Inflation — Prelude to Deregulation
In the late 1960s and early 1970s the economic landscape began to change. Those savings accounts that had served the country so well for so many years began to lose their luster. That 5% or 5¼% passbook savings account that had done so much for the middle class became a losing proposition. Why? Inflation.
Inflation is a market condition where prices are increasing throughout the economy. At a minimum, inflation eats away at the value of money. If incomes are increasing at a rate of 4% per year, for instance, while inflation is running at a rate of 1% or 2%, inflation simply reduces the real value of the increased income. When inflation begins to exceed the rate of increase in incomes, however, it can become particularly painful. A person whose income rises at a rate of 4%, when overall prices of the goods in the economy are rising at a rate of 6%, eventually begins to notice that he or she can buy noticeably less stuff, despite the rise in income.
Inflation first started becoming an issue in the late 1960s. President Nixon implemented wage and price controls in the early 1970s when inflation got to 6%. (Wage and price controls are a series of laws that prohibit price increases by retailers and manufacturers and also prohibit wage increases by employers in an effort to prevent inflation. As often as not, such laws end up distorting the economy and resulting in shortages of various goods.) By the late 1970s and early 1980s, inflation had reached a high of 13% per year.
By the time inflation had reached 13%, most consumers realized that the old passbook savings accounts, with their maximum permissible interest rate of 5.25%, were a losing bet. They realized that if their savings were earning just over 5% but their costs of living were rising at 13%, they were, in effect, losing money. This was especially true in terms of “purchasing power” (what they could buy with their money). Consumers became motivated to find other forms of investment for their savings.
In view of this demand, all kinds of new investments started to appear. One of the most influential was “money market funds.” These are mutual funds, where a company will raise money from thousands of people; they take one person’s $10,000 and another person’s $5,000 and yet another’s $20,000 until they have millions of dollars to invest. They would then invest in “jumbo” certificates of deposit, which were exempt from the federal regulations regarding maximum interest rates. By pooling this money, they could earn much higher rates of return. For a while during this period, investors could earn as much as 15% interest in a money market fund.
By the late 1970s, so many people had realized that savings accounts were a losing proposition that the savings and loan industry realized that it could no longer attract significant amounts of money from depositors. Yet the federal regulation limiting the returns on savings accounts remained in place. The savings and loan industry was faced with oblivion.
In 1979, the financial industry persuaded Congress to pass what has come to be known as “financial deregulation.” There were several facets to this legislation, not least of which was a provision repealing the limit on the interest rates which could be paid on savings accounts. In order to allow savings and loans to attract new deposits, Congress felt that the industry needed to be able to offer market rates of return.
While the repeal of the interest rate limitations was one of the most pressing issues addressed by financial deregulation, Congress decided to also eliminate other regulations, including the following:
- It allowed savings and loan associations to participate in consumer banking, such as offering checking accounts and credit cards.
- It allowed banks to get involved in mortgage lending.
Savings and Loan Bail Out
The years that followed were extraordinarily difficult for the savings and loan industry. A great many institutions were unable to survive the transition and became insolvent. Since the deposits in these institutions are insured by the federal government, it fell to the taxpayers to bail out the depositors in those failed institutions. This process became known as the savings and loan “bail-out” of the 1980s, and cost taxpayers literally hundreds of billions of dollars.
A common perception of that time was that the savings and loan bail-out was caused by fraudulent behavior by the management of the failed savings and loans. While there were instances of such behavior, it was a relatively small part of the problem. The truth is that the savings and loan bail-out was not caused by any one factor alone, but rather by a series of inter-connected problems.
One of the major factors was a problem that was virtually unavoidable given the structure of the industry. Since the inception of the industry, and particularly since the 1950s, the savings and loan industry had been “borrowing short and lending long.” What this refers to is that their deposits were largely short-term in that they were mostly in the form of savings accounts where the depositor could withdraw the money at any time, while their loans were long-term, in the form of 30-year home loans. As long as interest rates remained stable, there was no problem since they were able to lend out their deposits for significantly more than what they paid their depositors. By the late 1970s and early 1980s, however, interest rates got as high as 18%, but the savings and loans still had many old mortgages on their books at 6%, 7% and 8%. When interest rates increased, the old low rate mortgages put them in the position of borrowing at high rates and lending at low rates, a sure recipe for disaster.