Charles Calomiris is the co-author, with Stephen H Haber, of a new book entitled "Fragile by Design: The Political Origins of Banking Crises and Scarce Credit". It is an analysis of what Calomiris and Haber call the "systematic role of politics in the determination of banking systems' performance". Politics, in their view, matters when one is attempting to understand the causes of banking crises.
This is a book that wears its historicism on its sleeve—it contains accounts of systemic banking crises dating back to the 18th century which occurred in many different countries (though their focus inevitably falls on the United States). As such, it's a work of economic history and political economy—intellectual traditions that Calomiris, who I interviewed on his recent visit to London, is happy to place himself in.
JD: This preoccupation with deep history is not something one finds very often in the mainstream economic literature.
CC: One thing that my co-author Stephen Haber have in common is that we are transgressors par excellence, and have been successful in transgressing across disciplinary boundaries for decades. I’ve never been happy to be called something at the expense of something else. Steve is a professor of political science—he used to be a professor of history at Stanford but got his PhD in economics from UCLA. If you asked him to define himself he might say he’s an economic historian. I’m a professor of finance at a business school and would say pretty much the same set of things—that I see what I do very much as a combination of things. So this book belongs to the old-fashioned tradition of political economy.
Has the crisis of 2008 and its aftermath led to a revival of that tradition would you say?
Yes. People are dissatisfied with explanations [of the crisis] that don’t have a political dimension included in them. What we try to do is think through how the logic of politics actually works. There are winning coalitions and there are losing coalitions. For example, most of the narratives that you’ll hear, even coming from political scientists, about political struggles are often defined on partisan lines. But a very robust political bargain is one that’s going to be robust to electoral outcomes. And in fact, in US history and the history of many other countries, what you’ll see is the most successful political bargains being forged not within political parties but across them, in which groups which may have natural antipathy to each other but are brought together by a common interest in a particular banking arrangement.
That was true of the sub-prime crisis wasn’t it? You observe in the book how there was strikingly little Republican push-back against Bill Clinton’s version of the “Third Way”, which attempted, as you put it, redistribution through the banking system—specifically, through the massive increase in housing and urban development (HUD) mandates for low income lending by government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac.
Not only was there no push-back, but the GSE Act, which was part of this whole bargain, was passed under George H W Bush’s administration. It was magnified under Bill Clinton, further magnified under George W Bush and then blew up. But that’s not unusual in American history. In the prior bank bargain, the winning coalition was a rural populist group in alliance with unit bankers. Land-owning farmers didn’t particularly have a lot of love for bankers—you get a feeling for the antipathy if you read Steinbeck’s Grapes of Wrath—yet they were political allies in the design of the banking system that ruled in the United States from, roughly, the 1820s to the 1980s.
At the beginning of the book, you write: “Systemic banking crises like the U.S. subprime debacle of 2007-09… do not happen without warning, like earthquakes or mountain lion attacks.” Yet economists and commentators often talk as if crises were like that, as if they were entirely random, naturally occurring events.
The way most economists talk about banking crises is to say that banks are, compared to most other corporations, inherently vulnerable because they perform what are called a “maturity transformation” and a “liquidity transformation”. Those are fancy ways of saying that banks have relatively long-term, relatively opaque assets, and relatively short-term liabilities. So when concerns arise about banks’ asset quality, people can refuse to roll over debt which can lead to a general liquidity problem that tends to aggravate an already pre-existing solvency problem.
A big shock, therefore, is one that creates so much concern about the asset quality of banks that some banks are immediately likely to be insolvent, while other banks are going to become insolvent partly as a result of the reaction to this shock news with uncertain ramifications. Now, I think that’s a reasonable characterisation of a logical story about banking. The thing that is missing in that story is the recognition that there are many cases, both in terms of whole eras of time as well as some countries across time, that, despite having a history of large shocks and quite abundant bank activity and credit, have avoided banking crises. That then raises the question: what, in the narrative I was just describing, is incomplete? That’s the key point. It’s not that people are wrong to think that shocks are associated with banking crises—of course they are; there’s never been a banking crisis without a shock. The more important point is that there have been lots of pretty big shocks without banking crises. So it’s really regulation, broadly defined—Who gets to be a banker and with what powers? Who gets favoured access to credit? When losses occur, how will those losses be allocated?—that is going to determine whether a combination of abundant bank credit and a big shock will necessarily produce a banking crisis. A good example would be Canada, one of the five countries we study in the book. It’s a primary commodity-exporting economy with more volatile GDP than the United States. And yet, since 1792, the US has had 17 major banking crises and Canada has had none. That begs an explanation.
