How did Government Deregulation in the U.S.

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Contribution of Government Deregulation in the US Financial Market to the Economic Downturn of 2008 to 2012
Executive Summary
The purpose of this paper is to determine the contribution of the government deregulation of the US market to the economic downturn of 2008 to 2012. It reviews the Great Depression and provide some of the lessons that regulatory bodies and agencies would have learnt from the Great Depression and avoid future financial crisis. It also looks at different forms of deregulation that have taken place over the past years since the depression and how these deregulations contributed to the financial and economic crisis in the United States between 2007 and 2009. The paper also looks at roles the increasing deregulation within the US had played in the financial and economic meltdown. Under this section the paper looks at some of the deregulatory measures that were by the United States that eventually contributed to the financial crisis. It then look at the effects that the deregulation had on economic sectors such as housing markets and securitization.
1.0 Introduction
The 2008 to 2012 economic downturn has been blamed on very many factors. Deregulation has been promoted by the republicans since the 1980s has been blamed for the economic meltdown which has experienced since 2008. It has not been clear whether it is only deregulation of the financial markets to blame for the financial crisis that many countries underwent across the global. Some of the rules which are being enacted tend to favor the independence of the financial firms. Despite the fact that it is almost impossible to determine the exact cause of a financial crisis or economic meltdown, there are some of the common causes of many financial crisis that have been experienced in the past. Some of the factors are deregulation of financial markets, sophisticated financial innovations, excessive executive compensation, low interest rates, subprime loans for the mortgages and speculation.
Efficient markets are vitally important in both economic theory and the real economy (Prentis 23). The efficiency of the market depends on the state and the market. Market efficiency is based on three principles or tenets. One of the tenets is that markets are in equilibrium and unexpected events that cause disequilibrium are only temporary since market is able to self-equilibrate (Prentis 24). The other tenet of market efficiency is that stock prices full reflect all the available information (Prentis 24). It also says that asset prices reflect the intrinsic value of the asset and this makes prices to be accurate signal for making capital allocation. However, this assumption has been faulted by some behavioral economists. The third assumption is that market prices move randomly without any prior price changes (Prentis 24). This implies that investors can earn higher returns than the stock market when there is lower risk. However, the empirical studies prove this assumption wrong.
Financial regulation or lack of it has always drawn a lot of political conflict in the United States. This has led to several changes in central banking and banking has at times been outlawed or only lightly regulated. Financial regulation had reached its highest point when after the Great Depression of the 1930s. However, the disastrous experience with deregulation of savings and loans institutions in the 1980s did not reduce the enthusiasm for financial deregulation in the latter administration. The financial crisis which began in 2007 has been partly blamed on the deregulation measure among the financial firms such as relaxed capital requirements. For instance, in 2004 the Securities and Exchange Commission had reduced the capital requirement for the large investment banks at their request which made them to pile up debts (Kumar para.3). Despite being given the power to look into banks` risk investments, the Securities and Exchange Commission had not done even a single inspection of the investment banks. The investigations that were carried out had indicated that investment firms were involved in risky investments and had an increased reliance on debts (Kumar para. 3). However, these signs of trouble were ignored.
Financial regulation and supervision in the United States has always been affected by the powerful socioeconomic interests and values (Tymoigne 2). These forces have in some cases prevented the necessary changes that would enhance the regulation and supervision of the financial markets. Some groups have considered government to be the problem in the financial markets with its regulation and close supervision of the financial institutions. The result has been reactive and reluctant regulatory actions which have been very ineffective in promoting a safe and reliable financial environment for proper financial market operations (Tymoigne 2). Some of the measures taken by the government to make financial markets more effective have been rapidly made irrelevant. The other challenge that regulators face when regulating the financial is the fact that financial institutions in the U.S. have become big and complex. The regulation and supervision of these financial institutions has become a difficult task and this has result into systematic risks.
