Fallacies of market-friendly financial regulation conducted by the Federal Reserve in the 1990s and 2000s

Abstract

This article draws from the Minskyian/Post-Keynesian literature on the dynamics of the 21st century capitalism and points to the incompatibility between market-efficiency-based micro-prudential regulatory reforms—conducted by the Federal Reserve System in the 1990s–2000s—and financial system stability. We argue that these reforms rested on a twofold efficiency fallacy: efficient financial markets/regulation-free innovative dynamics and informational transparency seeking market-friendly regulation. Thus, the financial instabilities of the 2000s do not rest on accidental strategies of some irrational individuals but on the liberal regulatory changes implemented in the last decades. This article supplies evidence about the prevalence of this theoretical and policy stance, documenting through speeches and hearings given over the period 1999–2010 by the Fed’s officials. We then show that major regulatory changes conducted by the Fed were based on micro-prudential measures consistent with the blind faith of authorities in the capacity of free financial markets to self-regulate. This faith does not seem to be replaced by an alternative objective regulatory approach even in the aftermath of the world-wide 2007–2008 catastrophe. The major conclusion of this study is that a relevant alternative regulation should rest on a macro-prudential approach seeking to deal with the endogenously unstable dynamics of capitalism.

Keywords:

• Federal Reserve System
• financial crisis
• financial regulation
• New Neoclassical Synthesis
• self-regulation
• systemic risk

JEL CLASSIFICATIONS:

• G01
• G28
• H41

Notes

Notes

1 More accurately, this means that when we deal with the working of a capitalist economy, we deal with a specific monetary system which is not a mere real-product-exchange economy through some self-equilibrating market-price mechanisms but a private expectations-based decentralized accumulation economy where credit-money based debt-financing operations continuously result in financial relations tied up among various aggregated actors (mainly banks, enterprises, financial intermediaries but also households). The continuity of these relations determines the continuity of a capitalist economy. One of the very crucial contributions of Hyman Minsky to the economic theory is actually related to his alternative monetary analysis of capitalism: “In a capitalist economy money is tied up with the process of creating and controlling capital assets. Money is not just a universal ration coupon that makes trading possible without a double coincidence of wants: it is a type of bond that arises as banks finance activity and positions in capital and financial assets. Because of the special import of the relation between banks and money in our economy, these deposit banks will be emphasized in this chapter, with side remarks on nonbank financial intermediaries and investment banking.” Minsky (1986, 250). Minsky (Ibid, 278) explicitly adopts an endogenous money approach as a theoretical alternative to the mainstream economics: “Money is unique in that it is created in the act of financing by a bank and is destroyed as the commitments on debt instruments owned by banks are fulfilled. Because money is created and destroyed in the normal course of business, the amount outstanding is responsive to the demand for financing. Banks are important exactly because they do not operate under the constraint of a money lender-banks do not need to have money on hand in order to lend money.”

Criticizing the narrow view of bank, Minsky (Ibid.: 252) then points to the crucial role played by banks in a capitalist economy and also focuses on the difficulty of controlling the banking system: “In truth, the Federal Reserve’s control over banks is imprecise. Banking is a dynamic and innovative profit-making business. Bank entrepreneurs actively seek to build their fortunes by adjusting their assets and liabilities, that is, their lines of business, to take advantage of perceived profit opportunities. This banker’s activism affects not just the volume and the distribution of finance but also the cyclical behavior of prices, incomes, and employment.”

This is undoubtedly the core of the opposition between those who regard the economy in real terms as an engine of “natural optimal” equilibrium and those who maintain, on the contrary, that our world is monetary and must be organized by the visible hand of collective action.

2 Murphy (2015) gives a comprehensive account of the regulatory framework of the US monetary and financial system after the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) in the aftermath of the 2007–2008 financial crisis.

3 In this analysis, we seek to show the various ways through which the mainstream approach to market economy (that we call the Synthesis) appeared in the public messages of the major public regulators. However, we believe that some scientometric approaches (like the Cortext platform and the VOSviewer bibliometric analysis software, especially for keyword co-occurrence and also for co-authorship networks) could allow the study to perform concept-related bibliographic coupling analyses in a future version of this research that could be based on the use of some concepts and assertions in order to support ideology-guided economic policies and at the same time to make people familiar with these ideological assertions and believe in their relevance.

