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AMERICAN POLITICAL ECONOMY: FINANCIAL INSTITUTIONS

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In a series on American Political Economy, this third Post focuses on Financial institutions. The first Post (140201) outlined political Cycles between more and less national governance of the economy. The second Post (140208) highlighted the Political components of economic cycles. The final Post (140222) will reprise this main issue Dimension in American politics.     

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CENTRAL  BANKS 

Financial institutions have always been pivotal to political economy. That is obvious for public finance, the institutions through which governments raise and spend revenue. It is equally true of private finance, whose arrangements are defined by government and politics. Private finance has always been pivotal to “capitalism,” and has become ever more so as capitalism has developed (“financialization”). 

One might think that the USA –  until recently often regarded as one of the most advanced forms of current financial  capitalism –  has always been typical of advanced capitalism throughout the world. Then the political-economic history of the United States, in which financial crises were frequent, might lead one to conclude that “capitalism in general” is highly unstable. 

However, recent work on the comparative history of modern finance has highlighted that, historically, American financial institutions have been unique: decentralized in a compartmentalized way that makes them exceptionally unstable. Thus the USA’s endemic financial crises have NOT been the inevitable result of “capitalism in general.” Rather, they resulted from distinctively American decentralization and compartmentalization. 

(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.  On recent financial development in China, see Charles W. Calomiris ed. 2007. China’s financial transition at a crossroads.  New York NY: Columbia University Press, 432 pages.)   

Most political histories of the USA report the fights over whether it should have a central bank. They report the INSTITUTIONAL result: the USA had an only intermittent central bank from 1891 to 1831, no central bank from about 1832 to 1912, only a weak central bank until 1935, and a gradually strengthening central bank only after that. However, most political histories do not explain that this institutional result was extraordinary, given that most countries have found central banks necessary for economic development. 

Moreover, few political histories of the USA assess the ECONOMIC result of the USA’s checkered history. One might think that result not too bad since, even without a central bank, in the 1800s the USA quickly grew into the most powerful economy in the world.  However, that growth was accompanied by extraordinary instability that caused much suffering for businessmen, workers, and farmers – all this repeated periodically during the 1900s and 2000s. Meanwhile neighboring Canada –  with a more centralized banking system with nation-wide branches –  enjoyed both growth and stability.      

Different financial systems are more or less centralized or decentralized and more or less nation-wide or compartmentalized. As a result, different systems are more or less stable, more or less efficient, and provide more or less adequate amounts of credit. Along these dimensions, Calorimis and Haber compare some countries’ financial histories. Cana, early and continuously, has provided both stability and efficiency. Authoritarian Mexico and Brazil provided neither 

During the 1700s, prototype Britain actually started badly: its elitist “fiscal-military state” provided little credit and caused much instability. During the 1800s, democratizing Britain improved greatly, but in the 1900s did sometimes poorly, sometimes well. The arrangements that currently make London a global banking center are quite recent (post-1980s). 

In the late 1700s, USA finance began with abortive attempts to imitate elitist British finance. Then from about 1830 to 1980 a more democratic banking system usually provided ample credit but was somewhat inefficient and highly unstable. The arrangements that currently make New York a global banking center are quite recent (post-1980s). 

POLITICAL  BANKS 

Following Calorimis and Haber, the basic THEME of this Post is that banking is always political, for many reasons. Fragile begins by suggesting that to understand the banking arrangements of any country one should regard it as a political GAME played between multiple stakeholders: government and banks, creditors and debtors, bank insiders and outsiders, and ultimately all of these against taxpayers and public. (See Chapter Two of Fragile for details.) 

Government and banks need each other, both economically and politically. For banks to work, government must guarantee certain basic property rights and must manage stakeholders’ conflicting relationships. At the same time, the group in charge of government itself has both incentives and opportunities to behave opportunistically. Among other things, that group relies on political support from banks, creditors, and debtors.

The complexity of all this is itself important politically: in banking games, most players have no way to figure out exactly what is going on. The exact dynamics differ between authoritarian and democratic regimes, and between different kinds of each. Nevertheless, in all instances, what banking system emerges depends not on market criteria of economic efficiency but on political DEALS negotiated by the participants that reflect their respective political power. However, once institutions become established, it becomes difficult for later dominant coalitions to change them. 