Thesis Statement
The purpose of this paper is to determine the various ways in which the US financial market had been deregulated and how such deregulations had contributed to the economic meltdown. Some of the deregulation measures take include the repeal of the laws such as Glass-Steagall Act which have allowed commercial banks to engage in investment activities through their subsidiaries. The paper also looks at some of the effects of deregulation of the financial markets on the housing markets and securitization. Under this section the paper will examine some of the effects such as subprime mortgage crisis and inability to financial home mortgages by the home owners. Securitization of the home mortgage led to the transfer of risks from the lenders to the government owners entities making the banks to avoid screening of the borrowers.
2.0 Great Depression and the Lessons that Could Have Been Learnt
Great depression was a worldwide economic downturn that began in 1929 and ended in 1939. It has been considered the longest and most severe depression witnessed in history. It originated in the United States and spread across the globe resulting in adverse economic conditions such as decline in output, severe unemployment and acute deflation among other adverse economic conditions. There are several factors that have been attributed to the depression of the 1930s. One of the causes is the decline in spending which resulted in production. The manufacturers and merchandisers declined their production. The decline in spending in the United States spread to the other parts of the world causing economic downturn in other counts across the globe.
The decline in output in the United States is believed to have been caused by the monetary policy that was meant to reduce the stock market speculation. There was a great rise in stock prices and the stock prices reached their peak in 1929 (Romer 3). In order to slow down the rapid rise in the stock prices the interest were increased by the Federal Reserve. Higher interest rates depressed the spending some of the areas that that are sensitive to the changes in interest rates. The boom in housing construction had caused excess supply of housing which later experienced decline towards the depression. The U.S. stock prices reached their peak and it became impossible to anticipate future earnings. This made the investors to loose confidence in the US stock markets resulting into stock market bubble burst. Some of the investors liquidated their holdings making the prices to fall by 33 percent within a span of 2 months. The stock market crash resulted in a great decline in the aggregate demand of the United States of America.
Figure 1: Real GNP Per Capita
Source: Gene Smiley
Figure 2: New York Stock Exchange Sales and Securitized Issues
Source: Gene Smiley
Figure 3: Stock Price Index Prior to the Great Depression
Source: Gene Smiley
The great depression is also believed to have been caused by the monetary contraction which made many banks to panic. The panic by many banks in the United States made many depositors to loose confidence in the solvency of the banks and demanded that they be paid their deposits in cash (Romer 3). The process of hasty liquid made many banks to fail. Banks experienced widespread banking panic. Many banks were closed and only the banks that were deemed to be solvent by the government inspectors were permitted to reopen (Romer 3). About a fifth of the banks in the United States had failed by 1933. The money supply declined causing a reduction in spending. The wages and price were expected to be lower in the future and this prevented many people from borrowing despite the low interest rates.
The administrate of the United States ought to have learnt from the mistakes that led to the Great Depression such as housing bubbles that had also caused the recent financial crisis and economic meltdown. The regulators should have put in place measures that ensure that housing market is not overvalued. This should have been done prior to the recent recession by ensuring that there is proper regulation of the housing market. The regulators prior to the recent recession also should have looked into the interest rates trends and the risks of varying trends of interest rates. Lower interest rate is considered to be one of the factors that contributed to the great depression of the 1930s. The regulators such as Federal Reserve should not have lowered the interest rates to 1 percent since lower interest rate was likely to result in housing bubbles which has some risk for the financial and economic systems.
3.0 Deregulation in the US Financial Markets
3.1 Background
Regulation of the financial markets began at the time of independence. For instance, the interest rates were set a limit of 8 percent at the time of independence (Sherman 3). Some of the regulations that were put in place remained in place until the late nineteenth century when the some of the regulations. Some of the lenders started charging higher interest rates. For instance, the Uniform Small Loans Law, passed in 1916 had permitted the regulated lenders to charge borrowers up to between 24 and 42 percent and this made many business operating within the small loans market to make a lot of profits (Sherman 3). The central bank was established in 1914 as a step towards ensuring that the supply of money is controlled through conducting monetary policy and regulating the bank. The regulation was to be carried out under the Federal Reserve System. One of the regulations established under the Federal Reserve System is that banks were required to register and hold reserves at the Federal Reserve (Sherman 3).
