History Shows That Financial Meltdowns Are Preceded By Deregulation

An analysis by IMF economist Jihad Dagher shows that the U.S. could be setting itself up for another financial meltdown.

While President Donald Trump and Republican leadership have set about to burn down U.S. regulations, an analysis by the International Monetary Fund of the past 300 years of economic cycles finds that this is not the time for hardcore deregulation.

The blame for financial meltdowns often focuses on irresponsible traders and greedy bankers. But politicians, whose policies sometimes fan the flames, deserve scrutiny as well, according to a fascinating analysis of booms and busts since the 18th century by Jihad Dagher, an economist at the IMF. The research serves as a warning, of sorts, as the Trump administration seeks to relax banking regulations introduced after the last crisis.

The cycle of booms followed by deregulation, crises, and re-regulation has repeated itself over the past 300 or so years.

An example from 1825 offers an eerie prediction of the 2008 financial crisis:

Following the Napoleonic wars and the collapse of the Spanish empire, newly independent states in Latin America were seeking money and European financiers stepped in to lend it to them, as Dagher recounts it. A speculative loan market developed in London, and South American mining companies flocked to the London Stock Exchange. Markets were soaring, and members of parliament sat on the boards of some of the firms quoted on the exchange.

Despite concerns about shaky companies, politicians weakened enforcements and regulations that were put in place after the previous financial crisis—the South Sea Bubble in 1720. By the end of 1825, markets were in a “full blown panic,” according to Dagher’s research. Stock and bond prices crashed, leading to bank runs and failures. A year later, nearly 10% of England’s banks had collapsed, sparking perhaps the first major global banking crisis. Policymakers responded to the turmoil with a range of measures, including trying to shore up the banking system with greater levels of capital: “What ensued from the 1825 crisis was a series of laws, regulations, and reforms that touched all aspects of the financial sector,” according to Dagher.

Fast forward to 1990s and there is a similar story unfolding:

Government policies had a role in that panic, too. Fannie May and Freddie Mac, which purchase mortgage loans from originators, were given an affordable housing mandate in 1992, driving them to buy lower quality (subprime) mortgages to make borrowing cheaper. Policies to make credit more widely available for home purchases—a push that spanned multiple administrations—were further ramped up during the George W. Bush’s presidency. The industry lobbied hard for changes: Mortgage brokers and bankers tripled their contributions to Bush’s re-election campaign in 2004 (paywall).

After the housing bubble burst and billions of taxpayer dollars were used to stem the collapse of US financial institutions, politicians responded with the biggest overhaul of financial policies since the Great Depression. The Dodd-Frank Act of 2010 set out ways to wind-down failing financial firms, tightened oversight of the sector, created a new agency for consumer finance laws, and introduced stronger capital requirements, among a raft other measures.

And now we arrive at the point in this narrative where deregulation gains steam and learning from the past is more and more a fleeting option.

Both Republican and Democratic lawmakers are looking to gut Dodd-Frank, if not eliminate its provisions entirely, and Trump has indicated his people are “doing a real number on it."

But not everyone agrees this is the best course of action:

Before he left his post as vice-chairman of the Federal Reserve last year, Stanley Fischer warned in an interview in the Financial Times (paywall) that it was “extremely dangerous and extremely short-sighted” for the US to roll back regulations a mere 10 years since the last crisis.

Only time will tell how Trump-era policies will affect the economy down the road, but if the president continues down this path and history is a reliable indicator, Americans are likely up for another bumpy ride.