Most Pundits Are Wrong About the Bubble

The repeal of Glass-Steagall has helped us weather the storm.

It’s grind-your-favorite-axe day on the network news shows. The financial crisis is all the fault of dreaded “deregulation,” shout some pundits; others blame the “small government” mentality of the Bush administration and Republicans in Congress.

But haven’t federal and state tax revenues been growing even faster than home prices in most places in the U.S. over the past eight years? Hasn’t the problem with our government’s fiscal affairs been enormous growth in spending and entitlements not seen since the days of LBJ? Congressional Democrats — along with a surprising number of pork-barrel Republicans — demanded nonwar spending on a Great Society scale and the president gave in to buy their votes for the war.

As for the evils of deregulation, exactly which measures are they referring to? Financial deregulation for the past three decades consisted of the removal of deposit interest-rate ceilings, the relaxation of branching powers, and allowing commercial banks to enter underwriting and insurance and other financial activities. Wasn’t the ability for commercial and investment banks to merge (the result of the 1999 Gramm-Leach-Bliley Act, which repealed part of the 1933 Glass-Steagall Act) a major stabilizer to the financial system this past year? Indeed, it allowed Bear Stearns and Merrill Lynch to be acquired by J.P. Morgan Chase and Bank of America, and allowed Goldman Sachs and Morgan Stanley to convert to bank holding companies to help shore up their positions during the mid-September bear runs on their stocks.

Even more to the point, subprime lending, securitization and dealing in swaps were all activities that banks and other financial institutions have had the ability to engage in all along. There is no connection between any of these and deregulation. On the contrary, it was the ever-growing Basel Committee rules for measuring bank risk and allocating capital to absorb that risk (just try reading the Basel standards if you don’t believe me) that failed miserably. The Basel rules outsourced the measurement of risk to ratings agencies or to the modelers within the banks themselves. Incentives were not properly aligned, as those that measured risk profited from underestimating it and earned large fees for doing so.

That ineffectual, Rube Goldberg apparatus was, of course, the direct result of the politicization of prudential regulation by the Basel Committee, which was itself the direct consequence of pursuing “international coordination” among countries, which produced rules that work politically but not economically. International cooperation, in case you haven’t heard, is exactly what the French and the Germans now say was missing in the past few years.

So why blame deregulation and small government? The social psychologist Gustav Jahoda says that unreasonable beliefs often arise in circumstances where people lack control and need to believe in something to get them through a highly stressful situation. And a fellow named Machiavelli might help us to understand a different reason for simplistic explanations.

Here is the non-stress-relieving truth. Severe financial crises have occurred in many countries — roughly 100 over the past 30 years — and even on a global scale many times before. About 2,000 years ago, Tiberius solved an early global financial crisis by making huge zero-interest loans to Roman banks. Sound familiar? These unusual events often reflect a confluence of different circumstances; for the most part they are not the inevitable result of a single, foreseeable fault in the system.

So what really happened and what should we do to make things better? The current financial crisis, like many in the past, had its roots in several areas: loose monetary policy (from 2002-2005, the real fed-funds rate was persistently negative to a degree not seen since the mid-1970s); government subsidies for leverage in real estate (the list is a long one, but the government’s role in Fannie and Freddie tops it); and many other errors by the public and private sector, including longstanding flaws in prudential regulation (see aforementioned Basel rules).

As we try to devise solutions to the regulatory problems, there is plenty of room for improvement and lots of sensible ideas about how to proceed — all of which have been around for a long time. The single most important reform that is needed is the restoration of discipline in the measurement of risk within the banking system.

Academics have been calling for reforms — especially a minimum subordinated debt requirement that would create ongoing, market-based measurement of true bank risk — for many years. In fact, a study of that reform was mandated by the Gramm-Leach-Bliley Act of 1999. Although the study by the Federal Reserve indicated that the reform would be extremely helpful, the big banks successfully lobbied to avoid the imposition of discipline on their risk taking.

The starting point for reform is to begin with a dispassionate and informed assessment of what happened. History is messy, and the careful study of facts offers little satisfaction for one-note Johnnies. It’s easier to just invent one’s own history than to study the real thing (which may explain why invention is so much more popular).

All this reminds me of an old Doonesbury comic strip in which a history teacher tries to shock his class by telling them outrageous made-up facts, only to find that they finally seem to be taking notes. Neither Jahoda nor Machiavelli would be surprised.

Mr. Calomiris, a professor at Columbia Business School, is the author of “U.S. Bank Deregulation in Historical Perspective” (Cambridge University Press, 2006).

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