However, the attitude towards state regulation of the financial markets changed after the Great Depression of the 1930s. Some changes were initiated which have affected the financial systems to date. Some of the reforms that were initiated by the Congress had placed some limits on the interest rates that banks could offer on the deposits. The new controls were to ensure that competitive rates are removed so that the interest rates could not soar to exorbitant levels. A new system of deposit insurance for consumers was also created by the Glass-Steagall Act. This Act had created the Federal Deposits Insurance Corporation which guaranteed the consumer deposits up to a given level which help in reducing fears of bank failures.
After the Great Depression, restrictions were initiated restricting the rate of interest that could be charged by the banks on the deposit accounts. Savings accounts were capped at 5.25 percent while time deposits were limited to between 5.75 and 7.75 percent (Sherman 6). On the other hand, checking accounts were restricted to an interest of zero. However, the inflation of the 1970s affected the interest rates and interest rates soared above the limits that had been put in place by the regulatory body. The surging rate of inflation had made the investors to look for alternatives to counter the effects of inflation. They established money market funds that which operated without reserve requirements or restrictions on rates of returns (Sherman 6). This led to a shift of money out of the regulated accounts in depository institutions.
In order to enable the banks and savings institutions to compete favorably with other money markets mutual funds, an Act was enacted into law. The new legislation was to ensure that interest rate ceilings and other restrictive regulations are phased out. It also allowed the depository institutions to offer savers deposit accounts at competitive rates. Financial deregulation of the 1980s was meant to benefit the depository institutions especially the ones in the thrift industry (Sherman 7). The deregulated industry which is characterized with poor supervision is likely to get out of control when there is competition for deposits. The institutions engaged in activities that attract capital such as offering above market rates on deposits. The market expanded rapidly. However, the bust in real estate led to the failure of many financial institutions.
3.2 Financial Deregulation in the United States
The government intervention has been considered by many players in the financial markets to be the cause of the financial markets problems. The stakeholders have been advocating for self-regulation as the solution to the financial markets problems. The participants within the financial system are believed to understand how the financial systems work and the government has been considered to lack the expertise in the financial sector (Tymoigne 3). Therefore, the government ought not to put restriction on the financial market. There is wide belief that financial institutions and the economy will perform well for a longer time without the government intervention when they are properly managed and strongly competitive.
Deregulation began when the Depository Institutions Deregulation and Monetary Control Act of 1980 was enacted into law. This Act together with other Acts such as Garn St. Germain Act has been considered to be the cause for reckless behavior of the financial institutions within the thrift industry (Tymoigne 4). The first attempts to deregulate the market in the 1980s and early 1990s resulted into loans and saving crisis. Since the 1980s the US has been at the forefront in liberalization of the world financial markets. They have engaged in heavy deregulation of the markets and relaxation of the supervision and monitoring by the Federal Reserve (Ramadhan and Naseeb 2). Many financial products and derivatives have been introduced within the US market and across the globe. Many commercial and investment banks moved into the mortgage market and this heavy expansion resulted into bubbles that burst and froze the credit market (Ramadhan and Naseeb 3). The second attempt to deregulate the market in the late 1990s and early 2000s resulted in the 2008 to 2012 economic and financial crisis. The diversification of the financial activities had resulted in financial fragility as financial firms were moving from their coherent core business to the activities that they had limited experience. A good example of companies which undertook too much diversification is American Insurance Group (AIG). AIG engaged in excessive diversification toward unfamiliar activities and financial activities with a lot of inherent risks. For instance, one of its subunits in London had engaged in placing large bets in the credit default swaps market (Tymoigne 4).
Some of the laws such as the Commodity Futures Modernization Act removed some of the regulations on swap transactions. The Act left the swaps such as credit default swaps (CDS) and equity default swaps (EDS) unregulated by the relevant federal agencies. Lack of federal regulation and exclusion by the gaming laws made the CDS market to have a huge boom. The amendments of the laws also permitted institutions such as pension funds to participate in the securitization procedures and these involve risky mortgages and home equity loans (Tymoigne 6).
