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AMERICAN POLITICAL ECONOMY: POLITICAL BUBBLES

140208

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This Post is the second in a Series on American Political Economy. The previous Post (140201) outlined political Cycles between more and less central governance of the economy. This Post highlights the Political components of economic cycles. The next Post (140215) will focus on Financial institutions. The final Post (140222) will reprise this main issue DIMENSION in American politics.   

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BUBBLES,  ECONOMIC AND POLITICAL 

The 2008 Financial Crisis and ensuing Great Recession have prompted both economists and political scientists not only to examine those recent events but also to re-examine historical analogues. Financial crises and economic recessions have been endemic to American history, essentially occurring every few years. Notable ones occurred in 1792, 1796-1797, [1814-1815]  1819, [1825] 1837-1839, 1857, 1861, 1873, 1884, 1890, 1893, 1896, 1907, 1930-1933 , the 1980s, and 2008. These financial crises have often involved banking “panics” in which depositors “ran” on banks to withdraw their funds, sometimes causing banks to fail. Some but not all financial crises involved recession in the economy as a whole. (Bolding shows major recessions. Brackets indicate episodes that evidently were mostly only banking crises.) 

On the largely ECONOMIC side, for general purposes of  economic science, the best-known recent book reviews such cycles in many countries across many centuries. It argues that economic recessions caused by financial crises have been deeper and longer than economic recessions caused by other factors such as business cycles. (See Carmen Reinhardt and Kenneth Rogoff 2009. This time is different: Eight centuries of financial folly. Princeton NJ: Princeton University Press, 463 pages.)    

Other important recent work by economists has emphasized that the USA was unusual among advanced capitalist countries in having so many financial crises until so recently. From the 1830s until the 1980s, as a result of national and state politics and policies, most of the American banking system was uniquely localistic and compartmentalized and therefore somewhat inefficient and extremely unstable. The two main sides in American economic politics have been localist-agrarian Jeffersonians versus statist-developmentalist Hamiltonians (see previous Post, 140201).  Even as late as the response to the Great Depression in the 1930s, the localists prevented the statists from establishing a financial system that was more national and stable (see next Post, 140208). (See Charles W. Calomiris and Stephen H. Haber 2014. Fragile by design: The political origins of banking crises and scarce credit. Princeton NJ: Princeton University Press, 576 pages. Discussed in the next Post – 140215.)  

Specific dynamics differed across periods. Before 1863, a main cause of panics was private speculation in land, facilitated by government encouragement of settling new territories. From 1863 to 1913, panics were related more to political wars and economic cycles (business and seasonal). During the 1930s, runs on banks resulted from misguided national policy. The Federal Reserve System prevented banks from suspending convertibility, but failed to support banks with adequate funds. As a result, many banks failed. Those Depression mistakes were what economics professor Ben Bernacke studied and what Fed chairman Ben Bernacke strove to avoid in 2008, by flooding private banks with public funds. (On the history, see Charles W. Calomiris 2000. U.S. bank deregulation in historical perspective. New York NY: Cambridge University Press, 359 pages.) 

An important recent book by three political scientists on Political Bubbles details the POLITICAL components of American economic cycles. McCarty, Poole, and Rosenthal go beyond blaming collective misfortune simply on the misconduct of particular individuals (interests). They analyze the circumstances that induced and allowed that misconduct (ideology and institutions).Thus, in part, Economic bubbles are caused by Economic ideology, institutions, and interests. However, they are also accompanied by and partly caused by Political bubbles caused by Political ideology, institutions, and interests. Not only can these political components be dysfunctional, political polarization aggravates their dysfunctionality. (See Nolan McCarty, Keith T. Poole and Howard R. Rosenthal 2013. Political bubbles: financial crises and the failure of American democracy. Princeton NJ: Princeton University Press, 356 pages. ) 

Political bubbles is very good political economy:  analytically precise, historically grounded, and policy relevant. Note the book’s subtitle: “the failure of American democracy.”  The authors deem the current performance of American politics sorely inadequate and unlikely to improve. The USA’s 1787 Constitution has worked well on many issues under many political circumstances. However, that Constitution has been working increasingly poorly (policy gridlock) in the recent political environment (party polarization). 

OCCURRENCE:  HOW   POLITICS  ALLOWS  CURRENT  ECONOMIC  BUBBLES 

The first half of Political Bubbles argues that American politics is a main cause of American economic bubbles. Most generally, this is because, as bubbles arise, American politicians and policy-makers tend to share many of the same optimistic beliefs held by economic and financial actors. Some leaders may have some reservations but, in a democracy, one cannot expect politicians to go against the aspirations and expectations of their supporters, elite or mass. (Or, as Calomiris and Haber put it, against the political power of the currently dominant political coalition – Fragile 212). 

