By Arnold Kling
Those root causes were an ideology of market fundamentalism and the policies flowing from it. The idea that markets get it right and governments only get in the way, what I refer to here as market fundamentalism, is a powerful current in American thought…Even before the Reagan revolution, American anti-regulationist ideology had reasserted itself, and the policy pendulum had begun to swing in the other direction with the removal of Regulation Q ceilings on interest on the deposits and the elimination of regulatory restrictions on stock brokers’ commissions. The Reagan Administration pushed the deregulatory envelope, albeit more in the nonfinancial than the financial sphere. In the second half of the 1990s the Clinton Administration and Greenspan Fed then rejected proposals for regulating financial derivatives. This was followed after the turn of the century by Bush policies weakening oversight of the financial-services industry and limiting the resources provided the overseers.
The upshot was a situation where mortgage brokers were allowed to originate subprime mortgages in the absence of meaningful regulatory oversight. Banks were permitted to minimize costly capital cushions and raise leverage to dangerous heights. They were allowed to further economize on the need for capital by shopping for ratings on complex derivative instruments concocted from those subprime mortgages. They were able to enhance those ratings further by wrapping the resulting securities in credit default swaps obtained from lightly regulated and poorly capitalized nonbank financial firms like the American International Group. None of this was socially-redeeming business practice, as we now appreciate. But the temptation was irresistible given the heads-I-win-tails-you-lose structure of executive compensation and absence of adequate regulatory oversight.
Given their inadequate resources, it is not surprising that the Securities and Exchange Commission and other regulators were unable to detect even blatant frauds like Harry Madoff…
Thanks to Mark Thoma for the pointer.
So, there you have it. One minute, you take away regulations that limit the amount that banks can pay on deposits, and next thing you know as surely as night follows day you’ve got mortgage brokers making shaky loans and AIG issuing credit default swaps.
I want to suggest that Eichengreen is an exemplar of the ideology of technocratic fundamentalism, which is the belief that progressive-minded experts get it right and free-market principles only get in the way.
Incidentally, I Googled “SEC budget history” to see if I could check up on the claim that Bush had starved the SEC and I found that Robert Murphy had done this eighteen months ago, and it turns out that the SEC funding and staff increased spectacularly under President Bush. Eichengreen never looked at the data, he just inferred, based on his technocratic fundamentalism, that if the SEC failed to catch Madoff, it must be because it lacked resources.
And is Eichengreen in favor of restoring interest-rate ceilings on bank deposits and re-regulating stock brokerage commissions? If so, then he should make such proposals explicit. If not, then he has no business talking about those deregulations as if they illustrate that market fundamentalists were running amok.
In my view, the most important regulatory failures were in housing policy and in bank capital policy. In neither case was there a clear-cut role for free-market fundamentalism. Housing policy had a variety of ideological influences. And in my view, bank capital policy went wrong primarily because of “cognitive capture” of the regulators. Both the private-sector and public-sector experts were in agreement that financial innovations, primarily securitization, allowed institutions to manage risk in ways that permitted higher leverage without threatening safety. That turned out to be wrong.
Was it that the regulators placed too much trust in the private sector, as Alan Greenspan testified? That may be part of the story. But government was heavily involved in making securitization central to mortgage finance and in making credit rating agencies central to the regulatory process.
If Eichengreen and others of who share his political outlook wish to make any headway with people like me, they will have to show that they have some indication that technocrats can make honest mistakes. Instead, if you blame all of the mistakes on free-market ideology, you come across to me as a technocratic fundamentalist, and you are only writing for people who share your ideological bubble.