Some of the amendments were also made in favor of the subprime mortgages. These amendments were meant to assist the low-income households to access mortgages from the financial institutions through providing the down payment. The government was promoting homeownership for the low income earners through reducing the financial requirements and costs (Tymoigne 7). Such moves by the Clinton and Bush administration have been blamed for the financial crisis which began in 2008. The legislations such as American Dream Down payment Act of 2003 were meant to encourage financial institutions to be more flexible and provide borrowers with help in different areas. Other home loan mortgage institutions have also been blamed for the boom in the subprime loans which is considered to be among the major causes of the financial crisis in the United States. The boom led to many defaults in the subprime loans.
The U.S. government has not been taking measures to tame the financial markets. They have been passing the legislations that that significantly increases the power of the financial institutions. The legislations passed in the recent years such as the Financial Modernization Act have critical in deregulating the US banking and financial systems (Chossudovsky para.24). The new rules that were ratified by the Clinton and Bush administrations allowed the commercial banks, brokerage firms, hedge funds, institutional investors, pension funds and insurance companies to invest in the business of one another (Chossudovsky para.25). Some of the laws such as Glass-Steagall Act of 1933 which were meant to do away with practices such as corruption, manipulation of financial information and insider trading. These changes in legislation have led to the transfer of the control of the U.S. financial services industry to a few large financial institutions. The behaviors and control by the large financial conglomerates has led to elimination of competition, displacement of state level banks, and failure of many smaller banks (Chossudovsky para.26). The local-level businesses have suffered in the hands of the financial giants as these financial institutions engage in setting up the interest rates that serve their interest.
4.0 The Role of the Financial Deregulation in the Economic Meltdown
Financial deregulation is believed to have played a very important role in the 2008 to 2012 economic meltdown. The systematic dismantling of the regulations which were meant to prevent the financial markets from collapse is believed to be one of the major causes of the recent financial crisis. Some of the financial market players are believed to be behind the dismantling of all the regulations that were meant to protect the investors from the banks and financial institutions. Lack of proper regulation by the government agencies had created loop holes for the banks and other financial institutions to behave in a reckless manner such as engaging themselves in very risky investments. Some of these practices have led to some problems that have been discussed below.
4.1 Repeal of the Glass-Steagall Provision of the Banking Act
The Glass Steagall Act was meant to separate the commercial banking and investment banking. This was due to the fact that commercial banks could misuse their deposits to finance questionable transactions such as financial speculations (Morrow para.33). The regulation was enacted since the government had the belief that commercial banks played a role in the speculation in the 1930s and this contributed to their insolvency and loss of public confidence in the banking system. However, this law was repealed and most of its provisions were successfully removed paving way for the commercial banks at Wall Street to operate as investment banks. The removal of the remaining restrictions by the Clinton administration in the year 1999 made the banks to operate both as commercial and investment banks (Morrow para.33). The commercial banks traded in risky investments which include complex derivatives which were difficult to and price.
Some analysts and legislators have upheld that repeal of the Glass-Steagall Act is one of the main causes of the financial collapse. Those who hold this view believe that allowing the banks and other financial institutions to operate both as commercial banks and investment bank is a big mistake. This is due to the fact that commercial banks would divert their reserve capital to engage in risky investments that are not good for the financial market performance and economy. Allowing commercial banks to take part in securities activities is believed to have contributed to the financial collapse and explosion of the financial derivatives (Crawford 130). The Glass-Steagall was meant to bar the banks from engaging the risky activities and without removal of some of the restrictions the derivatives market would not have attracted many financial players. In addition to the repeal of the Act, the credit rating work was also flawed.
