Reagan Responsible for the Financial Crisis? Not!

Is Reagan Responsible for the Financial Crisis? Fiscal conservatives like to ask the question, “What would Reagan do?” To ask this question about their political hero is akin to a traitor status being associated with the questioner. Of course the blame is being handed out by each party to the opposition. But to target an act in 1982 seems a little far fetched. Read Dr. Bill Woolsey’s article below as he goes logically through the sequences of actions taken to determine the answer to the question By the way – the answer to “Is Reagan responsible?” is NO!

By Bill Woolsey, Special Economic Correspondent of The Free Enterprise Foundation

In a recent NYT column, Paul Krugman sought to blame deregulation by the Reagan administration for the current financial crisis. In reality, commercial banks and thrifts continued to be heavily regulated after Reagan’s terms in office. The crisis was not caused by any actions taken by President Reagan but by a speculative bubble in housing, which was exacerbated by massive lending into the bubble. However, the specific regulatory structure that we had (and continue to have) encourages depository institutions to make mortgage loans and especially to invest in AAA tranches of mortgage-backed securities. To the degree that commercial banks and thrifts were part of the problem, the regulators were egging them on.

Liberal economists wish that regulators would correct market failures. When reality shows that regulators have been part of the problem, they begin to grasp at straws. Over the last thirty years, there has been some deregulation—much of which allowed competition to benefit depositors and reduce risk. But, the limited deregulation that occurred was not related to the crisis.

Krugman asserts that the Garn-St. Germain Act of 1982 made the high levels of private debt that exist today possible. The key element of the act was to end the government-backed restraint on competition on interest payments for depositors. Free competition encouraged saving rather than borrowing. Krugman claims that the new lending powers given to thrifts caused the S&L crisis of the eighties. In truth, the industry was already in crisis because they were funding thirty year fixed-rate home mortgages with savings accounts—a business mandated by regulations developed during the thirties When the inflationary policies promoted by the liberal economists of the sixties and seventies resulted in extraordinarily high interest rates in the late seventies, the S&Ls needed to pay high interest rates on the saving accounts or their depositors would withdraw their funds. Meanwhile, the interest rates they earned on the fixed-rate thirty year mortgages they had made in the sixties and seventies, remained low.

This was the impetus to finally allow depository institutions to compete for funds—if they didn’t, they would all go broke. The fundamental problem with the thrift industry was a lack of diversification—holding only home mortgages made them subject to failure if interest rates suddenly increased. And, of course, today’s crisis has not been caused by savings and loans making too many business or consumer loans.

The saving and loan crisis did worsen during the Reagan administration. The problem was a regulatory policy of “forbearance” where insolvent institutions were allowed to continue to operate. Further, the regulators encouraged investors to purchase thrift institutions and grow them out of their problems, funding new loans with government-insured deposits. By a liberal use of campaign contributions, these growing thrifts found plenty of politicians, including Democrat Speaker of the House Jim Wright, to pressure regulators to allow real estate developers to use their captive thrifts to fund their projects.

That disastrous failure of regulation resulted in the current scheme where regulators are not supposed to allow depository institutions to operate without adequate capital. In banking, capital is net worth, the difference between the assets and the liabilities of the institution. It is the amount of money that the owners—the stockholders—have at risk in the institution. While banks mostly fund their loans and other investments with depositors’ money, a small part of the money they lend comes from stockholders. The S&L crisis occurred because they continued to operate even after the stockholders had lost all of their money, and so there was no capital. Yet, the specifics of the current system of regulation requires stockholders to put up even less of their own money for real estate loans, exactly the problem that deregulation of the thrifts was supposed to solve. Regulators work for politicians, who like regulation that funnels funds into real estate.

While depository institutions are partly responsible for the current crises, the key problem has been with “investment banks,” like Bear Stearns, Lehman Brothers, JP Morgan Chase, and Goldman Sachs. Investment banks don’t accept deposits or make loans. However, they do borrow money by issuing short-term commercial paper and hold portfolios of securities. This is nothing new. It has been part of their traditional business of underwriting corporate stocks and bonds for over a century. What was unusual was a new application of these traditional tools. They were a key part of the crisis because they borrowed using greatly expanded amounts short term commercial paper, including overnight commercial paper, to fund and hold large portfolios of mortgage-backed securities that were improperly rated by the principle rating agencies.

The reason for capital regulations of depository institutions is to protect depositors from loss. Because of government backed deposit insurance, depositors can lose next to nothing, so it is really the government that is being protected from loss. Investment banks don’t accept deposits, and there is no government insurance for those lending to investment banks. However, they are subject to capital requirements by the Securities and Exchange Commission so that they can complete trades when they operate as brokers and dealers of securities. The amount of money that the owners—stockholders—of the investment banks put into the portfolio of mortgage backed securities before our financial meltdown was small compared to how much money came from those lending to the investment banks. Even this small amount would have been considered adequate by regulators—they considered AAA mortgage backed securities to be so safe, that depository institutions could keep as little as 2 percent capital!The most troubling aspect of the current crisis has been the willingness of politicians to bail out the banks and, especially, the investment banks that lent into the speculative bubble. The market system is a system of profit and loss. Without the fear of loss, there is little to deter any business, including banks, from taking excessive risk for the chance of spectacular gains. With regulators, Congress and Bankers scratching each other’s backs, regulation has proven ineffective. At best, regulators prepare to fight the last war, while politicians are happy to structure regulation to benefit special interests. It is time to stop the bailouts and let Wall Street take its losses.

Copyright © 2009 by William Woolsey and The Free Enterprise Foundation. All rights reserved

About the author: Professor William Woolsey is a member of The Free Enterprise Foundation's editorial staff and senior writer on national economy reporting. Dr. Woolsey is a distinguished Professor of Economics in the Citadel’s School of Business Administration and a former Libertarian candidate for Congress.

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