Introduction
The central contention of this collection is that the literature focusing on the 2008 financial crisis and the reforms in its wake miss large, fundamental trends in finance that preceded and have continued after the crisis itself. We examine financial regulation in a broader context to make this point. We try to demonstrate that financial regulation at the global and domestic levels remains inadequate on a number of fronts, with each chapter providing a different angle to prove this central point. Most of our chapters focus on US (United States) examples, but we argue that the same issues remain unaddressed at the global level. While we do not claim that the regulatory gaps we discuss are the sole causes of financial crises, we contend that failure to address them inevitably raises the probability that they will occur again, thus exacerbating middle and working classesâ anger against finance, capitalism, liberalism, and even democracy (Foroohar 2016).
The failure of regulatory reform at the domestic and global levels can help to explain the political backlash to finance around the world. While the Occupy Wall Street movement has ended, politicians such as New Yorker Donald Trump and UK (United Kingdom) Labour leader Jeremy Corbyn have railed against finance. Although President Trump later brought Wall Street into his administration, claims about corruption on Wall Street were an important part of his election campaign. Reports regarding the evasion of taxes through offshore finance such as those concerning technology giants Apple and Microsoft only add fuel to the tensions evoked by lower wages in the labour market. Furthermore, technology-based leaks such as the Panama and the Paradise Papers have reinforced the perception that financial regulations favour elites to the detriment of middle classes. In the developing world, such leaks have revealed massive corruption through capital outflows from the public sector, with elites investing in a wide range of Western and other offshore assets. These revelations only deepened the ire of Western electorates that no one was held criminally accountable for the questionable and at times fraudulent acts that led to the 2008 crash.
Though the chapters in our volume use different departure points, we organise our analysis of the global financial system in each chapter around four principles. First, we trace the long-term roots of the 2008 financial crisis to regulatory problems in the financial sector dating back decades. Second, we examine the nature of proposed reforms for the financial sector since 2008 and expose their strengths and shortcomings. Third, we focus on the challenges that prevent the building of long-term stability and trust in the US and international financial systems. These challenges include market failure, government failure, regulatory capture, moral hazard, offshore finance, illicit capital flows, fraud, conflicts of interest, and barriers to entry in the financial sector. Fourth, we advance concrete proposals to address these issues. All our chapters are underpinned by the common assertion that the rules of liberal capitalism have long been distorted to the benefit of a small group of firms and individuals.1 Our recommendations promote fair competition, simple regulatory rules, uncompromising regulatory practices, and greater cooperation among policy makers at the international level.
We begin with an illustration to demonstrate that a series of financial reforms have overlooked the fundamental issues of financial regulation for a long period, going back more than a century. We argue that there are deeper issues with financial regulation that have never been adequately considered.
Historical Precedents and Nagging Problems from Financial History
While it is beyond the scope of this collection to review the entire history of financial crises and the factors behind them, a few illustrative notes will help to demonstrate that the regulatory issues we discuss are nothing new. In other words, though the financial system itself is ever evolving, the fundamental weaknesses that we focus on have not changed.
In early US history, banking was largely regulated at the state level. An important regulatory development came naturally, through the establishment of Clearinghouse Associations among banks to provide liquidity in crises. These associations took hold around 1857 and were sometimes matched by deposit insurance at the state level. Hendrickson (2011, 34) considers that they also were conducive to moral hazard, as banks experiencing a run would rely on others to bail them out. Financial crises occurred on a regular basis in the nineteenth century, most notably in 1837 and 1857, and a series of panics from the 1870s through 1907 . The post-Civil War turmoil forced policymakers to find a new means of intervention to create stability in finance, a situation that has been repeated throughout history.
This came at the end of the nineteenth century. The conclusion of some was that the US needed an official gold standard to create confidence in the currency, the ability to defend it, and a supposedly automatic adjustment of currency exchange rates in response to deficits or surpluses. The adoption of the Gold Standard in 1879 paved the way for the hegemony of financial institutionsâunshakeable âpro-goldâ forcesâto the detriment of big farmers and, to a lesser extent, of industrialists (Frieden 2015, 49â103). A strong debate around using a mixed currency reserve, including the famous campaign for including silver by Democratic candidate for President William Jennings Bryant in 1896, ensued. However, the gold standard was ultimately adopted in 1900 (Friedman and Schwartz 1963, 111â120).