4 For instance, Dodd-Frank Act in the United States and the Basel III agreement.

5 We mean by “deregulation” an institutional transformation of the public regulation and supervision mechanisms into some market-relying self-regulation frameworks. Such a transformation usually requires a frank retreat of restrictive public rules in order to reduce the constraining character of the regulatory framework in force and then to let market actors take care of themselves, and also, of macroeconomic stability.

6 Such a position mainly rests on a specific interpretation of the results of the General Equilibrium Theory (see, for instance, Arrow and Hahn 1971; Debreu 1998). Although beyond the scope of this article, it is worth noting—very briefly—that actually, the general equilibrium foundations are used in two opposed ways within the literature. One way is the conceptual approximation among the concepts of equilibrium, optimum and efficiency. This approximation, though usually used in a confused way, is supported by various works in terms of market rationality against shocks and downturns, like the Real Business Cycles models (King and Plosser 1984), the Rational Expectations models (Lucas 1972) and the New Keynesian interpretations (Mankiw 1989) (see Stadler 1994, for a comprehensive overview). This perspective was reinforced by the work of Eugene Fama who developed the “Efficient market hypothesis,” regarded as the basic reference for the assumption of efficient financial markets (see for a historical presentation of this hypothesis, Sewell 2011). Hahn (1983) argues in unequivocal terms that Monetarism and its corollary, the Rational expectations theory cannot offer a plausible solution to the most pervasive economic problems. Another virulent critique comes from Hahn and Solow (1995) who show how the New classical view got macroeconomics wrong.

Another way, also called “the mainstream economics,” consists of thinking of the working of markets in imperfect terms through more dynamic tools, such as game theoretic models or information economics, in order to assess the way and the scope of public interventions in markets through alternative regulatory frameworks. From this perspective, 2014 Nobel laureate Jean Tirole (Laffont and Tirole 1993) might be regarded as the representative of this second branch of the equilibrium economics that focuses on the issues related to market regulation and optimal incentives mechanisms. For a recent version of this current, see Léautier (2019).

7 In a review of a book of Alan Greenspan, Mankiw (2013) documents “the social dynamic of the economics profession” and point to the “standard route to becoming a star economist”:

“Step 1 is to attend an elite college, like Harvard (Bernanke), M.I.T. (Summers) or Brown (Yellen), followed by a top Ph.D. program at a place like M.I.T. (Bernanke), Harvard (Summers) or Yale (Yellen). Next, establish yourself as one of the smartest kids on campus, though not necessarily one of the most popular. While in graduate school, find a prominent mentor. For Bernanke, it was Stanley Fischer (later governor of the Bank of Israel). For Summers, it was Martin Feldstein (later Ronald Reagan’s chief economist). For Yellen, it was James Tobin (a former adviser to John F. Kennedy). If your dissertation is good enough, you get to become an assistant professor at yet another elite institution, like Stanford (Bernanke), M.I.T. (Summers) or Harvard (Yellen). There you spend your time teaching and, more important for your future career, writing scholarly papers. These papers may be unintelligible to mere Muggles, but that’s O.K. Your goal is to impress your fellow economists. If your articles are sufficiently numerous, well published and widely cited, you are eventually awarded a tenured sinecure in a top economics department or business school, like Princeton’s (Bernanke), Harvard’s (Summers) or Berkeley’s (Yellen). Having achieved this rung of success, you are on your way to becoming an economist’s economist. At this point, paths diverge. Most economics professors are content spending their careers at universities. Some temporarily depart from academia to make a small contribution to the policy world. (…) But most of these professors-on-leave soon return to the comforts of the ivory tower. Yet a few tenured economists become restless with the obscurity, slow pace and petty politics of academia. They yearn for the fame, fast pace and petty politics of Washington. With the help of political benefactors, they find themselves in positions of real authority. Bernanke, Summers and Yellen are examples. (…) Greenspan’s rise to prominence came entirely from political appointments. He served as chief economist to Gerald Ford from 1974 to 1977. He was appointed Fed chairman by Reagan in 1987 and then reappointed by George H. W. Bush, Bill Clinton and George W. Bush. He kept the job for an astounding 18 years.”

8 Since the market value of Nasdaq companies that peaked at $6.7 trillion in March 2000 bottomed out at $1.6 trillion in October 2002.

9 Several companies were accused of fraud and misleading investors by the U.S. Securities and Exchange Commission that charged fines against Citigroup and Merrill Lynch, among others.

