Growth question, does deregulation create inequality? Deregulation at the

Growth in post war United States, a
period known as “the golden age of capitalism,” brought never-before-seen
prosperity and growth to the American people. In 1978 the average worker made
$48,302 (adjusted to 2010 dollars) and his CEO made $393,682 (Reich, 2013). However,
the golden age began to wane in the late 1970’s and wealth inequality has been
increasing drastically since. In 2010 a similar worker averaged $33,751 and the
CEO averaged $1,101,089 (Reich, 2013). For the worker that is a 30% decrease in
wages, for the CEO that is a 180% increase. There are many theories explaining
the increase in inequality such as; technological change, loss of collective
bargaining, minimum wage, and even corruption. Inequality in the United States
has grown exponentially and in the wake of the recession of 2008, caused in no
small part by deregulation and securitization, we must ask ourselves how free
the free market should be. Should banks be unregulated by the government and
left fully in the hands of the free market? The purpose of this paper is to
examine the idea that bank deregulation is a cause of inequality and answer the
central question, does deregulation of banks and financial institutions create,
add to, or have any effect on inequality?

In what follows several points
relating bank deregulation, financialization, and inequality will be discussed.
There are two basic drivers of inequity, mechanisms that increase wealth for
the wealthy and those that stagnate or diminish wealth of the poor. This paper
will examine how bank deregulation fuels both mechanisms. The paper will be
broken into four sections with each section containing a brief summary. The
final section will be the conclusion to bring the sections to a central
analysis to answer the question, does deregulation create inequality?

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Deregulation
at the state level

The first major steps towards
deregulation happened at the state level. Prior to the 1970’s states had laws
restricting the interstate and intrastate expansion of branches and banking
activity. Many states had limitations on branch expansion within the state. The
bank could have several branches but operated with separate licenses and
capital. Some states would only allow a bank to have a single branch in the
entire state. Over time, pressured by changes in banking technology, these
restrictions were loosened in an effort to improve bank performance. Those most
affected by state deregulation were in rural areas. Previously with banks being
limited in branching, and in some cases only allowed one branch, rural areas
rarely had a bank of their own. The less wealthy rural areas had limited access
to loans, loans they could use as an investment in education, or for business
ventures, loans that would, over time, have the possibility of increasing their
income. Another issue prior to deregulation was local bank monopolies. The
large local institutions, devoid of any competition, were better able to set
higher interest rates, unfavorable terms and be more selective of loan
approvals. Deregulation at the state level resolved both of these problems.
Rural areas were given access to loans they could in turn invest in education,
increasing their income, and increased competition limited the power of local
monopolies (Beck, Levine, and Levkov, 2010).

Empirical evidence by Beck, Levine,
and Levkov (2010) shows that deregulation also increased the wage of low
skilled workers. They conclude that demand for unskilled workers (those with 12
years or less of education) increased in deregulated states along with the
hours worked by unskilled workers, relative to skilled workers. They also show
that due to the increase in demand for unskilled workers, unemployment
decreased. Their findings suggest that bank deregulation created competition
amongst banks which in turn stimulated growth, raising the demand for unskilled
workers.

Interstate and intrastate
deregulation decreases inequality by increasing the income of those with lower
incomes, as they were the most affected by regulated banking. In summary,
deregulation at the state level did not contribute to inequality but in fact
helped to decrease inequality. However, during the same time period, inequality
at a national level was increasing. The biggest take away is that deregulation
increased competition and the increase in competition in turn benefited the
poor by increasing their income and therefore reduced inequality. From this we
can conclude that bank competition decreases inequality at the state level.

 It is important to mention that Beck, Levine,
and Levkov (2010) also found that the decrease in inequality only lasts a short
time, leveling off after approximately 8 years. 
They conclude “deregulation has a level effect on inequality, but does
not have a trend effect.” We must now move our attention to bank deregulation
at the national level to determine its effects, if any, on inequality.

Deregulation
at the national level

The stock market crash in 1929 and
the resulting depression forced government regulators to question the need for
bank regulation. The first regulatory bill to come after the crash was the
Glass-Steagall Act of 1933. The act clarified a separation between investment
and commercial banking. At the time, when a person deposited money into their
bank account, the bank would use those funds to make investments, and the
returns from those investments were profits for the banks. Banks made riskier
and riskier investments, and when the stock market crashed those investments
failed. There was a run on the banks, and when the limited cash on hand the
banks had was exhausted, the average citizen suddenly had lost most, if not
all, of their money. The motivation behind the bill was to prevent banks from
making risky investments with depository funds by separating depository and
investment banks, therefore taking the risk away from every day banking and
protecting savings in times of crisis.

