It is surprising that in all of the discussion of the 2007-2009 financial crisis, there has been little attention paid to a remarkable and puzzling fact: since 1840 the United States has had 12 major banking crises, while Canada has had none!
Charles Calomiris and Stephen Haber--in their new book Fragile by Design: The Political Origins of Banking Crises and Scarce Credit (Princeton University Press, 2014)--explain this as a consequence of the differences in the political institutions of Canada and the United States, which supports their general argument that whether a banking system is stable or fragile is the result of political choices in what they call the Game of Bank Bargains. It also supports their claim that banking crises arise not from market failures but from winning political coalitions designing fragile banking systems that provide short-term benefits--wealth and power--for members of the coalition at the expense of the long-term public good. Every banking system is created by political deals, and those deals are guided by the logic of politics, not the logic of the market.
They present their reasoning through a coevolutionary history of states and banks engaged in a Darwinian struggle for survival with competing states and banks (16, 60-61, 73-83, 85, 93, 105-106, 492). The mutual dependence of states and banks is shown by the fact that every nation-state today has some form of government-chartered bank, and by the fact that nation-states and chartered banks have both emerged since 1600, because the creation of the modern state has depended upon the cooperation of rulers, merchants, and financiers. Merchants have needed states to enforce their contracts and defend their trading routes. Rulers have needed merchants to build the domestic and international networks of commerce that sustain the state's economy and its imperial power. Merchants have need financiers to create and manage complex financial instruments. Rulers have needed financiers to provide the funding for the wars required for building a modern state. And the financiers have needed the state to enforce their financial contracts. The chartered bank pulls all three groups together in exchange for the lucrative special privileges provided by the state.
In 1694, King William and Parliament founded the Bank of England as a joint stock, limited liability company that would have a monopoly in lending money to the British government. No other banks in England were allowed to take the form of a joint stock, limited liability company. All other banks had to be organized as partnerships, and they were limited to six members. From 1689 until the defeat of Napoleon in 1815, England fought a series of expensive wars with France; and the Bank of England was designed to provide the finance for those wars. The bank's charter was renewed nine times between 1694 and 1844, and each time the bank provided the government a low-interest or no-interest loan. The British government defeated its military rivals because it was able to borrow more money than they could and at lower rates of interest. After the defeat of Napoleon in 1815, Great Britain was the only world power.
In contrast to the English banking system, a different kind of system developed in Scotland. "The Scottish system," Calomiris and Haber observe, "came to represent the very model of competition, innovation, accessibility to credit for the private sector, and stability--all the things the English banking system could have been but was not" (101). The Scottish banking bargain was very different from the English bargain. The fundamental difference was the free chartering of banks in Scotland and the free competition among the banks. There were three specially chartered banks: the Bank of Scotland (1695), the Royal Bank of Scotland (1727), and the British Linen Company (1746). There were also many provincial banks freely chartered under common licensing rules. The banks were free to open branches, and these branches could be opened in remote locations with a lower overhead cost than opening a completely new bank. These branching banks provided a broad access to credit. Because of their greater size, competitiveness, and diversification of risk, the Scottish banks had lower rates of failure than the English banks.
Canadian banks have also had low rates of failure, and one of the reasons is that like the Scottish banking system, the Canadian system has been based on a nationwide network of branching banks. A large bank with many branches benefits from economy of scale, from diversifying its risks, and from being able to shift funds across regions in response to differences in demand. Canada's constitution of 1867 established a federal system in which the central government made economic policy and a monopoly on the right to charter banks. This led to a banking system with a few large chartered national banks having many branches, which brought efficiency and diversification of risk.
Calomiris and Haber show how the rules for the Game of Bank Bargains in the United States have differed from those in England, Scotland, and Canada. In the history of bank bargains in the United States, they indicate, there have been three periods with three different dominant coalitions.
In the first period, from the Revolutionary War to the early decades of the nineteenth century, a coalition of political elites at both the state and national levels, under the intellectual leadership of Alexander Hamilton, established a banking system to finance the revolutionary war and then the new government under the Constitution. The Continental Congress created the first chartered bank, the Bank of North America, in 1781. This was a privately owned commercial bank that had a special relationship with the government as its fiscal agent, and it provoked opposition from local banks without charters and from critics who challenged the special privileges of the national bank as the product of a corrupt political bargain. In 1791, the new central government established the Bank of the United States to replace the Bank of North America. This was a private commercial bank, owned and operated by wealthy Federalist financiers, that made the federal government a shareholder, while also giving loans to the government that were repaid through the dividends the government received as a shareholder. In exchange for this financing of the government, the bank received lucrative privileges from its government charter--including limited liability for its shareholders, the right to hold federal government deposits, and the right to open branches across the country. No other banks had such privileges. State governments, however, exercised the power to charter banks within each state; and they could model their charters on that of the Bank of the United States.
