The week of 15 September 2008 saw the near-collapse of the U.S. financial system. It is clear that the economic problems we are currently encountering are tied to attempts to deregulate financial markets that began in the 1990s.
Since the Reagan Revolution of the 1980s, it has been an article of faith among political conservatives that with deregulation, market forces take over, and the Invisible Hand automatically yields efficient markets. From this perspective, deregulated companies have no choice but to behave efficiently because the market forces them to do so. Shape up or die.
In practice, this view is seriously flawed. Consider the financial sector. The financial industry does not come close to reflecting conditions of the perfect competition or imperfect competition needed to make the Invisible Hand work. As they teach in Econ 101, perfect and imperfect competition require many buyers and sellers, none of whom can affect the price of goods sold. Clearly, given the current structure of the financial industry, financial deals are made by a handful of large institutional and individual players that operate through an old boy network. Investment bankers, Wall Street and mortgage packagers do not operate under conditions of perfect or imperfect competition. Given this reality, Econ 101 suggests that letting deregulated companies do whatever they want will not lead to market efficiencies.
Beyond this, for free markets to work, you need to let failed businesses die. The bail outs of Fannie Mae, Freddie Mac, Bear Stearns, and AIG show that in the financial sector, even politically conservative politicians are not willing to let this happen. What deregulation has done is to encourage financial players to take crazy risks in pursuit of enormous upside gains with no attendant downside penalties. Adam Smith must be spinning in his grave.
Consider also deregulation of the airline industry, which began in the late 1970s. The structure of the airline industry was – and remains – oligopolistic. That is, there are few players in the industry, and any one of them through pricing actions can affect prices in the industry overall. For example, if one airline reduces prices, then others often follow suit. In the short run, falling prices benefit consumers. But in the long run, oligopolistic markets can lead to “destructive competition,” where enterprises engage in price wars. Ultimately, as players become bankrupt and drop out of the game, monopolistic conditions can arise, resulting in price hikes and reduced service. As a frequent flyer, I have benefited nicely by deregulation of the airlines industry. As an economist, I also recognize that government intervention may be needed from time to time to avoid the nasty consequences of destructive competition.
The point is that for deregulation to work, lawmakers need to be well-educated on Econ 101 principles. They must recognize that Adam Smith’s Invisible Hand yields efficient markets when you have many buyers and sellers, low barriers to entry into a business, perfect information on market conditions, and products that are largely commoditized. These conditions do not exist in most industries that are deregulated. Consequently, when deregulating an industry, lawmakers must impose appropriate constraints on the deregulation efforts and avoid relying on unfettered free markets to solve problems.
COMMENTS
David Frame, your article is excellent. Let's get this information out to the people. They need to know about the Gramm- Leach-Biley Act. We need an email campaign and a March on Washington to put a stop to big Companies ripping off 95% of Americans and also the people of third World Nations( especially Africia with Blood Diamonds and oil). In this day and Age we should not have to work all our lives just to make ends meet while a few people make more money than they could every spend in a 100 lifetimes (Rupert Merdock) at our expense and the expense of Mother Earth. Econ 101 talks about supply and demand, we the people need to begin to demand the ability to pay our homes off in 5 years(instead of having a mortgage that you pay interest on for years not to mention the closing costs, what ?ss thought those up), we need to demand energy efficeint homes ( using alternatives energy instead of paying the metor), we need to demand good food( instead of Monsanto's GMO's and McDonalds) and we need to demand Healthcare instead of disease managemant with doctors selling dangerous drugs and completely useless ones(statins&SSIR's). People need to wake up and realize that there is no way that a Medical Doctor can find out what is wrong with you in their 5 to 10 minute office visit. And remember Senator Phil Gram received 1.5 million $ from the financial industry in campaign contributions. The Gramm-Leach-Biley Act repealed the Glass-Steagall Act of 1933 and now once again the majority of Americans are payiny the price. Please don't forget Reaganonomics when they deregulated the Saving& Loan Industry and created the biggest financial bailout at the time with 3000 S&L's closing and Neil Bush walking away with Millions. Let's not forget Enron. The prime example of corporate raiding. Merril Lynch made a $60 million deal with them to manipulate the stock price to make in insiders rich and suck the life saving out the the people. So people make an honest living providing real goods and services to all and live in harmony with Mother Earth or she will erase you from the planet. ( Note that the ice caps of the world are shrinking at an alarming rate and thanks to George W. we were not among the 167 nations that signed the Global Warming Treaty- He signed a $7 million book deal, but he can't read or speak English, you be the DESIDER if you are going to buy such a book. What STAR-TEE-GAR-REE will you adopt?
David Berglund 03/26/09 03:40 pm ET
It's sad that the Adam Smith theory stopped with the phrase "deregulation." I would note that the social responsibility he advocated is completely missing from Reaganomics, which we live under yet.
If what has happened now isn't enough to convince the "free marketers" that this Invisible Hand does not belong to God, what will do it?
There is in fact a role for the government and at this time it comes with strong responsibility.
Teri 09/30/08 10:30 am ET
An authoritative treatment of deregulation in the airlines industry has been published by Borenstein and Rose and is titled: "How Airline Markets Work ... Or Do They? Regulatory Reform in the Airline Industry (100 pages long, PDF file), http://www.nber.org/books_in_progress/econ-reg/borenstein-rose10-3-07.pdf
J D Frame 09/27/08 11:30 am ET
Major steps to deregulate financial services include (but are not limited to) the Depository Institutions Deregulation and Monetary Control Act of 1980, the Garn-St. Germain Depository Institutions Act of 1982, and the Gramm-Leach-Bliley Act of 1999 (which repealed the strict rules of the Glass-Steagall Act of 1933). The unintended consequences of financial deregulation are captured authoritatively in Strunk and Case, Where deregulation went wrong: a look at the causes behind savings and loan failures in the 1980s (http://www.worldcat.org/oclc/18220698), published by the United States League of Savings Associations in 1988.
What the current financial crisis shows is that to the extent that government agencies do not pursue their regulatory responsibilities diligently, we have an unofficial form of deregulation. This is why the SEC is under fire these days (whether deserved or not), being accused by critics of employing a hands-off regulatory role over the last few years.
J D Frame 09/27/08 10:34 am ET
The financial industry has never been even close to being deregulated.
You are an absolute fool if you think otherwise.
JB 09/26/08 02:07 pm ET
As a unionized employee for a major airline in the U.S., I see deregulation as an attempt to drive down the cost of labor so upper management can benefit. During airline regulation, profits were built into the overall negotiations with the controlling government authority, the Civil Aeronautics Board (CAB). Profits, pay raises for labor and management, and growth were foregone conclusions but limited. Today, the executive pay and bonuses grow unfettered on the backs of labor. I am currently working at 1992 pay rates unadjusted for inflation. Our management has taken unprecedented pay and bonuses even after labor saved the company from sure bankruptcy. They have yet to fulfill their promise of sharing in the gain and are prolonging all current negotiations.
A. T. 09/26/08 11:00 am ET
You obviously didn't actually learn anything in your Econ classes.
Master of Business Administration 09/26/08 10:22 am ET
A very accurate, and to the point article. To bad our lawmakers do not understand Econ 101, and humanity's worship of money.
NextGov Reader 09/26/08 10:02 am ET