Glass-Stegall had also set
restrictions on interest rates for depository accounts. However, in the late
1970’s high inflation started to eat away at gains from depository accounts, so
investors needed something better. Investment banks created money market mutual
funds (MMMF) where they would combine money from different investors to buy
commercial stocks.  MMMF were not
regulated and became increasingly popular with investors. As the economy
evolved the Glass-Steagall Act was slowly phased out, starting with the
Depository Institutions Deregulation and Monetary Act (DIDMCA).  The act aimed to allow banks to compete with
MMMFs by phasing out interest rate ceilings. Several other small acts during
the 1980’s and 90’s ultimately lead to the death blow of the Glass-Stegall Act,
the Gramm-Leach-Bliley Act. The Financial Modernization Act (FMA), as it was
also known, removed all restrictions on combining investment and depository banks.
The FMA and its numerous deregulatory predecessors created two major drivers of
inequality, the creation of what Carow and Kane (2002) call “megabanks” and
securitization.

A megabank is the combination of
two (sometimes more) financial institutions, typically combining a depository
bank with an investment bank, and in some situations, an insurance company. One
particular case of a megabank creation that sets an example of the power these
institutions have is the creation of Citigroup, Inc. In 1998 Citicorp and
Travelers Insurance Group announced that they were going to merge, a merger
that was, at the time, illegal. Prior to the announcement top executives from
both firms had spoken to government officials including the president, Bill
Clinton. The companies went ahead with the merger, although it was still
illegal, and formed Citigroup, Inc. The newly formed mega-bank was given a year
extension giving the government time to repeal Glass-Steagall and allowing the
creation of the largest financial services company in the world (Mars, 2010). This
is a prime example of the power megabanks have. On the state level deregulation
drove competition and ended local monopolies; the paradox is that on the
national level deregulation drove the creation of monopolies. As it was
intended (national level) deregulation drove competition. However, that
competition lead to mergers, and mergers created megabanks, and megabanks
monopolized the financial industry.

As banks become larger and combine
distinct types of financial institutions (insurance, depository banking, investments)
they become harder to regulate. Each aspect of the company is subject to
different regulatory agencies. Depository banks are governed by the FDIC,
investment banks are governed by the SEC, and insurance is typically governed
at the state level. The mergers leave the government struggling to effectively
monitor these new institutions. The complex nature and speed of transactions of
securitized assets (discussed below) meant that firms themselves were not
certain who owned what at a given time (Mars, 2010). This made it even more
difficult for regulators, so they started to take a hands-off approach and
entrusted the firms to self-regulate. Eventually, in 2004, the SEC changed its
requirements making reporting information to the SEC voluntary. Sherman (2009)
states; “The system of voluntary regulation relied on the internal computer
models of these firms, essentially outsourcing the job of monitoring risks to
the firms themselves.”

Prior to the 1970’s a home buyer
would get a 30-year mortgage at their local bank and that bank would hold onto
that loan for the entire term. For the banks, this meant that they had to be
careful who they lent to, so they had high standards for home buyers and it was
rare that someone would default on their mortgage. However, as banks began to
deregulate, depository institutions began to sell their mortgages to investment
banks in order to free up capital. The investment banks would then pool
thousands of mortgages together (sometimes also including student loans, auto
loans, and credit-cards) to create Collateralized Debt Obligations (CDOs). The
banks would then sell CDOs to investors and when homeowners paid their mortgage
every month the payments went to the investors. CDOs were then broken into tranches
(French for “slice”) based on the quality or safety of the underlying loans. Senior
tranches being the safest with lower interest returns and juniors being riskier
but with a higher return.

This was a good and safe system for
a long time. Because of high underwriting standards the loans were being repaid
and everyone was making money. This made CDOs popular with investors and soon
they ran out of mortgages to pool together. The CDOs then started being filled
with subprime loans.

A subprime loan is a high interest
rate loan offered to people who do not qualify for a traditional loan. They
would use teaser rates or interest only balloon loans to entice borrowers to
buy a home with unfavorable terms. Subprime lenders only offer these types of
loans and received large profits from them. The mortgage industry then became a
numbers game: as the subprime lenders would create loans they would be sold to
another institution within a week (Baradaran, 2015), so the more mortgages they
created, the more they could sell and the more profit they would make. Lenders
began to push subprime loans on low income borrowers as well as those who could
qualify for a conventional mortgage. Brooks and Simon (2007) reported that as
of 2006, 61% of subprime borrowers’ credit scores were high enough for them to
qualify for a conventional mortgage.