Indeed, it's one of the premises of the book that banking crises are, geographically speaking, unevenly distributed and that the standard narrative of such crises can’t account for that. And that leads you to reject accounts of the “endogenous” instability of the banking sector such as Hyman Minsky’s, in which, as you put it, “financial markets and banks oscillate between moments of excessive optimism and excessive fear”. Is this an explicitly anti-Minsky book?
Not really, no. At the end of the book, we do mention both Hyman Minsky and Charles Kindleberger. But I think Minksy would certainly have accepted that good regulation can prevent banking crises from happening. I didn’t want to create the impression that this is somehow an anti-Hyman Minsky book. But I would say this: asset bubbles aren’t the same as banking crises. There are few countries that manage to avoid ups and downs in asset prices. That doesn’t necessarily mean they have banking crises. To get a banking crisis, you also need to have your banking systems and risk-management apparatus dysfunctional. That, I think, is an important distinction.
Saying that human behaviour tends to produce these waves of booms and busts, which Minsky did … it was a mechanical, mathematical analysis which assumed that a lot of things happened. It assumed that during booms financial institutions would have a tendency to get over-leveraged. It assumed that during busts they had a tendency to react excessively on the downside. Now, that is not necessarily the case, and Minsky was not a historian. Kindleberger, though he was an economic historian, was not really as familiar with banking history as he was with asset markets. I don’t think that those theories are general, correct propositions about real econonomies. I think we’ve over-theorised a bit. The potential for banking crises exists in the fundamental structure of banks which is potentially fragile. But not necessarily fragile.
So models like Minsky's bump up against the brute fact of geographical variation in your view? There’s one geographical variation that you’re particularly interested in and that is the strikingly different experiences of banking crises in Canada and the US. Are you arguing that there’s something peculiarly “crisis-prone”, as you put it, about the US banking system?
Yes. We trace it to the politics of the founding of the United States as a revolutionary country. Although it went through an initial phase of what you might call “crony capitalism”, it rapidly moved, by the 1820s and certainly by the 1830s, towards a new model of banking comprising what one might call local monopolies with limited entry. That was very peculiar and it lasted in the US until the 1990s. Which is an unbelievable fact, given that it was the only country on earth doing this.
There were many shocks in US history during which that model was tested politically—notably the Civil War, both world wars and the Great Depression. There were six banking panics in the US between 1873 and 1907, after which we established a National Monetary Commission in 1910. The National Monetary Commission arranged academic studies of all the major countries’ banking systems and their historical operation. There were three studies of Germany, three of the UK, I think three of Canada. Belgium had one, Mexico had one, Italy had one. The scholarship of the period was impeccable. Those studies are classics that are still being used by economic historians. What do we learn from them? We learn not just about the history of those countries, but also that the National Monetary Commission, when asked to explain the peculiar history of the US, was fully informed that the history of US instability was the result of the industrial organisation of US banking. But change was not on the menu, politically.
What we did instead was create the Federal Reserve System, which was self-consciously intended as a macro-prudential device, as a means to change the shape of the aggregate economy’s loan-supply function over the seasonal frequency. In other words, to reduce liquidity risk in the banking system on a seasonal basis, and therefore make loans more elastically supplied across the seasons. That was the main goal of the Federal Reserve. And we know from several studies that it actually achieved that goal, which did improve somewhat banking stability. But it didn’t prevent banking crises.
