The political banking cycle

A couple of weeks ago, The Economist reported that Mel Watt, the new regulator of the US federal housing agencies Fannie Mae and Freddie Mac, wanted those two agencies to stop shrinking and continue purchasing mortgage loans from banks in order to help homeowners and the housing market (also see the WSJ here). To twist the system further, the compensation of the agencies’ executives will be linked to those political goals. Mr Watt used to be one of the main proponents of more accessible house lending for poor households through Fannie and Freddie before the crisis.

As The Economist asks, “what could go wrong?”…

Lars Christensen and Scott Sumner also find this ridiculously misguided government intervention horrifying. I find myself in complete agreement (and this is an understatement). Who could still honestly say that we are (or were) in a laissez-faire environment?

This, along with UK’s FLS and Help to Buy schemes, made me think that there has been a ‘political banking cycle’ throughout the 20^th century. Why 20^th century? From all the banking history I’ve read so far, populations seemed to better understand banking before the introduction of safety net measures such as central banks, deposit insurances or systematic government bail-outs. When financial crashes occurred, blame was usually shared between governments and banks, if not governments only. This is why many crises triggered deregulation processes rather than reregulation ones. This contrasts with the mainstream view our society has had since the Great Depression: when a financial crash happens, whatever the government’s responsibility is, banks and free market capitalism are the ones to blame.

This political cycle looks like that:

The worst is: it works. Politicians escaped pretty much unscathed from the financial crisis despite the huge role they played in triggering it*. The majority of the population now sincerely believes that the crisis was caused by greedy bankers (see here, here, here and here). This is as far from the truth as it can be (I don’t deny ‘greed’ played a role though, but channelled through and exacerbated by a combination of other factors, i.e. moral hazard etc.). Unfortunately, it is undeniable: politicians won. And not only politicians won, but they also managed to self-convince that they played no role in the crisis, as the example of Mr Watt shows (he either truly believes that government intervention in the US housing market was a good thing, or he has an incredibly cynical short-term political view).

The crucial question is: why did 19^th century populations seem more educated about banking? The answer is that the lack of state paternalism through various protection schemes forced bank depositors and investors to oversee and monitor their banks. Once protection is implemented, there is no incentive or reason anymore to maintain any of those skills.

Who is easier to manipulate: a knowledgeable electorate or an ignorant one?

PS: This chart is mostly accurate for democracies that have a populist tendency. Not all countries seem to be prone to such cycle (this can be due to cultural or institutional arrangements).

* I won’t get into the details here, but if you’re interested, just read Engineering the Financial Crisis, Fragile by Design or Alchemists of Loss……. or simply this NYT article from 1999.