 In the 90’s subprime loans were added to CDOs
with better performing mortgages usually with about 5% of the loans in the pool
being subprime (Mars, 2010). So even if all of the subprime loans failed, the
CDO would not. However, as the CDO market became even more popular subprime
loans began to take up more and more of a percentage of CDOs. In some cases,
the loans that were not used in one CDO (due to risk) were packaged together
with other unused subprime loans to create a new CDO. The CDO, now made up of
mostly subprime loans, was given a safe rating because it was seen as diversified.
So, a CDO made up of mostly subprime loans was rated as highly as CDOs with
only 5% subprime loans. Carow and Kane (2002) point out that this type of
activity did not create economic value, but redistributed wealth. While the
CDOs did not create value for the American economy, wages in the financial
industry, created by bonuses and fees, have risen drastically (Philippon and
Reshef, 2012).

With the government placing the
task of regulation in the hands of the banks themselves, the issues with
securitization went on unnoticed and unquestioned. The problem with
securitization is that it puts the risk ultimately on the American tax payer.
In the old system if a mortgage failed the bank who had the loan would be
liable for the lost funds. With securitization, when the loan was sold by the
originating bank the risk fell to the institution that had bought it. When that
loan was added to a pool of loans to make a CDO, the risk was then passed to
the investor. When one loan in a CDO fails it is just taken out and replaced by
another. However, as was examined in 2008 just after the teaser rate expired
for subprime loans, so many of the mortgages failed that they could not simply
be replaced, and the CDOs failed. When the CDOs failed it was akin to a modern
day run on the banks except investors didn’t have to race to the bank to get
what they could because their money was already gone. In the wake of the crisis
retirement investments lost approximately $2.4 Trillion, “Of the 18 million
workers aged between 55 and 64 in 2012, 4.3 million will be poor or
near poor by the time they’re 65” (Ghilarducci, 2015).

To reexamine the creation of
Citigroup, Inc. points out another crucial factor in relating bank deregulation
to inequality, political power of the financial industry. As mentioned above,
Citigroup had such an influence on the government that they were able to openly
break the law. Not only were they able to break the law, but the government
changed the laws at the discretion of the banks. Banks, and any other
corporation or industry, gains power through lobbying and political donations.
Between 1998 and 2008, the financial industry spent over $5 billion on lobbying
and campaign contributions (Mars, 2010). Campaign contributions help officials
get elected, and once elected companies pressure officials to vote for
regulations that favor that company. Lobbying puts similar pressures on elected
officials hoping to sway their vote. The power banks get from these
contributions is most evident in a study by Blau, Brough, and Thomas (2013)
where they examine how Troubled Asset Relief Program (TARP) funds were
distributed.

TARP, also known as “the bail out”
was the government’s response to the financial crisis of 2008. The idea was to
buy the failed CDOs from the banks and the banks would use that money to reinvest
in the economy stimulating growth, lifting the country out of recession. TARP
funds were given out over several payouts starting in October of 2008. Their
findings suggest that 62% of firms that lobbied in the 5 years prior to TARP
received funds in the first two payouts and 95% of firms that lobbied received
funds in the first nine payouts. Firms that lobbied received TARP support
21.34% sooner and for evert dollar spent on lobbying firms received between
$485.77 and $585.65.

Reich (2013) examines what he calls
“the virtuous cycle” when money is invested into the economy via private sector
growth it creates a prosperous economy. Each aspect of the cycle fueling the
next, economy expands, wages increase, higher tax revenue for the government,
the government invest more, productivity grows, the economy expands. He also
examines an opposing trend he calls “the vicious cycle” where money is taken
out of the flow of the economy. The economy contracts, wages stagnate,
consumption decreases, tax revenue decreases, production decreases,
unemployment rises. He concluded that the deregulated financial system creates
high wages at the top that are not reinvested in the economy. He points out a
common misconception of what is often called “trickle-down economics” (President
Ronald Raegan’s economic policy). The idea of trickle-down is that by giving
tax breaks and other incentives to the wealthy, the wealthy will reinvest that
money into the economy creating growth for the economy as a whole. Reich (2013)
shows that the wealthy do spend more in dollar value than the poor and middle
class, however, as a percentage of income, the wealthy spend far less. This
means that the wealthy are holding onto a large portion of their money and not
investing it into the economy. Carow and Kane (2002) explain that bank
deregulation “redistributed rather than created value.”

