Nolan McCarty, Keith T. Poole and Howard Rosenthal. Political Bubbles: Financial Crises and the Failure of American Democracy. 2013. Princeton: Princeton University Press.
This book is an indictment of the American political system, not for causing financial crises, but for making them worse through political action or inaction. In the authors’ view, financial bubbles have been accompanied by “political bubbles.”
Financial bubbles occur when the prices of financial assets rise far beyond their “fundamental” value, the value that could be justified by some rational economic analysis. They are driven by excessive optimism, or by the desire to encourage and profit from the optimism of others. In the case of the housing bubble, the overvalued assets were risky subprime mortgages and the complicated financial instruments that were based on them.
A political bubble is a “set of policy biases that foster and amplify the market behaviors that generate financial crises….Rather than tilting against risky behavior, the political bubble aids, abets, and amplifies it.” The authors identify three channels through which this political amplification of financial bubbles occurs: the three I’s of ideology, interests, and institutions.
The authors see an ideology as a belief system whose rigidity “inhibits the rational adaptation of policy to the circumstances of financial crisis.” Ideologues hold to their policy positions even when the results are unfortunate. The ideology of free-market conservatism is most conducive to financial bubbles, but other ideologies play a role. The egalitarian belief system more common on the political left supported efforts to broaden home ownership by making mortgage loans to lower-income buyers. This gave political cover to predatory lenders, who could claim to be promoting the public interest with tricky subprime and adjustable rate mortgages.
The authors use a spatial model of Congressional voting that places each issue and each legislator along a single dimension from liberal to conservative. The model is remarkably successful in predicting how most legislators will vote on most issues, accounting for over 90% of votes cast in the most recent Congresses. By calculating and comparing the average ideological scores of each major party over time, the authors conclude that ideological polarization is at an all-time high. This has occurred primarily because the Republican Party has moved more to the right. To put this in historical context, polarization has risen and fallen in tandem with economic inequality, the last peak having been reached in the Gilded Age. The authors see a reciprocal relationship between economic excess and political polarization:
In periods in which there are huge economic rewards to unfettered markets, support for free market conservatism increases–especially among those individuals and groups who benefit the most….Political polarization leads to political gridlock that makes economic reform difficult. Not only can the economic losers not form a coalition to redirect the allocation of resources, but the government cannot effectively respond to those economic shocks and crises which in turn further increases polarization.
I think that’s a pretty good summary of our political impasse.
Looking beyond legislators to those who influence them, individuals and organizations who are profiting the most from financial bubbles have strong motives to support policies that sustain those bubbles. As the financial services industry expanded and thrived in the bubble years, it also gained political power. “Campaign contributions from the financial sector increased almost threefold between 1992 and 2008, even after adjusting for inflation,” making it by far the largest source of contributions to political campaigns.
The book also cites the work of Larry Bartels, who demonstrated that actual legislative votes correspond most to the desires of high-income constituents, and hardly at all to those with low incomes.
Powerful financial interests influence politicians with information as well as money. Complex financial issues are often challenging for individual legislators to understand, and corporate lobbyists are only too happy to “help” them.
The interests of politicians easily come to overlap the interests of their most powerful constituents. Many have been rewarded for their pro-business policies with high-level positions in the very businesses those policies help.
A variety of institutional arrangements make the American democratic system very sluggish in its response to financial crises. “The problem is that political power in the United States is so fragmented, separated, and checked that policy change requires extraordinary consensus and mobilization.”
For example, we elect our Congressional representatives with frequent elections conducted in rather small legislative districts. That can make representatives less responsive to national needs than to the demands of local constituents, especially the richest and best organized. In the Senate, permissive filibuster rules effectively require a 60-vote majority just to bring a bill to a vote.
Financial regulators suffer from a “low regulatory capacity.” They lack the resources and expertise to keep up with the growing and complexifying financial sector. Often they end up relying on the industry they regulate for information, talent and expertise, making them vulnerable to “capture” by that industry.
The political bubble in the recent financial crisis
In the period leading up to the financial crisis of 2008, ideology, interests and institutions combined to amplify rather than counter the growing financial bubble:
The lethal concoction that destroyed the investor society and the broader standard of living had five components— all rooted in our Three I’s. The first was deregulation that permitted innovative new financial instruments, such as exotic mortgage products, collateralized debt obligation tranches, and credit default swaps to emerge without meaningful regulation. The second was deregulation that permitted financial firms to engage in a riskier range of activities. The third was a reduction in the monitoring capacity of regulators, either through deliberate neglect, as reflected in the tenures of Alan Greenspan at the Federal Reserve and Harvey Pitt and Christopher Cox at the Securities and Exchange Commission (SEC), or as a result of the failure of staffing and budgets to expand at the same rate as the markets they were supposed to regulate. The fourth was the shifts in competition policy that allowed the creation of financial institutions that were too big (and too politically powerful) to fail. The fifth component was the privatization of government financing of mortgages through Fannie and Freddie, which created two additional too-big-to-fail institutions.
Financial deregulation took place during a period of three decades, heavily driven by ideology and interests. In the early 1980s, federal law deregulated interest rates, overriding state usury laws and allowing adjustable rate mortgages. These “quickly got distorted into ‘teaser’ loans with low introductory interest rates that later reset to usurious levels.” Exorbitant interest rates made it increasingly profitable to lend money even to people with a high risk of being unable to repay the principal. Complex financial derivatives whose value depended on subprime loans were exempted from regulation in 2000. Once these deregulations had occurred, institutional limitations combined with ideology and interests to block reform. All of the numerous attempts in Congress to curb predatory lending failed.
A number of forces came together to support risky lending as a way of encouraging home ownership. Free market conservatism generally opposed financial regulation. In addition, Republican administrations were anxious to promote the “ownership society,” in which more people could build private wealth instead of relying on government. For most people, wages were stagnant, but they could build wealth anyway if they could obtain a mortgage loan and leverage a small down payment into some growing equity. Bill Clinton and other Democrats also promoted home loans to broaden the middle class and create a more egalitarian society. So an expansion of home loans had much more bipartisan support than direct housing subsidies to low-income households, which would cost the taxpayers money.
Implementing the federal role in expanding home ownership was largely the responsibility of two “Government-Sponsored Enterprises” (GSEs), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Both entities helped finance home ownership by buying qualifying mortgages from lenders. “Lenders in turn used the proceeds of these sales to issue more mortgages, which lowered borrowing costs and stimulated housing demand. The subsidy embedded in Fannie and Freddie was enhanced by the ultimately correct perception that the government guaranteed their debt. This guarantee reduced their borrowing costs below those other corporate borrowers.” Congressional legislation under both Republican and Democratic administrations encouraged the GSEs to back more mortgages for lower-income households. Even if the mortgages they backed were fairly safe, the additional capital enabled private lenders to make shakier loans and sell them off to unsuspecting investors. The authors are certainly not endorsing the view that the financial crisis was all the government’s fault; they regard that as an ideological position appealing to those who think that free markets can do no wrong. They are only showing how political factors helped inflate the financial bubble.
In the end, this way of creating an “ownership society” was a colossal failure. Rates of home ownership peaked and then crashed, especially for the ethnic minorities who had the lowest rates to begin with. Free-market ideology, sprinkled with a few liberal good intentions and a lot of money in politics, amplified the worst financial crisis since the Great Depression.