Platt Perspective on Business and Technology

Considering a cost-benefits analysis of economic regulatory rules – 1

Posted in macroeconomics, outsourcing and globalization by Timothy Platt on March 30, 2012

Regulatory oversight is and has been a hot source of political debate and disagreement in the United States, and the contentiousness of this simply reflects a wider ongoing debate. But this is more than simply an area of political disagreement and polarization. The issues revolving around regulatory law and its application impact on individual businesses, on entire industries, on nations and national economies and their trade balances, and on regional economies and the global economy as a whole. And from a different but very important perspective, regulatory law and oversight of businesses and business practices impact strongly on marketplaces and on the individuals who comprise them through their purchasing and investing decisions.

Much of this debate revolves around questions of cost and benefits. I agree that these issues are and should be central to the design and implementation of any regulatory policy. But a through representation as to what those costs and benefits are, and for whom and over what time frames is usually absent from this debate. My goal in this posting and the series to follow is to at least attempt to shed some light on this larger and more interconnected set of issues. And I start with a brief accounting of a piece of United States history that preceded and led into the Great Depression, and to banking practices that contributed to that happening. With this, I set the stage for what I will discuss with a working example of regulatory law and regulations politics at work.

In the years before and leading up to the Great Depression, a significant number of banks in the United States collaborated together in groups, forming holding companies. This provided collective strength of scale. And the holding companies that these banks joined pooled stock shares tended by their member banks, distributing risk with a goal of effectively reducing it for their individual member banks, while raising pools of collective working capital that those member banks could tap into and count upon as reserve funds.

These banks were for the most part financially sound and certainly in the boom days leading up to the stock market crash of 1929. True, there had been economic downturns in the past and even runs on banks and panics that would trigger them. I cite the Panic of 1893 and the soon to follow Panic of 1907 (and note the Panic of 1873) by way of example. But the economy had been seemingly so strong and so stable and throughout the Roaring Twenties that as well-known and respected an economist as Irving Fisher would proclaim that “stock prices have reached what looks like a permanently high plateau.” And I note here that for his successful contributions to both economics theory and practice, economists of the stature of Milton Friedman and James Tobin would call Fisher “the greatest economist the United States has ever produced.”

Banks and their holding companies, and the economy in general looked strong and stable, and headed towards staying strong and stable and very long-term. So many, many banks as standard practice came to accept stock from their own holding companies they belonged to as acceptable collateral on loans they offered – and even as preferred collateral. And then the house of cards collapsed and the market crashed, leading as a first panic-inducing step to the Great Depression of 1929. And stock prices and their deemed values plummeted and suddenly all of those banks were burdened with what amounted to vast amounts of unsecured loans – the stocks that they were backed by were on their way to becoming worthless. And bank runs commenced as panicked bank customers went to take their money out and in huge numbers. And the way that the banks in a holding company were interconnected through seeming stability pre-crisis and now through palpably real vulnerability, when one bank in a holding company went into crisis that pulled all of the other banks in that holding company into crisis too. And those banks began to fall like rows of dominoes, each bank failure triggering the next.

The stock market was in fact beginning to recover when a panicked US Congress passed the Smoot-Hawley Tariff Act of 1930, paralyzing international trade and cutting off markets to US production. But that is another story that I might turn back to later. For purpose of this discussion, I turn to a much more positive and constructive response: the Banking Act of 1933, more commonly known as the Glass-Steagall Act.

The Glass-Steagall Act was enacted with two fundamental, interconnected goals in mind: to increase public confidence in banks and other financial institutions, and to reduce the likelihood of a next panic or depression by banning the types of high-risk activities on the part of banks that contributed so much to the development of the crisis of 1929 and beyond.

In many respects this can be seen as an omnibus banking regulatory act. Its provisions, among other things, set up the Federal Deposit Insurance Corporation (FDIC), protecting bank depositors from fear of loss of their investments in the event of bank failure and limiting certain forms of speculative activity on the part of those banks. This provision was designed to prevent runs on banks and it has worked – banks have failed since then but their investors have always been protected through that by the full faith and credit of the United States Government and they have not faced loss for any amounts covered under the provisions of that law. There have been no subsequent runs on banks covered under the FDIC.

The FDIC itself has never been seriously challenged, but in recent decades much of the rest of the Glass-Steagall Act has come under direct attack by anti-regulatory voices in Congress, as backed by and pushed by banking and other financial sector lobbyists. To cite just a few of the changes enacted in this way, cutting away at the Glass-Steagall regulatory framework:

• The authority of the Federal Reserve to regulate interest rates in savings accounts under Regulation Q of this law was repealed by the Depository Institutions Deregulation and Monetary Control Act of 1980. This act raised the level of deposit insurance coverage under the FDIC from $40,000 to $100,000 but it also allowed banks and other covered institutions to offer as much or as little return as interest as they saw fit and without any regulatory oversight.
• Much more importantly for purposes of this discussion, but consistent with this basic deregulatory trend, the Gramm-Leach-Bliley Act of 1999 effectively removed separation between investment banks which issue securities and commercial banks which generate revenue through deposits and other customer-facing banking services. The deregulation also removed, and this is crucially important here, all conflict-of-interest rules that had prevented investment bankers from serving as officers of commercial banks.
• And these changes and particularly deregulatory changes coming from the Gramm-Leach-Bliley Act contributed directly and strongly to creating the financial crisis that we have come to know as the Great Recession, starting in 2007 and continuing until 2010 or even into 2011 depending on how its ending would be formally determined.
• Quite simply, this deregulatory move allowed bankers to hemorrhage depositor funds into high risk investments – for which the banks and bankers involved faced no direct risk even as they saw vast personal potential gain.

I end this brief and I add selective historical narrative here and one immediate and obvious lesson that might be taken from it is that regulation is good and that left unregulated, banks and other financial institutions will take risks that with time, and predictably will lead to crisis. The actual lesson to take from this is a lot more complex and nuanced, and I will turn to that in my next series installment. As a foretaste to it I will simply note that the absolute levels of potential risk and benefit are not as important as the symmetrical distribution of risk and benefit as shared – ideally, at least, equally by all involved stakeholders. And the real risk of instability and crisis comes from risk and benefits distribution asymmetry. I will also add here that not all regulatory control works and not all of it is beneficial – and that symmetry of benefit and of perceived benefit from regulatory control become important too.

You can find this and related postings at Macroeconomics and Business and also at Outsourcing and Globalization.

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