The modern financial markets are rocked by catastrophic shocks with remarkable regularity. Such events have been apparent throughout history, perhaps most famously manifest in the form of the 1929 stock market crash that gave way to the Great Depression, and the 2007 US mortgage crisis that triggered the great recession. With drastic consequences following in the wake of financial crashes, the financial markets have been targeted for decades by economic and financial policy that is meant to eliminate the occurrence of such crashes. However, history is also filled with examples of policies greatly compounding the impact of these events when they inevitably occur. In the wake of such major failures of policy, it can be tempting to decide to give up on trying to regulate and mitigate the worst effects of financial crises, but this temptation should be avoided. In any case, though, it can be helpful to understand the case against regulation in the case of financial markets.
The greatest contemporary example of misguided economic policy of any kind is arguably the period of aggressive deregulation of the U.S. financial sector in early 2000s. This deregulation, the brainchild of then-Federal Reserve Chairman Alan Greenspan, permitted banks to expand in both size and risk to what are, in retrospect, horrifying levels. The biggest of banks received a designation of being “too big to fail”, a misleading distinction that meant that the banks were so big that they were strong enough to play an integral role in the stability of the economy, and serve as a pillar that holds up the financial market even when confidence vanished and made for crisis conditions. The flip side of this coin was the implication that these banks were also too big to be allowed to fail, thanks to their central role in the movement of financial capital in the economy. The result was that the banks felt comfortable in the expectation that their central role in supporting the world economy meant that the U.S. Government would bail them out of trouble. So, in the pursuit of profit, these firms acquired immense risk, and when the house of cards collapsed, their expectations were confirmed. The ensuing crisis eliminated trillions in wealth on paper, and resulted in a recession felt across North America and Western Europe.
Another great example of the futility of trying to eliminate financial crises can be seen in the example of the collapse of the Thai Baht in 1997. The late 1990s brought unprecedented globalisation with the widespread availability of the microprocessor and the advent of the internet. Suddenly, the world was far more connected, and this posed opportunities for certain businesses in third-world countries that could take advantage of low wages and newly available resources. Thailand saw this opportunity and capitalised by setting a fixed exchange rate that would provide stability to the country’s economy and notionally prevent massive fluctuations in the value of its currency, since these changes would harm Thai firms and consumers. This policy of a fixed exchange was sustainable as long as there was confidence in Thailand’s economic stability. The moment this faith in the Thai Baht broke in May of 1997, and the Thai central bank could not perform the trades necessary to maintain the pegged value of its currency. The eventual removal of the Baht’s fixed exchange rate came too late to spare the impacts of that disastrous policy, and that crash destabilized the entire regional economy of Southeast Asia.
With such drastic examples in the history books, you might ask why economic policymakers might believe that they can regulate, stimulate, or magic away financial crises. Ultimately, the field of academic finance is remarkably young, and as such, new ground-breaking ideas are fairly common. The policies of Alan Greenspan were built on new developments that suggested that certain central bank influences and a reliance on a few robust firms could serve as the foundation of perpetual healthy growth. It is the development of such new ideas and instruments that noted economist John Kenneth Galbraith argued is central to the outsize consequences of financial crashes. In spite of these failings, the argument for avoiding policy intervention is weak. I would never be so presumptuous as to propose that policy can eliminate financial crashes, but the actions of the former Federal Reserve Chairman Bernanke in 2007-2008 reveal the remarkable help a few educated policy moves can bring to a struggling economy. Furthermore, the noted Dodd-Frank banking regulation act includes provisions to greatly reduce the type of risky banking practices that triggered the 2007 subprime crisis and the 1980s savings and loan crisis. The most notable of these is the so-called Volcker rule, named after former Fed Chairman Paul Volcker, which bans commercial banks from participating in high-risk investment techniques.
There is no doubt that history contains many examples of failed policies and regulations regarding the financial markets. In some cases, these misguided actions actually grew the effects of the crash and caused the economic impact to be far greater than it otherwise would have been. However, a case against Alan Greenspan is hardly a case against the positive role that central bankers and financial market regulators can have in sheltering the economy and the average consumer from the worst of a financial crisis. Ultimately, the anti-interventionist view is myopic and illustrates a limited understanding of crises and how they come about.
Picture taken titled, "Federal Reserve Bank Cleveland", taken by Craig Hatfield on January 8, 2006, obtained through Creative Commons (https://flic.kr/p/NUpny