The History of Regulating the Financial Markets: The Great Depression and 2008

As much as investing is crucial to our economy, so are the rules which regulate it. As shown in history, when regulation was misguided or lacking, massive financial and economic crises have happened, most notably the Great Depression and Great Recession. Why are regulation so important? Most clearly, they prevent the misconduct which places excessive risk, usually on other less powerful actors. In this article, I will discuss the historical development of financial regulation in the US.

Pre-Depression Regulation

Before the 1900s, investing was an activity almost completely for the rich. Only the wealthy could find the money to invest and afford the risk of loss. Since it was restricted to so few people, it was also restricted in complexity and regulatory oversight; most pre-industrial revolution investing was in the form of private joint-stock companies, which are private agreements of shared ownership, and bonds from banks and governments. These required very little regulation as most joint-stock companies were formed with personal business associates and most bonds were issued by reputed institutions. However, as their was little regulation, investing was considered extremely risky to the less wealthy. It is important to note that the early flexibility in investing did fund the developments of factories and railroads in early America. These enterprises were lucrative, but minute in comparison to the big business of the 1900s.

The Industrial Revolution in the early 1900s granted a greater disposable income to the middle class, which they began investing in stocks and bonds, usually through brokerage firms. This practice grew and grew, causing the 1920s to be known for its booming stock market where more people began putting their money. Despite the increasing complexity and size, before the abrupt end of the boom, the only meaningful regulation of investing was the Blue Sky Laws. The Blue Sky Laws were a set of state laws which required the issuers of securities to disclose some basic information about their business. The general purpose of these laws was to protect investors from being ripped off because of a lack of information. However, since these laws were on a statewide basis and most administrations were dominated by pro-business forces, the laws were impossible to enforce federally and thus had little effect.

Floor traders gather on the floor of the exchange to buy and sell securities in the early 1900s

The Great Depression, 1929

The Blue Sky Laws definitely did not prevent the sudden and severe crash of stock prices on October 29th, 1929 which sparked the Great Depression. Before the crash, the prices of securities were vastly inflated; during the 1920s, stock prices rose continually because investors expected them to continue rise, leaving the book value of stocks far above the actual fair value. This phenomenon is called a bubble. Additionally, high-level stock brokers manipulated stocks prices in the short run to make off with immense profits and leave the uninformed investors holding the bag. And when expectations turned the other way, naturally the bubble popped, and the prices dropped severely. However, the collapse of the stock market would not have snowballed into the Great Depression if it were not for the banks.

Despite the Federal Reserve being established a decade earlier, banks were not properly regulated. Out of greed, they loaned much of their deposits to regular people to invest in stock markets, more than to commercial ventures, and when all that loaned money in the stock market disappeared overnight, the American public lost faith in the banks and rushed to withdraw money from them. However, since banks did not have enough currency in the vault to repay depositors, many banks went out of business, further ruining consumer expectations. All this lead to a drying up of credit and loans, which are vital to business investment and consumer spending. The Federal Reserve could have counterbalanced this by pursuing an expansionary monetary policy and pumping money into the economy, but it didn’t. As a result, the economy came to a halt in the 1930s: business laid off workers, which caused a drop in consumer spending, which in turn caused businesses to lay off more workers. At the Great Depression’s peak, or trough, the unemployment rate was 25%, and men all over the nation left for California in search of jobs, where there were none.

Roosevelt (and Hoover to a much smaller extent) tried to mitigate the depression by increasing government spending in the form of public works. Roosevelt’s package of government programs was called the New Deal, and it had a small alleviating effect on the depression, dropping the unemployment rate from 25% to 14%. The real solution, however, was the U.S.’s entry into World War II, which kicked the U.S. economy into overdrive, dropping unemployment down to below 2%; it was in effect an extreme increase in government spending.

Resulting Regulation

The more lasting effect of the New Deal was its reform of the Financial Sector. The Securities Acts of 1933 and 1934 made the disclosure of financial statements, the business managers, and the past performance of a business; and established the Securities and Exchange Commission (SEC) which mandates the rules of securities markets and is in charge of enforcing regulatory laws concerning securities, which it actually did. The Glass-Steagall Act attempted to prevent bank misconduct and greed by splitting up commercial banking and investment banking and capping the percentage of a bank’s income which can from securities. In addition, it established the Federal Deposit Insurance Corporation (FDIC) which insures banks, preventing future bank-runs.

