The Dangers of Regulatory Capture

Adam12 makes a very important point in a comment on the previous post. In response to frequently made calls for increased or better regulation of banks and other private interests, he writes:

People recognize that increased regulation or state control of banking, however well-meaning, is not the answer. The track record of American regulators is not inspiring. See the SEC's mishandling of Bernie Madoff as an example. Wall Street has found ways to circumvent regulations for decades and isn't going to stop now.

What Adam12 is getting at is the concept of regulatory capture, a longstanding problem of government that has been studied for decades by political scientists and economists. Regulatory capture occurs when an agency charged with protecting the public interest by regulating the activities of private entities becomes a tool of the entities it is supposed to regulate. In turn, the private entities become embedded in the state and exercise unwarranted power over the policymaking process concerning the industry or activity in question. As the Wikipedia entry for regulatory capture explains:

The idea of regulatory capture has an obvious economic basis in that vested interests in an industry have the greatest financial stake in regulatory activity and are more likely to be motivated to influence the regulatory body than dispersed individual consumers, each of whom has little particular incentive to try to influence regulators. As well, we would expect that when regulators form expert bodies to examine policy, this will invariably feature current or former industry members, or at the very least, individuals with contacts in the industry.

An article in today's New York Times shows how this problem will likely affect the new financial reform bill:

The bill, completed early Friday and expected to come up for a final vote this week, is basically a 2,000-page missive to federal agencies, instructing regulators to address subjects ranging from derivatives trading to document retention. But it is notably short on specifics, giving regulators significant power to determine its impact — and giving partisans on both sides a second chance to influence the outcome...

...Regulators are charged with deciding how much money banks have to set aside against unexpected losses, so the Financial Services Roundtable, which represents large financial companies, and other banking groups have been making a case to the regulators that squeezing too hard would hurt the economy.

Consumer groups, meanwhile, are mobilizing to make sure that regulators deliver on promised protections for borrowers and investors. They worry that the shift from Capitol Hill to the offices of regulators could put the groups at a disadvantage.

“It’s out of the public eye, so a natural advantage that we benefit from — public outrage — we lose that a little,” said Cristina Martin Firvida, a lobbyist for AARP, which advocates for older Americans. “We know there’s still a lot here left to do.”

The ongoing fiasco of the BP oil spill in the Gulf of Mexico is another powerful example of the dangers of regulatory capture. Minerals Management Service (MMS), the agency supposedly in charge of regulating companies engaged in deepwater drilling, was completely captured by the industry. The New Orleans Times-Picayune reports that an MMS office in Louisiana accepted gifts from oil companies and let oil company employees write up inspection reports, all against a backdrop of general corruption and mismanagement within the agency.

Such considerations raise a very important question: is the effective regulation of massive private corporations by the state possible, or is regulatory capture an inevitability in a capitalist political economy?

Wall Street Rising: 1980 -

In this chapter, Johnson and Kwak briefly sketch the story of how from 1980 until today, Wall Street burst free of the regulatory restraints of the postwar period and became the economic and political behemoth it is today.

The authors begin their discussion by comparing the wealth of Salomon Brothers, the paradigmatic 1980s investment bank, and today's JPMorgan Chase, headed by "President Obama's favorite banker," CEO Jamie Dimon:

At the time [July 2009], JPMorgan Chase had over $2 trillion in assets...$155 billion in balance sheet equity; and it earned $4.1 billion in operating profits in the second quarter alone. By comparison, the 1985 Salomon Brothers, even after converting to 2009 dollars to account for inflation, only had $122 billion in assets, $5 billion in equity, and $2 billion in operating profits for an entire year...Although Dimon voluntarily took no cash bonus for 2008, his total compensation including stock awards was still $19.7 million, more than three times Gutfreund's (the former head of Salomon) inflation-adjusted earnings of $5.8 million. And this was in a bad year for CEOs; in 2007, Dimon earned $34 million, Blankfein $54 million, John Thain of Merrill Lynch $84 million, and John Mack of Morgan Stanley $41 million. (p. 57-58)

Meanwhile, politicians friendly to the financial sector work hard behind the scenes in Congress to stand in the way of financial reform, and bankers balk at proposals to rein in compensation schemes that encouraged the kind of big-time risk taking that led to the 2008 financial crisis.

