Government Treatment of Financial Institutions during Two Financial Crises (3915 words)

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In 15-20 pages (American Economic History 20th Century)
Comparing the government treatment of the leaders of privacy finance after the 1929-32 collapse with their treatment after the collapse of 2008-date.

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Even today, the causes of the Great Depression are debated. A description of the causes of any depression, recession or financial crisis will always be subject to criticism because the issues are complex. For example, the asymmetric information structure of new complex financial derivatives have been blamed for the Financial Crisis of 2008, and these complex derivatives are only part of an even larger complex financial system of inter-related institutions. Nobel laureates in economics disagree on these topics. However, the government must take action based on the prevailing economic theories and statistics available to them at the time. Yet many of the similarities between the two government reactions to economic disruptions separated by eight decades are uncanny. Both involved multiple inquiries, testimonies and hearings involving virtual interrogations of Wall Street titans and resulted in a major overhaul of securities regulations. One major and important difference however is the unprecedented bailouts of financial institutions in response to the 2008 financial crisis. In contrast, the Fed did not provide any major bailout money to banks in the early 1930s.
Competing Behaviors: Fear of Moral Hazard and Regulatory Capture
Moral hazard is a term that refers to reckless behavior resulting from protections such as insurance. For example, if property is well-insured, the owner may be less vigilant in taking care of it. Overall this moral hazard imposes more costs on the insurance industry. This is because more insurance claims are made as more accidents happen to the property than might occur if insurance did not exist. For the US monetary and banking system, moral hazard is created by the Fed, as a “lender of last resort,” bailing out banks that are “too big to fail.” For government bailouts, the costs of moral hazard can be imposed on the tax-paying public. During the late 1920’s and early 1930’s, i.e., the Great Depression, government leaders were not willing to bail out banks because they believed it would only induce more risky behavior. In contrast, several financial institutions were bailed out during the events surrounding the 2008 financial crisis which developed in to the Great Recession. A particularly notable exception to the bailouts in 2008 was for Lehman Brothers.
Bailouts or the lack thereof are only one of two main aspects that government reactions to the Great Depression and the Great Recession have in common. The other has to do with regulating Wall Street. As a result of the Great Depression an important piece of legislation emergence: the so-called Glass-Steagall Act of 1933. This was designed to protect the banking system (depository institutions) from being contaminated by riskier Wall Street activities such as underwriting and trading securities. The system worked well so well for many years (with the exception of the savings and loan crisis) that eventually government leaders felt comfortable enough to repeal many provisions in 1933 Act. It was effectively dismantled with the passage of the 1999 Gramm–Leach–Bliley Act. The impact of this decision on market developments over the next twenty years that contributed to the Financial Crisis of 2008 is hotly debated. Yet many agree that it was an example of regulatory capture, and much effort has been put into restoring elements of the Glass-Steagall Act in the Dodd-Frank Bill. Regulatory capture is said to occur when regulators act in the interests of the regulated rather than the broader public.
The remainder of this report is organized as follows. The next section briefly describes the causes and results of the Great Depression to explain the origins of the government...
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