Depositors in a bank gather in a famous “bank run,” fearing for the security of their money

The regulation following the Great Depression was focused on fixing the banks, which it reasonably did. The establishment of the FDIC resulted in the elimination of the fear of bank runs; rather future crises, like the Great Recession, were caused by the drying up of loans. In addition, the separation of commercial and investment banking reduced the misconduct of lenders. In the future, predatory loans would be made, not by banks, but by other institutions. The role of the SEC increased; gradually, they began actively investigating and regulating financial misconduct. Now, it is an important check on the market. These laws formed the first steps of the basic regulatory system of banks. The biggest unaddressed problem was the ever-growing size of the banks.

The Great Recession, 2008

All of this added regulation was controversial after the Great Depression ended; many believed they reduced the flexibility and thus profitability of the financial markets, which made U.S. investment robust, and so the Gramm-Leach-Bliley Act repealed the Glass-Steagall Act in 1999. Bankers’ greed was again realized to the detriment of the U.S. economy: in the early 2000s, like the prelude to the Great Depression, banks made risky loans – called subprime loans – to finance assets – houses – which rose base on expectations. However, in this case, banks made the loans, not out of the belief that could collect on them, rather they planned to sell the bundle of risky loans to other financial institutions. These bundles were extremely profitable at first, as the prices of houses continued to rise, meaning defaults still led to profits.

A foreclosed home still struggling from the 2008 housing crisis

But in 2007, the housing bubble collapsed; houses which were purchased with massive predatory loans were now worth much less, and the people who took out the loans were unable to pay them back. Suddenly, banks were unsure what the value of their loans and securities based on loans was; and froze credit. Large financial institutions like Lehman Brothers were forced into bankruptcy, and others merged to survive.

Resulting Regulation

The government tried to take decisive action by bailing out banks, passing a stimulus package, and dropping the interest rate to 0%; all actions which were believed to keep credit and the economy flowing. However, there was still a significant recession and a sluggish, but constant, recovery. Officially the Great Recession of 2008 ended in June 2009. In 2010, The Obama Administration pushed through the Dodd-Frank Act, regulatory laws targeted toward permanently preventing another housing bubble: it mandated that all transactions of securities be made public; limited the types of risk banks could take on; proscribed a process to investigate and, if needed, dissolve large banks; and created the Consumer Financial Protection Bureau, which attempts to stop the type of predatory lending practices and financial misconduct which created the housing bubble. As an aside, the practices which caused the housing bubble and financial crash were new to regulators and investors, so it was unable to be properly managed.

United States President Barack Obama signs into law the Dodd-Frank Act to regulate financial institutions after 2008

It is still too early to absolutely declare whether these regulations worked, but there are some general conclusions which have developed. The practice of predatory housing loans have disappeared, but short-term predatory loaning and car and student loans have replaced it (partially at the fault of the government). And the CFPB has made significant progress for consumers, but many say it hasn’t taken enough action, especially after the current administration took over. Additionally, the Dodd-Frank Act has been called restricting to our traditionally robust financial market; this is troubling because our financial market is a catalyst for American growth and American economic supremacy. Furthermore, small banks were heavily burdened by the law, leading to a partial repeal of Dodd-Frank in 2018.

Conclusion

As the Dodd-Frank Act was partially rolled back in early 2018 and as the new Republican administration has taken a step back from regulation, questions have been posed whether more regulation of the financial market is needed. However, there are doubts that regulation will work. In the financial markets, there is robust innovation directed toward circumventing laws and earning the quick dollar. Therefore good regulation pursues the motives in addition to the methods: when greed and selfishness are curbed or prevented – either by decentralizing the benefits or limiting the returns – reckless actions are deterred into responsible ones.

Nevertheless, proper regulation of the financial sector is critical to everyone; it is in control of the transactions which determine the ability of the economy to flow. When those in control of the financial markets make poor decisions, out of greed or incompetence, there are severe consequences around the world. Both the Great Depression and the Great Recession caused global economic panic. Both crises precipitated from investors making decisions which were profitable in the short-run but placed great risk onto others (called moral hazard). Therefore, it is imperative that every investor does what he thinks is most profitable to his firm and in effect the economy in the long-run. The question is whether our government regulation is up to the task.