How did we ever get to this point? Johnson and Kwak frame their discussion around the transition from "boring banking" to "exciting banking," which has produced banking on a much bigger scale than was the norm decades ago. This shift began in the 1970s, when a general push toward deregulation in finance and the economy generally began during the Carter administration. Deregulatory legislation began to erode the firewall between commercial and investment banking created by the Glass-Steagall Act. Just as importantly (perhaps even more so), the emergence of academic finance and the Efficient Market Hypothesis, which held that financial products are always correctly priced by the market, provided intellectual justification for the shift toward deregulation, even though many other economists pointed out that this assumption stood on very shaky ground.

The push for deregulation kicked into high gear with the election of Ronald Reagan in 1980, whose administration vigorously sought to loosen restrictions on the financial sector and consolidate the ideological dominance of free market economic theories like the Efficient Market Hypothesis. Even so, the Reagan administration's deregulation drive was not entirely successful, at least partially because both houses of Congress had Democratic majorities during his entire tenure. Wall Street's economic and ideological power certainly grew during the decade of the yuppie, but at the time there were still countervailing political forces challenging its desired dominance. They would be swept aside before long.

As Johnson and Kwak argue, Wall Street's rise to political predominance through economic power was facilitated by the creation of what they call "new money machines": high yield debt , securitization, arbitrage trading, and derivatives. These new products fueled the growth of big banks capable of investing in the computing technologies and highly educated mathematicians and scientists that make this kind of banking possible. These developments, in addition to further deregulatory legislation enacted under the Clinton administration that broke down barriers between investment and commercial banking and encouraged a wave of bank mergers, facilitated the formation of a handful of megabanks that comprise today's Wall Street.

Questions for discussion:
1) The authors pay a lot of attention to the importance of ideology in facilitating the shift from the highly regulated postwar financial system to today's deregulated environment. Considering how deeply shaken and seemingly delegitimated the system was in 2008, why do you think that a similiarly powerful ideological countermovement advocating increasing regulation (or even more radical measures like bank nationalization) has failed to come to prominence?

2) The authors briefly touch on the question of homeownership in this chapter while discussing the effects of high inflation in the 1970s: "homeowners...profited while their debts were inflated away - helping to convince a generation of Americans that houses were the best investment they could possibly make." (p. 66) This is true, but I would argue that the appeal of homeownership is a deeper and fundamentally ideological concept - for decades, homeownership has been touted by almost everyone as the key to the American Dream, an indication of one's worthiness to be considered a full, contributing member of society. Indeed, the obsession with promoting home ownership was one of the causes of the current recession. Do you think that what I consider to be the cult of homeownership has delegitimized at all by the recent crisis? New York City has always been a city of renters and continues to have very low homeownership rates in comparison to the country as a whole (30.2% versus 67.1%), so our local perspective may be a bit skewed, but it doesn't seem to me that most people are rethinking the alleged superiority of owning your own home. What do you see and hear?

Other People's Oligarchs

After offering a brief history of the American financial sector in chapter one, Johnson and Kwak take on the history of financial crises in "emerging markets" from the 1970s through the 1990s. Why the abrupt change in focus? As they write at the end of chapter one,

the 1990s were a decade of financial and economic crises, but they were taking place far away, on the periphery of the developed world, in what were fashionably known as the emerging markets. From Latin America to Southeast Asia to Russia, fast-growing economies were periodically imploding in financial crises that imposed widespread misery on their populations. For the economic gurus in Washington, this was an opportunity to teach the rest of the world why they should become more like the United States. We did not realize that they were already more like us than we cared to admit.

