Arsonists in charge of the fire brigade

A favourite economic justification for state action is to deal with externalities--the effects on people of some action or transaction that they were not willingly a party to.  The problem with this is that the coercive nature of the state makes it a prime creator of externalities: since it has coercive power, it can force consequences on people they have not agreed to. While said coercive power makes the state, at least in theory, able to deal with externalities from private action, in practice, it makes the state a prime generator of externalities. Tyranny (taking the modern pejorative meaning, not the classical Greek technical meaning), the extreme version of forcing consequences on people they have not agreed to, is, after all, systematic negative externalities.

Democracy is supposed to make things better, by making all voters part of the political bargaining process. The problem with that is much of the art of representative politics is using the coercive power of the state to provide benefits to folk who do notice (and care and effectively politically express that noticing and caring) while shifting the costs onto those who do not. In other words, generating visible positive externalities paid for via not-usefully-noticed negative externalities. Politicians are entrepreneurs of externality. Appealing to politicians to deal with problems of externalities in general is rather like putting arsonists in charge of the fire brigade.

Which is not to say there is no benefit to democracy: a whole lot of externalities that undemocratic regimes impose are usually avoided because visible negative externalities have a rather harder time getting through when all voters are part of the political bargaining process. Nobel Memorial Laureate Amartya Sen's point that democratic countries do not suffer from famines is well taken and part of a wider process. (As Calomiris & Haber point out in Fragile by Design, democracies are less susceptible to extreme versions of the inflation tax than weak autocracies, for example.)

Of course, if groups of voters are permanently locked out of the effective political process, then the advantages in political bargaining that democracy permits will be somewhat attenuated. If folk have a weak sense of there being a common public sphere in which bargaining takes places (and is supposed to be stuck to), including various categories of other folk as not acceptable bargaining partners, democracy will also have difficulties having getting social traction to operate against even obvious negative externalities.

The jihadi critique of democracy as blasphemous is precisely because changing the law to reflect social bargains is to infringe on Allah's sovereignty, as the only legitimate law is Sharia, created by inference from the actions and words of Mohammad, God's final Messenger and Guide. More generally, taking as an affront to treat non-believers the same as believers, or folk of x skin colour the same as folk of y skin colour, rather gets in the way of effective broad social bargaining via the democratic process.

The above thoughts on politicians in representative democracies and externalities were inspired by Calomiris & Haber's discussion of the sub-prime crisis in Fragile by Design: the Political Origins of Banking Crises.

Imprudent community investment
Calomiris & Haber make it very clear that how the Community Reinvestment Act (CRA) came to operate was a central building block in the sub-prime crisis. Regulatory changes which (finally) allowed national branch banking in the US led to a wave of bank mergers, as firms tried to gain the too-big-to-fail subsidy--the implicit government guarantee which meant you could take higher risks with less capital coverage (i.e. seek more profits for any given level of capital backing). A classic example of what economists call moral hazard.

Mergers had to be approved, however, and so an alliance was forged between megabanks and community activists, notably ACORN. If megabanks undertook partnership arrangements with activist groups such as ACORN to have CRA programs run through said advocacy groups, then they would testify that the banks were "good citizens" and help get approval for the bank merger in question. If banks refused to play the game (or tried to have their own bank-run CRA programs), the activist groups would testify against the bank merger in question.

So, a winning political coalition was born. The banks got regulatory approval, the activist organisations got funding for their client base (and themselves) and politicians got credit support for low income constituents. All ultimately guaranteed by the taxpayer, but no-one consulted them. The megabuck-activist-urban politician coalition played the externality game very well. Positive externalities to people who noticed--and voted, donated, or advocated--and negative externalities to people who didn't.

The Clinton and Bush II Administrations, as well as a majority in Congress, liked this game of taxpayer-sponsored cheap credit to worthy groups so much they kept upping the ante. Regulatory and other pressure was put on Fannie Mae and Freddie Mac, government sponsored enterprises (GSEs), to "broaden" their credit provision--i.e. take on riskier and riskier low income would-be home-owners. With activist groups such as ACORN advocating and testifying in favour. The result--as having one set of standards for CRA recipients and another for other mortgagees would raise all sorts of awkward questions--was to massively shift upwards the level of risks of mortgages across the board. Which also helped protect Fannie Mae and Freddie Mac from regulatory challenge, since lots of middle class voters happily hopped on the (much) cheaper housing credit bandwagon and would not have appreciated having the cost of their home loans suddenly go up because regulators got antsie. (Thus, studies which compare CRA and non-CRA credit recipients miss the macro-point.)

As GSE's, Fannie Mae and Freddie Mac also had (implicit) government guarantees. So, someone was paying for this upward risk spiral--the taxpayers providing the implicit or explicit guarantees. But they had not been told they were being dealt into this game.

This was all not good, but it was not enough to cause the eventual sub-prime meltdown. If prudential regulation had adjusted to force adequate capital coverage, then the final collapse would not have been anywhere near as bad. But that is precisely what the regulators did not do. They refused to pick a fight that would cause them nothing but grief--remember all those middle class voters hopping on the cheap housing credit bandwagon. Plus megabanks and activist groups all poised to testify that the nasty regulators were blocking the dream of homeownership to millions of low-income, minority Americans. And not merely poised--when various folk (Republicans representing rural electorates, concerned academics, Fed Chair Alan Greenspan) expressed concerns about the level of risk being taken on, groups such as ACORN testified and lobbied to make sure that the legislative changes from the reform push expanded the risk-taking.

It was, after all, all about helping poor Americans, particularly from minority groups, achieve the dream of home-ownership. Never mind the possible consequences, feel the noble intent.

Republican House Speaker Newt Gingrich was notably active in protecting the interests of the banking-and-housing coalition. Who were (particularly the GSEs) very good at recruiting key political staffers, putting projects in key Congressional districts, etc. As Calomiris & Haber point out, being cross-Party is part of being a successful policy coalition.

Then the house of cards collapsed and the taxpayers finally discovered what they had been dealt into. Though, because "Wall Street" and "easy monetary policy" copped the blame, the full understanding of how they had been fleeced does not seem to have sunk in. As Calomiris & Haber point out, the Dodd-Frank reforms don't really address the key issues, because the megabank-activist-urban politician coalition still has the numbers in Congress. Indeed, the Obama Administration is still playing the same game. The housing-finance-subsidised-by-the-taxpayer-house-of-cards is being rebuilt as the "winning" coalition is still in place.

As Calomiris & Haber explain in detail, the US banking system has been perennially prone to banking crises because various winning political coalitions have ensured regulatory structures which make it so. All operating on the basis of positive externalities to people who notice (and count) and negative externalities to those who don't. A long series of the arsonists being put in charge of the fire brigade.

Calomiris & Haber also point out that various countries have successfully avoided bank crises. But that is a matter for another post.

ADDENDA To clarify, and in response to a comment, the above is about the sub-prime crisis. The causes of the Great Recession are another matter.  (The sub-prime crisis no more caused the Great Recession than the Great Crash caused the Great Depression: both global economic downturns were the result of disastrous monetary policies by central banks.)


[Cross-posted at Skepticlawyer.]