The global economy is undergoing tremendous changes that have contributed to the growth in the research interest on the role of government on economic growth. The role of economic policies, the type and their effects on the economy are major issues that have received widespread literature review. Economic interventions in the past have had significant effects on growth. The recession of 2008-2009 was a severe decline in economic performance since 1930 by advanced countries of Western Europe and North America. Data from the OECD shows that U.S. gross domestic product decline by 3.9% from later 2007 to 2009. The U.K performance was worse as it reported -5.5% while France grew at -2.8 with Germany reporting -4% growth. The world economy recovered in 2010 but such growth has been weak and cannot compare to other post-war recessions. The recession appeared to be the start of a protracted stagnation coupled with political instability. This paper assesses the role of the government deregulation in the 2007 recession. It examines different initiatives by the government to deregulate that eventually led to the recession.
Background of Government Deregulation
The recent financial crisis that led to the great depression left policymakers and scholars with many questions as to what went wrong. Key among the questions that have received widespread attention is government regulation or lack of it. The system of regulation did not produce the appropriate stimulus to avert the economic downturn. From this perspective, it would be advisable to examine the regulatory environment and the changes that might have contributed to the great recession. The Federal Reserve Act established the central bank in 1914 to control the supply of money in the country. The Federal Reserve was set up to conduct monetary policies and to regulate the banking industry. Member banks were to deposit reserves at the Federal Reserve but such did not earn any interest. However, banks accessed the discount window that allowed the federal bank to provide loans at below-market rates. The great depression altered the attitudes previously held concerning regulations of the financial market. The current system for example heavily borrowed from the 1930s. In 1933, the Congress reformed banking using the Glass-Steagall Act. The regulation Q one of the provisions of the act placed limits on the interest rates that financial institutions could offer to deposits. The competitive rate was eliminated by this provision and the rates were protected from growing to unimaginable highs. Similarly, institutions in the mortgage industry especially those in the mortgage lending were not left behind. Deposits in such funds had an added advantage to stimulate the flow of money to the housing sector.
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The Glass-Steagall Act brought into the scene a system of deposit insurance for the consumers by establishing the Federal Deposit Insurance Corporation which guaranteed consumers deposits to some level thus addressing fears of bank failures. The act further prohibited banks from engaging in nonbanking activities like securities and insurance. Firms chose to be simple banks which were engaged in lending activities or they could opt to be investment banks which were engaged in security underwriting and other dealings. In 1956 further regulations would extend the restriction s to the holding companies of the commercial banks.
There were also significant regulations in the securities market with the security Act 1933 calling on businesses to register their initial offers or any other subsequent sale of their securities. Such actions led to widespread transparency and disclosure in primary markets. In the following year, the Security and Exchange Commission was established by the Securities Exchange Act. The SEC was to regulate the stock exchange and enforcing other criminal acts that involve fraud in secondary trading. Firms were called upon to submit annual and quarterly reports to the SEC. The Commodity Exchange Act 1936 established rules for exchanging commodities and for futures trading the act was revised in 1974 establishing a commodity futures trading commission which is a federal regulator for the market. The SEC and CFTC depend on private self-regulation particularly as far as the operations of the exchanges are concerned.
Separate regulations were instituted for other deposit-taking institutions and other home mortgage loans for example credit unions and savings and loan association. In 1933, legislation created the Federal Home Loan Bank Board which was mandated with the responsibility of overseeing the savings and loans associations. The Bureau of federal credit was established in 1934. Its mandate was to oversee the functioning of credit unions. Additional reforms in 197o transferred overall oversight of the credit unions to the National Credit Union Administration.
Insurance companies, however, have only been subjected to state controls. According to a Supreme Court ruling in 1944, insurance activities were subjected to the interstate commerce law. However, the McCarran-Ferguson Act of 1945 returned the regulations of insurance companies to the state. It is evident that the reforms that took place in the first half of the twentieth century established a system of regulatory agencies some of which still remain today. Different agencies focused on unique activities and their priorities were different. However, the fragmented system had rooms for variation in different regions allowing for self-regulation by the private institutions.