 To conclude this section, bank deregulation
creates megabanks that take wealth out of the economy and redistribute that
wealth amongst themselves. This is done through CDOs and other financial
products that redistribute wealth rather than create value for the economy.
This is also evident in Philippon and Reshef (2012) where they provide
quantitative evidence that wages in finance have grown rapidly, compared to
other non-farming industries, since the 1980’s. Deregulation lead to risky
investments and subprime lending that most financial experts and economist attribute
to causing the 2008 financial crisis. The wealth gained by the megabanks
allowed them to lobby creating a relationship with government officials. Banks
took advantage of that relationship and as explained by Blau, Brough, and
Thomas (2013), 95% firms that lobbied would receive TARP funds in the first 9
payouts. Instead of reinvesting those funds into the economy, the banks paid
themselves large bonuses (Baradaran, 2015). The wealth of individuals in the
financial industry was relatively unaffected by the crisis they had caused
(Mars, 2010). At the same time $2.4 trillion in retirement savings was lost in
the wake of the crisis (Ghilarducci, 2015). In the introduction it was mentioned
there are two ways for inequality to happen, the wealthy become wealthier, or
the poor stagnate or become poorer. In the case of national level bank
deregulation, both situations are evident.

The
unbanked

Thomas Jefferson believed that if
the banks were able to gain too much power they would aid only the wealthy, at
the expense of the rest of the American people. As a rural farmer himself he
worried that a central bank would concentrate wealth in cities and leave little
to rural farming areas. He once said “I believe that banking institutions are
more dangerous to our liberties than standing armies” (Baradaran, 2015). State
level deregulation was effective in decreasing inequality because it gave
people in rural areas access to banking. Deregulation at the national level had
the opposite effect. Deregulation drove competition, banks merged, and the
number of bank branches decreased. As banks began to merge the profitability of
offering services to the poor diminished. Bank users were now seen as a source
of profit and the poor were simply unprofitable. Baradaran (2015) explains
“between 1984 and 2014, the amount of bank charters fell by over 60%.” Just as
Thomas Jefferson had predicted, driven to increase profits, banks left rural
areas in favor of wealthier cities. The gains for the poor that were made with
state level deregulation were reversed with national level deregulation. As the
state level deregulated the poor gained access to banking activities in turn
increasing income. National level deregulation reduced the number of banks decreasing
banking access to the poor. It reduced access by reduced branches but more so
by the refusal of banks to open accounts for the poor. Banks do not outright
refuse the poor, they use minimum balances to keep the poor out. The average
minimum balance requirement for a checking account is $400, and with half of
Americans unable to come up with $400 with out selling something or borrowing,
minimum account balances effectively keep the poor out (Baradaran, 2015). Left
with out a bank account, in order to cash their paycheck, they must pay a fee,
or to write a check (usually a money order) for their rent, they must pay a
fee. Baradaran (2015) explains “the average unbanked family with and annual
income of around $25,000 spends about $2,400 per year on financial transactions.”
National level deregulation makes it expensive to be poor. This is not just a
problem in rural areas. Banks did move from rural areas into the cities, but some
community banks and credit unions stayed behind giving the rural poor some,
although limited, access to banking. With offering banking to the poor being
unprofitable and the smaller institutions that serviced the poor being pushed
out, inner city poor were left with no banking options at all. As mentioned
above, when the poor are denied access to banks, they have to pay for it,
driving down the percentage of income being spent on consumption. And as
described by Reich (2013) when consumption decreases, production decreases, wages
stagnate or decrease, unemployment rises. To conclude this section; national
level bank deregulation reduced poorer peoples access to banks, decreasing the amount
of money they can spend on consumption and ultimately decreasing real income.

Conclusion

State level deregulation promoted competition,
and decreased local monopolies giving the poor access to banking activities. With
access to banks the poor were able to take out small loans that in time
increased their income. Bank deregulation at the state level had a decreasing effect
on the poor. However, the affects lasted only a short time, approximately 8 years.
With national level bank deregulation, we can observe that the same factor,
competition, had the opposite effect. At this point the relationship between
national level bank deregulation and inequality is abstract. From the research
collected, no empirical relationship has been evaluated. However, data does
suggest that deregulation creates high incomes for CEOs and board members of
megabanks along with high wages in the financial sector in general. Research
also shows that in the wake of the 2008 financial crisis, firms that had
lobbied in the past five years and had political connections received the
lion’s share of TARP (Troubled Asset Relief Program) funds. This tells us that
those at the very top of the managerial chain are less affected by crisis. It
has also been reported that instead of using the TARP funds to invest back in
the economy the large financial firms used those funds to pay themselves large
bonuses, increasing incomes at the top. The lack of value creation and
investment in the economy of the financial sector created stagnant real income
for the poor and middle class. The deregulation of banks has led to competition
creating large banking institutions that are unwilling to offer banking services
to the poor. This makes it difficult for those in poverty to gain wealth or
assets keeping them in poverty. This leads to the theoretical conclusion that
although bank deregulation itself may not cause inequality, it creates mechanisms
that allow earnings for the wealthy to grow exponentially when the income of
the poor and middle class remain stagnant.