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Dismantling the limitations on Wall Street greed was partly achieved because the rules became outdated and the presumed regulators, who themselves opposed regulations, failed to upgrade them.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.

Comments

[Minotaurus]

I agree with Jay Mandle 100%.
The whole Fiasco was established via Reagan, he was their first " Economy Puppet " that sold the "New Right" dream to the public.

[Pdubya]

yes, business leaders SHOULD BE THE LAST to set the rules. they are allowed to within our fiat system controlled by a NON-GOVERNMENTAL entity called the Federal Reserve. They create the moral hazard. They create lobby and whoring Congress.

The MARKET (the PEOPLE) and the rule of LAW should control the rules. And if allowed to, WILL. Enron got prosecuted at the State Supreme Court level, people went to jail and stock prices plummeted, AND they went bankcrupt....AS WAS SUPPOSED TO HAPPEN.

[Pdubya]

Regulation vs. deregulation is a must debate when they are frameworked within a fiat currency system controlled by a private bank - the Federal Reserve.

"Allow me to issue and control a nation's money and I care not who writes its rules!" Amshell Rothschild.

The New Deal was a designed managed market - Keynesian economics. It worked somewhat at first because we were still a production/savings/creditor nation based upon the gold standard. Now that we've become a debtor/consumer nation w/o a gold standard, the gross misgivings of a crooked system accelerated and capitulated exponentially.

We need to end the Fed. Return to our Constitution, a gold standard, and have only Congress issue it. First in order would be to stop spending. That includes a return to our constitutional foreign policy, non-intervention.

unless a bunch of the sheeple, including fundamentalist right and the progressive "globalists" (new world order) want the Amero. Does anyone think we will have more liberty when our currency is destroyed?

look, the market just trumped managed ecnomics. we could have had a recession. deep, painful but short lived.

what did our "representatives" do? they dumped more fiat currency into the fouled system, creating hyperinflation and brining on a greater depression.

If we need ANY regulation, it would be to regulated the Federal Reserve, Presidential Working Group, and the currency trust. End Sarbane-Oxley and bring back Brenton-Woods. Look to Hayek and Von Mises and our Constitution for a return to sound money.

[TerrapinCB]

We've been warned before about central banks by our forefathers. Andrew Jackson claimed his biggest accomplishment was helping end either the 1st or 2nd central banks that the US had setup. We're on the 3rd now, and the biggest question is how did our "leaders" fall for this again. If left to the citizens, it wouldn't have happened again.

"If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered." -Thomas Jefferson

[Pdubya]

p.s. mccain is just more of the same. vote third party.

[racetoinfinity]

"Common Cause" (www.commoncause.org) has been trying for 25 years or more to get publicly financed elections passed. The Congress has been unwilling to pass any of the many bills that have proposed it. Greed and reckless disregard for the public interest in Congress has caused this crisis as well as in Wall St. and The White House.

The blame for this disaster lies heavily upon the repeal of the Glass-Steagall Act, which was enacted after the crash of '29 to put a wall between commercial banks and investment banks. The guilty parties are a Republican Congress led by Phil Gramm and President Clinton influenced by Robert Rubin, all under heavy lobbying pre$$sure by the banking and financial industries.

[Ozarks]

Sounds like we should vote all the bums out, Demo's as well as repugs> If term limits is good enough for the Pres of US then we should impose term limits on all those bozo clowns in congress.

[ouroborous]

This is just a fantastic piece, and it points out that, although BushCo has been some of the most enthusiastic supporters of deregulation, the real problem IS deregulation, not just BushCo. The Democrats have fallen prey, too.

The Republicans do not want this story out because it would call into question the whole "deregulate and cut taxes" basis of Reaganomics, and Ronald Reagan is like a god to them...

[cpolevoy]

The Reckoning

This story is "ripped" from the headlines of today's New York Times. It is a detailed and scathing indictment of Bush administration anti-regulatory policies, gutting regulatory oversight and competence, and the incompetence of the S.E.C. under Bush.

As the article indicates, the entire 55-minute session that just may have led to the current nationwide/worldwide financial crisis can be heard at the following link:

http://graphics8.nytimes.com/packages/audio/national/20081003_SEC_AUDIO/SEC_Open_Meeting_04282004.mp3

The complete article can be read at

www.clearthemist.blogspot.com

or at

http://www.nytimes.com/2008/10/03/business/03sec.html?pagewanted=1&_r=1&ref=business

October 3, 2008

Agency"s "04 Rule Let Banks Pile Up New Debt, and Risk
By STEPHEN LABATON

"We have a good deal of comfort about the capital cushions at these firms at the moment." " Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.

[charon]

Although the second half of your analysis is good, the first half, about the political origins of deregulation, was somewhat lacking. Two things need to be pointed out to set the record straight. First, Reagan and the Republicans attacked regulations because they were easy targets. It cost nothing (in the short run) to rescind laws or gut regulations. It promised "freeing up" the economy so entrepreneurs (alleged experts in making money) could rev it up and get it going. It had an appeal to libertarian types and impulses in many voters ("freedom is good"). Regulations require longer, more complex explanations to justify their existence, and the voters rarely have the patience or the desire to hear such policy details.

The other point is that the battle to end regulation throughout the economy was funded by Richard Mellon-Scaife, Joseph Coors, and the other members who funded the ideological attack on the New Deal. They established think tanks, propaganda instruments, PACs, and other organizations collectively known as the "New Right" to defund the government, deregulate business, and further open up American markets to imports and in other ways weaken unions. Reagan was their figurehead in the White House.

The history of these events is a major part of the history of the present crisis, and needs to be remembered.