(p.38)

It may be hard to remember now, but the 1990s were a time of euphoric optimism not just among economic elites, but the mass of the population as well. The collapse of the Soviet Union and the end of the Cold War seemed to prove the ultimate triumph of free market capitalism and liberal democracy over all other competing systems, as Francis Fukuyama argued in his enormously influential 1992 book The End of History. The expansion of the high-tech sector and the emergence of the Internet seemed to portend a future of endless economic growth and productivity gains, which allowed for some growth in working people's wages. All this produced a dominant ideology that Thomas Frank called "market populism" in his book One Market Under God - the belief that the free market was the true expression of the people's will, not government, and that entrepreneurs were revolutionary figures with almost divine powers. Through the workings of the International Monetary Fund (IMF) and the Treasury Department, the U.S. sought to remake nations after our own image in the wake of financial crises because we had supposedly avoided all of the problems that give rise to them, notably the "tight connections between economic and political elites" (p. 55) that plagued countries like South Korea (chaebol), Indonesia (Suharto's crony network), and Russia (the oligarchs).

But as Johnson and Kwak argue, by 2008 the U.S. economy looked increasingly like those of the emerging markets in the 1990s, and the government's policy response to the crisis - bailing out major banks with strong political connections like Goldman Sachs, while letting smaller and less well connected banks fail - was almost completely at odds with the kind of advice it gave to other nations in the 1990s. "It began to seem as if our government was bailing out its own, uniquely American oligarchy." (p. 56) How we got to this point is the question taken up by the authors in chapter three.

Question for discussion:
For years, the United States dispensed advice (whether it was wanted or not) to other countries about how their economic and financial systems should be structured. Is there anything that the United States could learn from other nations that have not been so adversely affected by the recent crisis and recession? As commenter Larry M. said in response to the previous post, "we might look to the Canadian model of tightly governed, state-supported banks as a basis of comparison to our system," though he personally does not advocate that our country adopt such a model. What other options might we be able to turn to?

Thomas Jefferson and the Financial Aristocracy

In the first chapter of 13 Bankers, Johnson and Kwak briefly trace the history of the relationship between financial and political power in the United States from the beginning of the Republic through the 1990s. The authors frame their discussion around the post-Revolution conflict between political tendencies represented by Thomas Jefferson and Alexander Hamiltion, the country's first secretary of the Treasury. Jefferson and his followers in the Democratic-Republican party (the forerunner of today's Democratic party) wanted the new nation to remain a primarily agrarian society based on a broad middle class of small farmers living under a limited government. Opposing them were Hamilton and the Federalist party (one of the forerunners of today's Republican party), who wanted a strong central government to create the financial and legal frameworks necessary for the creation of a modern, urban, industrial capitalist economy.

As Johnson and Kwak argue, Hamilton was likely right on the basic economic issues. It's hard to imagine a modern society built mainly on small-scale farming. But Jefferson was prescient in recognizing that the economic power gained by the new concentrated financial and industrial interests could potentially give them undue influence over government and warp politics and policymaking, threatening the premises of American democracy. This ideological conflict reached fever pitch in the 1830s, when Democratic president Andrew Jackson, an inheritor of Jefferson's mistrust of concentrated financial power, sought to revoke the charter of the Second Bank of the United States, based in Philadelphia and managed by the prominent banker Nicholas Biddle (the First Bank's charter quietly expired in 1811). After a protracted struggle, Jackson ultimately prevailed and the United States remained without a central bank or much of a coherent financial system until late in the 19th century, when the rise of large financial and industrial corporations raised new questions about the relationship between economic and political power.

The financial crises of the late 19th and early 20th century, notably the Panic of 1907 - which ended when the banker J.P. Morgan organized financial capitalists to lobby Washington for a multimillion dollar bailout (sound familiar?) - ultimately led to the establishment of the Federal Reserve in 1913. The Fed was supposed to regulate finance so that crises would be less rare, but financial interests made sure that the agency would remain basically under the control of private banks. This lax regulatory structure encouraged the wild speculation that helped to cause the Great Depression. In response, Franklin Roosevelt's New Deal banking regulations, notably the Glass-Steagall Act that separated investment from commercial banking, created a legal regime that heavily regulated banks and prevented major banking crises until the 1970s. The pendulum began to shift back toward less government regulation in the 1970s, but that's a story that Johnson and Kwak will address in later chapters.

