The Financial Revolution: The Vulnerabilities of Easy Money in the 21st Century

Photo by Ken Lund

Recessions are inevitable. But policymakers’ response to them can determine whether they will be mild or severe. For the better part of a century, conventional Keynesian wisdom on monetary policy has held that, when the economy is experiencing a downturn such as a recession, the central bank should increase the money supply. They usually do this by lowering interest rates or buying corporate bonds with the goal of incentivizing banks—who often reduce lending during downturns—to increase their lending. Such a policy of “easy money” should, in theory, increase access to money for businesses and consumers alike, giving entrepreneurs and firms the capital they need to invest in and grow their businesses and putting money in the hands of consumers to boost consumption and aggregate demand, thereby raising GDP and helping the economy bounce back. However, a nascent body of literature in economics and political science presents growing evidence that the “easy money” policies that have guided the American monetary policy response to virtually every economic downturn since the Great Depression are flawed and that the credit booms often unleashed by low-interest rates and increases in the money supply in the past forty years have steadily transformed the landscape of the American financial sector. Rather than protect against economic downturns, these policies have actually increased our vulnerability to catastrophic recessions.

The U.S. financial sector has seen fairly steady growth throughout the postwar period; since 1950, the financial sector’s share of GDP and number of employees has grown at a roughly constant rate. But this steady growth masks a significant transformation of the financial sector that began during the 1980s, often called the “Deal Decade.” The 1980s were a period of intense consolidation in corporate America. By 1988, corporate mergers and acquisitions had achieved five times their level in 1980. And between 1987 and 1989 alone, over two thousand firms were acquired by other firms. Financing these acquisitions required enormous amounts of capital, the lion’s share of which was supplied through debt financing.

This growth in debt financing was spurred by the falling cost of debt beginning in the early 1980s. The start of the decade was marred by the continuation of the stagflation of the 1970s, an economic conundrum characterized by stagnant economic growth and high inflation, a trend that pushed the Federal Reserve to raise interest rates in order to restrict the money supply. As such, interest rates peaked in the early 1980s and, while inflation subsided, the economy fell into recession, causing the Fed to reverse course by precipitously lowering interest rates. Lower interest rates then meant that debt financing became cheaper than equity financing, driving firms to choose to finance their acquisitions with debt rather than equity.

Alongside falling interest rates, the 1980s marked the start of a deregulatory crusade that persisted with fervor until the onset of the Great Recession. This deregulation created an environment in which the financial sector could entrench itself deep within the mechanisms of the real economy—sectors of the economy that pertain to the production and flow of real goods and services, such as food and real estate—and in which the distinctions between traditional banks and other financial institutions would become increasingly blurred. 

The deregulatory push was initially spurred on by the collapse of the savings and loan industry in the 1980s and 1990s. Certain regulations had already begun to be rolled back in the 1970s and early 1980s, but the rollbacks accelerated as savings and loans institutions collapsed. Before the savings and loan crisis, one major deregulatory move was the authorization of interest-bearing checking accounts in the 1970s. This development coincided with the rise of securitization in financial markets and gave banks and their financial partners a new pipeline of investor capital. In exchange for high yields, money deposited in these accounts would be offered as loans or invested by banks, giving banks more capital to work with and allowing everyday Americans to earn interest on a spending account. The advent of interest-bearing checking accounts also allowed bigger banks to further muscle into the savings and loan industry and foreshadowed a creeping trend towards consolidation in the banking sector.

These early deregulatory moves contributed to the onset of the savings and loans crisis in the mid-1980s and actually became more widespread after the crisis began. The collapse of so many savings and loans institutions created a demand for savings and loan services that savings and loan institutions could no longer satisfy. Banks, though, were not gripped by the same issues that plagued their savings and loan counterparts, so they were primed to fill the void, which incentivized more deregulatory measures in order to allow banks to further establish themselves in the savings and loan industry. And, as banks continued to edge their way into the savings and loan industry, they brought their financial partners with them as well. 

The 1990s brought even more financial sector deregulation and with an even more ravenous resolve. Since the Great Depression, American commercial banks had been barred from engaging in investment banking, but foreign banks did not have this limitation. As such, towards the end of the twentieth century, American banks began to complain that they could not compete with multi-service banks abroad if they were limited to only offering commercial banking services. In response, Congress passed the Gramm-Leach-Bliley Act, repealing sections of the Glass-Steagall Act of 1933 that mandated the separation of commercial and investment banks. This most significant of Clinton-era banking reforms effectively broke down the last major barrier to banking sector consolidation. Banks could now engage in any and all financial activities from savings and loans to insurance to securities and investing. Furthermore, big banks were now firmly planted in the everyday functioning of the real economy. Further deregulation would continue to occur in the early years of the 21st century, primarily focused on relaxing lending standards amidst the growing housing bubble, but the metamorphosis of the financial sector had largely been completed by the close of the millennium. 

