Twofish's Blog

November 12, 2007

A brief history of recent US finance

Filed under: austrian economics, economics, finance — twofish @ 4:16 pm

50 Cent: Really? Explain how US banks were able to offer fixed rate mortgages before the 1980s without a liquid market for derivatives.

Simple. Between 1933 and 1980, the Federal Reserve set interest rates. Under regulation Q, all retail savings rates in the United States were set at 5.25% and checking account interest was set at zero. Once retail savings were fixed, then the government through FHA set the lending rates at below market rates, making it easy for people to finance home purchases.

It was a massive successful system that worked for about 50 years, but ended up being unsustainable. One thing that killed it was the inflation of the 1970’s. Once you had inflation, people were no longer willing to save at 5.25% when inflation was at 10%, and people invented clever things like money market accounts and certificate of deposits to circumvent Regulation Q. Another thing the fact that the government couldn’t increase interest rates meant that it didn’t have a way of controlling the inflation of the 1970’s. Also, the US government could pretty easily set interest rates and do whatever it wanted domestically in 1933 to 1965 when US markets were the only game in town. In 1948, if you didn’t like the lousy interest that the US government was setting for you, you pretty much were stuck since there was no where else in the world you could move your money to. This stopped being true in the 1960’s which was one reason the system broke done. Another was Vietnam and the Great Society. Have a major war and not increasing taxes means that the wealth has got to come from somewhere………..

So finally in 1980. the US government gave up, deregulated interest rates. This quickly lead to a huge set of banks making stupid loans creating an early savings and loan crisis in the US. It also very quickly lead to the formation of a derivatives market in the mid-1980’s. By the early-1990’s, there was a demand for people who could calculate the value of those derivatives, which led to lots of physics Ph.D.’s being hired on Wall Street.

The Chinese financial system looks in some ways like the US financial system of 1965, but there are lots of pressures for floating interest and currency rates. It’s not that floating interest or currency rates are morally better or worse, it’s that like the US in the late-1970’s, China is finding that it *must* to certain things in order to avoid chaos. What I find fascinating about the history of US finance from 1970 to 1990 is that pretty much *none* of it was planned.

The other thing is that among the financial innovations that people found scary in the late 1970’s were money market funds and certificate of deposits. Money market funds turn out to be a great thing since it means that you can basically have a checking account that pays interest, which is a hellishly difficult thing to create.

Also, one curious thing is that the US retail derivatives market is not nearly as well developed as the Asian or European markets. In the US, you can’t go into a bank, and buy a complex structured note, and there are dozens of legal, cultural,. and regulatory reasons why not. In the UK, you can.


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