Weekend long reads (Dec. 5, 2014)

Readers will notice that there hasn’t been much activity here since Thanksgiving. My absence is partly due to traveling I’ve had to do, being engrossed in my new book (The Power Broker by Robert Caro), and other academic obligations, which will continue next week. Nonetheless, I have provided some long reads here as they seem to one of the more popular types of posts. I hope to have the third part of the series on sectoral investment patterns up by the end of next week.

Fracking tantrums


Research and academics

The contemporary context of investment in the United States, part 2: definitions

This post is second in a series on the contemporary state of investment in the US. The first is here. The purpose of this post is to provide some definitions and context. There are three questions: first, what processes does “investment” refer to; second, who invests; and third, what patterns should interest us? To define and identify what investment activity matters (for economic growth and development in the US for the next decade or so), I rely mainly on some of the writings of critical/heterodox economists Hyman Minsky and John Kenneth Galbraith.

What is investment?

There are two common usages of the term “investment”. The first is the buying and selling of shares of companies that are publicly listed on stock exchanges. This set of activities is not the sort of investment I’m talking about in this post. No doubt, the stock market can be a source of capital for companies, which can then be deployed for investment. More often than not, however, the stock market functions as a market for corporate discipline and control (mergers, acquisitions, takeovers). The investment I refer to here is the accumulation of fixed assets (such as capital goods [like machinery], inventory, property, physical structures) for the purposes of generating income.

Let me offer a short digression here. Many would say that the two definitions above reflect a financial definition and then an economic definition of investment. In casual, daily conversation, that might be acceptable. However, if you have read Hyman Minsky then you would be aware that both processes are actually interlinked and co-constitutive. That is, the accumulation of fixed assets happens very much according to what is happening in capital markets (of which stock markets are a sub-set). More specifically, Minsky argues that the financing (particularly when financed through debt) and pricing of capital goods occurs in capital markets. The point is that the capital goods and fixed assets that are used for investment are also financial assets. And because these financial assets are accompanied by ownership claims and are financed, this implies that there are cash flow obligations: the debts that were used to finance capital goods accumulation must be validated. Those obligations are met by splitting off part of the income produced by those assets, either as dividends, interest payments, or perhaps (in dire situations) from the sale of capital goods. To make a long story short, Minsky demonstrates that these arrangements can precipitate a depression in the event that financial asset prices collapse, which he argues is possible if capital goods accumulation is financed in too speculative a manner. Otherwise stated, the capitalist system itself sows the seeds of its own crises. I suggest you read this or this.

Where does this leave our definition of investment? There are at least six elements: it refers to a (1) process of accumulating (2) capital goods, which are simultaneously (3) financial assets that are (4) owned by capitalists/entrepreneurs and (5) might be financed through debt, for the purposes of (6) generating income.

In the next section, I’m briefly going to discuss why (5) and (6) do not always apply but rather depend on who is doing the investing. Nonetheless, I think that the definition here is workable and sufficiently distinguishes this set of activities from the “investing” (asset trading) that commences every day with the ringing of the bell at the New York Stock Exchange.

There are a couple of other points I’d like to add here concerning how investment might influence the larger political-economy. Recently a book was released that contained a number of previously (I believe) unpublished essays by Hyman Minsky (they may have been published in a few academic journals) on the topic of jobs, employment, and welfare. I recommend this one, too, for a general introduction to Minsky’s thought and its application to employment. In the introduction and throughout that book, the reader might notice that the US economy is characterized as observing a “private, high-investment strategy”. I think there are two very important points in that phrase. First, investment is private: it is subject to ownership by individuals, not the state. This point should interest anyone who conducts cross-national comparative research: you cannot compare the investment process in a country like the US, where investment happens by entrepreneurs and households, with a country like China, where capital expenditures are determined largely by committees in state-owned businesses appointed by the (Communist authoritarian) state. It may be a minor point, but I think it is worth bringing up.

The second point is much more important: “high-investment strategy.” What does that imply exactly? The idea is that the US economy in particular generates growth by stimulating investment. That is, more private ownership of capital goods. Such a strategy is executed, in the US at least, by various policies: a tax code that favors capital goods accumulation (incentives for depreciation, tax credits); a favorable business environment (low regulation of business, which decreases the cost of doing business generally); and government contracts that partly underwrite profits in select industries, typically those that require high capital goods consumption (armaments, construction, airlines). Thus “growth” in the US economy is primarily pursued by creating favorable conditions for income generation by businesses.

