusch 1–2).

These changes came as a result of a three-pronged focus esteemed by the Reagan administration based on cutting taxes, creating new jobs through all sectors regardless of gender or nationality, and removing the government's role in regulation (Heubusch 2). By the end of the 1980s, promoters of deregulation only had to point to the numbers to validate their calls for continued liberalization of the economy.

The steady wave of policy shifts continued through the end of the 1980s and into the 1990s. In 1989, the Financial Institutions Reform and Recovery Act removed the Federal Home Loan Bank Board and the Federal Savings and Loan Insurance Corporation with a transfer of respective responsibilities to the Office of Thrift Supervision and the FDIC (Sherman 1). In spite of President Reagan's departure from office, his policies continued to resonate in the nation's capital. The merger further diminished the size of the government and ensured sent a resounding message that insolvent government institutions would be held accountable. By 1994, Congress approved the Riegle-Neal Interstate Banking and Branching Efficiency Act. This bill, through mutual Democratic and Republican support, removed controls on interstate banking and branching (1). It appeared that Reaganomics had taken firm root in consistent policy shifts towards deregulation.

At this figurative halfway point between the beginning of deregulation and the crash of 2008, it is important to consider the results of Reaganomics. Former economic policy advisor to the Reagan Administration William A. Niskanen takes an objective look beyond the corridors of ideology at the advancements and setbacks engendered by the administration's policies. In his report, Niskanen outlines the three adverse legacies left upon exit from the White House. Federal debt held by the public rose to 38.1% of GDP; an additional $125 billion was wasted as a result of failing to address the savings and loan problem (corrected by the 1989 Financial Institutions Reform and Recovery Act as highlighted by Sherman); the administration nearly doubled trade restraints to 23% of exports (Niskanen 3). However, positive growth did occur in the economy in terms of other measurements such as "sharp reductions in marginal tax rates and in inflation" (3). These advancements came at a reasonable cost even as Federal revenue share of GDP did not substantially decrease and unemployment was not negatively affected over the long term (3). With these policy implementations, deregulation gained the necessary momentum to continue its progress well beyond the 1990s.

In 1996, the Glass-Steagall Act took a major political blow. Designed to limit economic liability by separating the banking sectors, Chairman of the Federal Reserve Board Alan Greenspan elected to permit banks to own up to 25% of their investments in securities (Sherman 2). As any competent bank could easily manage such a large balance, the Glass-Steagall Act was rendered nearly obsolete. Effectively in 1998, the first mega-finance firm came into existence as Citigroup, Inc. joined "a commercial bank with an insurance company that owns [sic] an investment bank" (2). One year later, Chairman Greenspan oversaw the complete repeal of the Glass-Steagall Act (2). It was at this point that "too big to fail" became a veritable possibility.

Some financial analysts believe that this was the beginning of the downfall of the deregulation movement. Weissman sees the issue in rather epic proportions of financial service companies taking aim at higher risk activity in exchange for higher profits in the 1970s, relaxing regulation on cross-ownership between the financial service tools in the 1980s, and "civil disobedience" in the case of the Citigroup, Inc. mergers in 1998 (Weissman 1). Effectively, the entire repeal movement was viewed as a mistake. Nevertheless, Weissman proposes four lessons to gain from the repeal of Glass-Steagall. First, the Act itself was not a form of regulation itself but rather an industry structure to keep financial service companies focused on doing one task set task; next, the support of FDIC insurance policies provides a recipe for trouble when depository institutions gain their financial backbone through speculative banking practices as in the case where Bank of America acquired Merrill Lynch (2). Weissman finds the political power wielded by these massive institutions to be completely out of line with the needs of the American people and the interests of democracy, ultimately calling for greater regulation of the lobbying process and a stop to the seamless transfer process of top industry officials to top government positions (2). In effect, Weissman's argument is two-fold. Glass-Steagall existed as an industry structure to provide economic stability and protect against venturing in risky banking practices with questionable capital sources. However, the degrading of the act revealed the power money can buy within the democratic system, a power that ultimately must be regulated in the interests of the public good. At the time, however, the repeal of Glass-Steagall only further accelerated the deregulation policy.