More Information

https://www.law.cornell.edu/wex/blue_sky_law

https://www.law.cornell.edu/wex/securities_act_of_1933

https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp

The Business Cycle: Is a Recession Soon?

It seems like the US economy crashes every decade or so, and there is some fact in this; the US economy and every other economy undergoes alternating periods of expansion and depression. This phenomenon is called the business cycle.

What is the business cycle?

Specifically, the business cycle refers to the fluctuation of the economy about the potential level of GDP. The potential level of GDP is the GDP when all resources are efficiently used and there is a normal rate of unemployment. The real level of GDP falls below potential GDP when resources are not used efficiently or when the unemployment rate rises above the natural rate. The real level of GDP rises above potential GDP when resources are overused – like destructive logging or disastrous pollution – or when some people who are economically unemployable are given jobs.

The business cycle consists of a period of expansion relative to the trend of long-term growth, after which the economy will reach a peak. Then, there is a period of contraction/recession relative to the trend of long-term growth, after which the economy reaches a trough. Then, the business cycle begins again. Cycles are not regular in length; sometimes depressions can occur within a couple of years, while other times decades may past without another severe depression. Government policy and regulation can have a huge impact on speeding up or delaying the cycle.

During the period of expansion, real GDP will rise, unemployment will fall, and inflation will increase; however, real income — income adjusted for inflation — will also rise, meaning consumers can buy more, and businesses produce more. Generally, everything which is part of a “booming economy.” This period is also called the inflationary period. In contrast, unemployment rises, and prices fall during the period of recession. Correspondingly, the real income will fall, slowing the economy.

What affects the business cycle?

The causes of the business cycle are not yet agreed upon, but it largely can be attributed to 2 things: supply and demand. When supply or demand is changed rapidly – shocked – the economy is pushed away from the equilibrium position; for example, when oil prices rapidly increase, like in 1973, the supply of goods is sharply reduced, slowing the economy and reducing output. When demand falls, the economy is likewise slowed because there is less consumer spending. An increase in either will have the opposite effect.

Common supply shocks are sudden changes in input prices, natural disasters, and technical discoveries. Natural disasters, like the Dust Bowl during the Great Depression, disrupt production, decreasing supply, while technical discoveries increase supply by facilitating production; the industrial revolution in the early 1900s led to the great imbalance between the supply of products and demand, resulting in crashes caused by too many goods and not enough consumers.

Demand shocks are caused by changes in consumer and business expectations; and financial crashes. If consumers and businesses expect financial hardships ahead, they will cut their spending, causing a decrease in demand. If they expect good economic developments, they will increase their investment and spending. Financial crises destroy the wealth stored in financial instruments; this causes consumers to spend less as they have less money. Additionally, financial crashes destroy consumer and business confidence, also decreasing spending.

Government and Federal Reserve Policies

After the Great Depression, the US Government has taken up mitigating the expansion and contraction, attempting to keep real output as close as possible to potential output. Its effort can be categorized as fiscal policy and monetary policy.

Fiscal policy is composed of changing government spending and raising or lowering taxes. These measures are decided on by the President and Congress. They are targeted toward increasing demand in depression and decreasing demand in an expansion, as demand is composed of – among other things – government spending and consumer spending, which depends on taxes.

Monetary policy is manipulating the supply of money in the economy. This is done solely by the Federal Reserve, the U.S. central bank. Increasing the money supply, or the amount of money in the economy will decrease the real interest rate, which increases investing from businesses and spending from consumers. Businesses invest more because money “costs” less to borrow and invest as the interest rate is the payment made on loans. Inversely, consumers will want to save less because they earn less on the money. Decreasing the money supply has the opposite effect of decreasing investment and consumer spending. It is important to note that I am talking about economic investment, which refers only to spending made to facilitate the future production of goods. As consumer spending and investment spending are a part of aggregate demand, controlling the money supply controls demand indirectly.

Where are we in the business cycle?

Recently, in the news, you might have seen news about President Trump disagreeing with current Chairman of the Federal Reserve, Jerome Powell. Their spat is fundamentally about the business cycle: the extremely low unemployment rate and robust growth in the stock market have convinced Chairman Powell that the US economy is approaching the peak of the business cycle, and so he has started to raise interest rates, which is contractionary monetary policy. Of course, this means slowing the economy to bring it closer to the long term trend line and to prevent or ameliorate the predicted-impeding contraction. President Trump, however, wishes to sustain growth, doubting a recession is imminent and that the expansion is coming to a close.