There are number of problems associated with such a strategy, and I’ll quote the four that are mentioned in that volume on employment by Minsky. These can be found in a summary around kindle location 358-382.

First, a tax code that is geared towards more investment will increase inequality between the owners of capital and labor. For what it is worth, inequality on its own does not necessarily spell economic disaster. For instance, if you have read Thomas Piketty’s book, you’ll know that countries can endure long periods (centuries) of inequality without encountering, say, collapse and ruin. Certainly, there are issues of justice and quality of life that arise from high inequality, but the evidence that inequality might lead to economic and financial crisis is wanting. Politically, I don’t worry about inequality because the President and most American political leaders are not Rockefellers, Morgans, Vanderbilts, Carnegies, Fords, or Hearsts. In other words, the money eventually runs out.

[An aside: one of my favorite economists (Deirdre McCloskey) has recently written a review of Piketty that I suggest everyone read. It’s there on the home page in pdf form.]

Second, the income that accrues to owners of capital can lead to opulent consumption by them and emulative consumption by the masses, leading to inflation. There is a natural experiment here in the period 1964 to 1974 in the US, as employment tightened, defense spending escalated with the War in Vietnam, and the economy enjoyed an investment boom (initiated, by the way, with tax cuts passed during the Kennedy and Johnson administrations).

Third, government spending on defense (contracts to specialized and sophisticated high-technology industries) creates demand for high-skilled, high-wage labor. In turn, this widens the inequality among workers. Again, we can observe the effects of growth in high-technology sectors on wages and skills across occupations by observing the period from 1994 onwards, when the revolution in computer chips and the internet began. This was not totally the result of government spending (in fact, US defense spending dropped off after 1990, leading in part to the recession of 1991), although much of the US advanced technology industry grew out of companies that received defense contracts. Nonetheless, this is a serious problem for worker quality of life and, I would argue, for growth prospects between regions and metropolitan areas.

The final problem Minsky describes of a high private investment strategy is that if the tax code and business environment privilege capital spending, then rising business confidence hence banker optimism will erode lending standards while also increasing the riskiness and speculative nature of investment. The result can be a financial crisis and recession. It is worth noting that the 2008 crisis was not the result of excessive optimism by corporate businesses. Rather, the 2008 crisis was the result of a housing boom and a highly leveraged household and and highly leveraged, speculative, and corrupt financial sector.

At this point, I’ve elaborated enough on what I mean by investment. Now I’m briefly going to outline some key differences between the sources of investment.

Who invests?

I mentioned earlier in my definition of investment that it might be financed through debt and that the purpose of investment is to generate income. I’d like to add some caveats to that with the help of John Kenneth Galbraith.

In a previous post containing links, I had one from the St. Louis Federal Reserve documenting that credit to non-corporate non-financial sectors has remained low following the crisis. That to me was a key indicator of who is able and willing to invest in the current economy. We have at least three major groups here: the corporate sector (AT&T, Wal-Mart, ExxonMobil, DuPont, Microsoft); the household sector (you and me); and the financial sector (banks and lenders big and small). Each of these sectors have very different sources of capital and ways of generating income. The corporate sector, which as you can tell is populated by very large companies that are often structured in what economists would call an oligopolistic market (where they can influence prices of inputs and outputs), gets most of its capital (for the purposes of future investment) from retained earnings. In other words, expansion programs, research and development, development of new products are financed from last year’s profits. These business do not typically take out loans from banks to finance their activities, although they certainly float bonds and stocks as part of their complex capital structures. The main point is that these companies seek to make the supply of capital (like they do for all other strategic costs) a “wholly internal decision” (Galbraith, 2007, 34). Chapters Three and Four in The New Industrial State are the relevant backgrounds for this interpretation.

As such, investment is not necessarily financed through debt. In addition, investment may not happen with the aim of producing income. Galbraith describes that in these large corporate enterprises, the managerial hierarchy is responsible for long-term planning; this includes when and whether to make capital expenditures. The ultimate goal of the corporation, then, is not income or profit generation, but rather the elimination of uncertainty. The corporation seeks stability. The process of investment, we can deduce, will fall in line with how corporate managers attempt to achieve that stability. An oligopolistic market structure allows companies to pursue goals other than the relentless pursuit of profit, contra the neoclassical economics dicta.

