Union Labor News / 2009 / July / Article 

How Deregulation Caused Great Recession

Making Sense of the Meltdown – Third in a Series on the Economic Crisis

By Sachin Chheda, Director, Wisconsin Fair Trade Coalition

In his essay, “A Call to Arms,” Harvey Rosenfield lays out how Wall Street spent more than $5 billion in campaign contributions and on lobbying in order to get Congress to deregulate the economy which led to the current economic meltdown. The essay, which serves as introduction to the report “How Wall Street Sold Out Main Street” (available at www.wallstreetwatch. org), explains in excruciating detail the step-by-step deregulation pursued by big banks and conservative ideologues, and how middle-class taxpayers and families have been, and are, paying the price.

As we’ve discussed in previous columns, and as readers know from watching the news, their own bank accounts, or discussions with family members – the American economy is in deep trouble. Despite valiant efforts by the Obama Administration and Congress to invest in job creation, the unemployment rate has risen sharply and is approaching 10%. While not at the crisis point of the 1930s, our current era is being referred to now as the Great Recession.

However, while the labor movement supports investment in green jobs, infrastructure and education – we must recognize that also addressing the deeper problem of deregulation is what will prevent future crises and ensure economic stability and growth for working families.

Three key bad decisions stand out. First, the repeal of the “Glass-Steagall Act.” This important regulation, passed at the height of the Depression in 1933, stopped regular banks from acting like insurance companies and investment banks. This reduced risk to depositors and kept the economy essentially stable for 60 years.

However, strong economic growth in the 1990s led to the desire by the rich to get even richer, and a desire to merge huge corporations with business models that were essentially in conflict. Starting with the merger of Citibank and Travelers Insurance, pressure increased to end what was seen as an archaic regulation.

What is a Credit Default Swap?  A Credit Default Swap, or “CDS,” is an unregulated scheme that acts like insurance against the potential of default. However, there are two big differences between regular insurance and CDS. First, in regular insurance, the company providing the insurance is regulated and transparent – they follow the rules about insurance and protect themselves against unneeded risk. Second, in regular insurance, the entity buying the insurance has a stake in not wanting to use it – they are insuring something they own, and don’t want it to fail. With Credit Default Swaps, the guarantee, or “default swap,” is made by a big company like a bank, and the entity buying the swap is an investor speculating – betting – on a default. The investor wants there to be a default, so they can get paid big bucks. And there’s no limit to how many default swaps can be sold – so some big banks made sales for billions of dollars more than they could actually cover – sometimes 60 times as much. When mortgage-backed securities lost tremendous value in the housing crisis, companies such as Lehman Brothers lost everything, and banks who had sold CDS betting that Lehman Brothers wouldn’t fail were on the hook for tens of billions of dollars they couldn’t cover. So a dip in housing values and a contraction in economic growth snowballed into the banking crisis, the deepest recession since the Great Depression, and millions of families losing their retirement savings.

However, the repeal of Glass-Steagall, with President Clinton’s support, led to some predictable bad decision-making. In the new deregulated climate, banks were no longer required to make safe investments with depositors’ resources (your checking and savings accounts). Instead, they could invest in risky, creative financial instruments like credit default swaps and mortgage-backed securities. These risky investments crashed in 2008, and instead of just taking down a few investors crazy enough to gamble with their money, every big bank in America was at risk of failure.

Market Free For All

Second, when they had the chance, both the White House and Congress consciously decided to refuse to regulate. They didn’t just fail to act, or fall asleep on the job. They actively decided that risky derivatives (bets on the future price of securities, bonds, or other financial instruments) should not be regulated. By passing the Commodities Futures Modernization Act in 2000, and quashing attempts by the Commodity Futures Trading Commission to regulate derivatives, Clinton administration officials joined with right-wing loonies like Phil Gramm to allow a free-for-all in the financial markets – where gambling replaced prudent investing.

Wall St. Bets Take Taxpayers to the Cleaners

The third major bad decision was the Security and Exchange Commission’s move in 2004 to allow banks to voluntarily set their own risk limits. It used to be that banks could only risk 12 times the money they actually had (known as the debt-to-net-capital ratio). After the SEC removed the limits, some banks risked 40 times their capital or more – and left taxpayers on the hook to help depositors when their investments crashed.

These rules – or lack of rules – went global after the U.S. took the plunge. In a future column, we will address the role of predatory lending and the housing crisis, also viewed through the deregulatory lens. Suffice it to say that while we are demanding more investment in job creation, health care reform and access to collective bargaining rights for more workers, we need to also demand a fresh look at what a responsible regime of regulation looks like.

Action Item #3

This month’s action: Hold Congress accountable for building an international system of deregulated economies. Call Senators Herb Kohl and Russ Feingold and ask that they sponsor the 2009 TRADE Act, which would require review and renegotiation of past international agreements that contributed to the meltdown, and set in stone a new set of benchmarks protecting middle-class families. Also call Congresswoman Tammy Baldwin and thank her for already becoming an original co-sponsor.

Senator Herb Kohl: 608-264-5338

Senator Russ Feingold: 608-828-1200

Rep.Tammy Baldwin: 608-258-9800

Next month: Health Care’s Impact on the Meltdown