Calomiris and Haber delve into the comparative analysis of bank crises and politics in America, Britain, Canada, Mexico, and Brazil.

Calomiris and Haber delve into the comparative analysis of bank crises and politics in America, Britain, Canada, Mexico, and Brazil.

Charles Calomiris and Stephen Haber (2015)

 

Fragile by design: the political origins of financial crises

 

In their in-depth analysis Fragile by Design, Charles Calomiris and Stephen Haber introduce a fresh conceptual framework for better understanding credit abundance and financial chaos within political constraints. Capitalist democracies such as the U.S. and Canada maintain ample credit in the financial system so long as populist forces cannot dominate the policy agenda. Strong autocratic states such as Mexico can also achieve asset market stabilization at the cost of restricting credit. On the other hand, weak autocracies such as Brazil often require inflationary finance and suffer from financial fragility. In macrofinancial history, populist ideologies influence key policy decisions such as bank reorganization, deposit insurance, and the U.S. Community Reinvestment Act. The populist forces often represent the root causes of American bank instability in the recent subprime mortgage default contagion and Global Financial Crisis 2008. By holding populist forces in check through wise and prescient political calculus, Canada remains crisis-free in stark contrast to America. Calomiris and Haber bring political considerations front and center in exploring the bank histories of America, Britain, Canada, Mexico, and Brazil. These case studies help highlight how subpar political choices and decisions can weaken institutional structures such that financial systems become both unstable and crisis-prone with low economic growth, employment, and capital investment accumulation over time. Political factors often shape the institutional trajectory for asset market stabilization. It is quite reasonable for politicians and bureaucrats to believe that political factors play an important role in the provision of bank capital. However, populist ideologies often tend to be the true culprits behind financial crises in America, Britain, Mexico, Brazil, and even East Asia.

 

What political factors often make some financial systems fragile by design?

Political factors and constraints can make some financial systems fragile by design. This fragility usually cannot follow from a set of fundamental forces in all countries. However, this fragility takes on several different characteristics in autocracies and democracies. Each ideology is subject to its own political perils. Asset markets and financial institutions become unstable in strong autocracies due to an ever-present threat of general expropriation by the states, whereas, weak autocracies often tend to finance their regimes through (hyper)inflation as local financial power gives way to threats of local expropriation. In global financial history, Mexico fits into the first category, and Brazil fits into the second category.

On the other hand, democracies build and develop their own financial markets and institutions in light of whether liberal or populist forces dominate the policy agenda. Liberalism here carries no specific social connotations in the modern global society, but rather reflects the grand philosophy of U.S. founding father James Madison. In this classical sense, liberalism regards elections as conducive devices for placing limits on politicians and bureaucrats who operate within institutional structures. In this fundamental view, these institutional structures tolerate private rent protection at the expense of the general public. Sometimes, the U.S. populist forces seem to decentralize the financial system to establish a new set of independent banks with inadequate opportunities for scale economies and diversification benefits.

In stark contrast, Canada remains crisis-free throughout its macro financial history. This asset market stabilization arises from the fact that the Canadian government often manages to develop sound and robust institutional governance structures to constrain populist forces in the financial system with multiple branches. Britain can serve as a hybrid. This hybrid model transforms from ancient autocratic cronyism to modern liberalism with a welfare state partly due to populist forces and demands. In America, Britain, and Canada, a game of bank bargains between politicians and bankers often causes fresh financial outcomes and innovations.

Charles Calomiris and Stephen Haber warn against allowing populist ideologies to excessively affect banks and other financial institutions. Instead, mega banks with multiple branches can serve as effective national champions in most rich countries. Madison liberalism requires public regulatory agencies such as the Treasury and Federal Reserve System to monitor these mega banks and systemically important financial institutions (SIFIs). This central regulatory oversight empowers legislators and voters to protect citizens from rent seekers in the financial system.

 

The historical episodes and case studies of America, Britain, Canada, Mexico, and Brazil can help inform better future asset market stabilization policies.