We got a wave of banking crises in the 1920s. A wave of banking crises in the 1930s. We had them in the 1980s and now we’ve had one again. What’s remarkable is that people in Canada studying the US banking system in 1910 reached identical conclusions— which was that the Americans were crazy. Why were they creating banking systems that were so crisis-prone? The reason they were crisis prone was that “unit” banks were isolated in particular areas, they were very undiversified—a big shock comes to a particular crop and wipes out all the banks in that particular area. In Illinois in the 1920s, they held a referendum on unit banking. And they preserved unit banking. It’s very important to understand that this was not the unit bankers doing it all by themselves. And there’s a bigger lesson here which is that banking disasters and banking regulation is never the result of only of bankers’ political influence. Bankers can’t do it alone.
Although this is an avowedly empiricist piece of work, it does lay down some general principles, among which is the assertion that, contrary to what you call a “libertarian fairytale”, there is no banking system without the “police power” of the state.
Absolutely. Let me give an example that illustrates the point we are trying to make there. Many libertarians like to talk about the historical experience of Scotland as a model for banking. I agree with them that Scotland is a wonderful model for banking. Almost everything of any use in commercial banking was created in Scotland by the mid-18th century. And then you look down to the south, at that primitive country England, and wonder why the English were so ignorant, when Scotland was just the other side of the border. The English had a much more unstable, less credit-abundant system. It was much less competitive—the Bank of England had a monopoly charter until 1826.
A libertarian would look at this contrast and say that Scotland is brilliant and England somewhat stupid. But they have the same sovereign. They were actually, in some sense, two sides of the same coin. Someone had to bear the brunt of making the state survive. And the only way to do that was to create institutions of public finance. If libertarians understand that an exception has to be made for the military, then they also have to understand that part of the military is the funding of it. So we have an iron law which we call the “Iron Law of Credit Supply”: there’s a chance you can have a banking system which will provide credit to the private sector once all the needs of the state have been satisfied. But until that has happened, it can’t occur. What’s interesting about England and Scotland was that Scotland’s banks didn’t have to support British public finance because England was doing that. And so there’s an interesting triangulation going on politically, and there’s a qui pro quo: the Act of Union was like an act of unilateral disarmament by the Scots, which I think is part of the laissez-faire banking regime there.
It’s not wrong to say that it’d be desirable to have a banking system by Scotland, but you can’t have a banking system like Scotland unless you’re lucky enough to be like Scotland and have another country, with the same sovereign, which is taking care of all the public finance problems. Not too many countries have that. So, inevitably, for most countries the banking system has to be a compromise between state interests and private interests. There’s no way to get politics out of the banking system, because banks require the state to give them their charters, to create and enforce the rules. And states need banks to help them survive. There have been states where there is no taxation—Kuwait is one. There have been states without armies—Costa Rica is one. There have been no states that haven’t had chartered banks.
I'd like to talk now about the gestation of the most recent banking crisis in the US. You write that it was the outcome, first and foremost, of a “political bargain”. As you’ve been saying, that’s true of all banking crises throughout history. I’m particularly interested in the role that you assign in the aetiology of the last crisis to the Clintonian, “New Democrat” version of the "Third Way".
I think that Bill Clinton’s “Third Way” can best be described as a brilliant political strategy for achieving his goals. And it wasn’t his intention that things turn out the way they did. Given all the constraints—a divided Congress, a federalist system—he figured out a get-around in the form of using the Community Reinvestment Act and the GSE Act to a particular set of purposes. If the US didn’t have those constraints, it might have dealt with inequality of opportunity more directly, through fiscal means. But that wasn’t on the menu.
What you got instead was redistribution through the banking system.
Exactly. And particularly through risky subsidisation of mortgages. It’s a very sad story. I want to point out, though, that it was President George H W Bush who invented it. This is a bipartisan enterprise. It’s true that Bill Clinton was perhaps the most enthusiastic magnifier of these subsidies, but they were magnified further under George W Bush. Newt Gingrich becomes the Speaker of the House of Representatives in 1994. Why isn’t reform to rein in some of this risk part of his “Contract with America”? It’s because he was part of a coalition—a coalition for higher risk. One of the key things that you see is that the dividing line between the winning coalition—formed by urban activists, politicians and the newly emerging mega-banks— and the losing one was not between Democrats and Republicans. In fact, it was an urban versus rural dividing line. The losing politicians were people like Richard Baker from rural Louisiana. Shelby from Alabama. Gramm, the senator from Texas. Jim Leitch from Nebraska. What these people had in common was that they were representing primarily the old and now losing part of the bargain; people who used to be the dominant group, but no longer were. So there’s more going on here than partisan politics.
