Gramm, AEI Panelists Set the Record Straight on Deregulation and the Financial Crisis

WASHINGTON, JANUARY 27, 2009--While casting about for causes of America's financial crisis during the heat of the presidential election last fall, many in the media and Congress hit upon a theme of rampant "Republican" deregulation. That narrative stuck. But is deregulation really to blame? AEI convened a panel of financial experts from across the ideological spectrum headlined by former Senator Phil Gramm (R-Texas), to address not only what caused the current crisis, but also how to prevent the next one. As Gramm said: "He who writes history determines the future. . . . What is perceived by the general public to be the cause of this crisis will have a profound impact on the response of Congress."

Retired from public office since 2002 and now the vice chairman of UBS Investment Bank, Gramm explained his role in crafting two pieces of legislation: the Gramm-Leach-Bliley Act of 1999 (GLBA) and the Commodity Futures Modernization Act of 2000 (CFMA). According to Gramm, GLBA "doesn't deregulate anything." In fact, the bill "does not have a deregulatory section in it." Instead, it repealed provisions of the Glass-Steagall Act of 1933 that prevented affiliation between commercial and investment banks. Considering the prominent failures and rescues of banks, insurance companies, and securities firms in 2008, GLBA offered a convenient target. Unfortunately for that theory, Gramm said, the regulations in Glass-Steagall were already more like "Swiss cheese" by 1999, and even without GLBA, not one of the investment banks that failed or had to be rescued by the federal government in 2008 would have been in violation of Glass-Steagall anyway. 

In 2000, when Congress was debating CFMA (which was intended to give "legal certainty" to credit default swaps for regulatory purposes), Gramm said that "nobody had ever heard of credit default swaps." Ultimately, Congress determined that "swaps are not futures," even though it had been suggested by at least one commodities regulator that they were. According to Gramm, swaps were still regulated based on the laws already in place regarding the swap's "underlying assets," often some derivation of subprime mortgage loans. Contrary to the media narrative, CFMA enjoyed bipartisan support at the time it was passed and, like GLBA, was signed by President Bill Clinton.

Rather than blame deregulation, Gramm pointed to the "politicization of the housing market," for which he himself admitted some responsibility. Gramm said the laws were not faulty, but rather it was the regulators themselves, who "lacked the will to act because they thought the process was safe."

Gramm's claims were largely supported by the panel. Adam S. Posen, deputy director of the Peterson Institute for International Economics, admitted that "there hasn't been that much deregulation in the last few decades." Posen believed the crisis has exposed the flaws of ratings agencies, and he suggested doing away with them altogether, embracing a policy of buyer beware. Posen went on to castigate Fannie Mae and Freddie Mac, saying their collapse should have been no surprise. "If something is half public and half private, it will cheat and it will fail."

Eswar S. Prasad of Cornell University and the Brookings Institution agreed that much of the current crisis could have been avoided if regulators had simply applied "the rules that are on the books." The rest of the world, according to Prasad, believed in the American financial system and its regulations, and consequently gave the United States "enough [financial] rope to hang itself" when those regulations were flouted for the sake of political and financial expediency.

AEI's Allan H. Meltzer and Peter J. Wallison addressed the way to move forward, or, more accurately, the way not to move forward. Meltzer pointed out the importance of allowing prices to find a floor. "When the housing market stops declining," Meltzer said, "we'll sort the system out." He recalled a meeting with President Jimmy Carter during the recession in 1976 at which Meltzer predicted Carter's stimulus policies would give the economy a "temporary high," leaving Carter to "run for reelection with a lot of inflation"--which is exactly what happened. In Meltzer's formulation, "capitalism without failure is like religion without sin." You can't have one without the other, and the benefits of each far outweigh the costs.

Wallison was even more pointed in his criticism of the current reactionary sentiment manifested in public calls for increased regulation. It would be a mistake to extend to other sectors of the economy "regulation that has so clearly failed when it has been applied to the banking industry," he said. Specifically, Wallison pointed to the "pernicious idea" introduced in a recent G30 report, that the federal government should increase regulation (and hence federal protection) for "systemically significant" companies. "Once you identify a company as systemically significant," Wallison warned, "you are essentially saying it's too big to fail. And what do you get when a company is too big to fail? We already have two; they're called Fannie Mae and Freddie Mac."

--JOSH EBOCH

For video, audio, and event information, visit www.aei.org/event1862.

Peter J. Wallison addresses the financial crisis and financial regulation in several recent issues of his Financial Services Outlook series. AEI scholars' work on the financial crisis is also available at www.aei.org/financialcrisis.

For media inquiries, contact Veronique Rodman at 202.862.4870 or vrodman@aei.org.

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