The 1930s witnessed the enactment of landmark pieces of securities legislation, many of which were directed toward preventing a recurrence of the factors that either caused or contributed to the Great Depression. At the time, one of the purported causes of the Crash of 1929 and its aftermath was identified as excessive speculation in capital markets by ostensibly unregulated banking institutions using depositor funds. Eighty years later, we are faced with an almost “déjà vu” as financial market reform occupies the center stage of public debate. The rhetoric today is eerily reminiscent of the rhetoric of yesteryear.
The new administration has “imitated the intellectual and vocal techniques of typical European revolution,” in which the “first demands were powers of dictation over industry and agriculture and finance and labor.”1 These words were delivered in a speech by Herbert Hoover on March 7, 1936. Hoover had lost the 1932 presidential election to then-Governor Franklin D. Roosevelt (FDR) of New York, and this comment referred to aspects of FDR’s New Deal legislation, including financial market reform.
Hoover was a free market advocate and feared the impact of a strict regulatory framework on commerce. In that speech, Hoover went on to say that “a great area of business will regulate its own prices and profits through competition. Competition is the restless pillow of progress.”2 He equated the New Deal to European collectivism and implied that FDR’s ambitious policies would derail American liberty.
Notwithstanding the resistance of Hoover and other free market ideologues, Congress passed the Securities Acts of 1933 and 1934 and the Glass-Steagall Act in 1933 to address some of these issues. Many commentators believed those acts to be either unnecessary or excessively severe. The Glass-Steagall Act, in particular, met with strong opposition.
Contrary to those concerns, however, 1930s financial reform helped establish a foundation of trust in the markets that arguably fostered decades of economic growth and prosperity. Ironically, Hoover acknowledged this fact, despite his general resistance to regulation. “Banking, finances, public markets and other functions of trust must be regulated to prevent abuse and misuse of trust,”3 Hoover said.
While our Congress debates and, ultimately, passes some form of financial market reform legislation, the clear division between free market purists and those who champion greater regulation to promote public welfare is apparent again. So, I suppose the conclusion that one could draw is that not much changes over time. That is also the conclusion of Kenneth Rogoff and Carmen Reinhart’s ironically titled book, This Time is Different, an excellent study of financial crises throughout history. This book effectively demonstrates that financial crises reflect repeated mistakes in terms of contributing factors and policy responses.
The benefits of a market-based economic system are most profound. Unconstrained by the shackles of an oppressive regulatory structure, markets have a remarkable ability to efficiently allocate capital to society’s most productive uses. Granted, the market did not create Google, but it facilitated its growth as it forged a marriage between entrepreneurs and investors that identified its growth potential. Just as the market determined Henry Ford’s Model T was superior to the horse and buggy, the market might determine someday that all newspaper and magazine content will be more efficiently delivered over Apple’s new iPad platform.
Society advances under the banner of progress as economist Joseph Schumpeter’s concept of “creative destruction” takes root. It is arguable that a central planning-based economic system would never have invested the capital to develop a product such as the iPad. Only markets facilitate the allocation of capital to new technologies from investors willing to assume the risk of an uncertain outcome. Ultimately, the markets reward those with vision as it provides the means by which that vision can be realized.
“The Securities Act proceeds on the theory that the United States government will not undertake to tell a man what risk he shall take with his money. It will, however, to the extent indicated, require that he be fully informed as to the facts.”4 That quote is from an article written in 1933 by professor A. A. Berle Jr., responding to criticisms that the Securities Act of 1933 was unnecessary and severe. This quote reflects the core ingredient of any market-based system – i.e., the trust that is required among all participants in order for a market to function properly. If trust is breached, the market will ultimately cease to function and collapse under its own weight.
The financial crisis of 2007-2009 uncovered numerous breaches of trust. All bear markets have the effect of exposing artifices of greed. Madoff, Stanford, Galleon, and a host of other fraudulent or illegal schemes have undermined the foundation of our capital markets.
The recent case filed by the Securities and Exchange Commission (SEC) against the investment bank Goldman Sachs is less clear from a legal standpoint, but it supports the notion that general business practices on Wall Street adhered, perhaps, to the letter of the law, but not its spirit. The SEC alleges that Goldman withheld material information from investors in a complex derivatives transaction. The information related to a third party that sought to capitalize from the collapse in value of those same derivatives.
When asked about the Goldman case, I acknowledge there is a balance between caveat emptor on the part of investors and disclosure requirements on the parts of underwriters and issuers. The case is complex, both in terms of the legal issues and the structure of the actual transaction. What seems pretty clear from publicly available information is that the transaction was designed to facilitate speculation in a certain market.
This is far removed from the 1930s version of investment banking in which firms such as Goldman would act as simple intermediaries between those with capital and those that needed capital. Using synthetic securities and derivatives, Goldman constructed a vehicle that would mimic the direction of a particular asset class and then found investors on both sides of the trade. Further, it is alleged that Goldman actively bet against certain clients on transactions the firm underwrote. Should such modern day practices be outlawed? That is the relevant question as the Goldman case becomes the focal point of broader financial market regulation.
With respect to the long-term impact of financial market reform, I worry that innovation and capital formation could be stifled. I worry that our markets could become less competitive. However, I recognize that the authors of the landmark securities legislation of the 1930s could never have anticipated the creation of collateralized debt obligations (CDOs), credit default swaps (CDSs), and other wizardry of Wall Street financial engineers.
I believe, therefore, the recent SEC securities fraud case against Goldman Sachs is likely to spur on new regulations that will modify the manner in which large financial institutions conduct their practices. I anticipate that legislative reform will focus on stricter capital controls, less leverage, and greater transparency. I further anticipate that a coordinated global effort at financial market reform will shrink profit margins for many of the large global banks.
While there is risk of “over-regulation,” I remain encouraged that much-needed regulatory reform will re-establish trust in the capital markets long term. While this also implies less available capital for small and large businesses alike, the system should be more stable. Moreover, it is likely that new financial intermediaries will emerge to serve neglected areas of the market, albeit at higher costs.
Reform today, as it was in the 1930s, does not imply an abandonment of free market principles. It is a necessary refinement, and I anticipate innovations will appear that facilitate the ongoing marriages of investors with entrepreneurs.
Ray Ryan is a Principal and Portfolio Manager of Patten and Patten, an investment management firm and Registered Investment Advisor in Chattanooga. Ray is a CFA Charter Holder, a member of the Advisory Board for UTC’s College of Business, and an Adjunct Professor of Finance at UTC. He is a graduate of Princeton University, where he had the privilege of taking a course taught by current Fed Chairman Ben Bernanke.
Article originally appeared in CityScope Magazine June 2010.