On December 10, the Program on America and the Global Economy of the Woodrow Wilson Center, hosted a book discussion featuring Nicole Gelinas, author of After the Fall: Saving Capitalism from Wall Street – and Washington. Gelinas, a Senior Fellow at the Manhattan Institute for Policy Research, highlighted how government has played a role in the financial services industry for over two decades and how market distortions gave rise to the current economic state of affairs. The discussion was moderated by Kent Hughes, Director of the Program on America and the Global Economy.

Gelinas argued that the seeds of the current crisis were sown in the early 1980's as the financial industry became more interconnected. Gelinas specifically cited the collapse of Continental Illinois National Bank and Trust Company in 1984. Upon its collapse, the government chose to bailout the institution rather than allowing it to fail, which signaled the adoption of a "too big to fail" policy for the largest or most complex financial companies. Gelinas argued that this led to a "sea change" in which a moral hazard emerged whereby actors operated without the "vital market discipline that the threat of loss provides."

According to Gelinas, complex financial instruments, such as unregulated derivates and credit-default swaps, escaped constraints on speculative borrowing and requirements for the disclosure of important facts. Gelinas said that while speculation is both "wonderful and necessary for the economy," it can lead to disaster when people borrow against every last dollar. Therefore, Gelinas stated that the government learned in the aftermath of the Great Depression, that putting limits on speculative borrowing meant that investors could lose money without it affecting the economy as a whole. Utilizing these new instruments, the market moved away from these consistent limits. Financial institutions were then free to speculate while not being entirely aware of where the risks lay.

As troubles mounted, the financial industry eventually posed an untenable risk to the economy, which led to government intervention. The question now is how to shape future financial regulation to prevent a collapse of this magnitude from happening again. Gelinas rejected the proposal being put forth by some policymakers—the creation of a systemic risk regulator, as not only ineffective but as an unacceptable maintenance of the status quo. Gelinas asserted that such micromanagement is ineffective because it incentivizes the market to please the government's "top-down risk decree." In defending that position, Gelinas maintained that just as most economic stakeholders could not have predicted the previous crisis, a new regulator will not be able to tell where the next disaster will come from.

While Gelinas could not support a risk regulator, she did offer another solution. Given recent events, Gelinas said it is clear that Washington must embrace a bottom-up process. First, Gelinas recommended that policymakers reintroduce market discipline by removing government subsidies for the financial industry. Second, Gelinas proposed that policymakers create prudent financial regulation as opposed to the current, "irrational regulatory framework" to ensure that the economy can better withstand the "inevitable excesses of optimism and pessimism." Gelinas maintained that these proposed solutions can create a level playing field in which both the market and the broader economy can maintain solid footing.

By Matthew Clarkson
Kent Hughes, Director, Program on America and the Global Economy