The second period in the history of banking in the United States began in 1836, with the closing of the Second Bank of the United States, after Andrew Jackson had stopped its rechartering in 1832. The new dominant coalition controlling bank chartering and bank regulation was composed of small unit bankers and agrarian populists. Under a system of free banking, individuals could open banks by registering with the state comptroller, and they did not need a charter from the state legislature. But this was not a completely open access system, because banks were not permitted to branch in most states, and this limited the entry of banks in sparsely populated areas due to the high overhead costs of opening a bank. Thus, this became a system of segmented monopoly banking. In this system of unit banking, local banks were tied to the local economy, so that bankers were more inclined to provide credit in difficult times, since they could not move their funds to different locations. And consequently farmers had a special interest in preserving restrictions on branching, because local unit bankers would tend to continue issuing credit to farmers during economic downturns.
The banking system supported by this coalition of small bankers and agrarian populists was remarkably unstable. From 1800 to 1907, there were 11 major banking crises. After the panic of 1907, a group of bankers and government officials convened as the National Monetary Commission to formulate proposals for reforming the banking system. They identified the unit-banking system as the primary problem, and they pointed to the stability of branch-banking systems like that in Canada. But since the dominant banking coalition was too powerful to allow fundamental reform, they proposed the creation of a new central bank that could make loans to banks that were under stress. Here they were following the example of the Bank of England that has become (since the middle of the 19th century) the lender of last resort in the British financial system. This led to the establishment of the Federal Reserve System in 1913. But this did not prevent a massive wave of bank failures from 1920 to 1933.
The Glass-Steagall Act of 1933 established federal deposit insurance, and it is common for high school American history books to assert that this was necessary to save the American banking system. In fact, this was the product of lobbying by unit bankers to support their banks and protect themselves from the competition coming from branch banking. In the 1920s, those states that experimented with deposit insurance found that this made their banking systems unstable, because when depositors were insured, they had less incentive to worry about the riskiness of banks, which encouraged imprudent lending that led to bank failures.
In the 1980s, the unit banker-agrarian populist coalition was weakened by various demographic, technological, and economic changes, which eventually initiated a third period of American banking history with a new dominant coalition of megabanks and urban activist groups. This shift became clear when the Congress in 1994 passed the Riegle-Neal Interstate Banking and Branching Efficiency Act, which allowed banks to branch both within states and among states. This brought about a series of mergers and acquisitions creating megabanks (like JPMorgan Chase and the Bank of America) with nationwide branches.
But if this system of interstate branch banking is more stable than local unit banking, as Calomiris and Haber argue, then we have to wonder why the Great Financial Crisis of 2007-2009 occurred. The common answer is that this resulted from an excess of "deregulation" and a foolish optimism that free markets without government regulation could regulate themselves. Not only were banks free to merge and open branches across the country, they were also freed from restrictions on interest rates on deposits; and they were freed from restrictions that had separated commercial banking from investment banking.
In 2011, the Financial Crisis Inquiry Commission created by the Congress issued its final report with its conclusions about what had happened in the Great Financial Crisis. The report declared:
"We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation's financial markets. The sentries were not at their posts, in no small part due to the widely accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves. More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have avoided catastrophe." (xviii)
And yet immediately after this passage, the report declares that regulators--in the Securities and Exchange Commission, the Federal Reserve, and other agencies--had all the regulatory authority necessary to protect the financial system, but they chose not to use it. In particular, policy makers and regulators "could have stopped the runaway mortgage securitization train," but they chose not to do this.
This points to what seems to have been the primary stimulus for the financial crash--the crisis in housing finance, and especially the market for "subprime loans." To understand this, Calomiris and Haber contend, we have to understand the new U.S. bank bargain that was struck through the influence of the coalition of megabanks and urban activists. There are two conditions for banking crises. Banks must make too many risky loans. And they must maintain too little capital to protect themselves against losses from those risky loans. This political coalition supported policies that promoted both of those conditions.