Calomiris and Haber assert that political institutions often allow populists to control mega banks and most other systemically important financial institutions (SIFIs) at the core of fragility in the U.S. financial system. In American financial history, many political coalitions of financial elites can continue to accrue economic rents as most national champions often tend to constrain both the commercial reach and purview of state banks. Since the core inception and establishment of the Federal Reserve System in 1914, the Federal Reserve Act has been the central legislation that aims to keep state banks as local enterprises. Specifically, the main explanation for the Global Financial Crisis 2008 relates to the lax and lenient subprime mortgage loan standards at Fannie Mae and Freddie Mac. Calomiris and Haber trace the crisis to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 and the Community Reinvestment Act of 1977. Moribund in the mid-1990s, the Community Reinvestment Act takes on new relevance as Riegle-Neal releases banks from the grip of both the populists and their unit banks. This legislative development allows banks to increase scale and efficiency through mergers and acquisitions and inter-state branches. The pervasive need for Federal Reserve System to consider bank mergers in light of Community Reinvestment Act principles precedes the American residential mortgage boom from the mid-1990s to 2006. Long prevalent pressures by legislators for banks to offer residential mortgage loans to low-income families manifest in the lax and lenient residential mortgage loan standards by Fannie Mae and Freddie Mac. Because many banks can move Fannie and Freddie mortgage loans off their balance sheets via asset securitization, the U.S. federal government assumes the eventual risk of subprime mortgage loan default. American taxpayers would ultimately become responsible for the subsequent asset relief programs for the largest banks in America during the Global Financial Crisis of 2008-2009.

In a deregulatory financial system, bank mergers and acquisitions permit bankers to take greater risks by choice. As the local unit bank fades into irrelevance in light of widespread bank consolidations, this mega trend thus heightens the challenge of overcoming information asymmetries in lax and lenient subprime mortgage loan standards. The bank bargain shifts an enormous volume of mega bank mortgage loans from Fannie Mae, Freddie Mac, and bank owners to taxpayers, creditors, or depositors. The subsequent pervasive subprime mortgage loan defaults trigger the Global Financial Crisis of 2008-2009.

Britain can serve as a hybrid. This hybrid model transforms from ancient autocratic cronyism to modern liberalism with a welfare state partly due to populist forces and demands. In America, Britain, and Canada, a core game of bank bargains between politicians and bankers leads to fresh financial innovations such as options, futures, currency and interest rate swaps, and other derivative contracts. In British macro economic history, money supply (or inflation) significantly correlates with economic output and industrial production. However, short-term interest rate adjustments co-move countercyclically and so tend to dampen the positive effect of money supply on economic growth, employment, and capital investment accumulation. The latter cause-effect nexus proves to be the heuristic rule of thumb in the macro economic science.

Canada remains crisis-free throughout its macro financial history. This Canadian asset market stabilization arises from the fact that the Canadian government often manages to develop sound and robust institutional governance structures to limit populist forces in the financial system with multiple branches. Many proponents of Canadian asset market stabilization point to the long prevalent record of narrower spreads between prime interest and deposit rates but higher stock returns (than in the U.S.) as supportive evidence of greater financial system efficiency. The higher stock returns usually arise from the fact that Canadian banks carry a larger share of productive assets (i.e. non-delinquent loans with principal and interest payments) on their balance sheets than U.S. banks.

Calomiris and Haber describe how the Mexican and Brazilian governments make bargains with banks in rare times of political turmoil. Even when state expropriation is likely, the bankers receive generous concessions to compensate for the risks of state expropriation. In recent decades, the Mexican financial system has changed from autocratic crony capitalism to strongman state expropriation (many decades after the Mexican Revolution of 1910-1920). This unique Mexican regime of state expropriation persists with no entry and competition of foreign banks. Capital flows remain quite volatile, and this volatility often affects whether external forces render Mexico susceptible to financial crises. In Brazil, the financial system has changed from inflationary repression to the gradual and smooth privatization of state banks during the ultimate transition to open democracy since the 1980s. In the Brazilian financial system, democratic capitalism now prevails in lieu of autocratic populism. In the prior cases of autocracies such as Brazil and Mexico, populism often causes autocratic actions to evoke either incremental changes or structural reforms for the main purpose of remaining in power. These changes and reforms include financial repression and currency manipulation under the guise of bank credit expansion.