FInally, I'd like to ask you about the regulatory response in the US to the most recent banking crisis. You think the Dodd-Frank Wall Street Reform and Consumer Protection Act is inadequate don’t you?
It’s 2,000 pages long, so in one sense it’s not inadequate! On the contrary, it’s excessive. But it doesn’t deal with the key problems that are revealed by a banking crisis. A banking crisis is about adequate capital relative to risk. So that means that you have to measure and in some sense control risk. It doesn’t mean that you want to limit risk, but that you want to have some control and measurement of it. When I and my colleagues talk about effective reform, we talk about that.
Dodd-Frank gave something to everyone, politically. There are specific quotas buried in it for women and minority hiring in the financial services industry, for example. It’s a grab-bag of handouts to a variety of interests. It also has things like the “Volcker Rule” in it. Now, even Paul Volcker [the former chairman of the Federal Reserve], whom I respect very highly, has admitted that the Volcker Rule really had nothing to do with this crisis. Volcker has had a particular set of beliefs about bank activities. Remember, he said that the only good financial innovation we’ve had in the last few decades is the ATM. Which is a very funny comment. But I don’t think it’s true. Volcker has a kind of antiquarian sense of banking. I don’t think the Volcker Rule, as it has been crafted, is going to do a lot of damage, but neither do I think it’s going to do a lot of good. It’s going to create a huge mountain of paperwork.
And look at what they exempted from the Volcker Rule’s application: real estate. If almost every banking crisis comes from real estate—agricultural real estate in the old days, or residential real estate today—why did they carve out [from the Act] the one thing that really created the crisis?
What about “too big to fail”? Senator Elizabeth Warren held a hearing recently in which she asked four economists if they believed that Dodd-Frank had ended “too big to fail”. All of them answered with a simple “no”. So, when you look at Dodd-Frank, there’s very little to love and a lot to dislike.
"Fragile by Design" is published by Princeton University Press (£24.95)
This is a book that wears its historicism on its sleeve—it contains accounts of systemic banking crises dating back to the 18th century which occurred in many different countries (though their focus inevitably falls on the United States). As such, it's a work of economic history and political economy—intellectual traditions that Calomiris, who I interviewed on his recent visit to London, is happy to place himself in.
JD: This preoccupation with deep history is not something one finds very often in the mainstream economic literature.
CC: One thing that my co-author Stephen Haber have in common is that we are transgressors par excellence, and have been successful in transgressing across disciplinary boundaries for decades. I’ve never been happy to be called something at the expense of something else. Steve is a professor of political science—he used to be a professor of history at Stanford but got his PhD in economics from UCLA. If you asked him to define himself he might say he’s an economic historian. I’m a professor of finance at a business school and would say pretty much the same set of things—that I see what I do very much as a combination of things. So this book belongs to the old-fashioned tradition of political economy.
Has the crisis of 2008 and its aftermath led to a revival of that tradition would you say?
Yes. People are dissatisfied with explanations [of the crisis] that don’t have a political dimension included in them. What we try to do is think through how the logic of politics actually works. There are winning coalitions and there are losing coalitions. For example, most of the narratives that you’ll hear, even coming from political scientists, about political struggles are often defined on partisan lines. But a very robust political bargain is one that’s going to be robust to electoral outcomes. And in fact, in US history and the history of many other countries, what you’ll see is the most successful political bargains being forged not within political parties but across them, in which groups which may have natural antipathy to each other but are brought together by a common interest in a particular banking arrangement.
That was true of the sub-prime crisis wasn’t it? You observe in the book how there was strikingly little Republican push-back against Bill Clinton’s version of the “Third Way”, which attempted, as you put it, redistribution through the banking system—specifically, through the massive increase in housing and urban development (HUD) mandates for low income lending by government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac.