Questions for discussion:

1) Do major concentrations of financial power, such as Wall Street banks, threaten the basic premises of American democracy as Jefferson and his followers argued? If so, then how is private control over big investment decisions that affect all of our lives justifiable?

2) Why do you think we have not seen the same kinds of financial reforms in the wake of the current crisis that we saw during the Great Depression? Financial interests were very powerful then as well, but Roosevelt took them head on. In contrast, it's difficult to imagine President Obama saying something like this:

"They had begun to consider the Government of the United States as a mere appendage to their own affairs. We know now that Government by organized money is just as dangerous as Government by organized mob. Never before in all our history have these forces been so united against one candidate as they stand today. They are unanimous in their hate for me—and I welcome their hatred." (FDR 1936 campaign speech)

3) Do you think that the bailouts given to many banks in the wake of the 2008 financial crisis were justified in any way? Should government be expected to step in to prevent the collapse of the financial system, or should the banks have just been allowed to fail?

13 Bankers: The Wall Street Takeover and the Next Financial Crisis by Simon Johnson & James Kwak

In June and July, Brooklyn Book Talk will be devoted to a discussion of 13 Bankers: The Wall Street Takeover and the Next Financial Crisis, an important new book by financial journalists Simon Johnson and James Kwak. In 13 Bankers, Simon and Kwak tell the story of how Wall Street grew into the political and economic powerhouse it is today, and how it has come to exercise vast influence in the White House and the halls of Congress. While you wait for your hold to arrive, I recommend taking a look at the book's introduction, which is freely available on the 13 Bankers promotional website. In the introduction, Johnson and Kwak begin to explain why they think the near collapse of the global econony brought on by the 2008 financial crisis hasn't yet resulted in the kinds of far-reaching reforms that many economists and politicians thought were necessary to avert future crises. Their argument is fairly disturbing:

Why did this happen? Why did even the near-collapse of the financial system, and its desperate rescue by two reluctant administrations, fail to give the government any real leverage over the major banks?

By March 2009, the Wall Street banks were not just any interest group. Over the past thirty years, they had become one of the wealthiest industries in the history of the American economy, and one of the most powerful political forces in Washington. Financial sector money poured into the campaign war chests of congressional representatives. Investment bankers and their allies assumed top positions in the White House and the Treasury Department. Most important, as banking became more complicated, more prestigious, and more lucrative, the ideology of Wall Street— that unfettered innovation and unregulated financial markets were good for America and the world—became the consensus position in Washington on both sides of the political aisle. Campaign contributions and the revolving door between the private sector and government service gave Wall Street banks influence in Washington, but their ultimate victory lay in shifting the conventional wisdom in their favor, to the point where their lobbyists’ talking points seemed self-evident to congressmen and administration officials. Of course, when cracks appeared in the consensus, such as in the aftermath of the financial crisis, the banks could still roll out their conventional weaponry— campaign money and lobbyists; but because of their ideological power, many of their battles were won in advance.

The political influence of Wall Street helped create the laissez-faire environment in which the big banks became bigger and riskier, until by 2008 the threat of their failure could hold the rest of the economy hostage. That political influence also meant that when the government did rescue the financial system, it did so on terms that were favorable to the banks. What “we’re all in this together” really meant was that the major banks were already entrenched at the heart of the political system, and the government had decided it needed the banks at least as much as the banks needed the government. So long as the political establishment remained captive to the idea that America needs big, sophisticated, risk-seeking, highly profitable banks, they had the upper hand in any negotiation. Politicians may come and go, but Goldman Sachs remains.

The Wall Street banks are the new American oligarchy— a group that gains political power because of its economic power, and then uses that political power for its own benefit. Runaway profits and bonuses in the financial sector were transmuted into political power through campaign contributions and the attraction of the revolving door. But those profits and bonuses also bolstered the credibility and influence of Wall Street; in an era of free market capitalism triumphant, an industry that was making so much money had to be good, and people who were making so much money had to know what they were talking about. Money and ideology were mutually reinforcing.

Over the next two months, we will cover a new chapter each week so that we might fully explore the many important issues the book raises. I hope many of you will stick around for the ride!