How government is to blame for global financial crisis

“There are unintended consequences of free markets. It’s not capitalism that has been the problem, but irresponsible governments and politicians who have allowed the financial system to explode by permitting the build-up of ludicrous amounts of debt and leverage.

“No one ever said that free markets could or would be self-regulating. That’s where people over the past few decades have got it wrong, and many are still in denial – look at Alan Greenspan, who is still defending free markets.”

-Chris Gibson-Smith, chairman of the London Stock Exchange

Isn’t that it exactly? That is certainly my argument. Here’s what I think happened.

Two years ago, I wrote a couple of posts on bank disintermediation. You had money market funds, eurodollar deposits, high yield markets and a bevy of other innovations which made banking a difficult business – especially in an environment of rising interest rates and regulated deposit rates. In the first post, “More on why big capital markets players are unmanageable”, I wrote that by the 1980s, banks were chomping at the bit to get into investment banking because retail banking had been disintermediated and was much less profitable.

In the second post, “How globalisation led to universal banking in America”, I wrote that “I am not a market pundit that thinks the repeal of Glass-Steagall was a catalyst for the credit bubble and crash.  Nor do I think regulatory reform should bring Glass-Steagall back as Paul Volcker seems to argue.” Countrywide was not a Glass-Steagall issue, nor was Bear or Lehman or any of the other major problems from the credit crisis.

In fact, the ‘fix’ for the investment banking business model was universal banking as all of the existing investment banks became banks (Merrill via a takeover by BofA and Morgan Stanley and Goldman Sachs via conversion into banks). Like the retail banking model, the broker/dealer model was bust because these firms lacked stable and less crisis-prone funding via retail deposits. This was a maturity mismatch; they borrowed short in liquid markets, leveraged up and lent or invested in long-term illiquid markets. That’s why they were all vulnerable and why Bear and Lehman were the first to fail in the liquidity crisis; it wasn’t because they were the most insolvent.

Meanwhile in Europe where universal banks got their clocks cleaned by global competition and retail disintermediation, the largest players levered up with bloated securities-laden balance sheets and moved very heavily into riskier investment banking and broker/dealer activities in order to keep up their return on equity. This is why they are now so undercapitalised.

Time and again, the government’s fix for disintermediation and lower profitability has been what former regulator Bill Black calls deregulation followed by desupervision and decriminalisation.

“My view is that a lack of regulatory oversight allowed the system to veer away from macro-prudential finance. This is not a case of Madoff-style fraud with everyone in finance cooking up schemes to defraud homeowners. Yes, these cases of predatory lending existed. However, I see the systemic risk as more pertinent.

“Systemically-speaking, the Ponzi phase is one of risky behaviour crowding out prudent behaviour in a world free of regulatory controls. If risky behaviour is temporarily rewarded with profit and this temporary period is long enough, then risky behaviour wins and drives out good behaviour.


“…The natural tendency toward greater risk in a stable macro environment is toxic when coupled with lax regulatory oversight and crony capitalism. Bailing out the system without punishing the fraud while permitting risky actors and their investors to escape the full consequences of their behaviour is a moral hazard. This invites more of the same in future.” –James Galbraith: How financial stability creates instability

Here’s the example I give in the UK.

“For example, before the bubble in the U.K., one might have seen relative debt constraints like three times income. That meant one could borrow up to three times one’s annual income – no ifs ands or buts. If you worked in the City and received a bonus, you might have convinced the bank to count half of it toward your income for loan purposes.

“As prudence was thrown out, these constraints were relaxed. The Bradford and Bingleys of the world used lower interest rates to justify jacking these constraints up to 3.5 times or four times income. Eventually these constraints hit six times in the UK.

“How do you compete against that as a bank? All of the business is going to Bradford and Bingley and you are getting stuffed. I guarantee you shareholders won’t like that. As an executive, you better find the holy grail of prudent but profitable lending or follow Bradford and Bingley on the road to easy money. Otherwise, you will be out of a job.

“Eventually, even the prudent relax their standards too – that’s how risky behaviour drives out good when risk is rewarded.”

The result: a criminogenic environment ripe for fraudsters.

So what I’m saying here is that business models in the financial services industry became stressed by competition. Many companies became unprofitable because they were’ ‘disintermediated’. The response was to lobby government for special treatment: Deregulation, desupervision and decriminalisation. Deregulation itself is not bad per se. But it is toxic when combined with desupervision and de facto decriminalisation.

My view is that all systems fail and we need to be prepared for that failure. But if you don’t enforce the rules, failure will happen again and again and reach epic and systemic proportions. We need to structure a system that sets basic mechanisms in place to prevent market failure but that is redundant enough so that it can deal with market failure. Doing this is the role of government, not of bankers.


P.S. – I anticipate that Occupy Wall Street, in focusing primarily on protesting against the banks, has invited the propaganda machine to kick in to demonize the protesters as a prelude to a more muscular response by government legitimized by anti-protester propaganda. Greater focus on government and its role makes this tactic less effective.

  1. Rob says

    I would also mention that from a large-scale government-at-fault perspective one should also add the role of central banks which for too long have allowed the rate of credit growth in the economy to outpace the organic growth rate of the economy. This has created massive economic imbalances/bubbles, over-leverage, and an oversized financial sector – which was further exacerbated by deregulation and desupervision of that sector. The perfect storm of financial disaster.

    The truly sad thing is that despite the world economy being brought to the precipice by all this, from a fundamental perspective, little has changed to improve the situation. The imbalances are still building. Therefore, we are guaranteed follow-on shocks to come.

    1. Daniel says

      I agree. To blame the free market, or to say that capitalism is at fault and caused the crisis that we’re in is based on an argument that fails to separate the idea of free enterprise from the monetary system in which our economy operates.

      I think that when bashing the banks (which might not be totally unwarranted), people seem to miss the fact that it is the government that provides the sector with it’s raw material, i.e. money.

      The central banks, in their infinite wisdom, have followed a flawed compass, i.e. price stability, which obviously is not enough to provide financial stability. Claudio Borio, of the BIS, describes this issue quite well:

  2. PLB says


    You say “doing this is the role of government” but that begs the question “why hasn’t it happened yet?”… Surely after 4 years of crisis you’d think it would have. Sadly, we only have that eunuch Dodd Frank to show. In passing, Corzine’s MF Global is imploding with a rumored 33:1 leverage over $6B of EZ bond exposure… We really haven’t learned much since 2008…

    So what is keeping governments from waking up? Well… they’re 120% captured by the financial industry and other lobbies favoring “hands off”… and that explains why OWS (in contrast to the Tea Party) is focusing mainly on Wall Street/Banks, at least for now… (they should go after the military-industrial complex and the health care/prescription drug system, etc.) … In other words, it is those corporations/lobbies that are responsible for our governments’ actions or inactions… I don’t think we can believe politicians all over sudden decided to deregulate, desupervise and decriminalize… they are responding to the wishes of the few…

    So should we be waiting for Banks/Corps to change… for incentives and Capitalism to change? Fat chance…

    In the end… resolving this crisis belongs to us… the people… 100% of the people… either through elections or other means. My fear is that the latter seems to be more and more like the only way…

  3. Dave Holden says

    The Oscar winning documentary “Inside Job” provides a compelling narrative on why we’re here. Fundamentally it’s moneyed politics.

  4. NOTaREALmerican says

    Concentrate the power and the sociopaths win.

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