Report #1: Government Intervention

We have looked at the causes of the financial crisis of 2007-2010, now we shall take a look at whether or not this was due to too little, or, not enough government intervention. As Thomas Jefferson once said, “the purpose of government is to enable the people of the nation to live in safety and happiness. Government exists for the interests of the governed, not for the governors”[1]. Therefore maintaining a healthy financial economy within a nation would fit this criterion of a government’s role in society. However, achieving this via intervention, or very little intervention, is open to much debate, depending on ideology. Whatever the path chosen however, governments ultimately failed to achieve Jefferson’s idea of government responsibilities. Minsky (1992) suggests that this isn’t a new phenomena, stating that the containment by governments of a deteriorating economy has “been inept in some of the historical crises”[2]. It is worth noting that he then went on to suggest that increasing complexity of the financial structure, coupled with governments acting as refinancing agents, makes the system behave more different than in other eras. Here we shall focus on whether the financial crisis was caused by too much, or, too little government intervention, analysing the types of intervention governments had in place and then assessing whether this contributed towards the financial crisis of 2007-2010.

The degrees of government intervention that we shall assess in this report will be taken from two regions – the U.K and the U.S.A. Both of these world economic powerhouses had their own means of governing and regulating the financial sector. In the U.K, government intervention in the financial sector had been sliced up in to three regulatory bodies. Problems were aggravated when the financial crisis struck due to a, “flawed tripartite arrangement between the Treasury, Bank of England and the Financial Services Authority (FSA)”[3]. The FSA  in particular was brought under much scrutiny, as it was responsible for monitoring capital adequacy and solvency.

A similar story of mismanagement in the U.S was in place, or as Buiter (2008) puts it, “a chaotic and balkanised structure of regulation of banks”[4]. The immensely complex nature of regulation in the U.S makes it unsurprising that intervention would be a failure. The multitude of government agencies that took control of the financial sector lacked cohesion. To add to this, the insurance sector, which was massively hit by the financial crisis (AIG in particular), was unregulated at a Federal level. However, the Fed did have better access to information about banks as it was one of the regulators. Although it had “fallen victim to regulatory capture by Wall Street”[5]. Due to the complex and seemingly ineffectual way of regulating the economy many governments took, we shall first look if too little intervention was the cause of the 2007-2010 financial crises. The inability to effectively establish a governing body would suggest a lack of intervention in the market when it was needed. In 2007, regulators themselves stated that investment banks had got much better at managing risks, though there was room for further improvement[6].

As has been the rhetoric for much of this report, a primary cause of the 2007-2010 financial crises was the housing bubble and the knock-on effects this had. Just before the housing boom occurred in 1996, Alan Greenspan, Chairman of the Federal Reserve, “concluded as did many others, that bubbles were not tangible enough to justify policy changes”[7]. Monetary policies followed Greenspan’s recommendation throughout his tenure, where credit volumes grew and consumer inflation remained low, “central banks-particularly in the U.S-felt no need to tighten monetary policy”[8]. This allowed banks to continue to offer sub-prime mortgage deals, which suited many governments who yearned for a high home ownership. Shiller (2008) agrees, stating that, “the very people responsible for oversight were caught up in the same high expectations for future home-price increase that the general public had”[9]. 

The lack of intervention in the housing bubble was not only constrained to the failure to implement an effective monetary policy. In the U.K, the bank-run on Northern Rock in September 2007 is a good example as to how too little government intervention helped to create the 2007-2010 financial crises. Prior to the bail-out of the bank, Northern Rock had followed an “extremely aggressive and high-risk strategy of expansion and increasing market share”[10]. The situation can question whether the government did enough to intervene. As was touched upon earlier, the FSA and Bank of England (BofE) had a mismatch of power – with the FSA holding information on financial institutions and the BofE acting as an agency to provide financial assistance. The FSA, for example, only held eight supervisory meetings between 2005 and August 2007[11]. Buiter (2008) says that because of this, “it is clear that separation of information and resources creates problems”[12]. Therefore the British government could be accused of not intervening, by not having a correct and efficient system in place to handle such a problem in the first place.