Following Calorimis and Haber, the basic STORY of this Post is that, since about 1830, American financial organization has been strongly influenced by two successive coalitions between populists and bankers. These two coalitions have designed banking systems to meet their own economic and political needs. 

The first coalition was between agrarian populists and local bankers, lasting the enormously long time from the 1810s through the1970s! This system benefitted small farmers but created the “bank panics” endemic to American history. The second coalition was between urban activists and national megabanks, functioning well only for the amazingly short time from the early 1990s to the late 2000s. This system benefitted the megabanks but created the global 2008 crisis.  

LOCAL  BANKS

From 1776, the earliest American efforts to construct a banking system were Hamiltonian “statist-developmentalist”: the 1781 Bank of North America, the 1791 Bank of the United States, and the 1814 renewal of the Bank of the United states. However, Jeffersonian “localist-agrarianism” contested this elitist system all along, claiming that the central government did not have the authority to charter a central bank. The Jeffersonians soon abolished the central bank to favor a more “democratic” system, organized around small local banks without branches (“unit banks”). Despite many wars, depressions and other difficulties, Jeffersonians succeeded in keeping this system in place until about 1980! (Chapter Six) 

Economically, the unit bank system was quite a poor one whose instability itself precipitated the “bank panics” endemic to American history. No other country - and certainly no other advanced capitalist country – has had such a crazy system! Countries with more centralized banking systems that have nation-wide branches have been much more stable financially (e.g., Canada). So the explanation for the establishment and persistence of America’s distinctive system of unit banks is not economic but political. 

Politically, the highly decentralized system of “unit” banks reflected the highly decentralized nature of American politics. As well known, the 1787 Constitution divides central powers, allowing interests multiple points of access. The Constitution bases national representation on local constituencies, making representatives highly responsive to local interests. Federalism implied that there could be parallel banking systems at both federal and state levels. These proved incompatible under arrangements that allowed state branches of national banks to interfere with the local monopolies of local banks. Federalism also meant that the agrarian populist coalition could survive politically by winning only local contests. 

(One might add that the fact that American politics became organized around mass local parties probably mattered for bank organization.  Probably the early parties simply incorporated local banks into their local political machines, as they also incorporated local militias.)  

In the end, also decisive of financial organization were the particular political and economic environments that the political and banking systems faced. It was only when those environments finally changed (starting in the 1960s) that the unit bank system began to fail (finally collapsing in the 1980s). By then the forces undermining unit banking included the following.  Population and voters shifted from predominantly rural to predominantly urban.  New technology increased the information available to bankers and clients about each other and facilitated competition between banks geographically remote from each other.  Inflation induced depositors to move their funds from banks to new finance companies and money-market mutual funds. American banks were losing global market share. A wave of banking distress hit in the 1980s.

Small “savings and loans” associations – which finance local mortgages – were particularly hard hit. Their business model requires macroeconomic stability (little inflation) and banker prudence (low risk). Instead S&Ls experienced great economic volatility, which some bankers met by resorting to risky investments. The result was a cascade of bank failures. Eventually even unit bankers themselves came to view acquisition by a larger bank as preferable to losing everything. (195-198) 

MEGABANKS 

So, in the 1990s, the USA finally allowed the formation of large banks with nation-wide networks of branches –  “for the first time in U.S. history... and centuries after they appeared in other countries.” (153-154) There was reason to hope that the USA could finally achieve the financial stability enjoyed by other countries such as its neighbor Canada.  But things did not turn out that way. How did this new system, so promising in the 1990s, collapse in the 2000s?

As a framework for analyzing that question, Calomiris and Haber focus on what they regard as the heart of the matter. Why did banks made risky loans (Chapter Seven)? Given the riskiness of their loans, why didn’t banks keep appropriate reserves (Chapter Eight)? Fragile argues that political overseers would not have accepted either lax lending or lax reserves independently. The two had to go together as two aspects of the same political bargain . 

The bargain involved a core coalition between growing megabanks and previously disadvantaged borrowers (poor and inner-city). Megabanks needed political permission for their mergers and used lending to the disadvantaged to legitimize those mergers. In addition, urban activists got congress to mandate additional support by other organizations, particularly Government Sponsored Enterprises (GSEs) for managing mortgages. Politicians pressured the GSEs to lower their mortgage standards in order to make mortgages available to the “targeted” poor. The result was to lower mortgage standards for everyone. Suddenly the middle class discovered that it too could obtain loans with no income, no collateral, and (temporarily) low interest rates.

