Financial Market Failure as a Crisis in the Rule of Law: From Market Fundamentalism to a New Keynesian Regulatory Model

This article considers the financial panic of 2008 in historical context by analyzing the institutional and regulatory factors that contributed to the financial and economic crisis. The move away from a Keynesian regulatory model was a function of larger institutional flaws. The Keynesian regime of command-and-control regulation focused on macroeconomic policy objectives designed to achieve full employment, more equitable distributions of wealth and income, greater transparency in the regulatory process, and reduction in monopoly exploitation of consumers. Central to this regime was a model of central banking that required greater accountability to elected branches of government and the use of selective credit controls to complement general monetary policy measures. As the Federal Reserve (the Fed) became increasingly subject to agency capture by its private financial constituencies, it also became a leading force behind the deregulation of interest rates and lending standards, and the adoption of risk-based capital requirements. These trends, in turn, undermined the transparency of financial institutions and markets, and encouraged the development of an unsustainable, bubble economy. The privatized Federal Reserve System represents a profound rule-of-law failure that is reflected in today’s bailout model which socializes losses and privatizes gains for “too big to fail” financial institutions. This captured Fed represents a significant impediment to effective financial regulation and a proper balance of constitutional authority on monetary and fiscal policymaking between elected and appointed branches and private actors. This article recommends reviving the model of institutional law and Keynesian economics by suggesting a more complete and integrated approach to financial regulation that would keep competition within prescribed limits while allocating credit and capital away from private, speculative activity and into longer-term public investment in physical and social infrastructure. A necessary precondition is reform of the Fed’s institutional structure to safeguard monetary policy and financial regulation from a self-serving financial industry