Two other shifts would ensue before the entry of the 2007 subprime mortgage crisis and that 2008 failure of the Bear Stearns investment bank. At the turn of the millennium and the terminus of the Clinton Administration, Congress passed the Commodity Futures Modernization Act. This bill ended the regulation of credit default swaps and many other derivative contracts (Sherman 2). Next, in 2004, voluntary regulation came into effect where investment banks were allowed to take riskier wagers with less capital (2). By the 2000s, money evolved into an object to be used quickly and loosely. Banks jumped at the opportunity to use assets as they wished upon active policy encouragement from the government.

One of the most important shifts in the use of money came in the way mortgages were used. According to Sherman, the evolution of the market started at about the time of the Reagan administration with the Alternative Mortgage Transactions Parity Act of 1982 (12). Mortgage companies could use special features and tricky language through adjustable-rate and interest-only mortgages that were unclear to traditional consumers in order to create a new market where people with low credit scores and low levels of income could obtain a sub-prime mortgage (12). For a while, the process seemed to work. Americans stretched their dollars and the American dream itself grew in magnitude as more people became homeowners. It seemed as if everyone benefitted from the arrangement of non-conforming loans.

By 2006, mortgage banks hawked subprime loans as interest rates faced consistent reductions from the Federal Reserve. In the same year, the Wall Street Journal reported that "61% of subprime borrowers had credit scores high enough to qualify them for conventional mortgages" (12). The heavy advertising investment in these lucrative mortgages climaxed in the same year as non-traditional mortgages finally outpaced typical mortgages (12). Chairman Greenspan insisted on "ultra-low" levels for loans, further enabling companies to do their business with minimal cost effects (12). As money was stretched with creative bookkeeping techniques, the market became more and more vulnerable.

The situation was exacerbated by the value of the housing market bubble. Although home values historically kept pace with inflation, the peak of the housing bubble saw an average home value price increase of 70% across the nation (13). The immense profit potential appeared to be a fail-proof mission.

In 2011, Congress appointed the Financial Crisis Inquiry Commission to explain to industry leaders and the public why the 2008 crisis occurred. The commission highlighted the developments mentioned by Sherman and Weissman, focusing on the overpowering influence Wall Street wielded over Washington in selfish interests that suspended the financial system and took advantage of homeowners and mortgage investors (Thomas, Hennessey, and Holtz-Eakin, 1). However, Thomas, Hennessey, and Holtz-Eakin argue that it is foolhardy to contend that more government oversight would have prevented the crisis, providing an implicit reference to Coggan's summary of President Nixon's policies that enabled the joining of world currencies (2). As shown by the researchers, Reaganomics, aggressive banking tactics, and other measures implemented in the interest of the public good ultimately wielded a double-edged sword where deregulation destabilized the market economy and led to the 2008 financial crisis.

Works Cited

Coggan, Philip. "Link by Link." The Economist, 18 Oct. 2008, http://www.economist.com/node/12415730. Accessed 22 Mar. 2014.

Heubusch, John. "The Second American Revolution: Reaganomics." Reagan Foundation, 1 Jan. 2010, http://www.reaganfoundation.org/economic-policy.aspx. Accessed 22 Mar. 2014.

Niskanen, William A. "Reaganomics." Library of Economics and Liberty, 1 Jan. 2002, http://www.econlib.org/library/Enc1/Reaganomics.html. Accessed 21 Mar. 2014.

Sherman, Matthew. "A Short History of Financial Deregulation in the United States." Center for Economic and Policy Research, 1 July 2009, http://www.cepr.net/documents/publications/dereg-timeline-2009-07.pdf. Accessed 22 Mar. 2014.

Thomas, Bill, Keith Hennessy, and Douglas Holt-Eakin. "What Caused the Financial Crisis?" The Wall Street Journal, 27 Jan. 2011, http://online.wsj.com/news/articles/SB1000142405274870469800457610450052499828. Accessed 21 Mar. 2014.

Weissman, Robert. "Reflections on Glass-Steagall and Maniacal Deregulation." Common Dreams, 12 Nov. 2009, http://www.commondreams.org/view/2009/11/12-8. Accessed 22 Mar. 2014.