Theories of the Financial Crisis: Deference to the Financial Sector

[digg-reddit-me]Closely related to the previous theory of the financial crisis – that Goldman Sachs did it – is the more generalized version of this idea – that the financial sector itself – whether through political donations, lobbying, corruption of politicians, respect, fear, or any other means at their disposal – was able to demand and receive undue influence over the political processes affecting them.

Since Ronald Reagan took office in 1980, the financial industry has been growing more quickly than the rest of the economy – whether because of this or as a result of this, politicians of both parties have given the industry about every policy they wanted. The financial industry began to feel its oats when a cultural revolution swept America – the Reagan Revolution – which removed the various moral stigmas from money and profits just as the 1960s had from sex. Reagan also instituted several policies which served to concentrate wealth (thus enlarging the financial sector) and removing regulations. He cut taxes – especially for the wealthiest; he instituted a de facto Bretton Woods II agreement in which the savings of East Asia were transferred to America, thus enlarging the financial sector further and decimating our manufacturing sector; he ran massive deficits, thus super-charging the economy – from which the financial sector was a main beneficiary; he deregulated various industries thus allowing private enterprises to capitalize on the investments of the public in them; he reduced regulations overall, especially those on the financial sector.

Bill Clinton came into office with various plans to help out the middle class – to pass a stimulus bill, to tackle health care – but was forced by an unruly bond market to back off. Bob Woodward quoted Clinton realizing the power of Wall Street a few days into office:

You mean to tell me that the success of the program and my reelection hinges on the Federal Reserve and a bunch of fucking bond traders?

But Clinton came around and designed an agenda that would win Wall Street’s approval. He brought down the deficit – running surpluses even. He reformed welfare. He pursued free trade agreements – especially NAFTA. The Committee to Save the World – consisting of Treasury Secretary Robert Rubin, Assistant Secretary Lawrence Summers, and Federal Reserve Chairman Alan Greenspan (with an assist from Timothy Geithner) organized emergency interventions committing taxpayer dollars to help Mexico, the Asian markets, Russia, and domestic markets with the collapse of Long Term Capital Management in order to keep the markets stable and growing. By the end of his presidency, Clinton was a major proponent of deregulatory measures – signing the repeal of the New Deal era Glass-Steagall Act, forbidding the regulation of derivratives, and allowing off-balance sheet accounting. All of these changes greatly benefited the financial sector and were much sought after by the industry.

And then of course came further deregulation under George W. Bush and his proposal of various housing initiatives under the rubric of an Ownership Society. The deregulatory fervor was probably best symbolized by the efforts of the Office of Thrift Supervision (OTS) to bring more financial institutions under its authority. (Regulators were funded based on what companies they oversaw, so the various regulators began to compete to be more lax.) The head of OTS brought a chainsaw to the photo-op in which the heads of the various regulatory agencies attacked a stack of paper representing bank regulations to demonstrate their commitment to reducing oversight. As Simon Johnson wrote in The Atlantic regarding these many causes of the financial crisis:

[T]hese various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector.

His thesis is essentially this:

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a “buck stops somewhere else” sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits—such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

Whether politicians of both parties deferred to the financial sector because of their massive contributions to both parties or because the financial sector became the leading driver of GDP growth doesn’t really matter.

What’s clear is that when the financial sector wanted something, they got it. They blocked reforms; they got deregulation, free trade agreements, business consolidations, and policies that led to market inefficiences and bubbles they could exploit. The financial sector was pushing virtually every policy which contributed to the economic collapse – and politicians of both parties went along.