Robert Wade: The failure of financial regulation

Opinion

Most of the discussion of the causes of the global economic crisis has focused on the failure of financial regulation.

Regulators failed to prevent banks, hedge funds and other such entities from exceeding prudential lending limits.

The crisis occurred when the debt mountain became so big that lenders refused to go on rolling over loans.

To prevent repeat crises the solution is to beef up financial regulation.

This is true enough as far as it goes, but why did regulation fail on such a huge scale?

The first part of the answer is that the financial sector came to dominate the "real economy", as measured by gross domestic product.

The stock of global financial assets relative to world GDP grew from about 100 per cent of world GDP in 1980 to 360 per cent in 2007.

In the US, the financial sector earned more than 40 per cent of domestic corporate profits in this decade, having earned 20 to 30 per cent in the 1990s.

Average compensation was almost twice as high as the average for all domestic private industries in 2007.

This "financialisation of the economy", as it is called, reached a peak in the US and Britain.

As the financial sector grew more and more powerful, financial executives came to exercise a veto on public policy, and to ensure that regulators acted more as cheerleaders than as regulators, on the assumption that financial markets are efficient and self-regulating.

The Securities and Exchange Commission, one of the main US regulators, cut its enforcement staff by 11 per cent in 2005-07, and imposed 50 per cent lower financial penalties.

The second part of the answer is related to income distribution. The financial sector grew so large and generated such high profits because income, especially in the US and Britain, became extremely unequally distributed.

Most of the increase in income since 1990 accrued to a tiny proportion of households at the top, in "winner-take-all" fashion.

In the US during the seven-year economic upswing of the Clinton Administration, the top 1 per cent of households captured 45 per cent of the total growth in pre-tax income.

During the four-year upswing of the Bush Administration, the top 1 per cent captured no less than 73 per cent of the total growth.

By 2007 the top 1 per cent received 23 per cent of US disposable income, up from 9 per cent in 1980. (In 1929 the top 1 per cent had also received 23 per cent, and the percentage had then fallen continuously to reach about 10 per cent by 1970.)

The growing concentration of income at the top after 1980 was one of the main contributors to the fast growth of US financial markets.

And they in turn channelled income to the top of the distribution.

US politics came to be shaped by those representing the interests of the financial sector and households at the top of the distribution.

Naturally, they championed the "light-touch financial regulation" which enabled their rising prosperity and power.

Meanwhile, the average income of the bottom 90 per cent of the US population actually fell between 1973 and 2006 (having in earlier decades since World War II grown twice as fast as that of the top 10 per cent ).

You would think that in a democracy such a dramatic polarisation of incomes would create serious social and political tensions.

Why not in this case? This is the third part of the answer as to why regulation failed on such a scale.

As income polarisation increased, households in the bottom 90 per cent began to supplement their stagnant real incomes by borrowing.

US household debt relative to personal disposable income more than doubled between 1980 and 2006, from 65 per cent to 136 per cent (and 170 per cent in Britain).

This huge increase in borrowing _ in the form of mortgages, credit card loans, auto loans and the like _ helped to fuel the growth of the financial sector.

The central bank assisted the process by encouraging so much lending for house purchase as to generate fast-rising house prices after 2002, from which households were able to boost their consumption and pay for private education and health care by taking out home equity loans.

Households' rising debt-based consumption helped to mitigate tensions which would otherwise have erupted in the face of the polarisation of income, and kept democracy ticking over smoothly even as the top few per centiles of the population lifted free from the rest of the society.

Capitalism tends to alternate between periods of liberalism, in which market activity is subject to little regulation, and periods when states and societies try to regulate markets, especially labour markets, to stop people from being treated as mere commodities.

The open question is whether the current crisis will be severe enough to force a shift back towards a more social democratic capitalism, or whether we will go forward with a bit of tweaking of the liberal rules and face more big crises in the next decade.

* Robert Wade is professor of political economy, London School of Economics and winner of the Leontief Prize in Economics 2008.