01/22/2008 10:40 am ET | Updated May 25, 2011

Deregulation and the Financial Crisis

It would be nice to write off the current crisis on Wall Street and global financial markets as something that only matters to the investor class.

Unfortunately, the effects are already being felt in lower-income communities around the United States. Worst-case scenarios for what spins out from the U.S. mortgage meltdown are truly frightening -- a severe world recession is a distinct possibility.

Whether such worst-case scenarios can be averted, or softened -- and preventing the recurrence of similar crises in the future -- depends on abandoning the laissez-faire financial regulatory regime entrenched over the last decade.

The current crisis is the predictable (and predicted) result of a massive U.S. housing bubble, which itself can be traced in part to global economic imbalances that could have been prevented.

At least five distinct regulatory failures led to the current crisis.

Regulatory Failure Number One: Failure to Manage the U.S. Trade Deficit. The housing bubble (as well as the surge in leveraged buyouts of publicly traded companies ("private equity")) was fueled by cheap credit -- low interest rates. One reason for the cheap credit was an influx of capital into the United States from China. China's capital surplus was the mirror image of the U.S. trade deficit -- U.S. corporations were sending lots of dollars to China in exchange for the cheap stuff sold to U.S. consumers.

Regulatory Failure Number Two: Failure to Intervene to Pop the Housing Bubble. Along with an influx of capital, Federal Reserve policy kept interest rates very low. There were good reasons for the Fed Policy, but that did not mean the Fed was helpless to prevent the housing bubble. As economists Dean Baker and Mark Weisbrot of the Center for Economic and Policy Research insisted at the time, Federal Reserve Chair Alan Greenspan simply by identifying the bubble -- and adjusting public perception of the future of the housing market -- could have prevented or at least contained the bubble. He declined, and even denied the existence of a bubble.

Regulatory Failure Number Three: Financial Deregulation and Unchecked Financial "Innovation." A key reason that mortgages were made available so widely and with such little review of recipients' qualifications was a shift in which institutions hold the mortgages. Traditionally, banks made mortgages and held them. In the new era, banks and non-bank mortgage lenders made loans, but then sold the loans to others. Investment banks packaged lots of mortgage loans into "Collateralized Debt Obligations" (CDOs) and then sold them on Wall Street, with a promise of a steady stream of revenue from interest payments. These operations were pretty much unregulated. Despite the supposed sophistication of the investors involved, no one took account of how shoddy the loans were or -- more fundamentally -- the certainty that huge numbers would go bad if and when the housing bubble popped.

Regulatory Failure Number Four: Private Regulatory Failure. It was the job of ratings agencies (like Standard and Poor's, and Moody's) to assess the CDOs and give investors guidance on how risky they were. They failed totally, likely in part because they wanted to maintain good relations with the investment banks issuing the CDOs.

Regulatory Failure Number Five: No Controls Over Predatory Lenders. The toxic stew of financial deregulation and the housing bubble created the circumstances in which aggressive lenders were nearly certain to abuse vulnerable borrowers. The terms of your loan don't matter, they effectively purred to borrowers, so long as the value of your house is going up. Lenders duped borrowers into conditions they could not possibly satisfy, making the current rash of foreclosures on subprime loans inevitable. Effective regulation of lending practices could have prevented the abusive loans, but none was to be found.

Unfortunately, the consequences of the mortgage meltdown go far beyond the foreclosure epidemic, as horrible a toll as that is taking. The entanglement of the financial sector with mortgage instruments, and the ripple effects of the housing bubble, has made lenders uncertain of who even among large corporations and financial institutions is credit worthy. The resulting credit crunch endangers the functioning of the global economy. Financial markets are guessing wildly about the prospects of banks, insurers and other financial corporations, and the plunging value of stocks poses immediate dangers to the real global economy.

Less acute, but probably more profoundly, the popping of the housing bubble is driving down home prices. U.S. consumer demand over the last five years has been driven by consumers borrowing against the increased value of their homes; with housing values falling, that process is working in reverse. The depressed housing market is also ravaging the construction sector, a nontrivial portion of the U.S. economy. A serious recession looms as a real possibility.

Mitigating these harms and preventing the worst now depends on active and interventionist government -- a government stimulus plan, and aggressive efforts to force lenders to adjust mortgage terms and let people stay in their homes. Preventing financial panics of the kind now underway require new standards of transparency and regulation for high finance. The coming days and months will tell whether any lessons have been learned.