In contrast, when American entrepreneurs attempt to launch a business, the financing usually comes from residential mortgages and the purpose is the generation of income (they do not exercise oligopolistic power). A home is an individual’s greatest potential source of capital, save inheritances. Consider how easy it is (excuse me, how easy it used to be) for most people to get a mortgage or to refinance their home; this, too, surely was a reflection of the high private investment strategy (or at least should be treated in policy as such).

Obviously, between the individual entrepreneur and the oligopolistic corporation, there are a lot of businesses that do not have pricing power and that have access to various forms of financing that are not restricted to home mortgages or inheritances. These businesses, which could be termed ‘mid-sized’ and have several hundred employees (let’s say, fewer than 500), and which are typically in manufacturing, transportation, utilities, and related industrial sectors, do enter into debt contracts with banks and other lenders. However, I think that our focus should really fall to entrepreneurs and large corporations. For the former, the reason is that small businesses create a tremendous amount of activity, in terms of jobs and sales. Most small business also fail, so this is a tremendously inefficient set of activities. In the short-term, however, small businesses drive quite a bit of local economic activity while providing a lot of people (not just the small business owners themselves but also the people they hire) with an outlet for social and economic advancement.

In the case of large corporations, the interests of these entities set much of the industrial and social policy in the US, and they are responsible for the bulk of exports and income. Furthermore, municipal and state governments compete quite vigorously over corporations. Local governments offer tax incentives, provide physical infrastructure, train the workforce, etc., partly with the aim of attracting business activity, and therefore tax revenue.

What I’m getting at here is that there is a geography of investment, and two very important features of that geography will be households and large corporations. The financial system is also important in this geography, but these days it is less about the location and activities of banks and more about the location, organization, and prerogatives of special investment funds, like pension or hedge funds. With that, I’ll move on to the final question.

Measuring investment and identifying patterns

I won’t dwell on this point much because instead of telling you what I’m going to do, I may as well just do it. In the next posts in this series, I’m going to present the data I stumbled upon from the Bureau of Labor Statistics for output, savings, and investment. The data is organized by sector, that is, industrial sector following the NAICS codes and also by the divisions suggested above (household, financial, corporate, and others).

The most basic pattern to identify is change over time: which areas demonstrate growth and which demonstrate contraction? There are roughly seven years of annual data, which is not a large sample by any means. There will be some noise.

A subsidiary pattern is relative change. The 2008 crisis marks a point where we can evaluate how credit distress during and after the crisis was distributed between sectors and, consequently, what have been and will be the prospects for investment and therefore economic growth. In other words, we can determine to an extent what sectors are “holding back” growth. Recall that this endeavor was largely touched off by the New York Times article that asked that very question (see previous post). My goal is to further investigate that question.

The contemporary context of investment in the United States, part 1: introduction

The Great Recession (2007-2009) changed the context for investment in the United States in several ways. First, it created imbalances in the economy, in terms of losses and gains between economic (businesses, households, government) as well as industrial (agriculture, manufacturing, services) sectors. These losses and gains can be measured in terms of lost output, including employment. These are imbalances to the extent that contractions in output were unevenly shared across sectors.

Second, the political environment changed as new constituencies and alliances were formed, while others were made more obvious. An example of such a long-standing alliance that became stronger was the relationship between the Federal Reserve and large, globally-competitive financial companies. This relationship was codified in the emergency recapitalization (the TARP) and in the Dodd-Frank law. New constituencies emerged or became more pronounced, for instance as unemployment and homelessness rose, and they reflected a regional character (for the reason that the financial crisis and recession were, in fact, regional crises). These new constituencies and alliances generated pressures for different kinds of policy intervention, with varying success.

And finally, the macroeconomic context changed, given changes or stickiness in the informal rules of investment (such as tax rates, interest rates, the supply of credit). Similarly, economic development through the application of new technologies, discovery and extraction of fossil fuels, and global capital flows also have shaped the macroeconomic context.

Over the next several posts, I’m going to outline the context of investment in the US immediately before and since the financial crash in 2008. I will describe the nature of investment since the crash, with a focus on the distribution of investment activity between sectors (economic and industrial) as well as the nature of investment (private fixed assets: structures, equipment, intellectual property). Finally, I’ll briefly describe the kinds of companies and regions that were poised to reap the benefits of this changing context, and contrast them against those entities that have borne the greatest burden.

