MAGA May Well Be Laying the Foundations for the Next Financial Crisis

It’s hard, for example, to see whose interests Trump is serving by trying to kill New York’s congestion pricing scheme, which is already showing clear positive results

The Biden administration is continuing to roll back financial regulations put in place after the 2008 crisis, a move that economists say could increase the risk of another financial crisis.

The administration has already taken several steps to weaken financial regulation, including rolling back the Volcker Rule, which limits banks’ ability to engage in risky proprietary trading, and proposing to ease capital requirements for large banks.

Economists have long argued that financial institutions need to be regulated. Even Adam Smith, the father of capitalism, who witnessed the Panic of 1772, which hit Scotland, London and Amsterdam, argued for significant restrictions on banks.

The 21st-century financial system is, of course, far more complex than that of the 18th century, although there are some echoes. Notably, “stablecoins,” crypto tokens that can supposedly be redeemed at will for actual dollars, are a lot like the privately issued bank notes of the 18th and 19th centuries, which could supposedly be redeemed at will for gold and silver coins. The main difference is that while bank notes were clearly useful for legitimate business, cryptocurrencies still don’t seem to have any real use case other than money-laundering.

Did I mention that Howard Lutnick is now the Commerce Secretary? Lutnick has had close financial ties to Tether, which Bloomberg describes as

the stablecoin used by drug traffickers, terrorists and scammers to move money around the world.

And crypto aside, the complexity of modern finance makes it even harder for both consumers and investors to assess banking risks, so we need effective financial regulation to avoid or at least limit financial crises.

Yet the Biden administration is moving to loosen if not eviscerate financial regulation. And it’s doing so at an especially dangerous time.

In the aftermath of the 2008 financial crisis I, like many economists, became a fan of Hyman Minsky’s “financial instability hypothesis.”

At a time when many economists were arguing that financial markets are generally efficient in the sense that asset prices reflect the best information available, Minsky argued instead that they are driven by cycles of greed and fear.

A Minsky cycle looks something like this:

In the aftermath of a financial crisis, investors are well aware that markets can go down as well as up. They are cautious about taking risks, and especially about leveraging up — investing with borrowed money. And as a result of this caution, financial markets are calm with relatively few crises.

Over time, however, memories of past disasters fade, in part because those who remember bad things retire or move on, replaced by younger traders who have never experienced a major crisis. This eventually produces markets in which prices seem to go in only one direction — up — and whoever is most willing to take leveraged risks wins. Even those who intellectually know better get sucked in because of FOMO: fear of missing out.

This manic phase doesn’t just induce many people to take on risks they don’t understand. It also creates what the famed investor James Chanos calls a “golden age of fraud.” (I’ll be posting a long talk with Chanos this weekend.)

When it seems as if fortune favors the brave, con men or, sometimes, con women find it especially easy to attract suckers, especially if they can hang their promises on a narrative — say, the wonders of crypto or the limitless potential of AI.

The New York Times recently ran a heartbreaking story about how the president of a community-owned bank in Elkhart, Kansas fell for a crypto scam, destroying the bank and quite a few people’s life savings in the process. You can be sure that we’ll hear many more such stories once we reach the final stage of the cycle — the Minsky moment, when euphoria-driven asset price surges give way to fire sales as highly leveraged investors desperately try to raise cash.

Where do regulators fit into all of this? They can’t completely eliminate the Minsky cycle, which is deeply rooted in human psychology. But they can dampen it and limit the damage when the Minsky moment arrives.

Yale’s Gary Gorton has shown that the extensive financial regulations introduced in the 1930s produced a 50-year “quiet period” in which there were plenty of stock market ups and downs — notably the “go-go years” of the 1960s followed by the very depressed market of the 1970s — but there weren’t any serious banking crises.

But politicians are subject to the same mood swings as investors, so they tend to push regulators to loosen up precisely when they should be trying to rein in irrational exuberance. The Fed, which is somewhat insulated from politics and has a relatively long institutional memory — which has traditionally seen its role as being to take away the punch bowl just as the party really gets going (the original quote isn’t quite that snappy, but never mind) — has historically been the