Despite all of the deregulatory policies and other developments, banking remained a highly regulated industry. But the two major developments outlined here—falling interest rates and deregulation—provided a path for banks and other financial institutions to skirt around the cumbersome regulations imposed on the banking sector and set the stage for the meteoric rise of what is often called “shadow banking.” By some accounts, shadow banking—financial intermediation (the movement of money from investors to investees) carried out by non-bank financial institutions—has been around since the 1930s and the creation of the Federal Home Loan Bank, which, unlike traditional banks, funded its mortgage loans not through deposits, but by issuing debt securities. But, in the 1980s, the shadow banking subsector began to rapidly expand. 

The rise of shadow banking in the 1980s was driven primarily by a desire to leverage new innovations in financial technology to maintain high yields despite falling interest rates. Outside of the anomalous stagflation in the 1970s, high-yield low-risk investments are not common, so shadow banks had to find a way to satisfy investors’ demand for them even though such investments virtually did not exist. This was accomplished in large part by securities bundling. 

In the 1980s, shadow banks responded to falling rates by bundling more long-term higher-risk debts like subprime mortgages into short-term, low-risk securities. These securities were considered low risk for two reasons. First, they contained large bundles of debts so, if one or a few of the loans defaulted, it would not greatly affect the overall bundle, meaning the bundle could still produce a high yield. Second, they turned long-term debts into short-term securities. The shorter maturity period meant that it was less likely that too many of the loans included in the bundle would default before a holder was able to sell it. The shadow banking sector’s willingness and ability to provide this service of high-yield, low-risk investments drew in many investors and showed that, with the right manipulation of risks and benefits, financial institutions could turn everyday Americans into new investors.

Falling interest rates and financial technology innovations opened the door for fast growth and greater risks in the shadow banking sector, but it was deregulation that exposed the real economy to those risks. After the Great Depression, a fairly rigid regulatory regime held up a strong barrier between traditional banking (which is deeply embedded in the real economy) and financial services. But, in the 1970s and 1980s, that barrier began to slowly crumble. First, the collapse of the savings and loan industry and its subsequent takeover by the bigger banking sector fueled new avenues of investment in the shadow banking sector. The commercial banking sector’s close ties with shadow banks meant that deposits and loans were now being integrated into shadow banking, driving the rise of investment instruments such as mortgage-backed securities. This allowed shadow banks’ share of total credit intermediation to grow from  9% in 1975 to over 33% in the period between 2004 and 2013. But this masks perhaps an even more important development: the growing opacity of the shadow banking sector. 

Second, as the Gramm-Leach-Bliley Act broke down the last vestiges of the barrier between commercial banking and investment banking, it also broke down barriers between traditional banks and shadow banks. As banks began consolidating into ever bigger institutions through the merger of commercial and investment activities, they also began acquiring shadow banks at an increasingly rapid pace. Not only did this further intertwine traditional banks and shadow banks, but it also made it difficult to see where traditional banking ended and shadow banking began as more and more of their operations were increasingly being lumped into the operations of traditional banks. For example, the Federal Reserve Bank of New York noted in their 2014 report on shadow banking that shadow banks’ share of total credit intermediation in the period between 2004 and 2013 is likely much higher than 33%, but as traditional banks buy up shadow banks, their share of total credit intermediation becomes considered part of the parent bank’s depository credit intermediation. This means that, not only has it become more difficult to monitor and gather data on the activities of shadow banks, but also that their activities increasingly involve the deposits of everyday Americans. 

The major transformations of the financial sector beginning in the 1980s show that banking in the United States has fundamentally changed such that the conventional wisdom of low interest rates and bond-buying schemes in response to economic downturns requires reexamining. The financial technology revolution, deregulation, and shadow banks have created an environment where the risks of the “easy money” policies favored by the Fed outweigh the benefits. This was one of the most salient lessons of the 2008 financial crisis and the ensuing Great Recession. Rather than shore up the vulnerabilities of the financial sector, “easy money” policies since the 1980s only further exposed the savings and mortgages of everyday Americans to the whims and woes of financial markets, markets that had been fooled by innovative shadow banks into believing that high-risk, long-term debts like subprime mortgages could be shaped into safe, money-like securities. These vulnerabilities still exist and, as easy money policies start up again in response to the COVID-19 pandemic, American policymakers ought to ask themselves whether they are setting the stage for another Great Recession in the not-too-distant future.

Jaxon Williams-Bellamy (CC ‘21, LAW ‘25) studied economics, political science, and French as an undergraduate and plans to become a lawyer after law school. In his free time, he enjoys traveling, reading, and playing video games with his brothers and cousins.