Not only was there no push-back, but the GSE Act, which was part of this whole bargain, was passed under George H W Bush’s administration. It was magnified under Bill Clinton, further magnified under George W Bush and then blew up. But that’s not unusual in American history. In the prior bank bargain, the winning coalition was a rural populist group in alliance with unit bankers. Land-owning farmers didn’t particularly have a lot of love for bankers—you get a feeling for the antipathy if you read Steinbeck’s Grapes of Wrath—yet they were political allies in the design of the banking system that ruled in the United States from, roughly, the 1820s to the 1980s.
At the beginning of the book, you write: “Systemic banking crises like the U.S. subprime debacle of 2007-09… do not happen without warning, like earthquakes or mountain lion attacks.” Yet economists and commentators often talk as if crises were like that, as if they were entirely random, naturally occurring events.
The way most economists talk about banking crises is to say that banks are, compared to most other corporations, inherently vulnerable because they perform what are called a “maturity transformation” and a “liquidity transformation”. Those are fancy ways of saying that banks have relatively long-term, relatively opaque assets, and relatively short-term liabilities. So when concerns arise about banks’ asset quality, people can refuse to roll over debt which can lead to a general liquidity problem that tends to aggravate an already pre-existing solvency problem.
A big shock, therefore, is one that creates so much concern about the asset quality of banks that some banks are immediately likely to be insolvent, while other banks are going to become insolvent partly as a result of the reaction to this shock news with uncertain ramifications. Now, I think that’s a reasonable characterisation of a logical story about banking. The thing that is missing in that story is the recognition that there are many cases, both in terms of whole eras of time as well as some countries across time, that, despite having a history of large shocks and quite abundant bank activity and credit, have avoided banking crises. That then raises the question: what, in the narrative I was just describing, is incomplete? That’s the key point. It’s not that people are wrong to think that shocks are associated with banking crises—of course they are; there’s never been a banking crisis without a shock. The more important point is that there have been lots of pretty big shocks without banking crises. So it’s really regulation, broadly defined—Who gets to be a banker and with what powers? Who gets favoured access to credit? When losses occur, how will those losses be allocated?—that is going to determine whether a combination of abundant bank credit and a big shock will necessarily produce a banking crisis. A good example would be Canada, one of the five countries we study in the book. It’s a primary commodity-exporting economy with more volatile GDP than the United States. And yet, since 1792, the US has had 17 major banking crises and Canada has had none. That begs an explanation.
Indeed, it's one of the premises of the book that banking crises are, geographically speaking, unevenly distributed and that the standard narrative of such crises can’t account for that. And that leads you to reject accounts of the “endogenous” instability of the banking sector such as Hyman Minsky’s, in which, as you put it, “financial markets and banks oscillate between moments of excessive optimism and excessive fear”. Is this an explicitly anti-Minsky book?
Not really, no. At the end of the book, we do mention both Hyman Minsky and Charles Kindleberger. But I think Minksy would certainly have accepted that good regulation can prevent banking crises from happening. I didn’t want to create the impression that this is somehow an anti-Hyman Minsky book. But I would say this: asset bubbles aren’t the same as banking crises. There are few countries that manage to avoid ups and downs in asset prices. That doesn’t necessarily mean they have banking crises. To get a banking crisis, you also need to have your banking systems and risk-management apparatus dysfunctional. That, I think, is an important distinction.
Saying that human behaviour tends to produce these waves of booms and busts, which Minsky did … it was a mechanical, mathematical analysis which assumed that a lot of things happened. It assumed that during booms financial institutions would have a tendency to get over-leveraged. It assumed that during busts they had a tendency to react excessively on the downside. Now, that is not necessarily the case, and Minsky was not a historian. Kindleberger, though he was an economic historian, was not really as familiar with banking history as he was with asset markets. I don’t think that those theories are general, correct propositions about real econonomies. I think we’ve over-theorised a bit. The potential for banking crises exists in the fundamental structure of banks which is potentially fragile. But not necessarily fragile.
So models like Minsky's bump up against the brute fact of geographical variation in your view? There’s one geographical variation that you’re particularly interested in and that is the strikingly different experiences of banking crises in Canada and the US. Are you arguing that there’s something peculiarly “crisis-prone”, as you put it, about the US banking system?