Effects of the 2007 financial crisis
The 2007 financial crisis led to a credit crunch where financial institutions tightened the requirements for obtaining finance thus limiting the number of customers who could access credit. The crisis had many effects on households, financial institutions, businesses and the global economy. Some banks incurred huge losses which forced them to close down due to bankruptcy. They also lost a substantial amount of their capital as some of the loans defaulted and customers also lost faith in them. Banks could not attract deposits from their clients lending to additional challenges. Similarly, regulatory and capital requirements changed and reduced some of the profits as disclosure requirements eliminated hidden losses which were not always reported by banks. According to the Bureau f Labour Statistics, the financial crisis led to a decline in employment of 10% in 2009. There was a loss of about eight million jobs and households lost close to $19.2 trillion as household wealth. The real GDP declined by over 5% from its peak before the depression. The profits accrued to the banking sector drastically fell in the wake of the recession in both North America and Europe. Nonbank financial institutions like insurance companies, pension funds, and finance companies were also subjected to stricter regulations following the introduction of new rules. The profits of many firms also fell as consumption reduced substantially. Unemployment in the Eurozone continued to rise even after 2010. All countries across the globe experienced a decline in their GDP which was affected by a declining consumer power.
Government Deregulation
The U.S. Government engaged in deregulation to help address some of the challenges that were faced by the economy. It was widely believed that deregulation can reduce restrictions on conducting business, remove the outdated, inconsistent and unnecessary rule. It also tried to eliminate disfavoured regulatory impacts and to promote competition in a regulated market. In 1970 the Congress had changed its stance o regulation as both parties voted in support of deregulation. Lobbyists argued that economic regulation affected business operations and was outmoded and therefore the country should adopt self-regulation. The argument was that government regulations affect demand and supply which contributes to additional costs to the consumer. According to them, deregulation would increase competition and lower consumer prices. Different acts were passed by the Congress in support of deregulation in the different sectors of the economy. The establishment of a speculative market and deregulation eventually led to the great recession of 2007. Below are some of the deregulations that took place since 1970 and which had the greatest contribution to the economic meltdown.
Usury Laws
As far as 1970, different states were still using the Usury laws which were implemented at the start of the century. Such laws imposed interest rates ceilings which actually had no issues on the lending institutions. However, following the high inflation rates that set in after the Second World War, interest rate cap was no longer viable as inflation rates stood at 70%. The use of credit cards, for example, had experienced tremendous growth in the 60s and 70s. The Supreme Court in 1978 changed the landscape of usury regulation. In its ruling in Marquette National Bank v. First, of Omaba Service Corp , the court considered the state usury laws that apply to the bank lending across states. It was important to establish whether to use the bank's state or the borrower state. In its ruling, the court determined that the Bank home state law applied and therefore banks were given an opportunity to export interest rates regulations from one state to another. Financial institutions then relocated their operations to favorable states that had the lowest rates.
The court’s decision led to interstate competition as some tried to eliminate usury ceiling legislation to attract operators. South Dakota, for example, wanted to eliminate usury ceilings legislations. Such an arrangement would create employment and eliminate interest rate restrictions. The state moved hurriedly to amend legislation to allow Citibank which was in financial distress to move to the state. In one day the state had turned out to be a regulatory destination for the credit card industry. The move by South Dakota encouraged other states like Delaware to follow suit. Such a deregulatory environment was beneficial to the credit card industry. Banks relocated their operations to states with deregulatory ceilings where they could export their operations to the rest of the country. The outcome of the move was a complex one as all states apart from two still maintained the strict usury laws in their books yet banks charged any interest rates that they desired throughout the country. The ruling of the Supreme Court led to a de facto disappearance of the usury laws.
In Smiley v. Citibank 1996 , the court ruling noted that the penalties for late payment on credit cards constituted some form of interest thus overruled any state-level regulations placing limits on the charges. The judgment led to an increase in the fees from $5 to $39 or $40 and late charges became a significant revenue source for the industry. It also turned out to be a source of criticism from the consumer advocates. The effects of the usury ceiling contributed to substantial reforms where actions by a few states altered the regulatory framework of the country.
Removing interest rates ceiling
Since 1933, banks were restricted on the interest rate they could charge their deposit accounts. Regulations Q capped savings account to 5.25%. Likewise, time deposit was limited to 5.75%-7.75% based on maturity. Checking accounts had zero interest. The regulations were aimed at preventing any rate wars at any level and identified institutions that dealt with mortgage lending. Thrift institutions were permitted to offer interest on deposit accounts that was higher than that from the bank.