There is, however, a counter-argument, in that governments provided too much intervention, which resulted in the financial crisis of 2007-2010. This may, on some levels, be due to governments not wanting a repeat of the Great Depression that occurred in early 1930s (as a laissez-faire approach to financial regulation had been in place at the time). The U.S, which had been at the centre of the Great Depression, could be accused of offering too much intervention in the build up to the recent financial crisis - an opposite shift in policy. The urgency by the U.S government to increase homeownership was displayed by the Fed cutting the federal funds rate to 1% in 2003, up until 2004. This incidently was the period of the most rapid home-price increase. Government intervention in the U.S also took place in a slightly less obvious sense, via government sponsored agencies (GSEs), such as Fannie Mae and Freddie Mac, two major mortgage providers in the U.S.  De Laroisier (2008), argues that this “aggravated the situation”[13] of the housing bubble, resulting in overly inflated house prices. Thus mortgage payments for many people, who in the first instance, were not always entirely suitable for the deals they had been given. This, “unhealthy close relationship”[14] resulted in blocked reforms of GSEs, then a dodging of responsibility when things went wrong – “Fannie and Freddie had become classic examples of crony capitalism”[15].

However, it is worth taking another angle to our argument. The housing bubble problem was a microeconomic variable that held such prominence, it facilitated the creation of a macroeconomic problem. There is no denying that governments around the world aided the accumulation of this via their desires to have high home ownership. However, the housing bubble was not the only aspect of the economy which governments could be accused of intervening all too often. The Bear Stearns bail out in the U.S in March 2008 was effective in an immediate sense. However, it was structured to, “maximise moral hazard by distorting private incentives in favour of excessively risky future borrowing and lending”[16]. In effect this raised moral hazard within the banking sector; by suggesting that excessive risk-taking wouldn’t have the kind of consequences attached to it if this hadn’t had been the case. Ferguson (2009) agrees that the crisis was a consequence of “moral hazard in the form of implicit state guarantees, combined to create ticking time-bombs on both sides of the Atlantic”[17]. The expansion of the financial sector since the 1980s created a demon within itself, in that many governments, fearing an economic meltdown, were willing to intervene and bail-out banks. The growth of the financial sector meant that “banks could and did assume that they could enjoy implicit government guarantees, believing that they were ‘too big to fail’.

To summarise, there are arguments both for and against too much/too little government intervention in helping cause the financial crisis of 2007-2010. The age-old desire for high home ownership seems to be at the root of both arguments – whether it be turning a blind-eye to excessive and risky lending, or in promoting large scale lending by monetary policy. However, I feel that not enough quality intervention by governments is the most prolific cause - which was largely due to the badly organised and uncohesive regulatory and support structures.. The disorganisation and poor regulation meant that many institutions were able to continue to act in a manner which was unsustainable. I feel that this helped the housing bubble and its by-products, to mothball into what became the financial crisis of 2007-2010.

[1] http://www.quotesby.co.uk/quotes/q119342/

[2] Minsky: Hyman P.; Financial Instability Hypothesis; 1992: p.2

[3] Buiter, Willem H.; Lessons from the North Atlantic Financial Crisis; 2008: p.4

[4] Buiter, Willem H.; Lessons from the North Atlantic Financial Crisis; 2008: p.4

[5] Buiter, Willem H.; Lessons from the North Atlantic Financial Crisis; 2008: p.2

[6] The Economist; Risk and Reward; A Special Report on International Banking; May 19th 2007: p.15

[7] Shiller; Robert J.; The Subprime Solution; Princeton University Press; 2008; p. 40

[8] De Laroisier; Jacques; The High-Level Group of Financial Supervision in The EU; 2009; p.7

[9] Shiller; Robert J.; The Subprime Solution; Princeton University Press; 2008;

[10] Buiter, Willem H.; Lessons from the North Atlantic Financial Crisis; 2008: p.41

[11] Dowd; Kevin; Moral Hazard and the Financial Crisis; 2008; p.22

[12] Buiter, Willem H.; Lessons from the North Atlantic Financial Crisis; 2008: p.47

[13] De Laroisier; Jacques; The High-Level Group of Financial Supervision in The EU; 2009; p.7

[14] Dowd; Kevin; Moral Hazard and the Financial Crisis; 2008; p.15

[15] O’ Driscoll 2008 in -  Dowd; Kevin; Moral Hazard and the Financial Crisis; 2008; p.15

[16] Buiter, Willem H.; Lessons from the North Atlantic Financial Crisis; 2008: p.2

[17] Ferguson; Niall; There’s No Such Thing As Too Big to Fail in a Free Market; 9^th November 2009; p.1