In his recent New York Times Op Ed, Disaster and Denial, Paul Krugman argues that deregulation was the cause of the recent financial crisis, and that Republicans are simply in denial when they oppose increasing regulation. Krugman is wrong on both counts. The cause of the financial crisis was the housing bubble which was created by US government policy. And while there was deregulation, it had little effect on the financial crisis.

The cause of the financial crisis was the huge housing bubble, as can be seen in the graphs of historical home prices: http://en.wikipedia.org/wiki/United_States_housing_bubble. Prices increased 50% - 80% and more in the most populous areas of the country between 1998 and 2006. When the bubble popped, the financial crisis resulted. What was the cause of the housing bubble? The US government policy of pumping money into it. Currently there is a $12 trillion mortgage market. Three quarters of this market is government supported. First of all, Freddie and Fannie own or support about half of this total market: http://en.wikipedia.org/wiki/Fannie. Standards at Freddie and Fannie were low, and got lowered further as a result of government pressure (Barney Frank, George Bush, CRA) as well as the competition between the two companies (Freddie Mac was originally created to compete with Fannie Mae). Secondly, the Federal Home Loan Morgage Bank (FHLB) pumped in another $1 trillion. Other government entities contributed as well, in the form of mortgage insurance for below-par home buyers. Ginnie Mae (HUD) currently guarantees mortgages for $1 trillion, and FHA (also HUD) insures $560 billion. (According to the Wall Street Journal: http://online.wsj.com/article/SB10001424052970204908604574334662183078806.html). Contrary to Krugman's assertion that the government was not in the subprime business, these agencies are in fact packaging subprime mortgages. Even worse, they have the explicit backing of the Federal government. They are the next Fannie and Freddie, and the US taxpayer is on the hook if foreclosures continue. Nearly 9 of every 10 new mortgages now carry a Federal guarantee.

With government involved in over $8.5 trillion of the $12 trillion housing market, it is clear that it created the housing bubble. And there's no way to pop a bubble without an economic crisis. Standards were no higher in the government regulated entities than in the public market. And the taxpayer liability is far greater for government backed mortgages than on private mortgages. This will cost taxpayers hundreds of billions if not trillions of dollars if we do not stop backing overpriced and risky mortgages. (The housing market is still greatly inflated due not only to the aforementioned policies, but the fact that the Federal Reserve has been buying up MBS over the past year - over $1 trillion, plus the Fed is loaning money to investment banks which the banks are still using to pay back their TARP funds and purchase more MBS. The market will crash again once this artificial support ends.)

The mortgage interest tax deduction contributed as well to the housing bubble.

It's ridiculous to blame the crisis on deregulation when the cause was the popping of the housing bubble. Did deregulation contribute? Perhaps Krugman is referring to the repeal of the Glass-Steagall Act in 1998, which prohibited commercial banks from participating in investment banking practices. However, the hardest hit entities were standalone banks (WaMu, Countrywide) and standalone investment banks (Bear Stearns, Lehman). Citigroup seemed to do just fine. WaMu failed because home prices fell, threatening its solvency. Its largest creditor? FHLB, which is funded by tax-exempt bonds.

Regulations are relaxed over time, and in fact Gramm-Leach-Bliley, which repealed Glass-Steagall, simply made the current regulatory environment official. For example, Citigroup was created a year before the repeal. Furthermore, deregulation often has bipartisan support (Clinton supported the repeal, for example, and rejects any role of the repeal in the financial crisis). There's no way to cast blame on political parties, and while certain people might be right in certain situations, they might not be right in all situations, and even if they were, they don't live forever. There's no way to pick a perfect regulator.

Krugman argues that bankers loosened lending standards as a result of deregulation. That's ridiculous: they loosened lending standards because there was someone stupid enough to buy the stuff.  The biggest customers were Freddie and Fannie, who bought 33% of all subprime MBS in 2005, according to FHFA's report here.  Troubled assets (subprime and low documentation loans) comprise about 15% of their portfolio.  Furthermore, the FBI knew of the wide spread mortgage fraud in 2004 and did almost nothing.  And we're to believe that mild-mannered regulators would be more effective?

The other main contributors to the crisis were the ratings agencies: S&P, Moody's, Fitch.  They rated the junk AAA, and the reason stems from government regulation that gave them the power to control access to the credit markets.  (This is explained in The Cause of the Financial Crisis.)

Krugman's thesis undermines his whole argument: political pressure over time relaxes regulation. It's a fact of life.  There's no way to prevent that, and he offers no solution to the problem. Are we to be taught as children that the 'invisible hand' of capitalism is just a fairy tale? And what do we do with people who dare to look up the idea on the internet?

A recent study of international banking practices shows that regulations in fact reduce the safety of banking systems. While it's hard to determine the exact reason for this, it is probably due to the fact that they lull the public into a false sense of security.

Regulations can't work for so many reasons, including: business changes faster than regulators can oversee it, businesses are usually smarter than well-intentioned regulators, and regulators themselves come from the banking industry and often have conflicts of interest (personal, social, and financial), such as incentives to allow certain companies to survive.

And finally, his conclusion that anti-regulators are condemning us to repeat history is most disturbing, because in fact it's the government's continuing policy to inflate the housing market and bail out failed banks that will likely result in another financial crisis of even greater magnitude.

We must accept that regulations can't work, and we must take responsibility ourselves for the safety of our money.  If we allow the government to perform this task, we can expect the same outcome as before: financial crisis.  We must also decouple government and industry so that the taxpayer is not on the hook when a bank fails.

If we didn't have institutions that were too big to fail before, we certainly do now. Most financial institutions are now backed by so many government guarantees that failure will result in huge taxpayer losses. For example, now money market accounts are guaranteed and investment banks get FDIC insurance and can borrow directly from the Fed! And under the Democratic administration, banks are still able to hide hundreds of billions in asset losses. In the attempt by government regulations and policies to make everything safe, everything is put at risk.