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 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.

Studying phenomena at the meso-level

I’m currently reading Rough Country (http://www.amazon.com/Rough-Country-Americas-Powerful-Bible-Belt/dp/0691159890) by Robert Wuthnow. I’d like to highlight a couple things that I think make this a unique study and that sets an example for the kind of analysis that I aspire to.

First is the focus on Texas. The state is both an official jurisdiction but also a coherent region. It has a set of cultural, economic, and political institutions that have been shaped by its geography and history, it has several major urban areas, and it has its noted ecology. Yet it also presents an opportunity to examine the development of American history and its institutions as well. So, it presents a case study from which to deduce wider, national-level trends (beyond the valuable information on Texas).

Furthermore, he writes that an important “interplay [in his analysis] casts regional independence and personal autonomy against national identity and incorporation. The shifting definition of the region itself … emerges as a continuing theme” (pg. 7). This is a crucial venue for geographical study, as there is more to a ‘region’ than simply its official boundaries, but rather its interactions with peers and interactions with national trends, to say the least.

Second is the explicit focus on meso-level phenomena. In the words of the author: “The argument is rather about a series of processes that happen in distinctive ways and yet illuminate aspects of the relationship between religion and society that are best seen as this intermediate level of social organization” (pg 7). That is, his central object of study is the church (in the abstract), but more specifically the congregations and pastors in communities, and also the supporting structures such as religious conventions and higher-level organizations within specific denominations. He continues: “One of the processes derives from the ordering, chaos-reducing, nomizing role that nearly all discussions of the relationship between religion and society have emphasized” (ibid, italics original). So, the analysis is concerned very much with institutions in the most traditional sense–the incentives and discourses that guide behavior.

In academic geography (and perhaps other fields), you don’t often come across mid-level studies like this. Typically, case studies are concerned with organizations in specific places (a firm, a city, maybe a sector), and this occasionally can scale up to a more regional-level. I have not read much work that combines a thorough historical and geographical analysis of (1) a coherent region and (2) its institutions. Some examples of regions that deserve more study that come to mind but that also cross multiple official boundaries include Federal Reserve districts, large and varied ecological zones (Great Lakes, Gulf Coast), border lands (Mexico-USA), and metropolitan areas (often MSAs do not reflect a single municipal jurisdiction). Examples of mid-level institutions include police agencies, financial markets, banking markets (also cross multiple jurisdictions, in the USA at least), commodity supply chains (which get a lot of attention in geography), or federal agencies (those with branch structures, like the Social Security System or the Post Office).

My aim is to write up thoughts as I get through the book and how it is shaping my thinking on institutions, designing methodology, and the ‘meso-level’ in general.

American financial dysfunction

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
Australia 10 4
Canada 5 3
UK 11 9
USA 21 12

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.

Alternative indicators

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.

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.