Is a recession approaching?

After the stock market took two serious hits in early 2019, the Fed has eased off raising interest rates, as it could scare investors into a financial crash. Additionally, unemployment (3.8%) still remains below the natural rate (4-6%). These indicators show that the economy is in a fragile position above the long-term trend line. The last three contractions in America were 2008, 2001, and 1991, about once every decade. The longest period of expansion was after the 1991 recession, lasting about 120 months. Our current period of expansion has already reached 117 months, meaning the US economy is due for another downturn soon. As such, correct monetary and fiscal policy should be implemented to soften the fall.

The Inverted Yield Curve: Recession Predictor or Flawed Indicator?

If you follow the markets closely, you have likely heard of the infamous “inverted yield curve.” Many experts on CNBC may link this flip to a coming recession, or a bear market. The stock market responds to the news of the curve reversal with strong selling. Today, the indicator has just made its presence known again, and the market did in fact sell off, with the S&P 500 down 1.90%, the Dow Jones down 1.77% and the Nasdaq down 2.50%. All this occurred despite a massive rally since the 20%+ sell-off that carried into the end of December. The interest rate for the 90-day T-bill surpassed that of the 10-year Treasury debt security, the benchmark inversion. But is the inverted yield curve really a cause for worry?

NOTE: To understand the terminology in this lesson, you will likely want to understand bonds and U.S. Treasuries, so please read our lessons here and here

What is the yield curve? What does it mean when it inverts?

The yield curve displays various interest rates, or yields, associated with different length debt securities, such as Treasury securities or bonds, though “the yield curve” likely refers to the Treasury yield curve for Treasury securities. As you can see in the graph below, higher borrowing periods are associated with higher yields, or interest rates. This is because of something called Maturity Risk Premium, and according to the Motley Fool, it exists because “one of the dangers of investing in a long-term bond is the potential for it to lose value before it comes due.” If interest rates increase, for example, then the value of your debt security, such as your bond, will decrease. When purchasing a bond for a longer amount of time, you incur more risk of your security decreasing in value. Hence, the increasing nature of the yield curve.

In times of economic growth and a stable stock market, the yield curve and the bond market as a whole will be stable and “normal.” Returns in the stock market will be higher than those from bonds, so demand for bonds will be relatively minimal. However, what happens in a bear market is the exact opposite.

The yield curve can invert in a bear market. This is because the demand for safer, Treasury securities, which are safe and offer consistent returns through their yields, increases in bear markets. With this higher demand, the price of bonds increases, and accordingly, their interest rates decrease. The demand for short-term debt securities and Treasury securities, however, is not as strong in recessions. Thus, the interest rates for those short-term securities will rise. As a result, the inverted yield curve, as seen below.

You may commonly hear of the curve “flattening.” This, in effect, is a more moderate transition away from the normal, upward-sloping curve to a flat curve, in which the interest rates are very similar or the same for various maturity dates. Often, this flattening is the first step towards an inverted curve, as the inversion of the yield curve is often years in the making.

What does the inverted curve mean?

The true significance of the inverted yield curve has been of considerable debate for the past few years. The curve has flipped a few times in the past few years, yet the economy has continued its bull run. Some economists defend the inverted curve as a signal for a looming recession, that has proved itself many times. Others ignore its presence, citing strong growth prospects and corporate earnings in an economy. It cannot be ignored that the historical track record of the inverted yield curve is quite strong, accurately predicting the latest recession in 2008, and many prior to that.

In the global economy, there are some fears of economic downturn. Growth has been greatly slowed by the trade war, corporate earnings have been some of the worst in a while this year in Q1 of 2019, and political tension remains a potent force in the European Union. An inverted yield curve simply continues to increase investor fear, and increases expectations of a recession. The “fear index,” or the CBOE Volatility Index, spiked by 20.91% today.

