BERKELEY – Back in the late 1990’s, in America at least, two schools of thought pushed for more financial deregulation – that is, for repealing the legal separation of investment banking from commercial banking, relaxing banks’ capital requirements, and encouraging more aggressive creation and use of derivatives.

If deregulation looks like such a bad idea now, why didn’t it then?

The first school of thought, broadly that of the United States’ Republican Party, was that financial regulation was bad because all regulation was bad.

The second, broadly that of the Democratic Party, was somewhat more complicated, and was based on four observations:

·   In the global economy’s industrial core, at least, it had then been more than 60 years since financial disruption had had more than a minor impact on overall levels of production and employment.

While modern central banks had difficulty in dealing with inflationary shocks, it had been generations since they had seen a deflationary shock that they could not handle.

· The profits of the investment-banking oligarchy (the handful of global investment banks, including Goldman Sachs, Morgan Stanley, and JP Morgan Chase, among others) were far in excess of what any competitive market ought to deliver, owing to these banks’ deep pockets and ability to maneuver through thickets of regulations.

· The long-run market-return gradient – by which those with deep pockets and the patience to take on real-estate, equity, derivative, and other risks reaped outsize returns – seemed to indicate that financial markets were awful at mobilizing society’s risk-bearing capacity.

· The poorer two-thirds of America’s population appeared to be shut out of the opportunities to borrow at reasonable interest rates and to invest at high returns that the top third – especially the rich – enjoyed.

These four observations suggested that some institutional experimentation was in order. Depression-era restrictions on risk seemed less urgent, given the US Federal Reserve’s proven ability to build firewalls between financial distress and aggregate demand.

New ways to borrow and to spread risk seemed to have little downside. More competition for investment-banking oligarchs from commercial bankers and insurance companies with deep pockets seemed likely to reduce the investment banking industry’s unconscionable profits.

It seemed worth trying. It wasn’t.

Analytically, we are still picking through the wreckage of this experiment. Why were the risk controls at highly-leveraged money-center universal banks so lousy?

Why weren’t central banks and governments willing and able to step up and maintain the flow of aggregate demand as the financial crisis and its aftermath choked off private investment and consumption spending?

More questions arise from the policy response to the subsequent recession. Why, once the magnitude of the downturn became clear, weren’t governments eager to step in to return unemployment to normal levels, especially in the absence of higher inflation expectations, upward pressure on prices, or even interest-rate increases that would crowd out private investment spending?

And how has the financial industry managed to retain so much political power to block regulatory reform?

Moreover, how to restructure the financial system remains unclear. The Glass-Steagall Act’s separation of investment from commercial banking greatly benefited the established oligarchy of investment banks, but somehow the entry of competitors from commercial banks and insurers increased financial companies’ profits further.

There were significant profit opportunities for financial intermediaries that could find spare risk-bearing capacity, carve out securities to take advantage of it, and thus take a middleman’s cut from matching risks with investors who could gain from bearing them.

But the advent of derivatives concentrated risk rather than dispersing it, for there was even more money to be made by selling risk to people who did not know how to value it – or, indeed, what risks they were bearing.

And central banks’ failure to regard their primary job to be the stabilization of nominal income – their failure not only to be good Keynesians, but even good monetarists – raises the question of whether central banking itself needs drastic reform. Back in 1825, the Bank of England’s Governor Cornelius Buller understood that when the private sector had a sudden panic-driven spike in demand for safe and liquid financial assets, it was the Bank’s responsibility to meet that demand and so keep bankruptcy and depression at bay. How can his successors know less than he did?

It may even be the case that we ought to return to the much more tightly regulated financial system of the first post-World War II generation.

That system served the industrial core well, at least as far as we can tell from the macroeconomic aggregates. We know for certain that our more recent system has not.

J. Bradford DeLong, a former assistant secretary of the US Treasury, is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research.

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