In 1970, inflation rose to its all-time highs beyond the limits provided by Regulation Q. The restrictions worked perfectly well when inflation was less than 4%. However, as inflation exceeded 10%, investors opted to look for alternatives to deposit accounts. The commercial paper allowed investors to lend to the borrower without passing through the bank. Banks and brokerage firms established money market mutual funds that pooled small investor’s funds to enable the purchase f commercial papers. The money market funds conducted their activities without reserve requirements or other restrictions on the rate of return. Small investors liked them and they transferred their money from the restricted accounts in deposit institutions that paid lower interest rates.
In 1980 the Depository Institutions Deregulations and Monetary Control Act were signed into law by President Carter. Its aim was to allow banks to compete with money market mutual funds. A committee was established to enable a smooth transition from a regulated interest rate ceiling to a free regime in six years. Banks would be allowed to operate accounts with competitive rates of return. The federal deposit insurance was also increased from$40,000 to $100,000 and all banks were required to maintain reports and maintain reserves at the Federal Reserve.
The Garn-St Germain Act of 1982 was passed by Congress. It authorized thrifts to issue commercial loans to the tune of 10% of the of the assets and operate new accounts to compete in the market with other financial service providers. With such power, the thrifts acted more like banks and less like mortgage lenders. The act also provided direct capital support to institutions in distress while expanding the ability of federal regulators to deal with any form of institutional failures in the future.
Financial deregulations of 1980 were intended to support deposit institutions particularly the thrift industry. However, it altered the market composition. The thrift industry was in distress in the 70s due to the high inflation rates and its entire net worth in the 80s was approaching zero. Institutions failure was commonly driven by the pressure but no strong action was taken to address the trend. In deregulated environments with poor supervision, competition for deposits was bound to spiral out of control. Some firms obtained capital by providing substantial brokered deposits at high interest. The savings and loan industry experienced rapid growth from1982-1985 and investors identified new opportunities in the thrift industry and other financial institutions. However, the savings and loans assets in the home mortgages declined in 1981-1986 from 78% to 56%.
The tax reform act of 1986 led to the bust of the real estate. The tax cuts had done away with the tax havens that made real estate profitable investment options. Deposit from the thrifts also declined and many institutions failed. There were many claims from the loan insurance corporation that led to an overrun. In the following year, the government declared that the fund was insolvent but Congress recapitalized it with $10.8 billion. It was not the end of troubled institutions and drastic actions were needed. In 1989 Bush signed into law the Financial Institution Recovery and Enforcement Act which abolished the fund. The entire thrift industry had declined by 50% and the savings and loans crisis loss was estimated to be $210 billion where the thrift industry contributed more than $50 billion. The failures of the 1980s can be attributed to financial deregulation and public policy. Supervisory and oversight activities were insufficient and the government did not intervene quickly in the name of regulatory forbearance.
Repealing of the Glass –Steagall Act of 1933
The act established a clear separation of banking and commerce in the financial industry. It restricted firms engaged in banking activities from engaging in securities. The same thoughts were applied by the Bank Holding Act of 1956. The restrictions aimed at eliminating conflicts of interest and risk-taking in the two businesses. The act was effective at minimizing failure in the banking industry in the mid 20 th century. Banks started engaging the Congress as early as the 1960s with the intention of lobbying for the lessening of the restrictions imposed by the act. Banks complained that the restrictions were no longer function as the line between deposits and securities became blurred. Banks were interested in venturing into the municipal bond market as well as other security if they are to remain competitive. Regulators were sympathetic and many believed in the concept of deregulation.
In 1986, the Federal Reserve reinterpreted the Act giving banks an opportunity to derive 5% of their revenues from the banking business. In 1987 the Fed approved a request by several banks to engage in underwriting business. Banks could handle municipal bonds, commercial papers, and mortgage-backed securities. The Fed further reinterpreted the act giving banks n opportunity to hand certain equity and debt securities provided they do not exceed the 10% provided by law. In 1996, the Federal Bank ruled that bank holding companies could own investment banking operations to the extent of 25% rendering the Glass-Steagall obsolete as any institution could easily remain within the 25% limit. As financial institutions diversified, the industry was moving towards stronger consolidation. The interstate restrictions on banking and branching were removed from 190-1998. Banking institutions merged thus reducing by 27%.