Yes. We trace it to the politics of the founding of the United States as a revolutionary country. Although it went through an initial phase of what you might call “crony capitalism”, it rapidly moved, by the 1820s and certainly by the 1830s, towards a new model of banking comprising what one might call local monopolies with limited entry. That was very peculiar and it lasted in the US until the 1990s. Which is an unbelievable fact, given that it was the only country on earth doing this.
There were many shocks in US history during which that model was tested politically—notably the Civil War, both world wars and the Great Depression. There were six banking panics in the US between 1873 and 1907, after which we established a National Monetary Commission in 1910. The National Monetary Commission arranged academic studies of all the major countries’ banking systems and their historical operation. There were three studies of Germany, three of the UK, I think three of Canada. Belgium had one, Mexico had one, Italy had one. The scholarship of the period was impeccable. Those studies are classics that are still being used by economic historians. What do we learn from them? We learn not just about the history of those countries, but also that the National Monetary Commission, when asked to explain the peculiar history of the US, was fully informed that the history of US instability was the result of the industrial organisation of US banking. But change was not on the menu, politically.
What we did instead was create the Federal Reserve System, which was self-consciously intended as a macro-prudential device, as a means to change the shape of the aggregate economy’s loan-supply function over the seasonal frequency. In other words, to reduce liquidity risk in the banking system on a seasonal basis, and therefore make loans more elastically supplied across the seasons. That was the main goal of the Federal Reserve. And we know from several studies that it actually achieved that goal, which did improve somewhat banking stability. But it didn’t prevent banking crises.
We got a wave of banking crises in the 1920s. A wave of banking crises in the 1930s. We had them in the 1980s and now we’ve had one again. What’s remarkable is that people in Canada studying the US banking system in 1910 reached identical conclusions— which was that the Americans were crazy. Why were they creating banking systems that were so crisis-prone? The reason they were crisis prone was that “unit” banks were isolated in particular areas, they were very undiversified—a big shock comes to a particular crop and wipes out all the banks in that particular area. In Illinois in the 1920s, they held a referendum on unit banking. And they preserved unit banking. It’s very important to understand that this was not the unit bankers doing it all by themselves. And there’s a bigger lesson here which is that banking disasters and banking regulation is never the result of only of bankers’ political influence. Bankers can’t do it alone.
Although this is an avowedly empiricist piece of work, it does lay down some general principles, among which is the assertion that, contrary to what you call a “libertarian fairytale”, there is no banking system without the “police power” of the state.
Absolutely. Let me give an example that illustrates the point we are trying to make there. Many libertarians like to talk about the historical experience of Scotland as a model for banking. I agree with them that Scotland is a wonderful model for banking. Almost everything of any use in commercial banking was created in Scotland by the mid-18th century. And then you look down to the south, at that primitive country England, and wonder why the English were so ignorant, when Scotland was just the other side of the border. The English had a much more unstable, less credit-abundant system. It was much less competitive—the Bank of England had a monopoly charter until 1826.
A libertarian would look at this contrast and say that Scotland is brilliant and England somewhat stupid. But they have the same sovereign. They were actually, in some sense, two sides of the same coin. Someone had to bear the brunt of making the state survive. And the only way to do that was to create institutions of public finance. If libertarians understand that an exception has to be made for the military, then they also have to understand that part of the military is the funding of it. So we have an iron law which we call the “Iron Law of Credit Supply”: there’s a chance you can have a banking system which will provide credit to the private sector once all the needs of the state have been satisfied. But until that has happened, it can’t occur. What’s interesting about England and Scotland was that Scotland’s banks didn’t have to support British public finance because England was doing that. And so there’s an interesting triangulation going on politically, and there’s a qui pro quo: the Act of Union was like an act of unilateral disarmament by the Scots, which I think is part of the laissez-faire banking regime there.
