Three problems in US finance
US financial dysfunction manifests itself outwardly in at least three characteristics. First, the system as a whole displays a remarkable tendency towards catastrophic failure, in terms of severe contractions in profitability, widespread insolvency of organizations, and periodic illiquidity. Second, access to and cost of credit is uneven, across regions and between social groups. And third, there is quite a bit of redundancy, waste, and fraud. The fraud exists at two levels. First is the problem of white-collar crime, where executives in banks and other financial organizations use firm competencies and knowledge as weapons for their personal aggrandizement; and the second refers to the kind of fraud that most consumers experience (theft of personal financial information) as well as attacks on the integrity of bank electronic and security systems.
My reason for framing US financial dysfunction in this way is that I don’t see a coherent reform program that tackles the main problems of US finance. Often we hear about ‘breaking up the banks’, or the problem of cognitive capture of the regulators, the lack of transparency in securities markets, etc. These are problems that we fixated on following the 2008 crisis, but it is worth mentioning that there were efforts at financial reform during the 2000s (Sarbanes-Oxley, the bankruptcy reforms in 2005, attempts to regulate credit rating agencies) that didn’t produce a more stable, secure, or efficient financial system. The troubles ran, and still run, deeper. My objection to the current proposals, besides the fact that they rarely appear together in any kind of blueprint that weighs how they will be implemented, the ramifications for doing so, and economic rationale, is that they do not do anything for the long-standing problems in US finance: tendency to crisis, access/cost of credit, and fraud.
Essentially, these three problems, being unique to the US, reflect the outcome of the ‘Game of Bank Bargains’ as it has played out in the US (based on the analysis by Charles Calomiris and Stephen Haber in their book Fragile by Design). Calomiris and Haber discuss the problems of tendency to crisis and cost of credit, but do not focus much on the fraud angle. They also do not spend much time on two elements that I find particularly important: the types of organizations that are permitted to allocate credit (public sources, private institutions, and their specific institutional profiles) and the types of organizations that are set up to supervise the allocation of credit (centralized/decentralized agency; independent agency, or democratically accountable; financed by appropriations, or not; and the rest of its institutional profile).
The point of this post is to gather some evidence for the first of these problems, and to determine how the US fits in amongst its cohort of rich countries. In subsequent posts, I will gather the evidence for the other two points, and then be at a point where I bring all the evidence together to determine whether or not there is a solid empirical basis for the following paradox: how is that a rich and (formerly?) prosperous country like the United States can feature such a destructive element at the core of its economy?
Hopefully as I analyze the data, the argument will evolve and become more nuanced, if not thrown out altogether. Nonetheless, I think it is a good hypothesis and I think it already has quite a bit of support. I believe the answer to why this paradox exists has to do with the characteristics just mentioned, but, more specifically, I think it is important to highlight how the structure of finance systematically displaces the costs of its excesses and failures onto other parts of the economy and society. This conclusion, of course, assumes that the paradox exists.
The historical tendency to crisis
We really should not be surprised that there is this highly destructive element at the center of the economy, because capitalism is propelled by creative destruction. Yet the US stands out because its level of financial dysfunction is so much greater than peer countries. One way of showing this is to compare the US to a group of countries that share many of its institutional and economic characteristics. I’ve selected Australia, Canada, and the United Kingdom for this brief example.
The first step is to establish that the US is more prone to crisis than these countries. Using data from Carmen Reinhart and Ken Rogoff (http://www.reinhartandrogoff.com/data/browse-by-topic/topics/7/), I tally the number of years in which there was a stock market crash or banking crisis in the four countries between 1945 and 2010. The figures are collected below.
|Years between 1945 and 2010 spent in a|
|Stock market crash||Banking crisis|
In their book This Time is Different, Reinhart and Rogoff define these crises are as such. A stock market crash is where real equity prices decline by 25 percent. A banking crisis features bank runs leading to government intervention, or government intervention into the banking sector (closure, merger, takeover by public sector of a single or group of financial institutions). Canada is by far the most stable, while the USA has spent the most number of years in a crisis (almost a third of the post-war period has witnessed dramatic crashes in equity markets!). The UK and Australia are about the same for number of years of stock market crashes, but the UK is closer to the USA for number of years in a banking crisis.
Obviously, the years are clustered in time because a crisis often spans many years. For example, in terms of episodes, the USA has much longer banking crises than the UK. In the US, there was the S&L crisis, which Reinhart and Rogoff record from 1984 to 1991, and the recent crisis from 2007 to 2010 (when the dataset ends). The UK, by contrast, has a three-year crisis beginning in 1974, and shorter crises in 1984, 1991, and 1995, and then the recent one from 2007 to 2009. For Australia, there was a four-year crisis beginning in 1989, and in Canada, a three-year crisis beginning in 1983.
Much of the difference might reflect the fact that the US has had historically a very large banking population, as a consequence of the New Deal reforms (intra- and inter-state banking restrictions). In the US, once a banking crisis begins, it can affect so many more organizations before burning out. I will return to this point in another post.
Another dataset on banking crises has been compiled by economists working at the IMF. This dataset includes only “systemic” banking crises (available here: https://www.imf.org/external/pubs/cat/longres.aspx?sk=26015.0). These crises include the following elements: defaults of institutions in the corporate and financial sectors of a country; difficulty of institutions in these sectors in the timely repayment of contracts; an increase in non-performing loans; illiquidity; depressed asset prices following the crisis; rise in real interest rates; and, potentially, capital flow reversal. Such a definition is quite different from the banking crises in the Reinhart and Rogoff dataset, namely in that it attempts to include quantitative indicators.
Using that information, the IMF finds no systemic crises in Australia or Canada, and only in 2007 was the UK in a systemic crisis. In the USA, there were two crises beginning in 1988 and 2007. Even after adopting a stricter definition of a financial crisis, the USA surpasses its immediate peers in financial dysfunction.
Banking crises are more difficult to pinpoint historically because bank assets do not reveal conditions of crisis the same way that equity or real estate prices reveal a crisis in asset markets. This feature partly explains the loose definitions above and the reliance on qualitative indicators, such as government intervention. One criticism of using government intervention as an indicator of crisis is that it can become a self-fulfilling prophecy, while another is that there remains the question as to what level of intervention counts as a crisis. It may also be the case that individual countries or groups or types of countries (democratic, autocratic, young/old countries, English common law system, industrial-based) experience different types as well as different manifestations of crises. As eluded earlier, a banking crisis in the USA looks very different from one in Canada given the large number of unit-banks, the highly compartmentalized regulatory system, and the high level of capital mobility. My preference is to situate “crisis” in the context of these country-specific factors. Nonetheless, there is some value in comparative work.