The Long Wave Revisited

Doug Henwood dhenwood at panix.com
Thu Sep 10 08:22:15 PDT 1998


Carl Remick wrote:


>Thought this was an interesting quote from today's Wall Street Journal
>article, "Many Economists Think Japan Is in a 'Liquidity Trap,' And
>Breaking Out Will Require More Than Cutting Rates": "One reason the
>world has gone so long without a liquidity trap, says [Berkeley economic
>historian Barry] Eichengreen, is the tight financial regulation that
>followed the Great Depression, controls that have since been eased
>around the world. 'The possibility of a large-scale banking crisis was
>suppressed for decades after World War II,' he says. 'We've reaped many
>of the benefits of liberalization, but those benefits come with a dark
>side, and we're now seeing that in Japan.'"

This sort of thing reminds me of Albert Wojnilower's article "Financial zoos" in the New Palgrave Dictionary of Money and Finance. It was written in 1991, so it reflects the junk bond and S&L disasters and anxiety about the implosion of the U.S. financial system. Now that the U.S. financial system "looks" "sound," those references may seem a bit antique, but now it's looking like the U.S. debacle is being reproduced on a world scale, you can just change a few words and.....

Doug

----

FINANCIAL ZOOS. A country such as the United States, created by revolution and peopled by immigration, was bound to have a healthy mistrust of centralized power in general and financial power in particular. In a frontier society with uncertain transport and communication, banking, too, had its chaotic aspects. All the same, there was determined and strong opposition, of which significant echoes persist to this day, to any regulatory constraints that might inhibit local independence and confer control on distant or local monopolists. Whether 'free' banking in those early years was good for the country (or would be today, as a few still argue) remains controversial. But the recurrent though unsuccessful attempts to organize some sort of central bank, the many failed deposit-insurance schemes, as well as the ultimate establishment of distinct thrift institutions for small savers, testify to a good deal of discomfort.

It was in effect the populist view that every locality of consequence needed its own bank for its financial independence - and that a place large enough to deserve a bank should have more than one, because local bankers were regarded with almost as much suspicion as distant ones. As the country became more settled, regulation did indeed develop, but for the protectionist purpose of enabling this overpopulation of local ventures to survive. Even as the spread of the telephone and automobile rendered the monopoly fears largely absurd, the political response at the local as well as national level was to erect ever higher protective barriers. Local and national law limited loan interest rates, set geographical and line - of-business boundaries, restricted branching and entry, and established prudential standards and examination procedures that, whatever their main purpose, also restrained competition in lending. But despite these strenuous efforts, hundreds of banks were still failing annually as late as the 1920s.

Reflecting the dominance of localism, it was not until 1914 that the Federal Reserve System was established, and then only with a regional division of power calculated to impede centralized decision-making. It took at least a decade (from some points of view, much longer) for the central bank to function in a coordinated national manner and to achieve firm control over the payments machinery. Supervision over financial institutions to this day remains divided among the 50 states and at least five separate federal agencies. Current internal debates in the Federal Reserve, as well as in unified Germany and in the EEC, not to speak of the erstwhile Soviet Union, remind us that the establishment of a genuinely superregional central bank is a truly revolutionary act.

The catastrophe of the 1930s further inflamed hostility against big banks and produced more anticompetitive legislation to protect smaller ones. But now the barriers were raised beyond any point of doubt. Banking and the securities industry were divorced. Demand-deposit interest was prohibited and rate ceilings emplaced on time and savings accounts. Banks could no longer attract funds by offering higher interest rates. Still more drastic, federal deposit insurance was put in place for virtually all small balances. For most depositors, all banks became identical and completely secure, regardless of their balance sheets. Incentives to shift deposits, whether for advantage or out of fear, were all but eliminated.

Whatever its shortcomings in principle, this buttoneddown system functioned exceptionally well for some 35 years during which it was free of serious internal or foreign competition. Peacetime inflation and interest rates, real and nominal, were low, and national saving was high by today's standards. The system is aptly described as a well-kept and orderly zoo. Different species, such as banks, securities dealers, insurance companies, and so on, were neatly housed and fed in separate cages segregated by function and geographical scope. The bars between cages prevented the various species from preying on one another. Within each cage, to be sure, there was, as in a real zoo, competition as respects the pecking order, the best food, and so forth, but the vigilant (and correspondingly specialized) keepers made sure this never led to serious injury or death. Relations between the animals and the visitors, between the financial institutions and their clientele, were sober and sedate. By about 1950, the financial safety net had become as ubiquitous, invisible and taken for granted as the air we breathed. The contingency that financial fragility might become a constraint on monetary policy was almost unthinkable.

The deregulation of the 1970s and 1980s destroyed this idyllic arrangement. The destruction was done piecemeal, with little appreciation for the rationale of the existing arrangements, and with no particular plan or vision for the outcome. The chief instrument of the deregulation was the circumvention and eventual abolition of the restraints on deposit and lending rates, tantamount to smashing the barriers separating the animals in the zoo. The boundary between zoo and public was, however, kept intact and even reinforced. Deposit insurance and other safeguards in the event of misbehaviour or failure of financial institutions were expanded in response to the emergence of problems not experienced since the Depression.

THE REASONS FOR AND RESULTS OF DEREGULATION.

