11/03/2008 05:12 am ET | Updated May 25, 2011

The Political Roots of the Financial Crisis

The devastating financial crisis that has dominated our news recently is rooted in the politics of deregulation. Over the last twenty-five years, Wall Street has been able to achieve its primary political goal: the erosion of the regulatory mechanisms put in place by the New Deal. These were government controls placed on the behavior of banks and other financial institutions to prevent conflicts of interest and deceptive practices.

Dismantling the limitations on Wall Street greed was partly achieved because the rules became outdated and the presumed regulators, who themselves opposed regulations, failed to upgrade them. But much more important in the erosion of controls has been the political clout bought by Wall Street.

Since 1990 the Finance/Insurance/Real Estate has made political contributions in excess of $2 billion, far more than any other sector. In exchange, Congress has responded. Symbolic was the repeal, in 1999, of the Glass-Steagall law, the corner-stone of the New Deal financial regulation.

The financial community's triumph has greatly exposed the country to economic calamity. There has been an epidemic of crises and scandals since the 1980s after a long period of stability dating back to the 1930s. Recently, these events have brought the economy as a whole to its knees.

The crisis in the housing market occurred because banks figured out how to escape the risk that they might not be repaid when they issued mortgages. Instead of keeping the mortgages on their books, they sold them in complex "products" to investment banks.

The key point here is that because issuing loans was no longer risky to the banks, they marketed mortgages to people who would not otherwise be considered credit worthy.

This especially occurred in the form of "teaser rates." Interest on the mortgages in the first year was kept at very low levels. When in the second or third year the interest rate was reset there of course was the possibility that the borrower would be unable to make the monthly payments.
All of this came to a crashing halt when housing prices stopped rising. Borrowers who could not afford their monthly payments no longer could obtain additional loans. Defaults became epidemic.

The problem is that it was unclear who bore the risk of those defaults. The originating bank was far removed. They had sold the mortgages which had become part of complex packages held by investment banks and other financial houses. Even though those packages were little understood by those financial institutions, in their greed they disregarded prudent banking principles - just the kind of behavior the New Deal rules were designed to prevent.

When defaults on the mortgages held by these Wall Street giants sky-rocketed, they themselves confronted bankruptcy. But because their demise would cause horrific economic damage - declining investment and rising unemployment - the government has had to move to bail many of them out.

The result is a dysfunctional financial system that is imposing severe damage on the whole economy.

Now the fact is that innovations like dispersing risk over a group of investors can be economically beneficial. But as we have seen they also carry serious risks. The balance that has to be struck between the benefits and the risks is very delicate. Failure can threaten the entire economy.

Striking that balance is precisely the role for government regulation. It was not hard to see that - in the recent case - the number of mortgages issued to people who were not really credit-worthy was rising dramatically. It was similarly easy to recognize that the prices of houses could not continue to increase forever. Thus we are living through a calamity could have been - and was - predicted. And because the crisis was predictable, a properly functioning regulatory system could have avoided - or at least greatly mitigated -the crash and damage that is now being inflicted especially on the country's middle and working classes.

The government should have imposed limits on adjustable rate mortgages; deceptive lending practices should have been prevented; investment banks should have been required to hold greater amounts of funds in reserve than they did; banks should have been required to maintain reasonable standards of credit worthiness. In large part none of this was done because Wall Street used its political muscle to oppose them.

Its muscle, of course, was rooted in its contributions to political campaigns. What the country needed were politicians who recognized the need for new methods of regulation and acted swiftly. But instead the financial sector - with its eye only on its own profit margins - used its enormous wealth to reward politicians who ignored market excesses and to punish those who wanted to curb financial greed.

A lesson that goes back to Adam Smith is that business people are the last ones who should be trusted to set market rules. The effective policing of financial markets requires the construction of a rigid wall separating the market participants from government rule makers. Such a wall is necessary because of the very great likelihood that market participants - if entrusted to set the rules - will do so to their own advantage and game the system.

But when, as today, office-holders are dependent upon campaign contributions made by big investment houses and banks, the distinction between policing and participating is jeopardized. Wall Street firms can trust their political proxies to advance their narrow interests. It will take "clean elections" - financing electoral campaigns with public funds - to ensure that the wall that is needed will be not be breached.