11.4 The Great Deregulation Experiment

Deregulation and Its Impact

Starting in the late 1970s, the U.S. government began removing price and entry controls from several major industries. The idea was straightforward: let competition, rather than government agencies, drive prices down and efficiency up. In many cases it worked, but deregulation also introduced new risks, especially in finance.

Impact of Industry Deregulation

Airline deregulation (1978) removed government control over fares, routes, and market entry. The results were dramatic:

• Competition increased sharply, and average airfares fell significantly in inflation-adjusted terms
• New low-cost carriers like Southwest Airlines entered the market
• The number of available routes expanded, giving consumers more choices
• The tradeoff: some smaller cities lost service, and the industry went through waves of bankruptcies and consolidation

Railroad deregulation came with the Staggers Rail Act of 1980, which allowed railroads to set their own rates and negotiate contracts directly with shippers. Railroads became more efficient and profitable, though the industry consolidated heavily through mergers (for example, Burlington Northern merging with Santa Fe Railway). Shipping rates fell by roughly 50% in real terms over the following decades.

Banking deregulation unfolded across the 1980s and 1990s, removing restrictions on interstate banking and branching. This sparked:

• Growth of large, nationwide banks through mergers (Bank of America is a prime example)
• More competition and innovation in banking services, including online banking
• Development of new financial products and instruments

That last point, financial innovation, would prove to be a double-edged sword.

Regulatory Capture in Price Regulation

Regulatory capture occurs when a regulatory agency ends up being influenced or controlled by the very industry it's supposed to oversee. Instead of protecting the public interest, the agency starts serving the interests of regulated firms.

This happens because regulated firms have strong incentives (and resources) to shape the rules in their favor, while consumers are dispersed and less organized. The consequences include:

• Higher prices for consumers than a competitive market would produce
• Reduced competition and innovation
• Inefficient allocation of resources
• Rent-seeking behavior, where firms spend money lobbying for favorable regulations rather than improving their products

Regulatory capture is one of the strongest economic arguments for deregulation: if regulators can't stay independent, removing the regulations entirely might produce better outcomes than keeping captured agencies in place.

The Financial Crisis of 2007-2008

The 2007-2008 financial crisis is the most dramatic example of what can go wrong when deregulation outpaces the safeguards needed to manage risk. Several factors combined to create the worst economic downturn since the Great Depression.

Causes of the Crisis

The crisis built up through a chain of interconnected failures:

1. A housing bubble formed as home prices rose rapidly, fueled by lenders issuing subprime mortgages to borrowers with poor credit histories and little ability to repay.
2. Banks bundled these risky mortgages into complex financial instruments called mortgage-backed securities (MBS) and sold them to investors through a process called securitization.
3. An unregulated over-the-counter derivatives market allowed firms to trade instruments like credit default swaps (CDS), which were essentially insurance policies on mortgage-backed securities. The risks of these instruments were poorly understood, even by the firms trading them.
4. Financial institutions took on excessive risk chasing higher returns, while lending standards and internal risk management deteriorated.
5. A large "shadow banking" system of hedge funds and investment banks operated outside traditional banking regulations, amplifying the buildup of risk.

When housing prices began to fall, the entire chain unraveled.

Consequences

• Major financial institutions collapsed (Lehman Brothers) or had to be rescued (Bear Stearns)
• Credit markets froze, making it difficult for businesses and consumers to borrow
• Housing prices plummeted, triggering millions of foreclosures
• Investors and retirement accounts suffered significant losses
• The result was a severe global recession with unemployment peaking at 10% in the U.S.

Regulatory Responses

• The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) increased oversight of the financial industry, imposed stricter rules on derivatives trading, and introduced stress testing for large banks
• The Consumer Financial Protection Bureau (CFPB) was created to protect consumers from abusive lending and financial practices
• Banks faced enhanced capital and liquidity requirements, forcing them to hold larger financial cushions against potential losses

Systemic Risk and Regulatory Challenges

Three concepts from the crisis are worth understanding clearly:

• Systemic risk is the danger that a failure in one part of the financial system cascades into a broader economic collapse. The interconnectedness of banks through derivatives and mortgage-backed securities is what made the 2008 crisis systemic rather than isolated.
• Moral hazard arises when institutions take excessive risks because they expect a government bailout if things go wrong. The "too big to fail" problem is the classic example.
• Regulatory arbitrage occurs when firms exploit gaps or differences between regulations to minimize their regulatory burden. Shadow banking grew partly because firms could do bank-like activities without following banking rules.

These three challenges explain why regulating financial markets remains difficult even after major reforms. Deregulation can deliver real benefits in competition and efficiency, but the financial crisis showed that some markets require active oversight to prevent catastrophic failures.