This is an unusual chapter in my ongoing series, the earlier two dealt with more or less narrow topics. Granted, the second was a bit more broad, but it still was limited to the topic of "damaging competition". In this one, I intend to deal with a whole subject, and the many mistaken impressions of it on both the right and the left. That topic is "deregulation", and many mistaken beliefs that exist about this topic.

 Let me start by saying I won't be dealing with the question of why we should deregulate, or the harm that consumer protection laws do. That second is the subject of my next installment. For our purposes I will assume that we agree deregulation is, at least in theory, a good thing, as otherwise there is no reason to deregulate and none of these questions would arise. And, for those too young or forgetful to recall, during the heyday of deregulation, it was taken for granted, even by some on the left¹. So it is not that odd to make such an assumption.

Now, let us start with the most obvious mistaken belief, and that is that "deregulation failed". As the heyday of deregulation has passed, largely because of poor implementations, which were then exploited by those with a vested interest in regulation to argue that deregulation was a disaster, the public in general has come to accept, at least in part, the belief that deregulation somehow failed, that removal of government oversight made things worse, and thus proved that some areas of the economy require government intervention to function properly.

Three examples immediately come to mind, two of which were true failures, but brought about by incomplete deregulation, and a third which is actually a success story (or was until unrelated events changed circumstances), but which has somehow been sold as a failure. The first two are finance, exemplified by the S&L crash and our more recent woes, and the public utilities, mostly electricity. And the success story sold as a failure is to be found in aviation, with the (partial) deregulation of air travel.

Let us start with banking, specifically the S&L crash. While it has been "common knowledge" that deregulation caused the collapse of the S&Ls this is actually not true. There were a number of factors that contributed to this collapse. First, there was the regulatory environment before "deregulation", which required S&Ls to favor holding long term consumer debt, specifically mortgages. Thanks tot he Carter era inflation, this meant S&ls were stuck with a mass of low yield, long term paper they couldn't even give away, meaning they confronted their financial problems without adequate liquidity, or even assets they could liquidate². In addition to the mass of low interest loans, these thrifts were legally prohibited from engaging in even the limited diversification the traditional banks were. Admittedly, after deregulation they had wider horizons, but by then it was too late for many, they had already committed too much of their capital to a narrow range of investments. We were also dealing with an inflationary environment which, in itself, is enough to push investments into unprofitable avenues, as well as encourage companies to mistakenly pay out capital as profits. (See  "Inflation and Uncertainty".) Admittedly, by the early 1980's, Reagan's policies had slowed inflation dramatically, but by then much of the harm had been done³.

But far and away the biggest problem was deregulation, but not in the sense the critics mean. The problem is that the deregulation was not total. Seeing the thrifts failing, those pushing deregulation did not completely eliminate government involvement, they simply allowed the thrifts to put their assets into a wider range of investments, in a last ditch effort to stave off collapse. They did not remove government pressure to over-invest in mortgages, they did not remove the massive regulatory apparatus controlling the rates of interest paid or asked, and they most definitely did not eliminate the FSLIC. And that last is the death knell. You see, these banks were facing collapse. They were over committed to a limited range of investments, with only limited capital available for new investments. However, they also had government assurance that, should they become insolvent, the state would pay off the creditors, that is depositors. With that assurance, there was only limited exposure for investors and owners, who were, in effect, playing with other people's money. They would enjoy all the proceeds of success, but would insulated against all but a fraction of the costs of failure. Combine that with a desperate need for high yields to keep them afloat, and you have a recipe guaranteed to press these bankers into the riskiest investments imaginable.

However, to blame "deregulation" is to present a very misleading picture. The removal of regulations governing investments did allow for the final phase oft he collapse, the sinking of remaining capital into risky investments, and this, being such a visible activity, has often been blamed for the collapse, but it was hardly the sole, or even largest cause. The low interest 30 year mortgages in the thrifts' vaults were much more to blame than any investments. The investments were a last ditch grasp at salvation, and their failures may have hastened the collapse, but they hardly caused it. But even if they had, the investments were not the result of "deregulation", but of partial deregulation. The FSLIC and other government guarantees, both official and unofficial⁴ were what allowed the banks to engage in such risky investments. Without assurances they would not be on the hook for the complete amount of the loss, no bank would have engaged in such risky behavior⁵. It was not deregulation that was to blame, but incomplete deregulation.

The current collapse follows a similar pattern. While much has been made of the deregulaiton allowing banks to engage in a variety of non-banking financial activities, there is nothing to show those are to blame. After all, various companies have engaged in those activities for a long time without collapsing, and banks of all sorts have plenty of financial acumen, so why would they suddenly be unable to tell the difference between viable and non-viable investments? And why would the change in banking regulations suddenly cause insurers and other investment firms go bankrupt? They had nothing to do with these changes. No, the blame there is twofold, deregulation is a small part, and the government and economy are a large part.

