Eric Posner Reviews Edward Conard's "Unintended Consequences"

Capitalism Is Regulation
Eric A. Posner
The New Republic
July 5, 2012

The financial crisis of 2008 shook the faith of many people in free markets. It marked the end of a political consensus in favor of limited regulation and low taxes that began in the late 1970s. In that decade, an influential group of commentators blamed economic stagnation on strict regulation, high taxes, and lax monetary policy, arguing that these policies undermined incentives to invest and hence suppressed economic growth. Although their major policy proposals—deregulation of industry, low taxes, and control of inflation—are frequently identified with the Republican Party, deregulation began in the Carter administration, and this free-market agenda was advanced during the Clinton administration.

One of the most heavily regulated sectors of the American economy in the 1970s was finance. Banks were generally small, highly specialized institutions that could take deposits and lend money but by law stayed out of most other areas of finance (insurance, securities underwriting, and so forth); regulators limited the types of loans banks could make, their personnel, where they opened branches, the liabilities they held—almost every aspect of their balance sheet and their operations. Banking was extremely stable from the late 1930s through the 1970s, with no real crises. But critics pointed out that small banks could not compete with vast financial conglomerates in other countries, and noted that foreign banks were just as stable as American banks. Thus, the American system of highly regulated finance seemed to sacrifice economic growth without any gains in the form of enhanced financial stability.

It was this analysis that led Congress and regulators, starting with the Carter administration, to allow financial institutions to enter new markets and to borrow more and more against their assets, enabling them to grow more rapidly. Deregulation made its most rapid strides during the Clinton administration. A huge new market in financial derivatives developed; regulators did not attempt to regulate it despite worries about its size and opacity, or those who did were slapped down by the administration and Congress. And deregulation seemed to pay off. The size of the financial sector swelled, as did employment and bonuses.

But the financial crisis prompted a reappraisal. Critics of Wall Street argue that the crisis proves that deregulation failed. The erstwhile defenders of financial deregulation are on the defensive. It is against this background that one can best understand Edward Conard’s book. Conard presents himself as a critic of the move back toward regulation, exemplified by the Dodd-Frank Act, and as a defender of free market principles. He hopes to revive the deregulatory spirit of the 1980s and 1990s.

Eric Posner