Almost ten years since the beginning of the Great Recession, the fallout is still fresh in the minds of most Americans, politicians, and economists. The impact it had on the the greater part of the American people pushed Congress to pass reforms to protect their constituents and to prevent a similar crisis from happening in the future. This response is similar to actions taken after the Great Depression, a salient example being the passage of Glass-Steagall. As memories of the Great Depression began to fade, deregulation of the financial sector ensued in the 1980s and thereafter. This push for deregulation was grounded in theories of law and economics. In this post, I aim to examine those basic theories and the way in which they support deregulation, how the application of those theories contributed to the downturn, and how the theories are still used today in support of deregulation.
There are two schools of economics that will guide this discussion. The first is the school of macroeconomics. Macroeconomics examines “the decision-making of the whole economy instead of focusing on individual markets.” ((Macroeconomics, Investopedia, http://www.investopedia.com/terms/m/macroeconomics.asp (last visited Apr. 3, 2017).)) Narrowing the scope, microeconomics focuses on individual transactions and how actors in a given situation respond to certain events. ((Microeconomics, Investopedia, http://www.investopedia.com/terms/m/microeconomics.asp (last visited Apr. 3, 2017).)) Application of microeconomic theory focuses on achieving efficiency among transacting parties and looks to develop a model where one can locate an equilibrium and make adjustments in the policy to achieve that equilibrium. ((Id.)) Many theories of law and economics are grounded in microeconomics. While it seems that a macroeconomic approach to economic policy would make the most sense because of its more holistic view, economists and politicians have used, and continue to use, theories of microeconomics to argue for deregulation.
In the 1980s, the efficient market hypothesis, which is grounded in microeconomics, was used to push for deregulation of the financial sector. The efficient market hypothesis simply states that all public information is reflected in the price of an asset or security. ((David M. Driesen, Legal Theory Lessons from the Financial Crisis, 40 Iowa J. Corp. L. 55, 60 (2014).)) For example, in an efficient market, an investor can look at the price of a company’s stock trading on a national exchange and rely on the price of the stock as encompassing all past information that has been disclosed as well as on the proposition that future positive and negative disclosures will be reflected by increases and decreases in the stock price. This belief in the efficient market has led those in the field of law and economics to conclude that the financial market does not need a great deal of governmental regulation because the market is self-correcting. ((Id.)) Coupled with the idea that these institutions are rational actors, this belief had bolstered the argument that the government need not be involved.
This push for deregulation led to the erosion of the limitations put in place on the banking industry by the Glass-Steagall Act. In a broad sense, Glass-Steagall required that banks separate their general commercial banking business from securities activities. ((Reem Heakal, What Was The Glass-Steagall Act?, Investopedia (Nov. 16, 2015), http://www.investopedia.com/articles/03/071603.asp.)) By creating a wall between the two activities, the act was an attempt to “prevent the banks’ use of deposits in the case of a failed underwriting job.” ((Id.)) In the 1980s, many economists had come out against the strict barrier that Glass-Steagall had put in place, claiming that, from a law and economics point of view, the costs outweighed the benefits and, further, that the scheme was inefficient. As an example, William Shuggart supported repealing the act, arguing that it imposed costs with no apparent benefits for depositors. ((William F. Shughart II, A Public Choice Perspective of the Banking Act of 1933, 7 Cato J. 595, 612 (1988).)) He further argued that banks engaged in investments by adjusting for risk at the highest possible rate before transacting. ((Id.)) Another scholar in the field of law and economics, Daniel R. Fischel, argued that Glass-Steagall was misguided because these financial institutions valued their reputation, and would police themselves to avoid tarnishing that reputation. ((Daniel R. Fischel et al., The Regulation of Banks and Bank Holding Companies, 73 Va. L. Rev. 301, 305 (1987).)) Both of these justifications are grounded in theories of microeconomics that push for efficiency over regulation, assuming that banks are rational actors and take necessary precautions to protect the financial market. As we saw in 2008, this appeared not to be the case.
At the height of the Great Recession, a number of banks and investment firms were on the brink of collapse, and some required a government bailout to stay afloat. Otheres were forced to file for bankruptcy. Many scholars have pointed to Glass-Steagall’s repeal, and the attendant deregulation of a number of sectors in the financial industry, as an important catalyst of the financial crisis. In response to the fallout of the recession, the Obama administration advocated for a number of reforms to prevent a similar crisis from happening in the future and to protect the average American. The Trump administration has taken a different approach, and is seeming to have fallen back to using microeconomic theories to push for deregulation.
One example is Trump’s promise to repeal Dodd-Frank. The Trump administration has argued that Dodd-Frank imposes excessive costs on banks and that the “administration could write better, more efficient regulations and also expressed confidence that the market – smarter from the lessons of the crisis – would be able to regulate itself as restrictions were loosened.” ((Antoine Gara, With A Stroke Of The Pen, Donald Trump Aims To Wave Goodbye To The Dodd Frank Act, Forbes (Feb. 3, 2017), https://www.forbes.com/sites/antoinegara/2017/02/03/with-a-stroke-of-the-pen-donald-trump-will-wave-goodbye-to-the-dodd-frank-act/#4b9401611481.)) This argument is similar to that made by Daniel Fischel, mentioned above: that the banks are rational actors and efficiency with little government intervention should be goal. These arguments are not limited to the financial sector. Trump has argued for deregulation in a number of sectors of the economy, ranging from the oil and coal industries to the FDA. With a republican-controlled Congress, Trump may just get the deregulation he is hoping for.
While it may not be obvious that these basic principles of law and economics are a driving force behind deregulation of the financial sector, it is clear that their overarching themes are present in the reasons and goals of those pushing for deregulation. Are efficiency and the assumption that actors in the market are rational the best reasons to push for deregulation? History has shown that actors in the financial market may not always act rationally. Further, credible attacks on the efficient market hypothesis appear to have weakened that theory. Economists have claimed that changes in market prices can be a result of herd behavior and bubbles, and that therefore the market may not be perfectly efficient. ((Joe Nocera, Poking Holes in a Theory on Markets, New York Times (June 5, 2009), http://www.nytimes.com/2009/06/06/business/06nocera.html.)) A respected market strategist, Jeremy Grantham, vocally came out against the efficient market hypothesis and claimed that it “is more or less directly responsible for the financial crisis.” ((Id.)) It is time that the country’s economic policy focus on aspects of macroeconomics, which has a more long-range view and examines the economy as a whole, rather than fall back on certain efficient outcomes. These short-term goals are red flags and could put the economy at risk again should Trump make good on his promises.