The financial crisis and the future of regulation

Blame game

Two influential economists take a potshot at financial policymakers. Why don’t their criticisms add up?

Freefall: America, Free Markets and the Sinking of the World Economy. By Joseph Stiglitz. Norton; 361 pages; $27.95. Allen Lane; £25. Buy from Amazon.com, Amazon.co.uk

13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. By Simon Johnson and James Kwak. Pantheon, 280 pages; $26.95. Buy from Amazon.com

JOSEPH STIGLITZ and Simon Johnson have much in common. Both have held high-profile jobs within the economic policymaking establishment (Mr Stiglitz, an American Nobel prize winner, headed the Council of Economic Advisers under Bill Clinton and was chief economist at the World Bank. Mr Johnson, who is both British and American, is a former chief economist at the IMF). Both have become outspoken critics of the establishment. During the financial crisis they lambasted the American government’s handling of the bank bail-outs. They argued for nationalising Wall Street’s big banks and condemned the Obama team’s capital injections as a giveaway to powerful financiers that only exacerbated the problem of the too-big-to-fail banks. Both men have now written books laying out their indictments, and offering solutions.

In “Freefall”, which came out in January, Mr Stiglitz traces the origins of the crisis to a deregulatory fervour fuelled by the “ideology” of free-market fundamentalism and Wall Street’s political clout. This is an ambitious book, offering an analysis of the failures of academic economics and a call for a more inclusive, less materialistic society. The Great Recession, Mr Stiglitz argues, uncovered fundamental flaws in America’s late 20th-century form of capitalism. Righting them will require wholesale reform both of financial regulation and of the entire global monetary system.

As befits a man who won the Nobel prize for his work on asymmetric information, Mr Stiglitz dwells on the market imperfections and misaligned incentives that distorted decisions made by everyone from mortgage originators to credit-rating agencies. His depiction of finance’s failures is not novel, but it is well done.

Far less convincing are Mr Stiglitz’s sweeping, often vitriolic, criticisms of the “flawed” policy response. These include an attack on the fiscal stimulus where, he says, the Obama team failed to draw on “theory, empirical evidence and common sense” and on the bank rescue plan, which he describes as “among the most costly mistakes of any government at any time”. This blanket condemnation is not supported by the facts and undermines the book’s broader thesis. “Freefall” is, in essence, a call for stronger government to combat all the market failures that Mr Stiglitz sees in modern financial capitalism.

Mr Stiglitz argues that finance needs some structural change—the too-big-to-fail banks need to be broken up—and more and better regulation. After he has condemned today’s policymakers so roundly as incompetent and beholden to special interests, that prescription, and the author’s broader faith in government activism, sounds perverse. If policymakers failed as miserably as Mr Stiglitz believes, then he ought to be far more worried about the potential for government failure in the future. That dissonance is a glaring weakness in Mr Stiglitz’s book.

“13 Bankers”, which Mr Johnson co-wrote with James Kwak, a former McKinsey consultant, makes a narrower point, but has greater historical sweep and is the better read. The authors’ argument, first laid out in the Atlantic a year ago, is that America’s big banks act as an oligarchy, a group that has gained political power because of its economic power and then uses that political power for its own benefit.

Unlike oligarchs in emerging economies, Wall Street’s financiers do not use overt bribery or blackmail. Their tools are the soft power of campaign-finance contributions, the revolving door of jobs in government and on Wall Street, and the creation of a culture that equated Wall Street’s gain with America’s gain. But they are no less nefarious. Their power, the authors argue, explains why the Obama team chose the “blank cheque” option for dealing with the financial crisis.

To ensure the safety of the financial system and America’s democracy these behemoths must be broken up. The authors would like to limit the assets of any financial institution to 4% of GDP and those of each investment bank to 2%. That would mean dismantling six monster banks.

Suspicion of a financial oligarchy is a recurrent theme in America. From the fights between Thomas Jefferson and Alexander Hamilton over the “Bank of the United States” to Franklin Roosevelt’s Depression-era refashioning of finance, America has oscillated between admiration for and fear of bankers; between welcoming financial consolidation and preferring fragmentation. Messrs Johnson and Kwak deftly summarise this history before moving on to their description of how modern Wall Street—the most powerful and concentrated financial sector in the country’s history—both created the financial crisis and ensured a bail-out for its own benefit.

Like most conspiracy stories, “13 Bankers” contains a kernel of truth. Wall Street’s intellectual and political clout is considerable, and financial firms make far bigger campaign donations than any other industry in America, resulting in an unusual cosiness between financiers and Washington’s policy elite. That doubtless influenced the financial deregulation that preceded the crisis, helped shape the response and is plainly influencing post-crisis efforts at regulatory reform.

But, like many conspiracy theories, “13 Bankers” goes too far. It ignores evidence and arguments that do not suit its thesis. The Obama administration’s decision not to nationalise the banks is presented as prima facie evidence of the oligarchs’ power. The notion that there could also be some downsides to a wholesale government takeover of America’s big banks is given short shrift.

The authors argue that the banks’ oligarchic power stems from the size and concentration of American finance. No mention is made of the fact that America’s banking system is both less concentrated and smaller in relation to the economy than those of many other industrialised countries. Or that some of the most effective bank lobbying, for instance against a new consumer watchdog for financial products, has been by small community banks rather than Wall Street behemoths.

A broader perspective would have led to more nuanced conclusions. The origins of America’s financial “oligarchy”, for instance, might have more to do with campaign-finance rules and political appointees than banks’ size. The faith that Messrs Johnson and Kwak put in merely capping the size of banks is misplaced. The trouble is that such nuanced arguments would spoil the tale of villainy in “13 Bankers”. Their absence results in a book that is too crude to be convincing.