Introduction

There is a very suspect trend in this country over the last few decades. Every time there is an administration that pushes to deregulate – especially the financial industry – it seems to be followed quickly by a crisis. The next administration is seen as “cleaning up the mess” by clamping down on regulations yet again. Additionally, it seems to follow an alternating pattern of left vs. right.

While it is not as straightforward as this narrative suggests (it was Clinton who repealed Glass-Steagall, laying the groundwork for the Great Recession), there is certainly some truth to it. There are two reasons why deregulation leads to crisis, crash, and recession. However, “unchecked capitalism” is not to blame.

Unhealthy Organisms Die

The larger something is, the more fragile it is – by nature. As businesses grow larger, they become more susceptible to shock, disruption, and irrelevance. Just like an elephant is more fragile than a rabbit, dinosaur businesses are more fragile than startups.

Therefore, the only way for large companies to hold on to what they have is state coercion. Through lobbying, campaigning, donations, and bribery, large companies persuade the state to close the door behind them, effectively preventing competition through red tape. This is the opposite of capitalism and free markets. The problem is here is too much government, not too little.

When waves of deregulation sweep through landscapes full of the above, things start to break. This is painful but healthy. All the old, heavy, fragile, slow, and irrelevant big businesses start to crumble underneath their own weight as startups and competition start to devour them. This leads to job losses for some – and job gains for others. This leads to investment losses for some – and investment gains for others. Overall, the system is healthier long-term, even though it is painful for some short-term.

Cutting The Cord Rarely Accompanies Deregulation

Instead of the healthy scenario painted above, what happens more often is a continuance of government support and subsidy, without the restraints. In this scenario, which is much more common, regulations are repealed but Uncle Sam’s credit card stays in the hands of the irresponsible teenager (large corps).

This inflates the malinvestment, misallocation of resources, and allows the large, unhealthy companies to increase their stranglehold on the economy. Systemic crisis – as opposed to isolated bankruptcies – is the common outcome of this scenario.

Said another way, deregulation often leads to a systemic crisis. This is not because of capitalism or free markets. This is because the deregulation is not accompanied by a withdrawal of implicit/explicit bailout and subsidies. The moral hazard this encourages puts the whole system at risk instead of just the individual company.

During the financial crisis, banks knew that that plethora of government bailout programs and subsidies (FDIC, SIPC, the Treasury, the Federal Reserve) would not allow them to fail if the insane levels of risk they were taking on blew up in their face. They knew that if they failed, it would collapse the whole financial system, which would be too painful for politicians to bear.

It wasn’t the deregulation that caused the crisis. It was the bailout waiting to happen. Deregulation accompanied by the withdrawal of support would cause large fragile institutions to fail. It discourages risk rather than encouraging it.

Bottom Line

If we want a healthy economy and a healthy financial system, we need both deregulation and a cutting-off from government support.

While both of these exist together, you get a quasi-nationalized (socialist) economy. Inefficient, little growth, no innovation, and dissatisfaction. When regulation is repealed but the standing bailout remains, you get monstrous malinvestment paired with systemic risk-taking that puts the economy on the edge of a cliff.

However, if we end institutions like the Federal Reserve and FDIC that serve as a guarantee against failure, regulation can be safely removed as well. You are left with a system that thrives with competition. One that allows easy entry into industries, causing constant disruption. Companies rarely grow to sizes that are uncomfortable unless they are absolutely stellar. And as soon as they stop being the best option, competition is ready to devour them.

No systemic risk. No cronyism. No rent-seeking. No barriers to entry.

Yes, deregulation causes pain. When accompanied by cutting-the-cord, everyone ends up far better off.