On the Political Economy of Financial Deregulation

Drawing broadly on the literature on the political economy of the financial crisis, the paper looks at deregulation as a market driven process that culminated in a collective action failure. In the run up to the 2008 Financial Crisis strong competition and moral hazard went hand in hand and that raises a flag that needs explanation. The paper argues that opportunistic profit (rent) seeking was more the cause rather than the effect of moral hazard and regulation failure. Deregulation promised higher profitability partly because of better risk management made possible by advances in information technology and partly because financial institutions could take tail-risks the full cost of which they did not have to bear. The profits deregulation promised in turn incentivized financial firms to invest in tilting the political process to shape government policy. Because systemic risk cannot be fully privatized social insurance against it is inevitably a common pool (or open) resource, which means that there is an incentive for financial units to over-extract in the form of excessive risk taking in the absence of effective regulation. That explains why with deregulation market competition could culminate in excessive risk taking with mounting social costs. Using simple game theory the paper gives a stylized account of what sustained the deregulatory trend. In the course of deregulation, the regulators implicit threat of imposing discipline on financial institutions lost much of its credibility. That, combined with growing plutocracy go a long way in explaining why deregulation became a run-away market driven process that worsened the problem of moral hazard over time.