The next posts will frame investment in the US with the following specific questions. First, what do I mean when I talk about investment in the United States? I will outline that question by referencing JK Galbraith’s new book (The End of Normal) as well as borrowing some insights from Hyman Minsky. Let me add that I do not mean to advance any kind of coherent theory; that is way beyond my remit at the moment. Rather, I find it useful to identify useful metrics and relationships in the data that can eventually be situated within a wider theory, or can be used to advance or refute other ones.

Second, what are the current obstacles at the geopolitical and national levels to growth in investment within the United States? Off the top of my head, I can think of several important “obstacles”: the process of domestic credit allocation (including interest rates, integrity of too-big-to-fail banks, property development); the cost of raw materials (especially oil and gas); and, military commitments and the general financing of national security. Readers of Galbraith’s book will notice these topics are quite prominent in his account, while I have spent most of my very short academic career focused on the first.

Third, what is the current progress or state of the economic recovery since 2009? There are some subsidiary descriptive questions that point to my thinking here. Which economic sectors have returned to pre-crisis trends in output growth (contribution to GDP) and which remain stalled? Which industrial sectors? How did investment in private fixed assets respond to the crisis and aftermath? What about for investment in structures, equipment, and intellectual property? (If readers want to see what I’m getting at with these questions, take a look at this article from the NYT back in April: http://nyti.ms/1zZEVct; I am essentially expanding this kind of inquiry, which has been, incidentally, the empirical base upon which most of research has been conducted).

My doctoral dissertation advisor liked to say that a solid way to organize an argument follows the formula: what; why; and, so what. The what component here is really, where is investment happening in the USA (both in sector and locational terms). The why seeks to explain the relevant processes that propel the investment we see or hinder the investment we hope for (particularly, why it should be the case that despite there being a real recovery in material terms, there should be such a slow expansion in quality employment opportunities). The so what for me really comes down to distributional fairness. In other words, something that has been on my mind the last few years is whether the parties responsible for the financial crisis and disappointing recovery were the same parties that amortized its costs, or whether there has been a systemic and successful effort to push those costs onto other parts of society. Additionally, I want to explore the durability/sustainability of the investment that is happening. At the end of the day, we all want to be a part of a successful collective endeavor–the US economy. Hopefully I’ll find much to be proud and excited about as I dig through the data. Alternatively, hopefully I can provide some insight into how to rectify the processes that point to the contrary.

The loan to deposit ratio and the trouble with US finance

 The three problems in US finance revisited

In an earlier post, I suggested there were three core problems with US finance: tendency towards dysfunction; uneven cost and access to financial services; and, waste, redundancy, and fraud. I was just browsing through blogs and saw a post at zerohedge (http://bit.ly/1so7Gd9). It is entitled ‘All that is broken with the US financial system in one chart’ and shows the loan to deposit ratio at JP Morgan from 2008 to now. The question I’m asking myself is: does JPM’s loan to deposit ratio really tell us everything wrong with US finance? Does it reveal the US tendency to undermine profitability and stability by way of incentives to misallocate credit? Does it reveal the uneven ability for consumers to access credit on good terms? Does it reveal the wastefulness of the US system, the high incidence of consumer fraud, and the high incidence of white-collar fraud?

The first thing I note is that I don’t think the 2008 to 2014 period is satisfactory for answering these questions. Furthermore, there is no comparison to other large banks, even though JPM on its own has market power and can be considered a special case worthy of analysis. I don’t post comments on that blog, but I did notice in the comments section someone asking if there was a chart for the whole financial system. The implicit criticism, I think, was that JPM is not indicative of the rest of the banking system, even though it is the largest bank in terms of deposits, or at least in the top four. I think a better starting point is asking whether or not the loan to deposit ratio can capture the problems in US finance, and then proceeding with individual banks to understand how the ratio is constructed organizationally and geographically.

I’ve attached below a chart created using FRED (http://research.stlouisfed.org/fred2/), showing the ratio of loans & leases to deposits at US commercial banks. It begins in 1973 and continues monthly to the start of October 2014.

Loan to deposit ratio, US commercial banks

It seems to me this is another important institutional relationship in US finance. Some notable features include: (1) the ratio currently stands at its lowest level since the late 1970s; (2) it peaked during the dot.com bubble, and even the mortgage lending boom could not raise the ratio to its previous peak (which suggests some interesting limits to leverage); (3) it increased rapidly starting in the mid-1990s economic boom; and, (4) it had been in decline from the panic in 2008 until earlier this year.