10 For these approaches market imperfection does mean that there can exist some factors (resting on political, social, historical, human conditions of economies) that might affect the expected efficient working of markets and prevent them, at least at the short-run, from achieving Pareto optimal equilibrium. It is worth noting, in parallel to the remarks of the footnotes n°1 and n°6, that these various approaches converge toward two core hypotheses: amonetary (real) nature of economic relations and the long-term viability of the economic system thanks to the market mechanisms. We might then call such a theoretical stance the market viability doctrine. Thus, whatever the specific assumptions of each sub-model, these approaches rely on the long-term market equilibrium, whether general or partial, with or without public support.

11 See Harnay and Scialom (2016) for a detailed presentation of such a theoretical and political evolution.

12 It is worth noting that Alan Greenspan was the longest serving Chairman of the Fed between August 1987 and February 2006 and framed and implemented structural regulatory changes in the US financial markets and gave core direction to US and major world economies’ monetary and financial policies.

13 This view was iterated in several speeches given by Greenspan. See Greenspan 1997b, 1998, 1999a, 2000b, 2001a, 2002b, 2002c, among others.

14 We owe this remark to one of the Reviewers.

15 The case of Bernard Madoff, the former NASDAQ Chairman between 1990 and 1993, might be regarded from this perspective. Madoff’s Investment Securities society developed various very profitable products in the aftermath of the dot-com crisis while several SEC investigations resulted in neither a finding of fraud, nor a referral to the SEC Commissioners for legal action in the 2000s. Madoff’s business collapsed only after the beginning of the turmoil in late 2008 and Madoff became a sort of “black sheep” of the finance family.

16 The exchange between the Chairman of the US House Committee and Alan Greenspan (United States House Committee on Oversight and Government Reform 2008, 44–45) is very informative about the hesitation of the profession and the professionals to admit the weaknesses of their faith in liberalized markets:

Chairman WAXMAN. So you don’t think you were wrong in not wanting to regulate the derivatives?

Mr. GREENSPAN. Well, it depends on which derivatives we are talking about. Credit default swaps, I think, have serious problems associated with them. But, the bulk of derivatives, and, indeed, the only derivatives that existed when the major discussion started in 1999, were those of interest rate risk and foreign exchange risk.

Chairman WAXMAN. Let me interrupt you, because we do have a limited amount of time, but you said in your statement that you delivered the whole intellectual edifice of modern risk management collapsed. You also said, ‘‘those of us who have looked to the selfinterest of lending institutions to protect shareholders’ equity, myself especially, are in a ‘‘state of shock, disbelief.’’ Now that sounds to me like you are saying that those who trusted the market to regulate itself, yourself included, made a serious mistake.

Mr. GREENSPAN. Well, I think that’s true of some products, but not all. I think that’s the reason why it’s important to distinguish the size of this problem and its nature. What I wanted to point out was that the—excluding credit default swaps, derivatives markets are working well.

Chairman WAXMAN. Well, where did you make a mistake then?

Mr. GREENSPAN. I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such is that they were best capable of protecting their own shareholders and their equity in the firms.”

17 Main changes in the regulatory framework are often also signed and published in joint press releases by several US institutions, mainly: the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the National Credit Union Administration and the Board of Governors of the Federal Reserve System itself.

18 See FRB (2000a, 2000b, 2000c, 2000d, 2000e, 2001a, 2000b, 2000c).

19 With regard to the strength of this kind of faith, Ülgen (2015, 382–383) proposes, following Akerlof and Dickens (1982), an interpretation in terms of cognitive dissonance: “people who are able to make choices about future directions—given a set of (available) information—can also manipulate their own beliefs by selecting sources of information likely to confirm “desired” beliefs. When economic actors convince themselves that their decisions are relevant, they potentially make judgement errors due to the divergence between their beliefs and the true state of the world. But at individual (microeconomic) level, the true state of the world (e.g., the systemic macro situation) cannot be observed in any way but a posteriori. This makes a crucial difference between micro-rationality and macro-stability. The former is limited, as it is based on private information about the micro-environment, while the macro-stability seeks to assess the situation of the whole system and then to evaluate its possible deviation from sustainability/viability”

20 Regulation C implements the Home Mortgage Disclosure Act.

21 Regulation B implements the Equal Credit Opportunity Act.

Additional information

Notes on contributors

Juan Barredo-Zuriarrain

Juan Barredo-Zuriarrain is at Faculty of Economics, University of the Basque Country, Bilbao, Spain.

Faruk Ülgen

Faruk Ülgen is at Grenoble Faculty of Economics, University Grenoble Alpes, Grenoble, France.

Ognjen Radonjić

Ognjen Radonjić is at Faculty of Philosophy, University of Belgrade, Belgrade, Serbia.