Now that financial apocalypse has been (possibly) delayed a few weeks, let’s focus on the mortgage crisis and see what it teaches us about financial regulations in general. Mortgages once were great investments. When lenders were highly regulated and careful never to lend more than the underlying value of homes, mortgages provided a higher return than U.S. Treasury bonds with almost as little risk. People went to great lengths to keep their homes, and when they got in over their heads, lenders could still recover most of the principle.

The problem, of course, was that there was a limited supply of really safe mortgages. So originators started making slightly risky loans, followed by riskier ones, and then riskier still. Part of deregulation resulted in lowering reserve requirements, meaning that investors could lend out more and more money they did not have. Another part was that mortgages could be originated by institutions not subject to such regulation in the first place. It was not just a matter of bad loans, but of loans made with non-existent money. (Though it is not quite the same, a fair comparison would be check-kiting.) So as demand for mortgages rose, originators could provide a shakier and less sound supply. Since lenders could turn around and resell all or most of their notes, originators often ended up without liability for bad loans they made.

Why did buyers continue to invest in a high stakes version of “Find the Lady”? Think of the late Lehman Brothers or any investment fund with row after row of brokers, competing to look good to the boss. Once one desk bought into the game, other brokers stayed out of it at the risk of their job. Only a tiny percentage of investment funds, such as those controlled by Warren Buffet, were outside this environment of adverse selection.

And this is not an exception in finance. Investment funds are always under pressure to take bigger and more foolish risks. Any financial sector that grows big enough in the absence of regulation will turn into a bubble. The great depression, the savings-and-loan scandal in the ’80s, the internet bubble in the ’90s — all grew out of under-regulated environments. Heck, so did the South Sea bubble in the early 18th century.

Grist thanks its sponsors. Become one.

Environmentalists can learn two important lessons from this:

One: if regulation is essential to finance, then so-called “command-and-control” remains one important tool in making the economy both greener and more prosperous.

Two requires more explanation. Start with the premise that many of these regulatory failures are regulatory capture. Some of earliest, such as the South Sea Bubble, occurred before anyone really considered the need for such regulations. But, at least in the 20th and 21st centuries, lobbying and ideological victories by the very rich and powerful either prevent regulations from being instituted in the first place, or more recently, push the repeal of regulations that already exist and the non-enforcement of those that remain.

The existence of regulatory capture is one of the classic arguments against regulation. If the foxes will end up in charge of the henhouse, just let chickens loose in the woods to begin with. But if you agree that capitalism needs strong regulations uncontaminated by regulatory capture, that leaves quite a dilemma.

Grist thanks its sponsors. Become one.

The dilemma can be avoided, or at least replaced by a new dilemma, if you notice that most serious regulatory capture is instituted by those who are rich and powerful as compared to the population. There are exceptions, such as some of the extreme licensing regulations, where comparatively powerless trades protect themselves at the expense of people much worse off than themselves. But such cases are rare compared to regulatory capture by super-elite “Masters of the Universe.”

The solution is clear: Reforms, especially new regulations, have to be accompanied by increased social and economic equality. Capitalism needs regulation, but regulation tends to be undermined by extreme inequality. So people supporting market solutions need to support regulation to make those markets work — and more equality to make those regulations work. Ultimately, environmentalism can’t be beyond left and right. Even support for market solutions can’t be beyond left and right. If you support capitalism and markets and are serious about making them work, you have to support social and economic equality. Equality is not something nice, something extra to worry about later. It is fundamental to saving our asses from an environmental crisis like climate chaos, and fundamental to saving our asses from an economic crisis like the current depression.

My next post will deal with the relation between the financial system and “the real economy,” and why the line between them is not as sharp as it seems — why finance is part of the real economy, and why people who criticize the focus on finance have a lot of truth on their side, even though it needs to be stated better.

Reader support helps sustain our work. Donate today to keep our climate news free.