If you want a powerful and coherent explanation for the great subprime lending bust in the United States - and why the Canadian financial system, despite its proximity and shared characteristics, was remarkably stable – read the recently-published book “Fragile by Design” authored by two financial economists, Charles Calomiris and Stephen Haber.
The book’s sub-title “The political origins of banking crises and scarce credit” captures the essence of the authors’ findings. Their case studies, which include the origins, trials and tribulations of banking systems in England, Scotland, Brazil, and Mexico as well as the U.S. and Canada, are, collectively, convincing arguments for their conclusions.
Banking systems and financial crises, they demonstrate, are produced by political bargains that shape the institutional structure, incentives and regulatory framework within which banks operate. Historical context, the authors insist, shapes the environment in which institutions, such as banking systems, evolve.
"Fragile by Design" is a splendid example of an overly neglected approach to economic analysis – solidly-based historical narrative instead of tortured econometrics anchored on incomplete and spotty data. Economic historian and Nobel Prize winner Douglas North, a subject of this blog recently, must be pleased.
The Game of Bargains. The political bargaining process (The “Game of Bank Bargains”) takes place in both democracies and autocracies, such as Mexico and Brazil have been for much of their recent history. The Game determines three critical “institutional” parameters: how banks are chartered, how they are regulated, and how they interact with the state, particularly with respect to the government’s need for revenue.
From these institutional parameters flow the two critical factors in managing banks: how much capital they have to absorb losses and how much risk they will take in making loans.
For example, in the 19th century in the United States, the ability of state governments to charter and regulate banks meant that the rise of populism and expanding suffrage resulted in a “durable alliance” in many states between agrarian populists and the owners of small, single-office (“unit”) banks. Thus, this coalition lead to the demise of Alexander Hamilton’s beloved Bank of the United States and played an important role in making the U.S. banking system susceptible to periodic “crises,” restricting the flow of credit, and delaying the emergence of nationwide banking firms.
The same coalition was responsible for introducing deposit insurance, over the opposition of President Franklin Roosevelt and his secretary of the Treasury, who rightly feared that it would reduce the incentive of depositors to monitor bank management closely. More generally, Calomiris and Haber find that
. . . government safety nets tend to destabilize banking systems and such safety nets tend to arise not for reasons of economic efficiency but because they are outcomes of political bargains.
An unholy alliance. The authors show how the recent U.S. subprime mortgage boom/bust was driven by an unholy alliance between aggressively expanding commercial banks and housing activist pressure groups, such as ACORN and the “National Community Reinvestment Coalition.” They used the Federal Community Reinvestment Act to hold up bank mergers until the parties consented to pump funds into lowering their underwriting standards, as well as pressuring the two Federal housing finance agencies, Fannie Mae and Freddie Mac to do likewise.
Presidents and politicians from both parties were ardent boosters of these institutions and also encouraged them to lower their standards. A prominent example was Republican House Speaker Newt Gingrich, who ultimately garnered more than $1.6 million in consulting fees from Freddie Mac after he left Congress in 1999.
At well over 500 pages, readers may find the book needs a bit of editing: we are treated to very large servings of Mexican and Brazilian political as well as financial history when more modest portions would have sufficed. And there are too many retellings of the same facts.
But the bottom line of the book, that you cannot divorce the stability and effectiveness of a banking system from its interaction with the political environment and government, autocratic or democratic, comes through loud and clear.
Consequently, the authors are not terribly optimistic that future banking crises - in the U.S. at any rate - will be avoided, despite their commendable efforts to show how they arise.