More specifically, the “three “I’s” of Ideology, Institutions, and Interests each make their distinctive contributions.  

Ideology tends to ignore practicality to favor principles. For example, in the 2008 crisis, both Right and Left were too rigid. Conservatives adhered to “market fundamentalism” that opposed any government regulation of lenders and adhered to concerns about “moral hazard” that opposed any government assistance to borrowers. Progressives adhered to an egalitarianism that wished to extend home ownership to poorer Americans, regardless of their ability to pay. Crucially, this was reinforced by conservatives’ idea of an “ownership society,” a rare bipartisanship that proved hugely dysfunctional. (Calomiris and Haber agree – Fragile, Chapters Seven and Eight.) 

Interests affect policy through three channels. First, special interests mobilize constituencies to pressure congress. Finance doesn’t have a mass following to mobilize, but on the other hand doesn’t become a target of masses except in bad times. Second, special interests contribute to politicians’ election campaigns. Since about 1990 finance has contributed more and more money, opportunistically targeted on the parties and politicians with the most influence at given times for given purposes. Third, special interests lobby politicians by providing them with the information needed to legislate on complex matters. This occurs particularly in finance because finance has made finance particularly complex.    

Institutions shape the whole process. Under the 1787 Constitution, political power is so decentralized that changing policy requires extraordinary consensus and mobilization. Frequent elections shorten the time horizon of politicians. Representation is based on localities whose interests politicians must serve – until quite recently, very much including local banks. Senate and House, president and courts all provide veto points. There are many pivotal actors separated by wide ideological gaps between which policy is unlikely to change. Legislative gridlock prevents needed updating of regulations and diverts responsibility to regulatory agencies easily influenced by finance.     

Most specifically, in the occurrence of the 2008 crisis, the three political I’s underpinned the following mechanisms:   

Deregulation that permitted innovative new financial instruments to emerge without meaningful regulation.

 

Deregulation that permitted financial firms to engage in riskier activities.

 

Reduction in the monitoring capacity of regulators, either deliberately or because staff and budgets simply did not expand fast enough.

 

Shifts in competition policy that permitted financial institutions to become too big (and too politically powerful) to be allowed to fail.

 

Privatization of government financing of mortgages that created two more too-big-to-fail institutions. 

RESPONSE:  WHY  POLITICS  DOESN’T  PREVENT  FUTURE  ECONOMIC  BUBBLES 

The second half of Political Bubbles argues that, after a bubble bursts, American politics tends not to take the corrective actions needed to prevent another bubble.

In the first half of the 1800s, the American economy and population remained largely agrarian, represented most of the time by the localist Democratic party. Its financial policies opposed strong national banks and favored independent local banks. The Democrats’ response to the (frequent) collapse of bubbles was national bankruptcy laws and state debt relief that allowed farmers to escape their debts. Bubbles opines that, contrary to “moral hazard” arguments, evidently this financial leniency did not impair American economic development. Cancelled debt provides a fresh start not only to debtors but also to the economy as a whole. (Fragile emphasizes the economic costs of the economic instability that resulted from the financial leniency.) 

In the second half of the 1800s, the American economy became increasingly industrial and the population became increasingly urban, represented most of the time by Republicans. Nevertheless, Democrats retained enough of a veto that banking remained local – until about 1980! However, railroads emerged on a national scale and became “too big to fail;” railroad failures were handled by courts. Around 1900, the two parties and their class constituencies reversed their ideologies:  Democrats followed “the masses” in demanding national regulation of business; Republicans followed elite business in rejecting such regulation. Nevertheless, as late as the 1930s, both parties responded to the Great Depression first with traditional measures.    

Reviewing the policy responses to the main financial crises in American history, the second half of Bubbles finds four political regularities (153).

Legislative responses to financial crises and economic downturns have generally been limited and delayed.

 

The response often awaits a transition political power.  This partisan delay reflects the idea that the cause of the crisis is generally rooted in the ideology of the incumbent party.

 

Future change in political power often reverses the initial legislative response. The reversal contributes to the next crisis. This point is central to the inevitability of future financial crises.

 

Short-term reelection concerns undermine the search for long-term solutions.  

Bubbles concludes that delay is inherent in American democracy, that ideology is an important impediment to response, and that polarization increases the magnitude of these four regularities (154) 

CONCLUSION 

That the political response to economic crises is typically delayed defines a new historical unit for analyzing political economy: a unit that includes not just the dating of the economic cycles themselves but also the dating of the delayed political response. In these terms, currently we are still in the cycle that began in 2007-2008: its economic effects have begun to diminish but political remedies have mostly not yet been applied, let alone assessed and revised.  Historically, the main episodes were 1796-1800, 1837-1841, 1893-1898, 1907-1913, 1929-1935, and the 1980s.

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