As with the S&L deregulation, in some ways the banking changes were an effort to allow banks to remain solvent. The government had been pressuring banks to make non-viable loans for some time. Thanks to these loans, and rampant inflation, there had been a considerable housing bubble, which obscured the losses these loans represented. However it was evident that the financial sector was in trouble. The more regulated sectors of the financial industry, banks and insurers, were suffering losses, while less regulated companies were profiting in the inflationary boom. In an effort to dig banks out of the hole, banks were allowed to participate in some of these other activities. And again, just like the S&Ls, banks had only limited funds left for these investments, while their losses were insured by the states. And so, again, like the S&Ls they engaged in risky investments to try to earn the maximum returns.

One other similarity to the S&Ls, the investments, while damaging, were hardly the cause of the problem. And we can see this through the collapse of unrelated companies, such as insurers and investment firms. In fact, even the favorite conservative whipping boy, the Community Reinvestment Act, is not really to blame. Yes, the act made the situation worse (see "Place Blame Fairly, Regardless of Party" and  "Not Entirely to Blame"), the collapse itself was simply the outcome of inflation. In fact it was simply the return of the collapse we were facing immediately prior to 9/11. Even that was not the true start, this was simply the latest in series of incipient recessions, going back to the first Bush, through Clinton and the dot-com bust, to the younger Bush, all resolved through inflationary means, which simply postponed the collapse. While it is easier to blame a specific act or action, the truth is the banks were failing due to problems inherent in our regulated money supply, exacerbated by Nixon's closing of the gold standard and excessive deficit spending throughout the end of the 20th century. Deregulation played no role in causing it, and at worst, ill-considered partial deregulation exacerbated it slightly, speeding the collapse a little bit. It is hardly to be laid at the door of the free market.

Let us now turn to the second deregulatory fiasco, electricity. As there are a variety of scenarios, each state implementing its own particular absurdity, I will only touch on some highlights. For example, in my home state of Maryland, deregulation was accompanied by an agreement in central Maryland that BG&E would not charge above a certain rate, well below market, for 10 years, and, in exchange, BG&E was subsidized by the state. Of course, with BG&E subsidized and charging well below market, there was no way any competitors would enter the market, so BG&E remained a monopoly and when the caps ended, along with the subsidies, and prices rose, BG&E could charge whatever they wished. Though this was blame don deregulation, the problem was the ten years of monopoly status granted to BG&E, not deregulation.

A similar situation existed in California. Companies were granted some freedom, but were locked in to long term power purchase agreements, while also having rates capped. In other words, the government allowed some freedom, but imposed enough fixed costs and price controls, along with prohibiting the building of new plant, to ensure the eventual collapse of the entire system. Yet, again, the free market was blamed and deregulation was the favored target⁶.

Which brings me to the final example, and one where the blame heaped on deregulation is even more unfair. That is air travel.

First, let us establish one incontrovertible fact, airlines were never really deregulated, and are not deregulated today. There is still a massive amount of regulation surrounding civil aviation. What was called "deregulation" was allowing some tiny measure of market forces to enter the marketplace, and stop the government's practice of using regulation to maintain the same airlines in the market despite any inefficiencies.

Of course, once the barriers to entry were lowered slightly, and some of the regulations propping up various airlines were removed, airlines began to go out of business. That was to be expected, and even desired⁷. Though it was sold at the time, and since, as yet another "failure of deregulation", the closing down of airlines was overdue. The government had spent decades maintaining an inefficient airline cartel, setting up things to prevent new entrants and maintain old airlines, and inevitably the system was remarkably inefficient. Yes, when the restrictions were removed, the airlines went under, and for a time the market suffered, but look at the conditions today. Air travel is cheaper now than ever before.

Of course some complain saying that modern airlines do not provide the services common on yesterday's airlines, but that is not an argument. If people wanted those things, then airlines would provide them, and they do in first class. What modern airline service tells us is that people want mostly cheap travel, and don't care about frills. Of course, int he past, the cartels did not need to concern themselves as much with consumer wants, and, as they could not compete on pricing, as they largely locked into charging the cartel price, they competed on frills, which is why airlines offered so many extras while not offering lower priced services during the cartel era.

But what we have now is hardly the failure of deregulation, in fact it is a success story. With only minimal removal of restrictions, we eliminated inefficient airlines, introduced real competition, improved responsiveness to consumer needs, and even lowered prices significantly. Now, admittedly, after 9/11 many of these improvements suffered with the general decline of air travel, as well as the traveler unfriendly security restrictions, but despite that, the deregulated industry has fared well, something I doubt the cartels could have done. So, especially because they weathered 9/11 so well, I have to say the airlines are probably the best success story of modern deregulation, despite the many remaining regulations.

And the airlines bring me to another point, one where the right sometimes errs. The right, quite rightly, has a fear of both governmental power and those who toady to the government to gain advantage. They also often adopt the same moralizing tone as the left, hoping to enact free market rules to bring justice.

But there is one problem, sometimes in their zeal for both justice and to punish those who abuse government power, they forget both their principles and real interests of the firms in question. And so when someone suggests something such as deregulating airlines, they see it as benefiting the airlines, who are the villains in their minds. (A similar distaste exists for deregulating insurance, as they see the insurers as complicit in the attempts at creating universal coverage.)

