The deregulation culture is a central and not fully understood element in the story of how we got into the worst financial and economic crisis of the past 75 years. Understanding how culture affects policy provides important guidance for policymakers and regulators as they put in place new organizational structures charged with promoting and protecting efficient markets.
[IMGCAP(1)]For the better part of the past two decades Wall Street and Washington, D.C., placed much faith in the free market’s unparalleled ability to foster innovation that would create wealth. Our society exalted the ingenuity that designed ever more complex instruments to perfectly match the investors’ individualized tolerance for risk. This faith drove a parallel fear that any limitation or
regulatory measure would invariably impede the financial markets’ ability to create value through financial engineering. Confidence in the private sector went hand in hand with distrust of public actors and a lack of confidence in their basic intelligence or ability to serve the larger public good. The core conservative tenet of limited government loosened our attitudes toward financial markets across too much of the political spectrum.
Alan Greenspan and his Federal Reserve best represent this ideology. In fact, Greenspan said he believed “free and competitive markets are the unrivaled way to organize market economies; we have tried regulation, ranging from heavy to central planning and none of it meaningfully works.— President George W. Bush similarly argued that his core challenge was preventing financial regulation from burdening the economy.
And the Clinton administration operated in the context of the same prevailing values. The greatest concern we faced was shaking the markets’ confidence in significant financial instruments. Once it was clear to everyone that over-the-counter derivatives would be exempt from regulatory oversight, trillions of dollars flowed to once obscure — but ever opaque — products.
The culture of market fundamentalism applied to systemic risks in the mortgage market as well. It took the Federal Reserve — which had been given a clear directive by Congress as far back as 1994 to regulate the subprime market and rein in high-cost lending — until 2006 to issue guidance on “nontraditional mortgage product risks.— The Office of the Comptroller of the Currency, the regulator charged with overseeing national banks, even went so far under the Bush administration as to sue state regulators who attempted to provide guidelines for products and institutions within their states on the grounds of federal pre-emption. Eric Stein, now deputy assistant secretary for consumer protection at the Treasury Department, said of the OCC’s actions, “the result was a level playing field on a field with no rules.—
As the alarm bells rang more loudly and more frequently, the problem was not that the Bush administration’s regulators had no authority to act — guarding against systemic risks was always the regulators’ paramount obligation. The problem was that acting would go against deeply embedded instincts.
In the aftermath of the financial crisis, creating a more effective regulatory regime requires developing a structure with institutions that can break out of collective thinking and invite challenging thought. The goal of and belief in free markets alone must give way to a more sophisticated vision that wisely combines public and private forces to create and maintain efficient markets.
Efficient markets need regulation to set appropriate ground rules and establish transparency and fairness. The philosophy that celebrated a race to the bottom for a supposedly freer marketplace that would be the envy of the world and most attractive to global capital led to bad money and bad products crowding out the good.
In many ways the financial crisis was not a liquidity crisis but a credit crisis, as indicated by record spreads last fall between Treasury securities and interbank lending rates. Markets failed because no one trusted anyone else.
It is the role of regulators to provide the clear, consistent rules of the game that allow market participants — investors and consumers alike — to have confidence that no one else has an unfair advantage in any interaction. We’ll set the stage for a race to the top when ground rules are comprehensive and result in a level playing field, information is widely available, human behavior and not just a mythical rational actor is assumed, and participants know there’s a cop on the beat.
The deregulatory culture of the past two decades must be replaced with a system that is aware of how individuals, financial instruments and markets actually function. Regulation for its own sake is not the goal, but when the regulations are well-grounded in behavioral economics and sociology, for example, the quality of interaction between market participants can be improved.
Establishing a well-functioning regulatory structure with regulators who actively promote transparent and fair markets by laying out firm ground rules and calling fouls when they occur is not a recipe for infringing on financial markets. It is a critical step toward maintaining markets that do what they do best — creating wealth and improving our standard of living.
Sarah Rosen Wartell, an executive vice president of the Center for American Progress, served as deputy director of the National Economic Council from 1998 to 2000.