What U.S. History Shows About the Effects of Deregulation

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Deregulation, the removal or loosening of government rules on an industry, has been followed by lower prices in some industries and costly failures in others. After Congress deregulated airlines in 1978, the median round-trip fare dropped nearly 40 percent after inflation between 1980 and 2005. Savings and loans, home lenders funded by customer deposits, were already losing money when Congress widened their lending powers in 1982. The cleanup of those that failed cost taxpayers an estimated $123.8 billion.

The freedoms differed: airlines could set prices and routes, while savings and loans gained wider lending powers. Airlines had to compete for passengers. Savings and loans could take bigger risks while deposit insurance and, in the end, taxpayers covered the losses.

What gets deregulated matters more than the label

Even after delegating rulemaking authority to a federal agency, Congress can still amend the law behind a rule, or modify or repeal the regulation itself. Under the Administrative Procedure Act, an agency that wants to create, amend or repeal a rule generally must publish a proposal, allow public comments, review those comments and publish a final rule.

The word deregulation alone does not identify the protection being removed. Freedom to set a ticket price raises a different question from freedom to take risks with insured deposits. Nor does opening a market require abolishing every form of oversight; a price rule, a safety rule and a remedy for customers can be assessed separately.

Airlines: cheaper fares, uneven access

The Government Accountability Office (GAO) is an independent, nonpartisan agency that works for Congress.

Before 1978, the Civil Aeronautics Board controlled the fares airlines could charge and the routes they could fly. Congress deregulated the industry in 1978 to encourage competition and fares that better reflected airline costs. The Airline Deregulation Act was approved on October 24, 1978, but the old controls did not vanish overnight: existing orders, permits and rates stayed in effect until they were modified or ended.

Other federal roles continued as well: the Federal Aviation Administration still oversaw air navigation, safety and airport investment, the Government Accountability Office (GAO) reported in 2006. Because price and route controls ended while safety oversight stayed, lower fares are not evidence that removing safety rules would bring the same gains.

From 1980 to 2005, median round-trip airline fares fell nearly 40 percent in inflation-adjusted terms, according to GAO. GAO concluded that competition likely played a significant role in lowering fares, but that technology and other economic factors made it hard to tell how much of the drop was due to deregulation alone. Its 1980-to-2005 comparison found smaller fare reductions in smaller markets and on shorter trips, although small markets had net gains in connections and overall traffic.

In a 1999 review, GAO found that major airlines dominated operations at ten key airports, limiting competition and contributing to higher fares. Restrictions on airport takeoff and landing slots, along with a perimeter rule limiting certain flights at Reagan Washington National Airport, compounded barriers to entry. The airline example thus poses two separate tests: whether entry is legally allowed and whether competitors can actually reach customers.

The 1978 law also established Essential Air Service, which subsidizes airlines serving certain eligible communities. The Department of Transportation requests carrier proposals describing the service and the annual subsidy needed to provide it. The choice was not simply between government control of every route and leaving every town to whatever service proved profitable.

Trucks and railroads: more freedom to negotiate

The Motor Carrier Act of 1980 eased entry into trucking, removed operating restrictions and encouraged price competition. In October 1983, the Interstate Commerce Commission reported that rates in a segment of the trucking industry had fallen or were rising more slowly than before the law. GAO attributed downward pressure on trucking rates to both new entrants and declining economic activity.

A number of trucking companies failed because of competition and a declining economy, GAO reported in 1983. A study by the Teamsters union found a substantial increase in the percentage of workers with seniority rights who were on layoff, many of them for a long time. The study did not say how many of the laid-off workers had found other jobs. Lower rates for customers and lost jobs for workers can come from the same competition, so calling the change a success requires saying whose outcome is being measured.

Before the Staggers Rail Act, freight railroads faced bankruptcies, low returns, difficulty raising capital and declining market share, according to a Surface Transportation Board historical presentation. The Staggers Rail Act of 1980 gave railroads more freedom to set rates according to demand, encouraged contracts with shippers and streamlined procedures for selling or abandoning rail lines.

