Should the Financial System under Capitalism be Regulated?

Deepankar Basu

A view that is very popular among the votaries of capitalism rests on the alleged efficiency of the financial markets of a “well functioning” capitalist economy. Financial markets, it is claimed, provide the prime mechanisms for channeling funds from savers to the most efficient investment projects, thereby increasing the overall efficiency of the economy. Lack of well-developed financial markets are often interpreted as markers of underdevelopment and economic stagnation. That this is not always the case, that financial markets are unusually prone to “irrational exuberance”, that financial booms and busts are part of the regular functioning of financial markets if often forgotten by this fundamentalist viewpoint.

A more nuanced version of this view is marked by a more measured view towards financial markets. Proponents of this view start by asserting that the financial system is composed of two parts: financial markets and the web of interdependent financial institutions. They recognize the fact that financial markets, by themselves, are often unable or unwilling to perform several important functions (like collecting, processing and disseminating reliable information about borrowers; providing liquidity services; offering deposit and check-writing facilities) required for the smooth functioning of an advanced capitalist economy. Hence, they recognize the important role of institutions, especially financial institutions (like commercial banks, insurance companies, mutual funds, etc.), within the architecture of advanced capitalism. But very often they also go on to assert that the financial system works best if left to itself; that government intervention in the financial system creates unnecessary inefficiencies. When confronted with the evidence of endemic instability of the financial system, they argue that crises and problems have led, over the years, to the development of a host of institutions that are capable of dealing with such episodes; it is both unnecessary and undesirable for the State to regulate the financial system, they claim.

A closer look at the history of the financial system in the US – the leading capitalist nation today – will demonstrate that such a view is seriously misleading; the government has always had to intervene to put the financial house in order. In fact one can go further and assert that the financial system cannot properly function without supervision at crucial moments by the State, if not constant supervision. Let me illustrate this with three well-known historical instances when the State had to step in to deal with the endemic instability of the financial system in the US. These historical instances are important, apart from illustrative purposes of this article, for at least two more reasons. One, they are the defining interventions in the financial system of the US; the financial system as we know it today has been largely shaped by these interventions and the institutions created at those moments. Two, they destroy the facile opposition that is often constructed, both by the Right and even some on the Left, between private capital and the State; the State is an institution created to protect the interests of capital as a whole even though, on occasion, it has to act against some capitals (some firms or industries or even some sectors of the economy). These instance demonstrate clearly that even when the State acted against some financial firms or sectors it was doing so to save and strengthen the capitalist system.

The first major instance of government intervention stands at the very foundational moment of the modern financial system in the US. The unregulated banking industry in the US led to massive bank failures in the late 19th century: waves after waves of bank failures where savers lost their deposits and lenders could not borrow to meet their needs; this led the Congress to create the Federal Reserve System (the Central Bank of the US) in 1913.

Within less than two decades we come to the second major intervention: creation of the FDIC. In the late 1920’s, the US economy was into the biggest downturn it had ever faced: the Great Depression. During this traumatic period, there were thousands of bank failures again (along with a huge stock market crash) and confidence in the whole financial system was greatly eroded. The Congress again stepped in to create the FDIC (Federal Deposit Insurance Corporation) which was meant to deal with the problems that the unregulated banking industry could not handle: bank runs.

The third major intervention (also made around the time of the Great Depression) had been to restrict competition in the banking industry (i.e., to force some form of branching restrictions across geographical regions) and also to restrict the areas into which a commercial bank could enter (basically to separate commercial and investment banking to prevent conflict of interest).

The last instance of government intervention is important because over the last few decades, these laws and the supporting institutions have been generally nibbled away at. For instance, the Glass-Steagall Act of 1933 had created a “wall” separating commercial and investment banking; from the 1970s onwards the growing power of finance has been continuously trying to attack and change this very important law. Finally in 1999, the Gramm-Leach-Bliley Financial Services Modernization Act repealed the Glass-Steagall Act!

The effects are already coming to the fore in the form of major banks’ (like J P Morgan Chase’s) involvement in financial frauds and other irregularities (see the Spring 2007 issue of Dollars & Sense). For instance, Chase was one of the banks which had systematically assisted Enron in its accounting frauds. It had also, in its role as an underwriting agent – one of the main functions of an investment bank – sold Enron stocks to the public knowing full well that Enron was in bad shape. This is precisely the kind of “conflict of interest” that the Glass-Steagall Act was meant to take care of. Now that it has been thrown out, we can expect many more instances of such irregularities.

The bottom line is that I do not share in the optimism about the US financial system (which many people seem to harbour), nor do I think that there is any evidence for such optimism. To suggest that the US financial system has managed to take care of the problems of instability is to willfully ignore well-known empirical evidence. Here are a few: the Savings and Loan (S&L) crises through the 1980’s, the wave of bank failures in the late 1980’s, the stock market crash of 1987, the LTCM scandal in 1998 (when the Fed had to step in to bail out a major financial firm), the dotcom bubble and bust, the imminent meltdown in the sub-prime mortgage market …one could go on and on; but let us look a bit more closely at only two of these well-known episodes of financial trouble: the LTCM fiasco and the sub-prime mortgage meltdown currently underway in the US.

