Isegoria

The free-market system is politically fragile — especially the financial industry:

It is so fragile because it relies entirely on the sanctity of contracts and the rule of law, and that sanctity cannot be preserved without broad popular support. When people are angry to the point of threatening the lives of bankers; when the majority of Americans are demanding government intervention not only to regulate the financial industry but to control the way companies are run; when voters lose confidence in the economic system because they perceive it as fundamentally corrupt — then the sanctity of private property becomes threatened as well. And when property rights are not protected, the survival of an effective financial sector, and with it a thriving economy, is in doubt.

The government’s involvement in the financial sector in the wake of the crisis — and particularly the bailouts of large banks and other institutions — has exacerbated this problem. Public mistrust of government has combined with mistrust of bankers, and concerns about the waste of taxpayer dollars have been joined to worries about rewarding those who caused the mess on Wall Street. In response, politicians have tried to save themselves by turning against the finance sector with a vengeance. That the House of Representatives approved a proposal to retroactively tax 90% of all bonuses paid by financial institutions receiving TARP money shows how dangerous this combination of backlash and demagoguery can be.

Fortunately, that particular proposal never became law. But the anti-finance climate that produced it greatly contributed, for instance, to the expropriation of Chrysler’s secured creditors this spring. By singling out and publicly condemning the Chrysler creditors who demanded that their contractual rights be respected, President Obama effectively exploited public resentment to reduce the government’s costs in the Chrysler bailout. But the cost-cutting came at the expense of current investors, and sent a signal to all potential future investors. While Obama’s approach was convenient in the short term, it could prove devastating to the market system over time: The protection afforded to secured creditors is crucial in making credit available to firms in financial distress and even in Chapter 11. The Chrysler precedent will jeopardize access to such financing in the future, particularly for the firms most in need, and so will increase the pressure for yet more government involvement.

The pattern that has taken hold in the wake of the financial crisis thus threatens to initiate a vicious cycle. To avoid being linked in the public mind with the companies they are working to help, politicians take part in and encourage the assault on finance; this scares off legitimate investors, no longer certain they can count on contracts and the rule of law. And this, in turn, leaves little recourse for troubled businesses but to seek government assistance.

It is no coincidence that shortly after bashing Wall Street executives for their greed, the administration set up the most generous form of subsidy ever invented for Wall Street. The Public-Private Investment Program, announced in March by Treasury Secretary Timothy Geithner, provides $84 of government-subsidized loans and $7 of government equity for every $7 of private equity invested in the purchase of toxic assets. The terms are so generous that the private investors essentially receive a subsidy of $2 for every dollar they put in.

If these terms are “justified” by the uncertainty stemming from the populist backlash, they also exacerbate the conditions that generated the backlash in the first place — confirming the sense that government and large market players are cooperating at the expense of the taxpayer and the small investor. If the Public-Private Investment Program works, the very people who created the problem stand to grow fabulously rich with government help — which will surely do no good for the public’s impression of American capitalism.

This is just the unhealthy cycle in which capitalism is trapped in most countries around the world. On one hand, entrepreneurs and financiers feel threatened by public hostility, and thus justified in seeking special privileges from the government. On the other hand, ordinary citizens feel outraged by the privileges the entrepreneurs and financiers receive, inflaming that very hostility. For anyone acquainted with the character of capitalism around the world, this moment in America feels eerily familiar.

Americans have historically avoided a general anti-capitalist bias, but not a populist anti-finance bias:

This bias has led to many political decisions throughout American history that were inefficient from an economic point of view, but helped preserve the long-term health of America’s democratic capitalism. In the late 1830s, President Andrew Jackson opposed renewing the charter of the Second Bank of the United States — a move that contributed to the panic of 1837 — because he saw the bank as an instrument of political corruption and a threat to American liberties. An investigation he initiated established “beyond question that this great and powerful institution had been actively engaged in attempting to influence the elections of the public officers by means of its money.”

