The WSJ reports on a fascinating new paper by Columbia University finance professor Charles Calomiris (“The Political Foundations of Scarce and Unstable Credit“), which is based on a forthcoming book he’s co-authored with Stephen Haber. Here are some excerpts from the WSJ article “Why Canada Can Avoid Banking Crises and U.S. Can’t“:
Since 1790, the United States has suffered 16 banking crises. Canada has experienced zero — not even during the Great Depression. It turns out Canada can thank the French for their stable system.
That anti-populist political system — known in political science as liberal constitutionalism or liberal democracy — is a key ingredient in Canada’s stable banking track record. That’s because this kind of political system makes it difficult for political majorities to gain control of the banking system for their own purposes.
Populist democracies like the U.S., on the other hand, tend to create dysfunctional banking systems because a majority of citizens gain control over banking regulation that steers credit to themselves and to their friends at the expense of the citizens that are excluded from the banking system, he said. The contrast between the U.S. and Canada was part of Mr. Calomiris broader argument that dysfunctional banking systems — which are by far the norm rather than the exception around the world — are the result of political factors.
“Whether societies have dysfunctional banking systems is really not a technical issue at all. It’s a political issue,” Mr. Calomiris said, introducing his premise as “we do know how to avoid dysfunctional banking but that we make political choices – you might even say consciously” not to have functional banking systems for most of the modern era in most countries of the world.
The history of the U.S. banking system is one in which the government forms partnerships with different interest groups at different points in history, and those coalitions jointly influenced the way the banking system was regulated.
For example, a coalition emerged in the US during the 1990s of government, big banks, and activist consumer groups that helped fuel the housing crisis. Regulatory changes opened the door to a wave of mergers and acquisitions that created today’s megabanks. But banks still had to get approval – usually from the Federal Reserve – to complete those mergers and outside groups were able to weigh in on the wisdom of the deal as part of the Fed’s decision-making process.
Community groups, with the Clinton administration’s encouragement, used the Fed’s approval process to extract binding concessions from banks to loosen underwriting standards for poor, urban communities – concessions to which the Fed agreed, Mr. Calomiris argues. The banks had to apply the looser standards to everyone. That helped fuel an explosion in poorly underwritten mortgages that contributed to the depth and severity of the housing crisis, he contends.
All in all, Mr. Calomiris’ theory is a bleak one for the ability of financial reform efforts to make much of a difference.