Federal regulators retained a test of whether rates were reasonable. The act also provided for rate relief for captive shippers, meaning customers with no competing transportation option who might face unreasonably high rates. A customer with no workable alternative does not gain the same bargaining power as one who can switch carriers.

In 2007, GAO reported improved railroad financial health as carriers increased productivity, streamlined networks, adopted technology and expanded into new markets. Most rail rates had declined after 1985, but they began increasing in 2001, according to that review. A reform can improve an industry’s ability to operate without guaranteeing that its prices will keep falling indefinitely.

Savings and loans: new risks with old guarantees

Savings-and-loan institutions, often called thrifts, traditionally held most of their assets in fixed-rate home mortgages. As interest rates rose in the late 1970s, thrifts had to pay more to attract deposits while earnings from existing long-term fixed-rate mortgages did not rise with them. The industry recorded losses in 1981 and 1982. The crisis therefore did not begin with a single permission to make riskier loans; it began with institutions already under financial pressure.

The Garn-St Germain Act expanded savings associations’ powers to lend for commercial real estate in 1982. A history by the Federal Deposit Insurance Corporation (FDIC) found that high-risk development loans and mortgages on the same properties were most likely the principal cause of thrift failures after 1982.

FDIC also described insolvent thrifts, those whose assets were worth less than they owed, being allowed to grow and to trade interest-rate risk for the risk that borrowers would not repay. Greater investment freedom became dangerous when institutions in trouble could expand the amount at stake instead of recognizing their losses.

FDIC identifies a problem called moral hazard: deposit insurance can reduce insured depositors’ incentive to monitor an institution and encourage it to take greater risks. New lending powers, weakened discipline and permission for insolvent institutions to grow made a different combination from allowing competing airlines to offer cheaper tickets.

FDIC’s account also describes abusive owners extracting cash and using new development loans to conceal impending defaults, while stressing that most savings and loans were not fraud-ridden.

In 1989, the Financial Institutions Reform, Recovery, and Enforcement Act restructured thrift regulation and created the Resolution Trust Corporation to handle insolvent savings and loans that the old federal thrift insurance fund had covered. FDIC estimated the combined direct and indirect losses from handling those failures at $152.9 billion, divided between taxpayers and the thrift industry. Of that estimate, $123.8 billion represented taxpayer losses. That figure measures the cost of resolving the failures, not a price discount that can be compared directly with cheaper airfares. The policy lesson lies in the placement of risk: an institution could make the investment choice while the insurance system and taxpayers absorbed much of the eventual loss.

The financial crisis had more than one cause

A national commission, the Financial Crisis Inquiry Commission, examined the financial crisis of 2007 and 2008 and issued its report in January 2011. The crisis developed, the report says, when housing prices fell and mortgage borrowers defaulted and the trouble reached Wall Street. The commission’s members disagreed about the causes, and their competing assessments help separate changes in financial law from the choices firms made under those laws.

The Banking Act of 1933, commonly called Glass-Steagall, separated commercial banking, taking deposits and making loans, from investment banking, underwriting and dealing in securities.

The inquiry report describes Lehman Brothers’ failure and the threatened collapse of the insurer AIG, followed by panic, frozen credit markets and a deep recession. By the time the commission reported in January 2011, millions of Americans had lost jobs and homes, and the economy was still struggling to recover.

In November 1999, the Gramm-Leach-Bliley Act lifted most remaining Glass-Steagall-era restrictions, allowing qualifying bank holding companies to combine banking, securities and insurance activities. That change belongs in the history of financial deregulation, but the commission’s majority did not treat it as the whole explanation: its conclusions, described below, also cite other gaps in oversight and the risks firms took.

A second change concerned over-the-counter derivatives, contracts made outside a regulated exchange whose value depends on an underlying asset, reference rate or index. Such contracts can serve risk-management functions, as the Commodity Futures Trading Commission explained in its 1998 concept release.

The report describes the Commodity Futures Modernization Act of December 2000 as broadly deregulating this market. Some authority survived: the Securities and Exchange Commission kept antifraud authority over securities-based over-the-counter derivatives such as stock options, and the Commodity Futures Trading Commission’s powers over exchange-traded derivatives were weakened but not eliminated.

