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Causes Of The Great Recession: Too Much Or Too Little Regulation?

Causes Of The Great Recession: Too Much Or Too Little Regulation?

By Pallavi Mehra

American economist and op-ed columnist Paul Krugman argues that the financial crisis was caused by deregulation, whereas, Italian economists Giampaolo Galli and Alberto Mingardi argue that deregulation did not cause the financial crisis.

Paul Krugman, uses arguments from Edward M. Gramlich, a Federal Reserve official and Barney Frank, the former chairman of the House Financial Services Committee to support his point of view which is that false ideology caused the financial crisis. Krugman states that Gramlich had warned Alan Greenspan in 2000, the former chairman of the Federal Reserve that regulation of subprime lending should be increased. Gramlich also asserted in May 2004, that there was escalating fraud occurring in the subprime loans market. However, both of his warnings were ignored and subprime lending continued to soar even after people knew that there existed a housing bubble.

Krugman continues by noting that nothing was done to avert the crisis because of a “wrong ideology”. Krugman attributes the financial disaster to the “laissez-faire” philosophy that was rampant amongst the U.S government officials, specifically the ideology of Alan Greenspan. Krugman, continues to say that “there were and are men who believe that government is always the problem, never the solution, that regulation is always a bad thing.” Here Krugman is referring to Alan Greenspan, Larry Summers and Robert Rubin who were a part of the Presidents Working Group that was the most important body that advised the President on financial matters amongst others.  Krugman asserts this by claiming that the ‘these men’ were wrong as they trusted markets to correct themselves which did not happen which in turn caused the crisis.

Krugman quotes Barney Frank stating that the result of the sudden rise of unregulated subprime lending was a “tragedy” because of the fact that it was not regulated. Krugman maintains that deregulation resulted in fraud occurring on a large scale by credit rating agencies and lenders. In turn, borrowers and investors were cheated. The rating agencies cheated the investors by rating subprime backed loans with AAA rating, when in reality they were the worst type of loans and should not have been rated AAA.

According to Krugman, borrowers were cheated because they did not understand the subprime mortgages they were offered, for example, the adjustable rate mortgages that had low interest rates in the beginning and the rates suddenly shot up after the first few years. In addition, Mr. Gramlich asserts that the borrowers were those that were the least likely to understand these “exotic loans” and thus were the most likely to be cheated. Gramlich states that “the predictable result was carnage”.  Krugman reiterates to the readers that there was a reason regulation of the financial sector was first introduced, and the financial crisis proves that it is much needed.

On the other hand, economists Giampaolo Galli and Alberto Mingardi put forward reasons for why the financial crisis did not occur because of deregulation. The authors draw out approximately ten different arguments to support their point of view.  The arguments are clearly stated and can be differentiated. The first one is that a few months before the financial crisis it was commonly known within the global financial sector that the “U.S. financial markets were over-regulated”. Financial markets in Asia and Europe were benefiting, since Europe under the European Union was taking measures to deregulate finance. The economists continue by affirming that before the crisis, financial firms regarded the U.S as an expensive and hazardous country to operate in as there were high taxes and many government regulations, specifically regulations regarding “corporate governance and market manipulation”.

The authors assert that in fact many financial firms specifically firms involved in innovate financial practices were slowly moving out of the U.S. and into Europe because of the increasing number of legal cases against them. The economists argue that the U.S. government should not be criticized for their acceptance of over-the- counter (OTC) derivatives without regulations because there was a similar situation in Europe as well. In fact, the OTC market in Europe was nearly three times that of the U.S as argued by the authors.  Also, the ‘so called laws’ of deregulation cannot be blamed for the financial crisis in the U.S. as this was occurring in Europe as well. For example, many critics claim that U.S. banks were allowed to ‘over leverage’. The authors argue that many regulated banks in Europe were more greatly leveraged than many presumed deregulated firms in the U.S.

Giampaolo Galli and Alberto Mingardi contend that predatory lending practices that lead to supposedly unsound household debt cannot be blamed to the U.S. government’s deregulation practices. The economists add that the ratio of the household debt to disposable income was as great or even greater in European countries like Germany, Spain, Sweden, Ireland and the U.K. than the U.S.