Final Thoughts

The inverted yield curve is a good metric to use when predicting recessions, but it is not the only metric one should rely on. As with all occurrences in the economy, more context is needed to analyze and predict the future. If the curve inverts in a strong economy, then you can expect the curve to recover back to normal. But if conditions appear to be turning for the worse, an inverted yield curve can often confirm fears of bear markets in the future. As with all economic indicators, use the yield curve with a great understanding of underlying market conditions.

Data from finance.yahoo.com

What Does It Mean to Be Unemployed?

There are a lot of misconceptions about unemployment, the unemployment rate, and the labor force. The term “unemployment” seems to imply that it represents all members of a country’s population that are not working — intuitively, this makes sense. However, the term is more nuanced, and there is a reason for that. With various macroeconomic indicators, such as the recent report on jobless claims, it is difficult, yet important to understand how the economy operates around you. In this lesson, I will explain what it means to be unemployed, the different types of unemployment, and the labor force.

What does it mean to be unemployed?

To be unemployed means to be actively searching for work. Simple, yet often confused with other definitions. Most believe that to be unemployed is to be not working. However, this definition would mean that a full-time homemaker is unemployed. This definition would not be accurate, as this individual is not actually seeking employment opportunities in the labor force.

To be either employed or unemployed means that you are a member of the labor force, which is comprised of those who are working, and those who are seeking employment opportunities. The unemployment rate is calculated by dividing the number of those seeking employment in the labor force by the number of people in the labor force. The unemployment rate in the United States was 3.8% as of February 2019.

One of the most commonly analyzed indicators regarding employment is the “labor force participation rate,” or how much of the American population is actually in the labor force, divided by the “Civilian Non-Institutionalized Population” (more about this here). For example, a child is not legally allowed to work, and would likely not be working anyway as they would be a full-time student. Thus, the child, under 16, would not be part of the “Civilian Non-Institutionalized Population.” The labor force participation rate in the United States is 63.20% as of February 2019.

Types of Unemployment

There are many types of unemployment, but I will cover the main three.

1. Cyclical Unemployment

Cyclical unemployment changes inversely with regards to the strength of the economy. In strong economic and business conditions, cyclical unemployment will be low. In recessions, cyclical unemployment will be high. In such poor economic conditions, firms will not be able to afford to pay as many wages, so workers will be laid off. The economy is said to operate on a “business cycle” of various fluctuations between various conditions.

2. Frictional Unemployment

Frictional unemployment will always occur in an economy, regardless of the economic conditions at the time. For example, suppose John is working at Walmart. Then, suppose the wages at Target increase. John has the same skills to work at Target, and there is a higher wage that is being offered. Thus, John will quit his job and try to find employment at Target. During the time that John is unemployed, he is said to be frictionally unemployed. He is looking for a new job, and transitioning from one to another.

3. Structural Unemployment

Structural unemployment is the most commonly discussed today. Structural unemployment occurs when technologies are able to do certain tasks more efficiently than humans. Thus, the humans, which cost more, and are often less efficient, are laid off and replaced with the new technology. Structural unemployment especially affects individuals with lower education levels, in industries such as manufacturing. It is more difficult for technology to replace workers in industries that require higher levels of education, such as law or medicine.

Why does unemployment matter?

Unemployment is important to all members of a society. The unemployment rate is a good indicator for economic conditions. Additionally, unemployment is something that many are going to be faced with in the future, especially structural unemployment. Recently, Chinese venture capitalist Kai-Fu Lee could be seen on 60 Minutes saying that the world could lose 40% of jobs within just 15 years. Thus, it is something that the world must face in the near future. Most importantly, however, is that understanding concepts such as unemployment will give you an informed perspective of the economy as a whole.

What is the Stock Market?

What is the stock market? You may have heard of the NASDAQ. What about the NYSE? Have you heard of the CME? All of these are exchanges, or places in investors or traders can purchase or sell securities or equities (such as stocks, bonds, or commodities).

What is it?

Traders and brokers gather in a frenzy on the NYSE floor

The stock market is a place in which buyers, sellers, and brokers interact to buy and sell monetary vehicles such as stocks. However, when we refer to the stock market, we are often referring to U.S.-based stock exchanges, such as the NYSE (New York Stock Exchange) that you may often see on TV, with an expansive trading floor, and many stock brokers running around frantically. The NASDAQ is also a U.S.-based exchange, but interestingly, it is all virtual, and made up of a series of servers that are housed in Carteret, New Jersey. Regardless of the type of exchange, each serves the same purpose – to facilitate the buying and selling of stocks, bonds, and other equities.

