Dispelling The 'Deregulation' Myth

Dispelling The 'Deregulation' Myth




By INVESTOR'S BUSINESS DAILY | Posted Friday, September 19, 2008 4:20 PM PT

Politics: A dubious and dangerous idea seems to be gaining strength — that government caused the financial crisis by giving capitalism free rein. If anything, it hasn't done enough of that.

OK, we'll say it if no one else will: Thank heaven for Gramm-Leach-Bliley. If you've been listening to the fulminations from Congress and the campaign trail, you know that we're talking about the 1999 law that dismantled the Depression-era barriers between commercial and investment banking.

Democrats largely supported it at the time, and one of their own, Bill Clinton, signed it. Now they frame it as a Republican bill that helped send the nation on the path to perdition.

AFL-CIO President John Sweeney said it's time to roll it back: "The system of regulation of these integrated banks has failed, and it is clear that much stronger firewalls are needed." Majority Leader Harry Reid — one of 90 senators who voted for the bill in its final version — took off after its co-sponsor, Phil Gramm, who Reid said "was responsible for deregulation in the financial services industries that paved the way for much of this crisis to occur."

Maybe they know better, but they just can't resist kicking Gramm, who was dumped from John McCain's campaign back in July after suggesting that America had become "a nation of whiners." You don't scold voters in an election year, and Democrats still seem to think they can score points from Gramm's gaffe.

This is no way to start a serious policy debate. And to suggest that the free-market principles embodied by Phil Gramm in his Senate career are at the root of the current financial crisis is not only dubious, but also dangerous. If people are convinced that capitalism is the problem, they'll accept a regulatory regime that sharply pulls in its reins, shifting power from business owners to union bosses such as Sweeney.

So it's time for some fact-based discussion of Gramm-Leach-Bliley and the whole policy trend called "deregulation."

First, that bill didn't make regulation go away. It modernized the rules to fit the realities of the financial markets. Washington doesn't always get the rules right, but in this case it did.

Also, Gramm-Leach-Bliley didn't take down the firewalls between deposit-based banking and investments. Banks can't play the stock market or trade credit default swaps with your savings account. Investment and banking operations run under one corporate roof, but otherwise stay separate.

So why did banks and investment houses get into so much trouble? It will take a long and exhaustive post-mortem to answer that question fully, but one point is already clear: They made mistakes that had nothing to do with the 1999 law.

Commercial banks threw lending standards out the window in their rush to get new business. Like S&Ls of the 1980s, they would have gone wild without Gramm-Leach-Bliley. Washington, if anything, egged them on, but not because of free-market dogma. Banks and mortgage brokers were pumping up the homeownership numbers in America, and politicians were eager to take credit for that.

Wall Street, meanwhile, became a victim of its own innovation. It created new classes of derivative investments that spread — and, through leverage, amplified — the risk from the subprime mortgages produced by the banks. A new multitrillion-dollar market emerged almost overnight, lacking in transparency and reliable price signals. With their asset values in doubt, investment banks lurched toward insolvency.

If regulators failed here, it wasn't because of policies adopted years before. It was more of the same story that has played itself out over and over in modern finance: Innovation races ahead of the rules. Crises tend to take almost everyone by surprise — including the major players as well as the regulators.

Careful study in the aftermath can lead to smart policies that cushion the blows of future shocks, but it doesn't prevent them entirely. Nor should it. Capitalism needs some room for trial and error, bringing out new ideas and testing them in adversity.

In this respect, Gramm-Leach-Bliley has turned out to be smart policy indeed. By repealing the rule against banks owning investment firms, it has led to at least two crucial mergers — JPMorgan Chase absorbing Bear Stearns and Bank of America merging with Merrill Lynch. Morgan Stanley may be the next investment house to find shelter in a well-capitalized commercial bank.

You can spot the theme here: By taking down an outmoded firewall, the law is helping the financial industry cope with a once-in-a-lifetime crisis. Far from being the cause, this instance of deregulation, or whatever you call it, is part of the cure.



Email To Friend |