The last three reasons cited by the authors argue that in fact regulations caused more problems in the U.S rather than deregulation.  They state that many regulations overlap in the U.S. which was problematic to financial firms as they were answerable to numerous regulatory bodies. The authors use the analogy of a jungle and say that “the U.S regulatory landscape may resemble a jungle, but only because of all the choking vines”. Galli and Mingardi continue by claiming that the intricate regulatory structure in the U.S. is responsible for creating a moral hazard which has been widely attributed as a cause of the financial crisis.

Finally, the last reason given by them is that regulation and not deregulation creates incentives for risk taking.  They claim that regulation to an extent should be implemented, but when it is excessive and overlapping as in the case of the regulatory system in the U.S. before the financial crisis, the predictable outcome is a disaster. This is because firms have to take risks which they would not have if their actions had not been curtailed due to regulations and controls. Therefore, they not only affirm that deregulation did not cause the crisis, they go to the extent to state that regulation could be a contributing factor to the crisis.

They also state that after the crisis it is easy for policy makers to think of rules that could have averted the crisis. However, policy formulators should concentrate on the future instead of the past, as knowledge of regulations and its consequences will be required in the future. Finally, according to Galli and Mingardi, policy makers in the future should not blame the ideology of “laissez-faire” as a cause of the crisis. If they do so, they would be making a mistake due to the reasons stated above. This can be contrasted with Krugman’s assertions, as Krugman emphatically claims that the philosophy of ‘laissez- faire’ was wrong.

Galli and Mingardi thus refute the claim that deregulation caused the crisis. However, they do not refute any of the arguments that Krugman talks about. Galli and Mingardi assert that the U.S. financial sector was in reality over regulated and not deregulated. Therefore, they refute the claim by affirming that there was no deregulation, so it cannot cause the financial crisis.

After studying both the points of view, Krugman’s arguments still hold true. His statements regarding how deregulation caused fraud in the subprime lending sector are not disputed by Galli and Mingardi. Krugman, uses valid examples of the rating agencies and lenders to prove his point that fraud occurred on a large scale in the subprime lending market. Whereas, many of the arguments bought up by Galli and Mingardi are not validated. For example, they state that it was commonly known that the U.S. economy was over-regulated before the economic crisis but they do not give examples of this presumed overregulation.

In addition, the arguments where they compare the U.S. financial sector to the European financial segment and depict the European one as stable, does not hold true anymore with the collapse of the economies of Ireland, Spain and Greece. Besides, Galli and Mingardi’s point of view that over regulations caused the crisis can be refuted because they do not give any valid examples of any laws, regulations or controls implemented by the government before the economic crisis. The authors, Galli and Mingardi maintain that regulations increased risk taking by financial firms in the U.S. before the economic crisis, if they had mentioned these regulations and laws they are talking about their opinion would have more weight.

Galli and Mingardi state the same ideology that Krugman says is wrong. They claim that “regulation is inherently distortive” and go on to explain this statement with assumptions that are not validated with any real life examples. Their ideas have the same problem that certain economic theories have, its assumptions are wrong in reality. Krugman on the other hand, states real examples from the financial crisis to prove his point. This is the main difference between both the points of view. One is based on false assumptions while the other is not.

Pallavi Mehra is constantly consumed by wanderlust, is a concert enthusiast and a lover of food. She graduated from Dickinson College, USA as an Economics Major with Honors and was the President of the Model UN club. She has been taught by world-renowned Economics experts such as Vera Zamagni, the former president of a regional Italian government, and Gianfranco Pasquino, a former Italian Senator. Her areas of interest are contending economic perspectives, environmental economics, post Keynesian economics and European economic history. Pallavi is currently working at Rajvin Chemicals, Mumbai. Rajvin manufactures environmentally friendly crop-care products. She begins her Masters in Economic Policy Management at SIPA, Columbia University in July 2015. Email her at [email protected]

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