State interventions in financial crisis: A major blow to deregulation regime

[Naveed Yaseen]

By Ashfak Bokhari
SINCE Jimmy Carter era, regulation and state intervention had been looked down upon as dirty words in business and in Washington.

As a result, politicians of both Republican and Democratic parties had often passionately competed with each other to see how much of the economy they could free from what they called the ‘oppressive yoke’ of government control. The decline in the role of government, they argued, was essential for US competitiveness.

On September 16, the 30-year era of deregulation came to a sudden end with the Federal Reserve extending $85 billion to take an unprecedented 80 per cent stake in American International Group (AIG) to rescue the insurance giant, preceded by nationalisation of Fannie Mae and Freddie Mac, the colossal mortgage agencies. Suddenly, it was revealed that the US financial sector could not survive without government help – an unthinkable blow to the gospel of free market economy. (nationalisation was effected after central banks in China, Japan, Europe, the Middle East and Russia threatened to stop buying US bonds and debentures issued by the two shaky financial institutions.)

After the collapse of the financial markets, what remains to be seen now, says BusinessWeek, is how much deregulation is left when the dust settles. But one thing is certain that deregulation has lost its allure.

In areas ranging from food safety to airlines to trade, greater government supervision or intervention is becoming acceptable to business as well as to voters. Over the past couple of years, the mood has changed. For, there has been a series of food poisoning episodes. And, both consumer and industry groups have come out in favour of giving the Food & Drug Administration (FDA) stronger authority to monitor food safety.

The shift toward re-regulation is also evident in the presidential campaigns. In March, John McCain, the Republican nominee, had said that he had always been “for less regulation” and referred to himself as “fundamentally, a deregulator.” But in a September 16 speech, he adopted a different approach, saying: “Under my reforms, the American people will be protected by comprehensive regulations.”

Meanwhile, the decision of the last big independent investment banks on Wall Street, Goldman Sachs and Morgan Stanley, to transform themselves into bank holding companies subject to far greater regulation fundamentally reshapes an era of high finance that, according to New York Times, defined the modern Gilded Age. The firms requested the change themselves; it was a blunt acknowledgment that their model of finance and investing had become too risky. As such, it effectively returns Wall Street to the way it was structured before Congress passed a law during the Great Depression separating investment banking from commercial banking, known as the Glass-Steagall Act.

Joseph Stiglitz, the Nobel laureate economist, criticised the attitude of American banks which reject any suggestion that they should face regulation, rebuff any move towards anti-trust measures. “But when they are in trouble, all of a sudden they demand state intervention: they must be bailed out; they are too big, too important to be allowed to fail. We have become accustomed to hypocrisy.”

The crisis, he says, springs from a catastrophic collapse in confidence. The banks were laying huge bets with each other over loans and assets. Complex transactions were designed to move risk and disguise the sliding value of assets. “Financial markets hinge on trust, and that trust has eroded. Lehman’s collapse marks at the very least a powerful symbol of a new low in confidence, and the reverberations will continue.”

It is manifest that the Americans are now moving in the direction of more regulation and less deregulation. In fact, a kind of consensus has already emerged and the only question is that of how much. That’s a big change.

Over the past three decades, the US economy has more than doubled in size , yet the executive branch employs about the same number of people today as it did in 1978. Many regulatory agencies in Washington have even shrunk. Despite the growing complexity of the financial sector, the number of employees working at the Federal Reserve has decreased since 1990.

The deregulation movement started when Carter signed the Airline Deregulation Act of 1978. Later, it spread to sectors of energy, telecommunications and financial services, with the slogan of ‘less regulation, more growth.’ In 1999, the Financial Services Modernisation Act was adopted by the US Congress. Under it, all regulatory restraints on Wall Street’s powerful banking conglomerates were revoked “with a stroke of the pen.” As a result, commercial banks, brokerage firms, institutional investors and insurance companies could freely invest in each other’s businesses as well as fully integrate their financial operations.

This legislation had repealed the Glass-Steagall Act of 1933, a pillar of President Roosevelt’s “New Deal” which was put in place as a check against corruption, financial manipulation and “insider trading” which had resulted in more than 5,000 bank failures in the years following the 1929 Wall Street crash.

The repeal created an environment for an unprecedented concentration of global financial power and later effective control over the entire US financial services industry was transferred to a handful of conglomerates. What prevails today is a de facto system of private regulation; the “global financial supermarket” is overseen by the Wall Street giants and the supervisory powers of the Federal Reserve Board have been significantly weakened. The financial giants have the ability to overshadow the real economy.

Michael Hirsh, writing in Newsweek, describes the financial mess as “a titanic failure of regulation” but specifically holds Alan Greenspan primarily responsible for it. The former Fed chief once enjoyed a near-saintly reputation because of his reputed “feel” for market conditions. Hirsh blames him for ushering in an era of easy credit that accelerated the mortgage mania. But the much bigger problem was Greenspan’s passion for “regulatory minimalism.”

He recalls that under the Home Ownership and Equity Protection Act enacted by Congress in 1994, the Fed was given the authority to oversee mortgage loans, but Greenspan kept putting off writing any rules. As late as April 2005, when things were seriously beginning to go wrong, he was saying that sub-prime lending would work out for the “common good” without government interference. “Lenders are now able to quite efficiently judge the risk posed by individual applicants,” he quotes Greenspan as saying at the time. This is how he had his “feel.” New regulations were not put into place until this past July, under Greenspan’s successor, Ben Bernanke.

Greenspan, in a 2007 interview with CBS, had, however, admitted: “While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late.”

At the centre of current financial crisis is also the failure to adapt standard financial regulation to new financial institutions, such as broker-investment banks, off-shore based hedge funds and large derivatives markets that remain, for the most part, outside of the traditional authority of regulators. However, when things go wrong, as they did with Bear Stearns last March, their demise threatens to destabilise the entire financial system.

After years of irresponsible public deregulation and private mismanagement, the American financial system is now in serious trouble, and it may draw the US economy further down with it in the months and years to come.

http://www.dawn.com/2008/09/29/ebr15.htm