There are a number of different behaviors that affect the ratio. First is clearly the demand for credit, which is structured by access and cost. Demand, by this token, is affected by the organization of credit allocation, that is the specific institutions responsible for providing it (too-big-to-fail banks, savings associations, credit unions, payday lending). Second is the effect of interest rates, which affect willingness to take on risk by banks. Third is capital and other regulatory requirements.

So, does this institutional relationship reveal the problems in US finance? This question assumes that the three-problems are valid; they may not be, and this is a good exercise to work that issue out.

1. Tendency towards dysfunction

The ratio tends to drop around US recessions, but it is interesting to note that it did not drop as much during the S&L debacle. Leverage actually appears to have increased from 1985 onwards, even through 1987 when there was a sharp drop in profitability of US banks. Even during a banking crisis, leverage continued to grow. It did, however, respond dramatically to the latest recession and banking crisis, however it is hard to separate out those effects. Did leverage decline after 2008 because of demand or because of supply side factors? I don’t know. At the least, the ratio might anticipate collapses, in that periods of expansion in leverage are followed by contractions, which is to be expected based on periods of credit expansion.

2. Cost and access is uneven

In order for us to determine whether or not the ratio can reveal the problem of access, it would probably be best to disaggregate the ratio between types of organizations. First would be sector (commercial banks, savings associations, credit unions, non-regulated intermediaries); second would be size of organization; and third would be the region of operations. It would be great if there were data on the average ratio by banking markets served (which could then be related to other demographic features of those markets, such as income, population, etc), but that would be quite an undertaking. At least in general terms, the ratio suggests that there has been a significant pullback in leverage; as we cannot quantify the factors that contributed to that (it could be demand, regulation, and supply), it is difficult to know whether or not the pullback reflects lower willingness by consumers to take on debt or greater risk aversion by banks. The post at zerohedge argues that the flatlining in amount of loans outstanding indicates a conscious decision by the bank not to extend loans; I think we would need more data on the volume of loan applications as well as the rate at which applications are accepted. The Federal Reserve has survey data from banks, which speaks in a way to sentiment, but hard data would be more useful.

Another important point that comes to mind, and which returns to the issue of access and organization type, is that using commercial banks to determine lending might actually be misleading. As I’ve posted before, regulated banks are actually performing less lending. The ‘shadow’ financial sector has been encroaching on traditional lending markets for decades. It may be the case that the growth of shadow activities in financial markets has lowered the share of commercial banks in lending. To develop this line of inquiry further, one would need to explain that this pattern accelerated after 2008.

3. Waste and fraud

On the whole, the ratio really seems to be an indicator of system-wide leverage. It does not seem capable of tackling issues of consumer fraud, white-collar crime, etc.


I am weary of these reductionist articles that pop up on so many blogs and online news sites. The problems in the US financial system cannot be boiled down to any one factor. The sector is too heterogeneous for there to be even one set of factors. Clearly, there are more than three problems as well, but I’ve tried to make it so that other “sub-problems” can be filed under those categories. Again, the endeavor to determine just exactly what is wrong with US finance has to take place on a lot of levels–regional, sectoral, historical, institutional, etc. The key may be to generate case studies that are regionally and institutionally specific and see what kinds of patterns and differences can be identified. That said, I’m glad to add the ratio to the list of relevant institutions of finance.

Institutional change in lending

Who lends?

The declining share of deposit money banks in total credit lending indicates increasing diversification and specialization of capital markets. Organizations that are not deposit money banks include credit unions, money market funds, pension funds, insurance agencies, brokerages and other securities firms, financing companies, venture capital firms, hedge funds, and, at the lowest-tier of the financial structure, payday and other short-term, small amount lending.

Another way of interpreting the share of deposit money banks in total lending is as a share of lending that is not insured or supervised by the government. This is a bit misleading because there are public and private forms of insurance available to these organizations. Credit unions are insured by the National Credit Union Administration (NCUA, the equivalent of the FDIC), while most brokerage houses are insured by the Securities Investor Protection Corporation (SIPC), which has many of the same features as the FDIC. These programs insure depositors against losses; they do not include safety and soundness oversight. As such, the non-deposit money bank share is a reasonably good approximation of the amount of activity taking place outside the purview of public supervision.