4.2 Removal of the Selective Credit Controls
The earlier regimes had placed regulations that required that banks should maintain a minimum down-payments and maximum repayment period (Morrow 34). The main aim of these regulations was to reduce risk by ensuring that banks do not lend money to the subprime borrowers who were likely to default on their repayments. The absence of these controls ways a considered to be an avenue to providing people with loans without minimum down payment or documentation of income, an act considered to be risky. Some changes were made by the Securities and Exchange Commission that relaxed the capital base and the leverage restrictions. This led to many banks diverting their capital toward other non core banking activities and selecting their own leverage ratio as per their own models of risk (Morrow para.34). The banks` leverage ratios rose significantly due to the removal of the controls that had been put in place to regulate the banks.
4.3 Lack of Regulation of the Shadow Banking System
The other way in which the deregulation contributed to the economic meltdown down is lack of regulation of the shadow banking systems. The banks were creating special investment vehicles, equity funds and hedge funds which they are not regulated by the government agencies. The enactment of the regulations that protected the derivatives markets such as the Commodity Futures Modernization Act had led to many banks diverting the capital to the derivative markets. The market for the derivatives is non-regulated and it is considered a very risky market since information such as the value of the derivative is not available to the public. The fact that information such as exposure is not available affects the lending between the banks.
4.4 Failure of the Regulators and the Regulatory Bodies
The regulators and the regulatory bodies play a very important role in supervising the activities of the financial institutions. They are supposed to adequately supervise the banks, understand poor risk management practices of the private lenders and take action against the firms that use predatory practices (Morrow para.36). However, those who were supposed to be in charge of the regulation of the financial institutions did not take the steps that would protect the investors but rather prevented the regulation of the shadow banking system. Some of the people in charge of the regulations were politically connected to the administration and Wall Street making them to fail to effectively regulate the markets.
4.5 The Merger Problem
With the increased deregulation of the financial services, a new era of financial rivalry unfolded. Many large banks in America dominated the American finance capital and ended up suppress the rival banks within America and banking conglomerates in other regions such as Western Europe and Japan (Chossudovsky para.28). They also formed strategic alliances with other banks in other regions such as the largest banking giants in Germany and Britain. Several large mergers were formed between some of the largest banks and these mergers were approved by the Federal Reserve Board. One of the largest mergers that took place is the one between Citibank and Travelers Group Inc which combined their operations in 1998 to form a $72 billion merger (Chossudovsky para.29).
The strategic mergers and alliances between American and European banks have been considered to be the largest mergers across the globe since it has been involving some of the largest companies. These mergers have affected the operations of the smaller banks which are unable to compete in an environment which is dominated by largest banks and financial institutions. The smaller banks are forced to operate in unfriendly environment which make them to disappear.
The deregulation has been blamed for the increased monopolization of the financial services industry and this contributes to the disadvantaged position of the financial consumer. The mergers that are formed under deregulated markets have impact on overall stability of the United States and the global financial market. The merger among the largest financial markets makes a significant plunge on Wall Street to affect the US and the global financial market just like in the case of the recent global recession. The problems that are facing the Wall Street will spread to different financial systems across the globe. The mergers go against the Glass-Steagall Act which was enacted after the Great Depression to separate banking and the stock exchange in order eradicate cases of gross corruption and manipulation of the market by the giant banks. Many large banks organize huge corporate mergers that serve their own interests. These large corporations have been associated with insider trading and speculative booms that lead to stock market crash. The ceiling of the banks` ability to sell stock through their subsidiary had been lifted and this has permitted large banks to participate in practices that affect the financial markets. There have been complains of the stocks being grossly overvalued. The lifting of many restrictions on the banking activities has resulted in speculations, profiteering and plundering of assets that resulted in one of the worst financial crisis and economic meltdown in American history.
4.6 Deregulation of the Derivative Markets
The lack of regulation of the derivatives market has been associated with the recent financial crisis. The relaxed constraints led to over-extended financial system which was outside the control of the regulators (Reavis 6). Financial players overcrowded the financial systems by investing their capital in different areas leading to the decline in liquidity. The repeal of the Glass-Steagall Act has been considered to be of the major factors that led to the financial crisis. The changes that were made to the Act did a way with the restrictions which were meant to control the practices of the financial sector players....