The commission’s majority concluded that over-the-counter derivatives contributed significantly to the crisis. It said credit default swaps, contracts sold to protect investors against losses on mortgage-related securities, helped expand the market for those securities. Other derivatives allowed multiple bets on the same mortgage securities, amplifying losses when the housing bubble collapsed and spreading them through the financial system.

The inquiry commission’s majority concluded that widespread failures in financial regulation and supervision, along with decades of deregulation and reliance on self-regulation, stripped away important safeguards. The majority also identified failures in how financial firms were run and managed risk, excessive risk-taking, too little capital to absorb losses and heavy dependence on borrowing that had to be renewed each day. It found that collapsing mortgage-lending standards and the packaging of mortgages into investments spread dangerous loans from neighborhoods to investors worldwide. Taken together, the majority’s findings describe failures of rules, supervision and private decisions that could reinforce one another.

A dissent in the same report rejected broad explanations based on either too much or too little government. It said the majority’s view, that more restrictive regulation and more aggressive regulators could have avoided the crisis, largely ignores its global nature. The dissent emphasized a credit bubble in the United States and Europe that extended beyond housing, in which inexpensive borrowing encouraged riskier investments. The history supports examining what a particular reform permitted and how oversight worked, while resisting a single-cause verdict about Glass-Steagall.

In a separate dissent, commission member Peter Wallison, an American Enterprise Institute fellow, argued that government efforts to increase homeownership weakened mortgage lending standards and created risky loans that would default when the housing bubble burst. He said affordable-housing requirements for Fannie Mae and Freddie Mac, together with federal housing-agency policies, pushed lenders to compete for borrowers and make more high-risk loans than the market would have produced without government influence.

The majority reached a different conclusion: it said affordable-housing goals contributed only marginally to Fannie Mae’s and Freddie Mac’s purchases of risky mortgages, and that the Community Reinvestment Act was not a significant cause of subprime lending or the crisis.

California electricity: the rules that remained mattered

California’s governor signed Assembly Bill 1890, implementing electricity restructuring, in September 1996; the restructured market opened in April 1998.

California’s electricity restructuring froze the retail prices customers paid while letting wholesale prices, what utilities paid for power, depend on supply and demand. The state’s Public Utilities Commission also limited the utilities’ ability to sign long-term purchase contracts, which effectively required them to buy almost all their electricity through the California Power Exchange, a newly created market, generally no more than one day ahead. The utilities could therefore face changing purchase costs while the prices charged to customers remained fixed.

During winter 2000 and 2001, California experienced rolling blackouts, and two of its three major utilities became insolvent during the crisis. The California Power Exchange stopped doing business in January 2001 and later declared bankruptcy, while the state assumed responsibility for buying electricity for the utilities.

The Federal Energy Regulatory Commission identified drought-reduced hydropower, a natural-gas pipeline rupture, rising demand, high temperatures, outages at old generators and seller manipulation among contributors to the crisis. A March 2003 report by the commission’s staff found evidence of significant market manipulation in western energy markets during 2000 and 2001. The staff concluded that many trading strategies used by Enron and other companies violated provisions against gaming the market in the commission-approved rules for California’s power markets.

Tight supply and market abuse could push up the wholesale prices the utilities had to pay while their retail prices stayed frozen. The outcome cannot be understood by counting only the restrictions removed; the restrictions retained shaped how the market handled a shock.

What these histories can tell you about a new proposal

Start with the conduct the proposal would free up: setting prices, entering a market, combining financial businesses or choosing investments. Then ask whether customers have a usable alternative, whether the decision-maker bears the downside and whether someone can enforce the safeguards that remain.

Benefits and costs also need the same level of detail: cheaper for which customers, over what period and at whose expense? A national fare decline does not settle service in a small community, and a healthier railroad does not settle the position of a captive shipper. Promises about competition are strongest when a proposal explains how new competitors will reach the people who need them.

When a federal agency proposes to create, change or repeal a rule, the public can comment, commonly through Regulations.gov, and the agency generally must review the comments before issuing the final rule. A useful comment can identify the missing mechanism: an entry barrier, a risk shifted to insured customers or taxpayers, or a protection the proposed change would leave ineffective.