The 1907 crisis is of particular interest because it has been traced to the attempt by brokerage houses to corner the stock of the United Copper Company (Hendrickson 2011, 94). When banks were linked to stock price manipulation, bank runs ensued, reflecting a collapse of confidence in the systemâan early example of regulatory evasion and opportunism in the sense that the trusts involved, like modern day nonbank financial institutions were not covered under banking laws. Here again, the result was an increase in the scope of regulation without examining the underlying causes of the crisisâthough clearly identified by the Pujo Committeeâs investigation on the âmoney trustâ (1912â1913). The Federal Reserve Bank (Fed) was established in 1913 to substitute for the activity of the Clearinghouses. Shortly after, in 1914, the Fed had to bail out New York City which was close to bankruptcy, in what could be regarded as an early illustration of moral hazard, in the guise of âtoo big to failâ (Silber 2007, 4). By the early 1920s, new deposit and lending requirements promoted a wave of consolidating mergers among banks (Hendrickson 2011, 26). This period of US history (from the 1880s through the 1910s), also known as the âRobber Baronsâ era, was rife with familiar concerns regarding financial concentration and successful attempts, such as those by John D. Rockefellerâs allies James Stillman and Jacob Schiff to bypass regulationsâfor example, those preventing banks from owning equities and branching across state lines (Rockoff 2000, 681â683).
The 1920s are notorious for the creation of an asset bubble in the New York Stock Exchange. This reflects an early example of under-regulation amidst financial evolution; in this instance, the beginning of the shift of the centre of global financial gravity from the UK to the US. Exhaustion, both material and emotional, in Europe, along with war reparations and wartime market share gains amidst the blooming of manufacturing, gave the US economy a huge boost. Eventually, the irrational expectations discussed by Reinhart and Rogoff (2009) took over, with stock prices soaring well above reasonable levels. Thousands of investors were duped into believing that their savings would multiply forever, without understanding the fundamentally speculative nature of the bubble. The evolution of finance also revealed the limited ability of monetary policy to steady a mass market whose innovative complexity was underestimated by regulators, and an underlying panic that markets alone were unable to resolve. Precursors of âshadow banksâ took form in financial institutions that operated outside of the Federal Reserve System, and flooded markets with liquidity, despite efforts by the Fed to tighten credit (Duca 2017, 50â64). Starting in 1929â1930, the collapse of thousands of banks led to a series of important and equally resounding reforms. Keynesian policies were de facto adopted as the Roosevelt administration became a major source of credit and confidence along with fiscal stimulus and stringent financial regulations. The most famous legislative responses were the Glass-Steagall Act and the creation of the Federal Deposit Insurance Corporation (FDIC ). Glass-Steagall, enacted in 1933, was designed to insulate commercial banking activities from investment activities. The FDIC sought to reassure ordinary depositors by guaranteeing deposits even in the event of bank failure. According to Friedman and Schwartz (1963, 442), such insurance schemes would have reduced the severity of the 1929 crash had they been in place before the crisis.
However, every rose has its thorn. Deposit insurance and the expectations of bailouts started cementing moral hazard as a cornerstone of financial regulation (Grossman 1992, 800â821). Moreover, the separation of banking from investment activities indirectly contributed to the financialisation of the economy, where the financial sector became a dominant target as well as a source of investment. Furthermore, the promotion of investment houses created greater concentration in the financial sector, leading to the envy of bankers seeking greater returns, even if at higher risk. In this respect, the rise and fall of Salomon Brothersâwell known for its innovative and aggressive strategy in the 1980sâis very telling (Mayer 1993). In addition, the possibility for commercial banks to engage in certain investment businesses from the 1980s erased the traditional line between banking and investment, as transactions between the two sectors became intertwined, even before the repeal of the Glass-Steagall Act in 1999. What is needed is not a blind Glass-Steagall Act or a deposit insurance system, but a regulatory framework where financial institutions are involved in a limited set of business activities tied to reasonable performance. Our thoughts are consistent with Kindleberger ([1978] 2005) who points out that regulation has consistently failed to anticipate irrational, herding behaviour that often leads to runs on commod...