The reintroduction of fierce competition proved unfortunate for many zoo inmates as well as their customers. US financial intermediaries are now moribund with respect to their ability to support private sector risk-taking. Broadly speaking, the creditworthiness of the financial intermediaries is regarded as inferior to that of the borrowers. The whole structure suffers from an ominous undertone with respect to the credibility of the safety net. There may be fewer regulations, but governmental involvement and intervention in the specific decisions of financial institutions have become routine to an extent that would have been regarded as intolerable during the heyday of formal regulation. This is not to suggest that the old zoo could have been preserved but simply to point out that if the US financial (or the old Soviet) system is to be renovated, the mere abolition of constraints will not automatically give birth to desirable new structures.

Several forces combined to make major change unavoidable. Electronic advances in communication and calculation have made geographical restrictions increasingly irrelevant. More important, they have blurred or even erased the distinctions among deposits, loans and securities. Deposits can now be traded at fluctuating prices, like securities. Securities can be transferred and rendered cashable as efficiently as deposits. Many common types of loans can be packaged together as securities. It is worth mentioning that such 'securitization' (like computers and modern aircraft) was invented in the government and, even today, is used largely for government-backed loans that enjoy safety-net status similar to that of direct government obligations.

The old boundaries that demarcated the zoo cages no longer make technological sense. Indeed, it is a matter for debate whether any boundaries, including those between financial and industrial firms, are warranted any longer.

Also compelling the redrawing of the zoo was, of course, the renewal of international competition as financial strength revived outside the United States. Rules of competitive restraint that countries have laid down for their institutions to observe at home generally are not required to be observed abroad. Part of our zoo was disrupted from abroad and some of our members learned how to disorganize other people's habitats. Inevitably, in the same way that we are becoming a single industrial world, so the various financial systems are converging. The United States, having started with the most untypical system, has perhaps the longest and most difficult road to travel.

A critical ideological force conditioning deregulation was the general backlash against conventionality and constraint: the desire for more freedom and less responsibility. Such attitudes helped extravagant claims for the benefits of deregulation to achieve ready credibility. Ordinary human hubris also deserves mention. The most prosperous inhabitants of the gilded cages naturally tended to attribute their wellbeing entirely to their own efforts and to believe they could do even better if set free to forage on others' turf. Mostly they proved mistaken. They failed to take into account that liberalization would not be for themselves alone. The contests for new turf proved far fiercer than they imagined, while the safe home base from which they visualized themselves confidently sallying forth itself came under heavy assault.

There were far too many animals in each cage, and in the zoo as a whole, to survive in open competition. Most of the animals had enjoyed a sheltered existence like that of farm animals or even household pets. Now they were freed, each to become both predator and prey in an unfamiliar jungle that offered sharply reduced nourishment - that is, profit margins. Discovering new dietary sources - loans not made before, newly-invented securities and bets on security prices, new inducements to turnover - became a matter of survival. Initially the public was pleased. As borrower and speculator it welcomed the new and cheaper opportunities. As depositor and investor, the public saw little reason to be concerned because of its ingrained confidence in the strength and reach of the safety net. Caught in the middle were and are the supervisory and monetary authorities as well as the politicians.

Had they been left totally unprotected, the carnage among the financial intermediaries would have been unfathomable. Even so, thousands of deaths have occurred already, thousands of other firms are being kept alive artificially, and thousands more are consuming their capital. With so many sick animals roaming the old zoo grounds, the prospects of even the healthiest are put in jeopardy.

Every failure involves an immediate cost to the insurance funds and the risk of an infectious loss of confidence. But institutions that are allowed to linger on in 'neither-dead-nor-alive' condition are liable to have even greater liquidation costs later, while meanwhile they reduce the survival odds for the rest. No wonder that public policy has become ambivalent.

Everyone was aware, for example, of the temptation for failing institutions to take limitless risks to save themselves. The moral hazard created by deposit insurance was of little consequence while the old anticompetitive regulations were in force, particularly the interest-rate ceilings which prevented bankers from getting their hands on additional funds to put at risk. When, however, it became evident a decade or so ago that the savings- and-loan industry was doomed - the demise had in fact been foreseen and welcomed by the planners of both political parties - the policy reaction was to urge these domestic cats to pretend to be jungle tigers. To forestall depletion of the federal insurance fund, they were encouraged to enter unfamiliar lending fields, the accounting rules were gutted to hide the consequences, and the teeth pulled from the inspection and supervisory process. The 'too-big-to-fail' problem is similar. To postpone the immediate expense of cauterizing the wounds from a major failure, the urgent consolidation of the banking as well as the insurance industries has been postponed.

The current (1991) legislative proposals suffer from the same ambivalence. They propose to widen the scope and hence the risks of banking but include no resources to deal with the so-called 'exit' problem of closing unprofitable institutions while they still have capital. The public is willing, it appears, to pay the huge burial costs that will come later, but deems unacceptable much smaller (though still large) outlays to speed the exit of the not-yet-dead. (The real macroeconomic costs of the bail-outs, economists know, are a small fraction of the gross dollar outlays, but the public is not persuaded.) The upshot thus far is a political stalemate that seems to be degenerating into an intragovernmental turf war over who is to supervise which part of the disaster.

ALBERT M. WOJNILOWER



More information about the lbo-talk mailing list