Futures Market

The U.S. also has an exchange for financial derivatives and futures (we will cover these later). This exchange is called the CME (Chicago Mercantile Exchange), and is has a data center in Aurora, Illinois similar to the NASDAQ.

A look at the 16 exchanges with a market capitalization over $1 Trillion

There are 60 stock exchanges located across the globe, with each serving a different region. There is a stock exchange for London, one for Hong Kong, and even one for Australia. Within each exchange, countries that are local to the country in which the exchange is based are traded. Thus, U.S.-based companies will be traded in the U.S.-based exchanges.

The History of Stock Markets

The Amsterdam Stock Exchange, the first stock exchange

The way in which stocks are exchanged in an exchange has changed drastically over the past 400 years with the growing use of technology to facilitate liquidity and volume. The very first stock exchange, the Amsterdam Stock Exchange, as well as other early stock exchanges, were located in bazaars or open-air markets, in which buyers and sellers of stocks would shout across the room to make transactions. The CME (as I discussed earlier) started as an open-air market in which butter and egg futures contracts were traded. In the 1960s, digital marketplaces became a commonplace for stock exchanges.

The purpose of the stock exchange has not changed. Next time you hear someone talk about “the stock market,” remember that it is a place that facilitates the transaction of stocks and other securities.

What Is the Macroeconomy?

When you think of the world “macroeconomy,” you likely think of a magnified economy – the economy of a nation, perhaps even a global economy. This is the right idea. The macroeconomy is a certain economic institution or system that operates on a large scale. Rather than reducing economic units to the household or the individual, the macroeconomy focuses on aggregates – consumer spending as a whole, or investment demand as a function of interest rates for firms in a nation. The idea is focusing on the whole and the large parts, rather than the small part, which causes small, insignificant change or deviation.

Studying the Macroeconomy

In studying the macroeconomy, we want to think about the institutions, the economic indicators, and the groups that contribute to a magnified economic system. Examples of such institutions would be the Federal Reserve System, which sets benchmark interest rates, and can greatly influence dozens of important aspects and subsystems of the national economy. The stock market is another example, facilitating willing investors with companies – providing a necessary influx of capital from investors to new projects or infrastructure. An example of an economic indicator in the macroeconomy would be the GDP growth rate. How fast does an economy grow each year? What fiscal or monetary actions must be taken to adjust this rate?

In opposition, the study of the microeconomy would focus on small parts of the economic system. The individual, and how they choose to spend their money based on utility maximization principles, or the firm, which chooses how to price their products based on the structure of the industry in which they operate. These are important concepts as well, but not important in the grand scheme of the macroeconomy. One individual firm’s choices are insignificant in the macroeconomy – if a firm chooses to overprice its products in a perfectly competitive industry, that firm will be pushed out of business. This does not deviate the path of the macroeconomy, which necessarily solely depends on aggregate units, or large collections of such firms or individuals in the economy.

Suppose a group of individuals choose to spend more money – this will cause a significant change in the macroeconomy, which is why macroeconomists tend to only focus on aggregates.

The Importance of the Macroeconomy and Macroeconomics

In studying macroeconomics, or the study of the macroeconomy, we can better understand the economic trends that influence an economy. We can begin to understand why aggregate groups make decisions – if the interest rate is high, why does investment decrease? How is the nominal interest rate connected to the real interest rate? How does an increase in unemployment compensation affect the unemployment rate? These are all complicated systems that function as part of the macroeconomy.

Macroeconomics becomes even more complicated when we think of the macroeconomy on a global level. How do the economies of other nations influence the global economy? How do global recessions start? These are just a few questions that can be uncovered and answered through the study of macroeconomics.

Final Thoughts

Studying macroeconomics is incredibly important, because it can and will affect you. You may watch CNBC or Bloomberg Markets, and hear discussion of the Fed’s raising of interest rates. How will this affect that new mortgage loan you wanted to take out? You may overhear that the housing bubble is about to burst. You can use your knowledge of macroeconomics to understand that you probably should wait to buy that new house you wanted. These are all macroeconomics concepts, but they affect you. Understanding what is happening to the macroeconomy keeps you informed and financially ready for anything.