The share of deposit money banks in lending is an important institutional relationship for a national financial system. Data for this is collected in the US by the Federal Reserve and other agencies, and the Bank of International Settlements has put together a national cross-sectional, time-series dataset that can be found online (http://www.bis.org/statistics/credtopriv.htm). In the United States, this share rose from the 1940s until the 1970s, peaking below 60% before decreasing from the mid-1970s until today. It dropped substantially during the S&L crisis, as many hundreds of savings institutions but also commercial banks failed. The shares for the US, Australia, and Canada are presented in the figure below.


I include Australia and Canada for the reason that the three countries share similar geographical, historical, and institutional characteristics. They are large, demographically-heterogenous, continental-sized economies that are former British colonies, and so have legal systems based on English common law. Natural resource extraction and trade are essential components of their economic growth. Their experiences with financial crises, however, are somewhat different. For instance, the US has seen two banking crises in the last thirty years (S&L and 2008), while Australia experienced a banking crisis in the early 1990s (when a couple of government-owned savings institutions failed and several other institutions), but was largely spared from the 2008 crisis. Canada has seen periodic but isolated failures of banking organizations, but was also spared from the 2008 crisis. In effect, only the US experienced a ‘systemic crisis’ during the last three decades, which was in 2008. This disparity is even more remarkable in light of the fact that in all three countries, property markets underwent an incredible boom leading up to the 2008 crash.

A institutional model of financial crises

The issue of who lends is vital when considering why some countries are more prone to financial dysfunction than others. Charles Calomiris and Stephen Haber have argued in their book Fragile by Design that the frequency with which a country experiences financial crises is a result of how its fundamental political institutions distribute power between competing groups in society. In the US, historically, populists have exerted a level of influence over the structure of banking markets due to the alliances they have formed with local bankers. In Canada, however, the federal government has insulated the banking sector from populist influence and created a more stable framework that allows its few, very large banks to control much of the lending markets while also providing abundant and cheap credit. The US, by contrast, ranks comparatively low among high-income countries in providing affordable credit (witness the lack of affordable and government-insured borrowing options for low-income Americans in poor neighborhoods and cities).

The conceptual model–the Game of Bank Bargains–that Calomiris and Haber offer is a good counterargument to explanations of financial crises that invoke ‘speculative euphoria’ or ‘banker folly’ or other aspects of human behavior. Their argument has its limits, though. For example, they spend a great deal of time repeating the conservative bugaboo about the 2008 crisis that Frannie Mae, Freddie Mac, and the Community Reinvestment Act of 1970 distorted lending incentives and caused a deterioration of underwriting standards during the housing bubble. They also suggest that community activists teamed up with mega-bank interests to push through the financial liberalization reform program of the 1990s in exchange for greater lending to urban minorities. I think in doing so they alienated a number of readers who might have been inclined to use their model but were put off by the polarizing and discredited notion that the victims of the 2008 crisis–urban minorities–were responsible for the crisis.

This is obviously a shame, because I think it is crucial that we have a more informed conversation about how financial markets and specific banking organizations are used by the state to advance the state’s interests as well as to advance parochial or regional interests. Nonetheless, it is possible to use their model of interest group collusion to tell a different story about the 2008 crisis and why credit is allocated the way it is. The central process in that story is the transformation of legal foundation of the banking sector and the change in contractual relations between households, the financial sector, and the state. I’m going to outline this story and emphasize its geographical component.

A brief application/reinterpretation of the Game of Bank Bargains

At the end of the S&L crisis, the surviving, well-capitalized financial organizations were able to take advantage of (1) a buyer’s market in distressed financial assets, and (2) an appetite for regulatory reform at the national level, aided by an accommodative Federal Reserve Board. The S&L crisis affected mainly (obviously) savings institutions in the south and southwest states. The surviving banks were money center and investment banks in New York and other northeast financial centers, as well as the so-called super-regionals. For a more in-depth review of this period, I suggest you read a working paper by Gary Dymski entitled “Genie out of the Bottle: The Evolution of Too-Big-to-Fail Policy and Banking Strategy in the US.”

