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Fragile By Design
The Political Origins of Banking Crises and Scarce Credit
Charles W. Calomiris and Stephen H. Haber
(NY Times)
Five years after the drama that began in 2008 — the failure of one bank after another, the decline in the stock market and the freezing up of finance — we still cannot seem to agree about the causes of the crisis. There are some who like to pin all the blame on the corrupt business practices of Wall Street and the greed of bankers. Then there are those who think it was just one more example of the sort of irrational mass hysteria that gives rise to boom-and-bust cycles in financial markets. Still others focus on the inherent characteristics of banks that seem to make them especially vulnerable to investor panics — the fact, for example, that their loans and investments cannot be liquidated in a hurry, while depositors can withdraw their cash with the click of a mouse.
In their brilliant new book, Fragile by Design, Charles W. Calomiris of Columbia University and Stephen H. Haber of the Hoover Institution at Stanford take a wholly different approach. Why, the authors ask, are some countries so much more prone to crises than others? Why, for example, has Argentina had four in the last 40 years and Australia none? Why have the United States and Canada - two countries that have a common culture and similar legal arrangements, and that share a fundamental belief in a tempered free-market capitalism - had such different experiences with their banking industries? Since 1840 the United States has had 12 systemic banking crises and Canada has had none. The authors have a very simple answer: It all has to do with politics.
Calomiris and Haber argue that politics are baked into the banking business. On the one hand, the government sets the legal framework under which banks operate, regulates what they do and, most important, arbitrates the fraught question of how the losses among various contending interests — borrowers, depositors, bond holders, shareholders and taxpayers — are to be shared when a bank goes under.
On the other hand, the government often finds itself in a somewhat equivocal position when it comes to banks. For it is itself a big borrower and always in need of financing. Where better to turn to than the banks? In many countries, banks were originally licensed during the 17th and 18th centuries precisely so that financially pinched governments could raise money — the two most notable instances being the Bank of England and the Banque de France. To this day banks remain not only a tempting source of cheap funding for governments but also, increasingly, vehicles for channeling politically motivated loans at subsidized rates to important constituents and special interests. There is ultimately no way of getting politics out of banking.
The focus on politics helps enormously in understanding the history of banks, as the examples of the United States and Canada show. In the United States, because of its federal structure, banking policy ended up largely in the hands of the states. As a consequence, it was political elites at the state level, typically small-town merchants and farmers, that came to dominate. The result, for most of American history, was a fragmented system of tiny banks that were highly vulnerable to local downturns and subject to frequent panics.
By contrast, in Canada, primarily because colonial Britain wanted to limit the autonomy of French Canada, banking policy was centralized in the national government. As a result, Canada ended up with the complete antithesis of the American system: a small number of very large banks with an extensive and diversified network of nationwide branches, which proved to be relatively resilient during hard times.
It is now commonplace to say that our political arrangements have become dysfunctional. But I was still taken aback to read in “Fragile by Design” that, because of the way our politics interact with the banks, our banking system ranks way down in the international league tables for safety, alongside countries like the Philippines, Thailand, Turkey, Spain, Sweden, Ecuador, Brazil, Mexico, Colombia, Costa Rica, Chile, Uruguay and Bolivia.
'The game of bank bargains' is what Calomiris and Haber call the whole process by which the coalitions in power divvy up the spoils thrown off by banks and allocate the cost of bank rescues. At the heart of their book is a history of how this amorphous game has played out in five countries: Britain, the United States, Canada, Mexico and Brazil. The authors seem to have read everything on the subject, and their accounts, brimming with fascinating details and vignettes, are testament to their scholarship and breadth of knowledge.
While they do try to extract some general lessons from their case studies, history turns out as always to be too messy, contingent and subject to the vagaries of human agency to be slotted into neat boxes. About the only conclusion I was able to draw is that some democracy is good for banking systems, because of the limits on the power of the state, but that when democracy turns populist it is bad for the banks.
Unfortunately, for a book that is so illuminating about the interface between banking and politics in the past, the explanation given for the recent banking crises in Britain and the United States is a big disappointment. In Britain, the cost to taxpayers of bailing out the banks came to some 5 percent of G.D.P. and several, including the Royal Bank of Scotland (at one time the largest bank in the world), had to be partly or fully nationalized. And yet the authors devote barely a couple of pages to this crisis.
They do devote two chapters to the origin of the 2008 crisis in the United States. In essence, they say, banks were encouraged to engage in subprime lending by government pressure. And to make up for any erosion in profits this entailed, regulators turned lenient on capital requirements, allowing banks to rely much more heavily on borrowing. This was certainly part of the story. But a good amount of the subprime lending was done through nonbanks — mortgage lenders like Countrywide, investment banks like Bear Stearns and hedge funds — and a large percentage of the securities ended up in the hands of foreign banks, none of which were subject to the same United States government pressure. One has to conclude that the full story is much more complicated.
If your goal is to understand the origins of the recent financial crisis, Fragile by Design is probably not the book to read. But if you are looking for a rich history of banking over the last couple of centuries and the role played by politics in that evolution, there is no better study. It deserves to become a classic.
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