Under the Community Reinvestment Act (CRA) of 1977, banks were required to serve their communities. Various activist groups interpreted this to mean that banks should expand their mortgage lending in poor and inner-city neighborhoods where many borrowers would not be able to satisfy high standards to qualify for the loans. Bankers seeking mergers to create megabanks needed the mergers approved by the Federal Reserve Board, and the Board could be swayed by evidence that a bank had contracted with activist groups to channel credit to low-income communities. Then, under pressure from activist groups, Congress began to put mandates on the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac)--two government sponsored enterprises--to repurchase mortgage loans made targeted groups. To meet these demands, Fannie and Freddie had to weaken their underwriting standards. They began buying mortgages for people with weak credit scores, little or no documentation of income, and down payments of 3 percent or less. In 2006, 46% of first-time home buyers got mortgages with no down payment at all. These weaker standards were then extended to everyone applying for a loan, so that the American middle class was drawn into the dominant coalition, because now middle-class borrowers could qualify for more luxurious homes than they could afford to pay for, with the expectation that rising housing prices would protect them from financial disaster.
The analysis by Calomiris and Haber is guided by their Public Choice perspective--by their assumption that people generally pursue their self-interest, and that in a democracy, people form political coalitions to serve their selfish interests by getting politicians, who are motivated by their self-interest in reelection, to favor policies in the interest of the coalition, although it is contrary to the long-term public interest.
If that is true, then it is unlikely that good ideas about why banking crises occur--like the ideas conveyed by Calomiris and Haber--will ever lead to reforms to make banking crises less common and less severe. Therefore, Calomiris and Haber leave us with a deeply pessimistic lesson: "readers should not expect politicians or regulators to do much to prevent the next banking crisis" (281).
There seems to be two ways to escape from the fatalistic pessimism of Calomiris and Haber. One is to look to cases like the Canadian banking system as a model for reform. They never explain clearly why this can't be done, except to suggest that the institutional changes required to do this would be unfeasible.
Canada seems to show that the political Game of Bank Bargains can create a good banking system if the political institutions allow this. And Calomiris and Haber recognize this (499). But another possibility is to eliminate the political Game of Bank Bargains completely by moving from central banking to free banking. There has long been a debate between the relative merits of central banking and free banking, and libertarians have argued that in a totally free market, every individual would possess the right to become a banker and make his own banking policies. The only role of government would be to enforce financial contracts and punish fraud. (This debate has been surveyed in Vera Smith's The Rationale of Central Banking and the Free Banking Alternative [Indianapolis: Liberty Press, 1990].)
Although it's hard to find clear historical examples of a fully free banking system, Scotland comes closest to the libertarian ideal. Relying on Lawrence White's Free Banking in Britain: Theory, Experience, and Debate, 1800-1845 (Cambridge University Press, 1984), Calomiris and Haber agree with White that Scotland's free banking system was remarkably efficient and stable (103, 112-14, 169-71, 302-303). (Calomiris and Haber are silent about Murray Rothbard's argument that White is mistaken, and that Scotland was not really a free banking system at all.) But in their criticism of "libertarian utopianism," they insist that the Scottish banking system depended on "very special circumstances" that are unlikely to be repeated elsewhere (491).
They also argue that the libertarian understanding of the ideal state as confined to "providing defense and enforcing voluntary contracts under a clear rule of law" ignores the Darwinian historical reality that states without governmentally created banks have not been able to survive. They explain:
"Throughout history, military and economic competition among states has been a driving force in bank chartering and regulation. The fact that organized violence is a key function of the state has been the single most important reason that states have needed to charter and control banks. The narrow conception of the state that omits an activist role for government in the shaping of banking errs in two fundamental ways. First, as a matter of history, it ignores the central and necessary role of government in creating effective banking systems. The world of Renaissance banking was one of perennial credit scarcity. Second, it ignores the ineluctable logic of how--for better or worse--governments must create and allocate power: any government choosing to forbear from using banks as a tool to gain military and economic advantages would soon be replaced by a stronger government that did. Like it or not, banking policy will always be a powerful tool of statecraft. To narrowly conceive of the state as only a courtroom in which laws are enforced is to ignore the political foundations of all laws and the military and economic foundations of the competition among political regimes." (492)But doesn't this beg the question of whether central banking is the only possible way to finance a strong government, or whether the efficiency and stability of a free banking system could generate abundant credit for government?