Having described how political ideologies, interests and institutions help inflate dangerous financial bubbles, McCarty, Poole and Rosenthal turn their attention to what happens after a bubble bursts.
In the case of the bubble that burst in 2008, the political response was hampered for many reasons. Although the voters elected a moderate Democrat as President, the ideological positions within Congress changed very little. In fact, while the new Democrats elected in 2008 were mostly moderate candidates running in swing states, the new Republicans elected in 2010 were more often extreme conservatives from “red” states. After 2010, free market conservatism was even better represented in Congress than it had been before the crisis.
Although some large financial institutions failed, mergers and acquisitions–many of them arranged by government–created even larger ones that were truly “too big to fail,” giving them a kind of license to engage in risky behavior. The power of the financial industry to influence elections and shape legislation remained unchecked.
The institutional arrangements that make change difficult, such as the Senate filibuster, remained in place, and the number of bills that couldn’t be brought to a vote reached record proportions. By undoing some of the previous campaign finance reforms, the Supreme Court enhanced the political influence of powerful financial interests.
Responses to “pops” in American History
The difficulty of financial reform after the bubble popped in 2008 is fairly consistent with the historical experience. The authors draw four lessons from government responses in similar situations:
- Legislative responses to financial crises and economic downturns have generally been limited and delayed.
- The response often awaits a transition in 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 longer-term solutions.
In the case of the most famous financial crisis, the crash of 1929, the legislative response was delayed until the election of 1932. By then, the economic damage was severe enough to generate a massive shift in ideology and voting, which gave Roosevelt large majorities of pro-intervention Democrats in both houses of Congress. In addition, the Republican Party included more moderates in those days, as a result of a progressive reaction against Gilded Age inequalities that had been building for some time. As a result, “FDR was able to do business with practical, compromising politicians. In contrast…Obama is faced with a pack of ideologues.”
As an example of the difference, the Roosevelt administration was able to provide debt relief to millions of farms and homeowners, with massive approval from the general public. The Obama administration’s efforts to restructure failing mortgages were not only hampered by a lack of cooperation from lenders, but attacked as a subsidy for irresponsible borrowers, a reaction that launched the Tea Party movement.
Because of Congressional polarization and strong conservative opposition, the Obama administration’s major pieces of legislation–the economic stimulus package, the Dodd-Frank financial reform, and the Affordable Care Act–had to be carefully crafted to achieve a majority in the House and a filibuster-proof majority in the Senate. In all three cases, votes split along clear ideological and party lines, with only just enough votes to win. The bills couldn’t include anything unacceptable to their least enthusiastic supporters.
The authors regard Dodd-Frank as a very limited financial reform. It makes few hard-and-fast rules, instead leaving a great deal to the discretion of regulatory agencies, mostly the same agencies that have demonstrated low regulatory capacity and over-dependence on industry in the past. It didn’t bode well that the agencies missed most of their deadlines for issuing the new regulations required by the law. Dodd-Frank did little to eliminate the problem of “too big to fail,” or change the executive compensation practices that led to excessive risk taking, or regulate risky financial derivatives.
Another political response to the crisis, the Troubled Assets Relief Program (TARP) had a different political dynamic. It was proposed by the Bush administration as an emergency response to the banking crisis. The vote did not split neatly along liberal/conservative lines, since opposition came both from conservatives opposed to government intervention and some liberals opposed to government generosity toward big banks. It may have been necessary, but it wasn’t very popular at either end of the political spectrum.
The authors explore some of the nuances of political populism. In general, it “arises from mistrust of elites and the institutions they govern,” but it takes many forms. One populist current in American history is “distrust of big business, finance, and concentrated economic power.” Even stronger currents, however, are distrust of government and of cultural elites like intellectuals. Before the 1970s and the Watergate scandal, most people said they trusted their government to do the right thing most of the time, but in 2007 only about 20% still thought so.
When the financial crisis hit in 2008, the public generally supported government interventions such as more financial regulation and assistance to homeowners. Given the general mistrust of government, however, that support was hard to sustain in the face of limited and mixed results. Many people couldn’t see how the government was helping them, even as they heard about bailouts for big banks and low-income homeowners. In the face of relentless attack from the well-mobilized right, especially the Tea Party, public support for change withered. Meanwhile, the Occupy Wall Street movement was trying to mobilize opposition to financial elites and extreme inequality, but they suffered from an inability to agree on an agenda, disengagement with party politics, and hostility to any hierarchical organization.
I find it ironic that the economic failures of government–large deficits, wasteful wars, lax financial regulation–are clearly bipartisan accomplishments, and yet the resulting mistrust of government seems to benefit mostly Republicans as the most overtly anti-government party. Low expectations of government easily become a self-fulfilling prophecy.
McCarty, Poole and Rosenthal would like to see the political response to financial crises strengthened in these ways:
- “Use simple regulatory rules,” such as a simple “Volcker rule” that commercial banks cannot trade securities on their own account. Dodd-Frank let regulators write a several hundred page rule that is much harder to interpret and enforce.
- “Set rules that account for political risk,” for example that are strong enough to be useful even if total compliance cannot be achieved
- “Limit the activities of taxpayer-insured financial firms,” since federal deposit insurance gives taxpayers a stake in the financial outcomes
- “Reform compensation practices,” so that financial executives cannot receive large bonuses for making bad bets with other people’s money
- “Prevent ‘Too Big to Fail'” by actually limiting the size and power of financial institutions
- “Increase regulatory and prosecutorial capacity,” making regulators less dependent on the knowledge and talent of the industry they regulate
In order for reforms like this to occur, the authors see the need for a major shift of ideology, such as occurred during the Progressive Era around the turn of the previous century. Although Americans are generally agreed that the country is on the wrong track, they seem unable to define a more constructive role for government in setting a new direction. I suspect that a new generation will have to be heard from before this will happen.