LTCM (Long Term Capital Management), a very famous financial firm of the late 1990s in the US had been feted by Wall Street as one of most technologically sophisticated financial firms in existence; after all it had offered close to 40% annual returns for two years in a row and had towering figures from theoretical finance among its founding members. It was a “hedge fund” formed in 1994 and had, among its founder member two Nobel laureates in Economics: Myron Scholes and Robert Merton. Within four years LTCM was on the verge of collapse! More details about the the rise and fall of LTCM can be found here (there are lots of useful references at the end of this article; among others, there is a very nice PBS documentary on the whole episode which is worth watching.)

A little note about “hedge funds” might not be inappropriate at this point. A “hedge fund” is, to be brief and simple, a financial institution which pools the money of a few very rich individuals and then invests it around the world to make huge profits. Membership to hedge funds is not open; it’s stocks don’t trade in the financial markets; it is always very secretive about how it invests and also about who its investors are. Usually the smallest amount of money that is required by an individual to become part of a hedge fund (i.e., an investor who is one of the many whose money has been pooled into the hedge fund) is $1 million. In most cases, it is much higher. If we look at hedge funds from the point of view of ordinary citizens, we cannot escape the well-known (and increasingly well-recognized) fact that they are notorious for creating instability in financial markets, especially in the low and middle income economies. Their huge size and ability to move funds very rapidly gives them undue power and influence over small and medium economies (now even large economies are facing the music of hedge funds), whose macroeconomic stability is severely jeopardized by their investment strategies.

Coming back to the stunning LTCM collapse, it is important to remember that the Federal Reserve Bank of New York had to step in to arrange credit for its bailout. If the Fed had not intervened to bail out the tottering giant, it might have led to a asset price deflationary spiral leading to a string of failing firms and lost jobs and lost output and macroeconomic instability. For the purposes of this essay, it is merely necessary to note that the financial system could not deal with this problem on its own!

Let us now move on to the second story, a story that is still unfolding: the sub-prime mortgage lending crisis in the US. Referring to the sub-prime mortgage meltdown that is currently underway in the US, a recent report by the Centre for Responsible Lending has estimated that more than 1 million low-income families have lost their homes on net (i.e., after accounting for those who have gained home ownership) over the past nine years. Have the banks and financial firms that created this crisis lost much? It is doubtful whether the banks originating the mortgages, the focus of all the attention in the mainstream press, have really lost anything.

Let me remind readers that the “sub-prime” mortgage meltdown refers to the market for mortgage loans (i.e., loans for buying real estate) supposedly for low-income households without good credit histories. The rule of the game, as it evolved over the last decade, was that the house that is bought with the mortgage loan is used as collateral for the loan so that whenever a family fails to make a single monthly payment (there might be a little variation on this), it leads to “foreclosure” and the bank that had made the loan takes possession of the house to recoup its losses.

But why the term “sub-prime”? The attribute of “sub-prime” comes from the fact that most of these loans made on this market are at above-average (much above the market interest rate for mortgages) interest rates and at very onerous terms; the term contrasts this market with the “prime” mortgage market where loans are available at much lower interest rates. In most cases, these “sub-prime” loans are made in bad faith because the concerned families are “convinced” of the suitability of high-interest rate and “coaxed” into the loans at unreasonable terms. More often than not big banks use various kinds of methods to consciously keep out low-income families from the “prime” mortgage market (where they might have got loans at reasonable rates and terms); most of these families, needless to say, are either African-American or Latinos. Once, in this way, these families have been pushed out of the “prime” mortgage market and into the “sub-prime” market, the same banks turn into loan sharks and strip the low-income families to their bones. It is, therefore, hardly surprising that many families are unable to meet the monthly payments of the mortgage and lose their house and most of their life’s savings. That is what has been documented by the Centre for Responsible Lending and that is what is creating havoc in the lives of many working-class Americans.

These are but two small instances of the operation of financial system under advanced capitalism; one can very easily multiply them ad nauseum. The evidence, if one cares to look, strongly suggests that the US (or any other capitalist economy for that matter) will have to learn to live with inescapable instability; these episodes are as much part of life under capitalism as are economy-wide business cycles. Of course, under capitalism, the overwhelming cost of these episodes of financial and other forms of instability will be always borne by the working people. Hence, all political formations claiming to represent the interests of the working people must vociferously argue for the regulation of the financial system without taking recourse to the false opposition between the State and capital.

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One comment

  1. kindly help me to nigeria banking system under capitalism socialism and comunis

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