Beneath the Surface

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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:

1. Legislative responses to financial crises and economic downturns have generally been limited and delayed.
2. 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.
3. 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.
4. 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.

Legislative responses

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.

Public opinion

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.

Recommendations

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.

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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.

 Ideology

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.

Interests

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.

Institutions

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.

Continued