A few weeks back (I am catching up on my blogging), the Economist featured a terrific essay on “A History of Finance in Five Crises.” The conclusion of the essay – “successive reforms have tended to insulate investors from risk” and “this pins risk on the public purse … [t]o solve this problem means putting risk back into the private sector” – resonates. However, the Economist makes a few surprising errors of omission in reaching this point.
First, many financial crises occurred without much of a state bailouts or safety net. The Economist starts its history with the Panic of 1792 in the United States. By that point England had already experienced a crisis in the late 1690s and the South Seas Bubble in 1720 and France had suffered through the searing Mississippi Bubble (I discuss all of these in Chapter 2 of my book). The Economist then hopscotches to the Panic of 1825. Roughly every ten years after that, Britain experienced another bubble and crash (also detailed in my book). It is less than clear how government safety nets triggered these crises.
These crises point to a second omission: each of these 19th Century British crises – the Panic of 1825, the Panic of 1837, the Crisis of 1847 (it is a mystery to me what causes some incidents to qualify as a “Panic” and others to be a “Crisis”), the Crisis of 1857, and the Overend Gurney Crisis of 1866 – was preceded by a liberalization of corporate law or an expansion of limited liability for corporate shareholders. Some scholars wax poetic about the “sine curve” of regulation without tracing that back in history. Well, British corporate law (see also Chapter 2 of my book) provides the caffeine for that coffee. This corporate law history has several important implications:
State intervention in financial markets takes other forms than deposit insurance and government bailouts. This intervention often occurs before crises. Indeed, I argue that booming markets and bubbles create strong incentives for interest groups to lobby for, and policymakers to provide, legal changes that further stimulate markets. What I call “regulatory stimulus” goes beyond “deregulation” and includes government subsidies or legal preferences (think bankruptcy exemptions for swaps) for particular markets. It also includes active government investments in markets (think all those state land and money giveaways to 19th Century railways).
Regulatory stimulus in the form of changes to corporate law has particularly powerful effects. The corporate form provides ideal for lobbying for regulatory favors: corporations solve collective action problems by centralizing decision-making and allow managers to lobby with “other people’s money.”
Moreover, as the Economist hints but doesn’t quite hammer home, limited liability can generate moral hazard, which becomes particularly vicious if risk-taking can be externalized onto financial markets and taxpayers.
The Economist’s third omission is the most amusing (at least to nerds like me). The magazine notes that after the Overend Gurney Crisis in 1866, “Britain then enjoyed 50 years of financial calm, a fact that some historians reckon was due to the prudence of a banking sector stripped of moral hazard.” Many economists reckon that these years of calm owe more to the Bank of England finally assuming the mantle of lender of last resort in a banking crisis. The intellectual godfather of this was none other than Walter Bagehot, the legendary editor of the Economist. Perhaps this failure to provide credit where it is due owes to some intellectual Oedipal issues at the journal?
The fourth omission in the essay is perhaps the most unforgivable. The Economist talks about the Great Crash of 1929 without mentioning the critique that the Federal Reserve failed to serve as lender-of-last-resort and pursued a destructive monetary policy at critical junctures. Indeed, these are state interventions that many economists advocate that central banks take in the face of a banking crisis. These state interventions also provide a government safety net that can create moral hazard.
Which leads to the most biting criticism of the Economist piece: letting the economy burn in the wake of a financial crisis is pure but risks being purely destructive. Rather than focusing on unravelling government safety nets for markets, we should be thinking about how to regulate financial firms given their inevitability.
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