What this attitude misses is the fact that, while deregulation may seem to be rewarding existing firms for their misbehavior, deregulation is the last thing they want⁸. Yes, deregulation is generally good for an industry, but the firms that exist under strong regulation are hardly the best competitors, so deregulation, far from giving them free rein, actually is likely to cut their profits if not drive them from business, as newer, more agile competitors, kept out of the market by regulation, can now compete.

And so, while the right sometimes balks at deregulation of specific industries, they should really stick to their principles and always favor uniform reductions of government involvement, as such deregulation, far from rewarding the cartels and monopolies is their worst fear.

Which brings me back to my initial point. In the area of deregulation quite a bit of what we think we know is simply wrong. Deregulation is not responsible for the ills we have seen in those areas of industry often claimed to be deregulated, nor does it reward the cartels and monopolies that existed under strong regulatory regimes. By deregulating, we create a level playing field, where the cartels and monopolies are forced to compete, provide good service and lower prices, or else fail and be replaced. It is the situation we all claim to support, the competition politicians say they support, but so rarely do in practice.

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1. Not all in the 80's and 90's agreed that deregulation was a good thing, but after the miserable failure of the Nixon-Carter regulatory states of the 1970's, and the massive public rejection of HillaryCare and other big government solutions, culminating in the 1994 Republican victories, it seemed the public was, for the first time since the 1890's, completely united in supporting competition as the foundation of our economy. Granted, from the 1890's through the 1970's, competition was paid lip service, but from the 1890's, and certainly after the 1930's, there was always an assumption that competition was somehow "defective" and required government "tweaking" to work. The 1980's and 1990's saw a return to an earlier faith in the innate benefit of competition. It was short-lived, and incomplete at the best of times, riddled with contradictory beliefs, such as pushes for protectionism alongside free trade agreements, but, for the most part, the period of deregulation in the 80's and 90's was the first real revival of our national belief in the free market, no matter how imperfect that revival may have been.

2. This is similar to the situation prior to our current crisis. With lenders and investors holding a mass of low-interest loans, in a market with rising interest rates, they all found themselves unable to liquidate, and with the government reluctant to provide the insurance they had promised. It seems government efforts to force low interest housing loans on lenders and others often precedes a system-wide crash.

3. Not to mention that the inability to stay within the budget meant that the government continued to borrow. No longer able to inflate, they ended up borrowing on the open market, driving up interest rates farther and making the paper held by the S&Ls even more difficult to sell, as well as cutting off sources of short term capital for S&Ls facing liquidity issues.

4. The federal government had a long history of declaring "bank holidays" during the gold standard era to help prevent banks from losing their gold reserves during panics, and states had done the same before the federal government got involved. Since the advent of the federal reserve, banks were largely saved from collapse by release of money at the discount rate, well below market, and so it was certain that the S&L owners and investors were confident that the government would step in to prevent a widespread collapse of the system.

5. I have discussed this before when speaking of bankruptcy laws and other laws which subsidize or indemnify against risky behavior. See "To Correct Debra Saunders", "When Help Hurts", "Welfare for Malibu Residents" and "Subsidizing Irresponsibility and Poor Planning".

6. This example was mentioned before in "How To Blame the Free Market", an essay which dealt with many of the same subjects.

7. I spoke of this topic elsewhere in another context. It is likely, thanks to our familiarity with inflationary conditions, we have come to misunderstand what is a healthy rate of business failure. Though business failures are painful for those risking money to start a firm, in the larger scheme of things, it is probably best that all but the most effective businesses make way for better competitors. So it is probably that what we consider an excessive number of bankruptcies is actually a normal number under non-inflationary conditions. Similarly, in terms of the airlines, we were used to a cartelized air system with impossibly high barriers to entry, which allowed firms to remain in business despite incredible inefficiencies. The number of bankruptcies we saw certainly high, but you must consider it was effectively the bankruptcy backlog since regulation began being cleared all at once. And as we have seen, it was not repeated, even in the dark days after 9/11. (For more details on this topic in general see "Why"Negative" Economic Indicators Are A Good Thing", "Environmentalism For The Economy?", "Now I Get It!" and "Inflation and Uncertainty".)

8. I discussed this earlier in "Anti-Business Businesses ".

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POSTSCRIPT

Here are the earlier installments in this series:

Bad Economics Part 1 - A discussion of how prices disprove theories of resource depletion
Bad Economics Part 2 - A debunking of the many theories based on "defective" or "damaging" competition

Please visit the blog regularly, as it appears this series is actually going to be updated regularly, unlike many of my other series ideas.

POSTSCRIPT II

I have learned from years of experience that someone will inevitably take exception to my description of the S&L failure. And they probably will have a pretty good point, one that I overlooked. It seems every time I have brought up this topic since the late 1980's, someone has pointed out yet one more way in which the government set them up to fail. I am also sure someone will take issue with the relative weights I assigned to each factor. I am not sure why, but the S&L collapse seems to inspire more debate than any I know. Not sure why that is, but it has held true nearly every time I have mentioned the subject.