Calomiris and Haber are pretty much spot on

I recently finished reading Fragile by Design, the latest book of Charles Calomiris and Stephen Haber.

Let’s get to the point: it’s one of the best books of banking I’ve had the occasion to read. It is a masterpiece of banking and political history and theory.

Calomiris and Haber describe the stability and efficiency of banking systems in terms of local political arrangements and institutions, which contrasts with most of nowadays’ theories that don’t distinguish between banking systems in various countries and way too often seem to draw conclusions on banking from the US experience only.

They describe banks’ stability in terms of a ‘Game of Banks Bargains’: the tendency for populists and bankers to form coalitions that aren’t favourable for society as a whole but favourable for politicians’ short-term political gains and bankers’ short-term profits. Needless to say, this alliance is built at the expense of long-term stability and efficiency. Only countries that have built political institutions to counteract the effects of populist policy proposals have experienced a stable financial environment since the early 19^th century.

This thesis is extremely convincing and, while I find it unsurprising, it is so well documented that it is sometimes almost shocking. It clearly goes against mainstream Keynesian and Post-Keynesian theories, which consider financial collapses as a result of the normal process of human ignorance and panics. According to those theories, banks will fail at some point, hence the need for regulation and intervention early on. From most Keynesian books and articles I’ve read so far, collapses just happen. I’ve always been bewildered by the lack of underlying explanation: “that’s just the way it is”. Hyman Minsky’s Stabilizing an Unstable Economy is the perfect example: it draws general conclusions about the banking sector and the economy from a period of a couple of decades in the US… Knowledge of financial history quickly proves those arguments wrong.

The book isn’t without flaws however. It describes and compares the history of banking systems in England, the US, Canada, Mexico and Brazil. I found that either Brazil or Mexico could have been skipped (as covering both didn’t bring that much more to the thesis) in order to study more in depth another European (French, German, Italian) and/or Asian (Japanese, Indian…) banking system.

Also, while the (long) description of the political ramifications that led to the US subprime crisis is stunning, I believe the authors’ thesis is incomplete. There is no doubt that the populists/housing agencies/bankers alliance (or forced alliance) amplified the crisis by generating way too many low-quality housing loans through declining underwriting standards. However, this cannot be the only reason behind the crash. As I have described in many posts, properties have boomed and crashed all around the world in a coordinated fashion during the same period due to regulations incentivising house lending (and securitized products based on housing loans), as well as low interest rates. It is hard to argue that the Irish or the Spanish housing markets were the victims of US populists and US subprime lending…

Finally, what Calomiris and Haber describe is that free-market banking systems are less prone to systemic failures. From their work, it is clear that: 1. the fewer rules the banking system is subject to and 2. the less government intervention in the finance industry, the more stable the financial system. They demonstrate that the more lightly regulated Canadian system and the Scottish free-banking system were seen as almost ideal. Nevertheless, they seem to refrain from explicitly argue in favour of free-banking systems for some reason. I found this a little odd.

I certainly disagree with their view that banks can only exist when the state exists and charter them because of their interrelationship (i.e. states can raise financing through banks and banks get competitive advantages in return). Their arguments are really unconvincing: 1. it isn’t because such occurrences are rare in recent history that they cannot happen and 2. we have consistently witnessed throughout history, and in particular over the past decades, the spontaneous emergence of unchartered financial institutions (from money market funds to P2P lending firms) that respond to a private need for financial services. I do not think those are ‘utopian fantasies’ as this is happening right in front of us right now… States started to select, allow, charter and regulate those institutions when they needed finance. This does not imply that a limited and pacifistic state necessarily needs to use the same constraining tools.

In the end, those flaws remain minor and the book is easily one of my favourites. It deserves much more attention than what the media have given them so far (indeed, they go against the traditional ‘banking is inherently unstable’ tenet…). Unfortunately, the media are more interested in bank-bashing stories, putting in the spotlight much weaker books such as The Bankers’ New Clothes (by Admati and Hellwig)…

PS: FT’s John Kay also talks about the book here.