In 1999, the Financial Modernization Act or Gramm- Leach-Bliley Act did a final blow to the Glass Steagall. The act repealed all the restrictions on combining banking, insurance operations and securities in the financial institutions. It was a boon to the commercial banks because it gave them an opportunity to form megabanks. The act was termed as a crowning achievement for the efforts and lobbying in the financial industry. The repeal of the Glass Steagall ratified the status quo of the moment but was a strong piece of deregulation. The consolidation of the market caused difficulties for the regulators as different agencies were responsible for the oversight role. The growth in new types of derivatives, in particular, posed challenges for the regulators. Following the repeal of the Glass Steagall, the financial industry developed different derivative instruments. Concerns were also raised about possible risks of unregulated markets in the derivative instrument where there were no clear lines in the trade as no records were maintained thus could lead to disputes and uncertainties. Despite strong opposition to the free market, the federal issued a report that the derivative market needs no regulations.
The Gramm-Leach-Bliley Act deregulated the market and its sponsor Senator Phil Gramm wanted a strict language that would limit oversight. Trading in derivatives expanded quickly in a completely unregulated market where the nominal value increased from $106 trillion in 2001 to $531 trillion in 2008. Such massive expansion overwhelmed the technological and legal infrastructure. Banks which were the main players could make quick transactions and enter into contracts at free will and it was almost impossible to know who was owed and how much. Regulators believed in self-regulation of the firms in order to avoid any risks. In 2004 the Security and Exchange Commission approached the matter in a similar manner by discussing the regulation of the investment banks which needed looser capital requirements enabling them to hold fewer reserves and assume more debts. The SEC agreed to relax the rules creating the Consolidated Supervised Entities program for banks. Brokerage firms could volunteer to submit their reports on assets and activities to the SEC. Voluntary regulation relied on computer models owned by the firms that could be used to outsource risk analysis to the firm itself.
Banks used the process of securitization to pool assets and repackage them into securities. The illiquid assets could be turned into liquid securities that were sold to investors. Options and futures were also mixed together with insurance contracts allowing financial institutions to hedge against the possible outcome. Securitized assets and mortgage loans like Ginnie Mae, Freddie Mac, and Fannie Mae were followed by a nationwide push for homeownership that facilitated mortgage loans boosting the secondary market. Such securities were guaranteed by the federal government and had to meet the underwriting standards to ensure quality loans and limited risks. The mortgage market over the years evolved with restrictions having been lifted by the Alternative Mortgage Transaction Parity Act of 1982. Lenders also targeted low-income high-risk borrowers who also had low credit ratings using subprime loans. As profitability creased, the industry aggressively marketed the nonconforming loans to the consumers. Changes in the industry led to heavy investment with conforming and non-conforming loans appearing to be equal. By 2006, the nonconforming market had surpassed the conforming market. Such expansions were also driven by a decline in the interest rates as prescribed by the Federal Reserve. The rates remained low even after the collapse of the tech bubble. A relaxed monetary policy and new mortgage lending approach contributed to a housing bubble that emerged in the 90s. House prices had remained at par with inflation in previous years but at the peak of the bubble, house prices increased by over 70% having made adjustments for inflation. In some places, prices increased by 100%. There was a desire to maximize the profits and mortgage companies devised creative approached to expand their lending. As the market developed, regulators were tight-lipped to the activities 0f the firms. The system was vulnerable and its collapse was imminent.
References
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Gilbert, R. Alton, “Requiem for Regulation Q: What it Did and Why it Passed Away,” Federal Reserve Bank of St. Louis, February 1986. http://research.stlouisfed.org/publications/review/86/02/Requiem_Feb1986.pdf
Government Accountability Office (GAO), “Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System,” January 2009. http://www.gao.gov/new.items/d09216.pdf
Heiney, Joseph N., “Consolidation in the U.S. Banking Industry Since Riegle-Neal,” Clute Institute, IABR & TLC Conference, 2009. http://www.cluteinstitute.com/Programs/San_Antonio_2009/Article%20303.pdf.
Labaton, Stephen, “Agency’s ’04 Rule Let Banks Pile Up New Debt,” New York Times, October 3, 2008. http://www.nytimes.com/2008/10/03/business/03sec.html.
PBS Frontline: Secret History of the Credit Card, “Eight Things a Credit Card User Should Know,” November 23, 2004. http://www.pbs.org/wgbh/pages/frontline/shows/credit/eight/.
