The History of Deregulation: Why Greed and Stable Markets Don't Mix

THE HISTORY OF DEREGULATION: WHY GREED AND STABLE MARKETS DON'T MIX

By Steve Thomsen

You’re in line for the bank. People are filling the building to the brim with stacks of cash to make deposits with. It’s a lot easier to have someone else keep a close eye on your hard-earned money while you deal with life, after all. So when you go and make this deposit, the assumption is that the cash you’ve put in magically goes to an over-sized safe somewhere. The bank keeps their hands off your money until you request for it back. Simple, right?

Until very recently, you would be correct in this assumption. Depositor banks used to function just like the name implied: you drop your money off, they hang on to it. The banks were simply depositories, and your money was off limits to any of the institution’s riskier financial practices. This would include practices like investment banking (they weren’t allowed to gamble with your money), insurance for financial products (they weren’t allowed to use your money to keep theirs from going bad), and leverage for the firm (they weren’t allowed to pretend your cash is actually their net worth  or claim it as reserve capital). This was the safest possible way to keep the depositor bank from going bad.

There are actually three different types of banks: (WARNING: video is over an hour in legnth... if you have the patience, please watch!) These are, in a nutshell: commercial banks (where consumers deposit their money), investment banks (where investors buy financial products like mortgage payments and credit card debts), and insurance companies (where people buy policies to protect their investments from going bad.) These three institutions were separated by law to prevent a crisis. What I’m about to explain is how these were all combined and then used to destroy a massive amount of equity in the system, never to be recovered.

We learned our lesson about banking and its uses the hard way. You may have heard of a catastrophic financial emergency in the early 1900’s. It was called the Great Depression. We fell off a financial cliff due to unregulated banking activity. Banks were able to leverage their institute in much higher amounts than the actual money they had available. They were able to use depositor’s money to handle their own risky investments. And if anything went wrong… oh well, stuff happens. This careless attitude eventually caused the stock market to crash and millions of Americans to lose their jobs.

After this terrible financial tragedy, we were introduced to a new piece of legislation called the Glass-Steagall Act. What Glass-Steagall did was compartmentalize the banking industry to prevent certain elements of banking to interfere with customers. Specifically, it divided the banking industry into three very air-tight compartments: commercial banks, investment banks, and insurance companies. With this new piece of legislation, the financial industry was now strictly forbidden from speculating with depositors’ money. If big-shot investment bankers wanted to gamble, they had to do so on their own dime. And if they failed, they had to pay for the damage.

This is why we were able to avoid a single financial disaster for nearly 50 years. In that time, the American economy boomed. Part of that was because we had no major foreign competitors (Japan and Germany had been decimated from the war) but it was also thanks to the prevention of unregulated banking. We were safe, and so was our life savings.

In 1980, Ronald Reagan was elected the 40th president of the United States. Reagan’s aspirations as president were ambitious: he wanted to lower income taxes across the board, specifically through fixing the tax code and lowering corporate taxes (sound familiar?). The only way he could pull this off was with the help of then-Treasury Secretary Donald Regan, the former CEO of Meryl Lynch. Regan, who eventually became the White House Chief of Staff, was an investment banker hot-shot with a tenacity for getting the investment banks to go public. These formerly private firms were suddenly flooded with boatloads of cash, and people on Wall Street began making enormous sums of money.  Regan and Reagan came up with a saying: “turning the bull loose.” The bull, in this case, was the massive power of the financial industry.

Together, Reagan and Regan did just that: they de-regulated the once very-heavily regulated financial industry. Many things resulted from loosening the regulations: most notably, savings and loans companies didn’t need to sit on their hands with their depositor’s money. Now they were allowed to make risky bets with their holdings (AKA YOUR holdings.) The administration justified this practice by claiming that, in the hands of professionals, no foreseeable risk was involved.

Well, by this point we all know how well that turned out: out of the 3234 savings firms in the country at the time, 747 of them went bankrupt. The proverbial opening of the cookie jar was too enticing, and Wall Street got too greedy. They dug too deep into their capital reserves (AKA your money) and drove their firms into the ground. Consequentially, many people who invested their life savings into these programs lost it all. The S&L crisis ultimately cost tax payers $124 BILLION (!!) and, supposedly, our lesson had been learned.

In the 1992, Bill Clinton was inaugurated into office. A political mastermind, Bill Clinton was thought of to be the man who could fix everything with the economy. And in some regards people were right to feel this way. He was able to balance the budget and produce 4 surplus economic reports in a row. The deficit caused by the S&L scandal was being paid off. Surely, the Democrats had it right.

Unfortunately, this isn’t the whole truth. The Fed Chairman at the time was Alan Greenspan, who also served under Reagan. Alan Greenspan was an economist and former disciple of the infamous Aynn Rand. An objectivist, Greenspan did not believe in regulation in any way, shape, or form. He believed in self-motivated greed and the benefits it had on society. This was reflected very thoroughly by his policies and the ways he carried them out. And the biggest giant blocking his way to an unregulated economy: Glass-Steagall.

In October of 1998, Citibank broke the law. They merged with a financial giant by the name of Travelers. The reason it was illegal for Citibank to acquire Travelers was because A) the two firms were too large to be combined without putting the market at risk and B) its combining of various financial services like insurance and investment banking. Though this was blatantly against Federal law, Alan Greenspan turned a blind eye to the practice. The man in charge of monetary policy in this country was not going to pay any attention to a blatant crime. And that’s when the policy makers started scrambling to make the illegal Citibank-Travelers merger, well, legal.

And they succeeded. Glass Steagall was deemed outdated to the modern financial world. Instead, it was replaced with a new piece of legislation called the Gramm-Leach-Bliley Act. Senator Phil Gramm was one of the sponsors for the bill (hence the name), and he and his wife Wendy benefited tremendously from this new law. What G-L-B does is tear down the restrictions previously held on financial institutes that prevent it from gambling with depositor’s money. It’s a new day and age, they thought. They knew the modern world would be able to let professionals handle large sums of money, even if it wasn’t there’s, and come home with greater capital positions than previously held. It made mergers like Citigroup legal. It let banks leverage their firms at much higher rates. And, most importantly, it opened the floodgates for several new financial products to storm the market. It laid the red carpet for the ticking time bomb that was now the American financial institution.

We had learned our lesson. Then, as time passed by, we forgot. Then we went back to the same money games that led us into the Great Depression. And now, even after crashing the whole system yet again, we still haven’t seemed to learn our lesson.

In the next post I’ll go over what exactly happened when we let these floodgates open. We’ll learn that when we turn a blind eye to the hand in the cookie jar, we’ll be left with nothing but crumbs.