It’s not wrong to say that it’d be desirable to have a banking system by Scotland, but you can’t have a banking system like Scotland unless you’re lucky enough to be like Scotland and have another country, with the same sovereign, which is taking care of all the public finance problems. Not too many countries have that. So, inevitably, for most countries the banking system has to be a compromise between state interests and private interests. There’s no way to get politics out of the banking system, because banks require the state to give them their charters, to create and enforce the rules. And states need banks to help them survive. There have been states where there is no taxation—Kuwait is one. There have been states without armies—Costa Rica is one. There have been no states that haven’t had chartered banks.
I'd like to talk now about the gestation of the most recent banking crisis in the US. You write that it was the outcome, first and foremost, of a “political bargain”. As you’ve been saying, that’s true of all banking crises throughout history. I’m particularly interested in the role that you assign in the aetiology of the last crisis to the Clintonian, “New Democrat” version of the "Third Way".
I think that Bill Clinton’s “Third Way” can best be described as a brilliant political strategy for achieving his goals. And it wasn’t his intention that things turn out the way they did. Given all the constraints—a divided Congress, a federalist system—he figured out a get-around in the form of using the Community Reinvestment Act and the GSE Act to a particular set of purposes. If the US didn’t have those constraints, it might have dealt with inequality of opportunity more directly, through fiscal means. But that wasn’t on the menu.
What you got instead was redistribution through the banking system.
Exactly. And particularly through risky subsidisation of mortgages. It’s a very sad story. I want to point out, though, that it was President George H W Bush who invented it. This is a bipartisan enterprise. It’s true that Bill Clinton was perhaps the most enthusiastic magnifier of these subsidies, but they were magnified further under George W Bush. Newt Gingrich becomes the Speaker of the House of Representatives in 1994. Why isn’t reform to rein in some of this risk part of his “Contract with America”? It’s because he was part of a coalition—a coalition for higher risk. One of the key things that you see is that the dividing line between the winning coalition—formed by urban activists, politicians and the newly emerging mega-banks— and the losing one was not between Democrats and Republicans. In fact, it was an urban versus rural dividing line. The losing politicians were people like Richard Baker from rural Louisiana. Shelby from Alabama. Gramm, the senator from Texas. Jim Leitch from Nebraska. What these people had in common was that they were representing primarily the old and now losing part of the bargain; people who used to be the dominant group, but no longer were. So there’s more going on here than partisan politics.
FInally, I'd like to ask you about the regulatory response in the US to the most recent banking crisis. You think the Dodd-Frank Wall Street Reform and Consumer Protection Act is inadequate don’t you?
It’s 2,000 pages long, so in one sense it’s not inadequate! On the contrary, it’s excessive. But it doesn’t deal with the key problems that are revealed by a banking crisis. A banking crisis is about adequate capital relative to risk. So that means that you have to measure and in some sense control risk. It doesn’t mean that you want to limit risk, but that you want to have some control and measurement of it. When I and my colleagues talk about effective reform, we talk about that.
Dodd-Frank gave something to everyone, politically. There are specific quotas buried in it for women and minority hiring in the financial services industry, for example. It’s a grab-bag of handouts to a variety of interests. It also has things like the “Volcker Rule” in it. Now, even Paul Volcker [the former chairman of the Federal Reserve], whom I respect very highly, has admitted that the Volcker Rule really had nothing to do with this crisis. Volcker has had a particular set of beliefs about bank activities. Remember, he said that the only good financial innovation we’ve had in the last few decades is the ATM. Which is a very funny comment. But I don’t think it’s true. Volcker has a kind of antiquarian sense of banking. I don’t think the Volcker Rule, as it has been crafted, is going to do a lot of damage, but neither do I think it’s going to do a lot of good. It’s going to create a huge mountain of paperwork.
And look at what they exempted from the Volcker Rule’s application: real estate. If almost every banking crisis comes from real estate—agricultural real estate in the old days, or residential real estate today—why did they carve out [from the Act] the one thing that really created the crisis?
What about “too big to fail”? Senator Elizabeth Warren held a hearing recently in which she asked four economists if they believed that Dodd-Frank had ended “too big to fail”. All of them answered with a simple “no”. So, when you look at Dodd-Frank, there’s very little to love and a lot to dislike.
"Fragile by Design" is published by Princeton University Press (£24.95)