 

“We cannot stress this point strongly enough: the politics of regulatory approval of mergers set in motion a process whose ultimate outcome was that large swaths of the American middle class were able to take advantage of mortgage underwriting rules that, compared with those of any other country in the world and of earlier periods of America’s own history, were unbelievably lax. The result was the rapid growth of mortgages with high probabilities of default for all classes of Americans.” (12) 

 

More broadly, the bargain involved American politics as a whole. Calomiris and Haber argue that the alliance between emerging megabanks and disadvantaged borrowers reflected a political strategy endorsed by BOTH political parties, a strategy of redistributing income through the banking system. Rising inequality threatened renewed urban unrest that both parties wished to avoid.  More straightforward methods of redistribution such as public housing were too obviously increases in government spending and therefore too controversial. Politicians agreed that redistribution through finance was a politically expedient way to address rising economic inequality and urban poverty. Leading politicians from both parties endorsed it (Clinton’s “third way,” Bush’s “ownership society”).  (214) 

By 2008 the result was a gigantic American banking crisis with global ramifications. 

DISCUSSION

The stories Fragile tells bear on favorite themes in this Blog. 

On the one hand, the stories illustrate Michael Lind’s account of a dialectic in American political-economic history between Hamiltonianism and Jeffersonianism. On the other hand, on Lind’s logic, so many wars and depressions probably should have produced more change in America’s political finance. (For Lind, please see Post 140201.) 

On the one hand, Fragile confirms the sharp difference that Morton Keller posits between what this Blog calls Elite Republic (1730-1830) and Mass Democracy (1830-1930). Fragile also accords with Keller’s claim that Mass Democracy survived the Civil War, lasting well into the 1900s. On the other hand, the banking system established by Mass Democracy persisted even longer, well into Keller’s third regime, what we call Populist Technocracy (1930-2030). Arguably this persistence exemplifies what social scientists call “path dependence”: once institutions are established it is very difficult to get rid of them, regardless of the preferences of the current dominant coalition. (For Keller’s regimes, please see Posts 130504, 130511, and 130518.) 

The persistence of unit banks is also an example of what historical institutionalists call “layering” (or “intercurrence”): The persistence of a system from one era into another era with which it is not really compatible. The actual politics of the New Deal attempt to reform unit banking illustrate how that persistence occurs, despite the intentions of leading policymakers. The founders of Populist Technocracy WANTED to shift from unit banking to branch banking, but could not assemble the congressional votes needed to do so. So, unit banking stumbled along until changes in its environments gradually brought it to collapse in the 1980s. 

Finally, we should relate Fragile by design to the book on Political Bubbles reported in the previous Post (140208). Bubbles – by three political scientists – approaches American political finance from the political side. Fragile – by two economic historians –  arrives at a similarly “political” account of finance by approaching it from the economic side. (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.) 

Evidently Bubbles and Fragile come also from opposite sides of the American ideological spectrum. McCarty, Poole and Rosenthal begin from Left skepticism about financial elites and Left concerns about public welfare. Calomiris and Haber begin from Right preoccupation with property rights and Right suspicion of (redistributive) populism. Policy implications aside, attention to property rights leads Calomiris and Haber to illuminating microanalysis of banking politics. Moreover, Calomiris and Haber themselves try to go beyond current partisanship by showing that, since about 1990, BOTH parties have tried to use housing finance to redistribute income.  

Calorimis and Haber remark that the lesson from the story of the coalition between national megabanks and urban activists is that banking is “politics all the way down.”  “The power of a political coalition is precisely the power to get a public official to go along with something that he knows is not in the longrun public interest because it is in his own sort-term interest.” (212) They propose that, for understanding such situations, blame is not a useful term of analysis. 

McCarty, Poole, and Rosenthal are similarly “systemic” in their analysis, They are also somewhat impartial, remarking that “there is plenty of blame to go around.” Nevertheless, they repeatedly go out of their way to identify the actors MOST to blame, many of them the topmost leaders of American political finance.         

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