Throughout much of American history, state bank regulations were driven by concerns about the power of New York banks over the rest of the country, and the fear that big banks drained deposits from the countryside in order to redirect them to the cities. To address these fears, states introduced a variety of restrictions: from unit banking (banks could have only one office), to limits on intrastate branching (banks from northern Illinois could not open branches in southern Illinois), to limits on interstate branching (New York banks could not open branches in other states). From a purely economic point of view, all of these restrictions were crazy. They forced a reinvestment of deposits in the same areas where they were collected, badly distorting the allocation of funds. And by preventing banks from expanding, these regulations made banks less diversified and thus more prone to failure. Nevertheless, these policies had a positive side effect: They splintered the banking sector, reducing its political power and in so doing creating the preconditions for a vibrant securities market.

Even the separation between investment banking and commercial banking introduced by the New Deal’s Glass-Steagall Act was a product of this longstanding American tradition. Unlike many other banking regulations, Glass-Steagall at least had an economic rationale: to prevent commercial banks from exploiting their depositors by dumping on them the bonds of firms to which the banks had lent money, but which could not repay the loans. The Glass-Steagall Act’s biggest consequence, though, was the fragmentation it caused — which helped reduce the concentration of the banking industry and, by creating divergent interests in different parts of the financial sector, helped reduce its political power.

The 1999 passage of the Gramm-Leach-Bliley Act had little to do with the current financial crisis:

The major institutions that failed or were bailed out in the last two years were pure investment banks — such as Lehman Brothers, Bear Stearns, and Merrill Lynch — that did not take advantage of the repeal of Glass-Steagall; or they were pure commercial banks, like Wachovia and Washington Mutual. The only exception is Citigroup, which had merged its commercial and investment operations even before the Gramm-Leach-Bliley Act, thanks to a special exemption.

The real effect of Gramm-Leach-Bliley was political, not directly economic. Under the old regime, commercial banks, investment banks, and insurance companies had different agendas, and so their lobbying efforts tended to offset one another. But after the restrictions were lifted, the interests of all the major players in the financial industry became aligned, giving the industry disproportionate power in shaping the political agenda. The concentration of the banking industry only added to this power.

Luigi Zingales had a friend who worked as a consultant for the now-infamous insurance giant American International Group:

To prevent him from starting his own hedge fund, AIG offered him a non-compete agreement: a sum of money meant to compensate him for the opportunity forgone. It is a perfectly standard and well-regarded practice — but unfortunately for my friend, his payment under this agreement was to be made at the end of 2008. So he spent the early months of 2009 living in terror: His contract was classified as one of the notorious AIG retention bonuses.

At the height of the fury against those bonuses, he received several death threats. Though he had no legal obligation to do so, he returned the money to the company, hoping that the gesture might keep his name from being published in the papers. In case that failed to protect him, he prepared a plan to evacuate his wife and children. It was the responsible thing to do; after all, angry protestors had staked out the homes of several AIG executives whose names appeared in print — and only luck had prevented someone from getting hurt.

People don’t trust large corporations anymore:

In one recent survey, 65% of Americans said the government should cap executive compensation by large corporations, while 60% wanted the government to intervene to improve the way corporations are run. And those views hardly reflect confidence in the government: Only 5% of Americans in the same poll said they trust the government a lot, while 30% said they do not trust it at all. It is just that, at the moment, Americans trust large corporations even less: Fewer than one out of every 30 Americans say they trust them a lot, while one of every three Americans claims not to trust large corporations at all.

Such attitudes are common — outside the US:

In a recent study, Rafael Di Tella and Robert MacCulloch showed that public support for capitalism in any given country is positively associated with the perception that hard work, not luck, determines success, and is negatively correlated with the perception of corruption. These correlations go a long way toward explaining public support for ? America’s capitalist system. According to one recent study, only 40% of Americans think that luck rather than hard work plays a major role in income differences. Compare that with the 75% of Brazilians who think that income disparities are mostly a matter of luck, or the 66% of Danes and 54% of Germans who do, and you begin to get a sense of why American attitudes toward the free-market system stand out.
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In most of the world, the best way to make money is not to come up with brilliant ideas and work hard at implementing them, but to cultivate a government connection. Such cronyism is bound to shape public attitudes about a country’s economic system. When asked in a recent study to name the most important determinants of financial success, Italian managers put “knowledge of influential people” in first place (80% considered it “important” or “very important”). “Competence and experience” ranked fifth, behind characteristics such as “loyalty and obedience.”