Brazil and Mexico represent the cases for the negative financial outcomes that can result from political bank bargains. Nowadays, financial policy practitioners should consider whether the prior problems of inflationary finance, financial repression, or autocratic populism tend to fade into irrelevance in Brazil and Mexico. With greater economic certainty and asset market stabilization, these Latin American financial systems have become fundamentally similar to their North American neighbors. In this positive light, democratic capitalism hence helps dampen populist forces and demands in order to promote greater financial system efficiency and stability.

 

Global stock markets can serve as an alternative channel for generic finance and specific bank capital.

It may be too premature to assert that the American, British, Brazilian, and Mexican financial systems have been so dysfunctional that only a Canadian capital regime can offer a pragmatic solution. Calomiris and Haber provide this in-depth analysis of systemic financial fragility with the prototypical case studies. These case studies illuminate the comparative economic insights into the appropriate containment of autocratic populist forces for modern democratic capitalism. Global equity markets often serve as an alternative channel for generic finance and specific bank capital. The mega banks and other financial institutions can meet the comprehensive credit needs in a more cost-effective manner. Indeed, bank credit has helped boost both residential mortgage finance and lean startup entrepreneurship in recent decades. In practice, global stock markets are deep enough for democratic capitalists to fund high net-present-value capital investment projects to achieve key scale economies, network effects, and information cascades. When efficiency gains come to fruition in due course, these investment projects become conducive to long-run economic growth, employment, and capital accumulation. Perhaps Canadian banks are less crisis-prone, but preventing future financial crises is only one of many public policy goals in the broader business context. The central bank often has to deal with the mysterious and inexorable trade-off between inflation and unemployment. In order to better balance the dual mandate of both price stability and maximum sustainable employment, the central bank weighs interest rate adjustments, instrumental asset purchases, bank reserves, and other monetary policy decisions. From time to time, the fiscal authority learns to maintain a delicate balance between tax revenues and government expenditures. Further, better fiscal-monetary policy coordination helps avoid money supply or inflation to inadvertently fetter interest rate adjustments and other monetary policy instruments. On balance, fiscal stimulus, monetary neutrality, and asset market stabilization are both necessary and conducive to better macro financial results over time.

In their in-depth analysis Fragile by Design, Charles Calomiris and Stephen Haber introduce a fresh conceptual framework for better understanding credit abundance and financial chaos within political constraints. Capitalist democracies such as the U.S. and Canada maintain ample credit in the financial system so long as populist forces cannot dominate the policy agenda. Strong autocratic states such as Mexico can also achieve asset market stabilization at the cost of restricting credit. On the other hand, weak autocracies such as Brazil often require inflationary finance and suffer from financial fragility. In macrofinancial history, populist ideologies influence key policy decisions such as bank reorganization, deposit insurance, and the U.S. Community Reinvestment Act. The populist forces often represent the root causes of American bank instability in the recent subprime mortgage default contagion and Global Financial Crisis 2008. By holding populist forces in check through wise and prescient political calculus, Canada remains crisis-free in stark contrast to America. Calomiris and Haber bring political considerations front and center in exploring the bank histories of America, Britain, Canada, Mexico, and Brazil. These case studies help highlight how subpar political choices and decisions can weaken institutional structures such that financial systems become both unstable and crisis-prone with low economic growth, employment, and capital investment accumulation over time. Political factors often shape the institutional trajectory for asset market stabilization. It is quite reasonable for politicians and bureaucrats to believe that political factors play an important role in the provision of bank capital. However, populist ideologies often tend to be the true culprits behind financial crises in America, Britain, Mexico, Brazil, and even East Asia.

 

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