Suffice it to say that the type of organizations that were poised to reap the benefits of the post-S&L environment very much shaped the nature of the legal reforms of the 1990s. That is, the reforms included repealing intra- and inter-state branching restrictions, removing separations between investment and retail activities, and repealing size limitations. Less talked about consequences of these reforms include that the role of the Federal Reserve took on greater importance. For example, under the Riegle-Neal Act of 1994, the Fed was charged with approving mergers-and-acquisition (M&A) activity, while the organizational model of choice for accomplishing M&A activity was the bank holding company. It so happens that the bank holding company is supervised by the Federal Reserve.

An even less talked about event during this period, which likely had a strong effect on the nature of bank strategy, was the experience with Long-Term Capital Management. Without getting too deep into the details, the collapse of Long-Term in 1998 was marked by an incredible intervention by the Federal Reserve, which organized a private sector bailout by leaning on Long-Term’s creditors. Some of the lessons of that experience were: the Fed was willing to drastically intervene to prevent the failure of what it considered a systemically important institution; the use of complex instruments such as derivatives would continue as a risk management mechanism; and, a highly connected firm could be successfully resolved in the event of a crisis. I suspect the experience of Long-Term was on the minds of decision-makers at the Fed and elsewhere in the upper echelons during 2008 (it had only been a decade, after all).

So, who is at the table of the Game of Bank Bargains in the 1990s? The table is populated by New York investment and money center banks, super-regionals, the Federal Reserve, and various senators and administration officials representing those organizations. I think it is fair to say that there was nothing inevitable about this particular group advocating for the particular package of liberalization reforms. It seems quite opportunistic, in fact. The group’s identity reflect the survivors of a crisis in the housing finance and commercial property sectors in the 1980s and their strategic considerations.

Was there a viable alternative to their view of the ideal financial landscape? Not really. The savings association industry was in a shambles, and community, consumer, and housing advocates had made major gains in the reforms passed during and immediately after the S&L crisis (notably by imposing as much of the costs of the S&L resolutions on the industry itself). Their continued efforts were stymied by the George H.W. Bush administration. There doesn’t seem to be much in the way of any advocacy for a greater role of public options in banking, such as state banks (in the style of the Bank of North Dakota) or perhaps a postal savings system during this time.

So the legal foundation of the financial sector was radically altered between the early 1990s up to the early 2000s. The preferred organization for consolidation was the bank or financial holding company, the preferred regulator was the Federal Reserve, and the preferred solution to the bank profitability crisis witnessed in the 1980s was the removal of geographic barriers in banking markets. Another implicit element of the Game of Bank Bargains in this instance was the too-big-to-fail issue. The bailouts during the S&L crisis demonstrated the possibility that market mechanisms could be used to resolve failed assets, while the government emphasized its willingness to intervene directly into markets to prevent disruption. The effect of these reforms was actually, as shown in the figure above, to narrow the government’s zone of control over lending–new intermediaries popped up in the interstices between the big banks, which themselves were executing more trades and lending outside of their chartered, depository units.

The Bank Bargain of the 1990s was truly a new contract between a quasi-governmental agency (the Federal Reserve) and a collection of large institutions (many of which were already embedded within international financial markets) for control over the credit allocation process. It was guided by an ethos of liberalization that had been brewing before the S&L crisis, and in fact could arguably be seen as having instigated the crisis or at least made it worse (for instance, by deregulating interest rates under DIDMCA of 1990 and Garn-St. Germain Act of 1982).

Bottom line

One of the lessons for institutional change in lending, which is how I started this post, is that the choice of organization actually matters very much. Different types of organizations face different strategic considerations and observe specific locational distributions. Additionally, types of organizations fall more or less within the state’s influence. The Bank Bargain of the 1990s sought, given the ideological climate of the time, to limit the zone of control. One of the points I picked up on reading Calomiris and Haber’s account of the banking stability of Canada is that the state endeavored to maintain or increase the domain of lending covered by its preferred organizations (its large chartered banks) as new technologies and innovations arose. The example of REITs in the US (which precipitated a crisis during the 1970s, see Hyman Minsky’s Stabilizing an Unstable Economy) shows that while REITs were eventually legitimated, they remained an industry operationally separate from the chartered and regulated system.

These are only some preliminary thoughts, but I think they provide good support for a more thorough comparative analysis of the politics and institutions of credit allocation. The US, Australia, and Canada, I suggest, are excellent candidates for such an analysis. The conceptual model by Calomiris and Haber could be reapplied by adding the spatial perspective–the location of organizations, their structure, strategies, the competitive environment–and also by reframing the issue as the extent to which a country manages (and wants to manage) the quality of its lending.