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The president, congress, and the financial crisis: ideology and moral hazard in economic governance.

The worldwide financial meltdown of 2008-09 caught economists and policy makers by surprise, including the U.S. president and his chief economic advisors. While the Council of Economic Advisers (CEA), the U.S. Treasury Department, and the Federal Reserve (or Fed) expected a downward market correction from the dramatic boom in housing prices and homeownership, none of these economic agencies predicted the near collapse of the financial structure in the United States and its global economic repercussions. In his testimony before the House Committee on Government Oversight and Reform in 2008, Alan Greenspan, former Fed chairman, was asked by Committee Chairman Henry Waxman, "In other words, you found that your view of the world, your ideology, was not right, it was not working." Greenspan responded, "Absolutely ... that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well" (U.S. Congress 2008a, 2008b).

During the early months of the crisis, senior federal government policy makers, including the president, the secretary of the U.S. Treasury, and members of the president's economic team, as well as academic economists, shared these sentiments.

How was it possible that senior economic officials in the president's administration and prior administrations did not see this crisis developing or pursue policies to avert it? The basic argument of the article is that the system for governing the market--the institutions, rules, regulations, and personnel practices that shape the way the market operates--is central to understanding the development of and failure to anticipate the financial crisis. In developing this argument, the article focuses on the role of the president in interactions with the Congress, economic advisors, and the independent regulatory agencies. Over the course of three decades leading up to the financial crisis, the give and take of macroeconomic ideas representing different economic interests and professional views converged into a common set of policy preferences and ideology across political parties, the houses of Congress, the president, and professional experts. Reinforcing this development was a powerful political moral hazard a condition in which public officials and private interests had strong incentives to take actions mutually beneficial to them but adverse to the overall economy and the interests of the general public--that led to a decline in institutional checks and balances in economic regulation. The system of economic governance thus failed to function as envisioned, and thereby, contributed to the crisis.

These developments occurred during a time of significant economic change and financial innovation, making it difficult for the president and Congress, regulators, and private corporate directors to foresee the degree of risk building in the system. In this sense, the crisis represented a perfect storm in which financial innovations, a common set of policy preferences and ideology, and weakened check and balance governance converged to help bring the country to the brink of financial meltdown.

In general, governance consists of the institutions and decision processes that determine how society makes choices. It includes the Constitution, the basic structure of the legislature, the presidency, and the courts, as well as legislative procedures, legal rules, and administrative practices. In the private sector, it includes the basic legal framework for private organizations, corporate policies and practices, and boards of directors. In the United States, the Constitution established a "check and balance" system as the basic structure of governance for the society and economy. Consequently, the U.S. Constitution prescribes an independent judiciary, separate houses of Congress elected in different ways and for different terms, and a separately elected chief executive as president. This structure assumed the existence of sharp conflicts among sets of policy preferences of various political factions represented by the basic economic interests--landowners, industry, and workers (Madison, Jay, and Hamilton 1787).

The framers of the Constitution did not address the question of the role of the president in managing and regulating the economy. Although the founders did debate the creation of a central bank and the role of the U.S. Treasury, the federal government initially played a minor role in the economy with few civil servants and a small bureaucracy consisting mostly of the post office, military, customs, and tax offices. Over time, however, as the federal government's economic impact grew, the president and the executive branch came to play an ever-increasing role. The president represented the only political leader with a national constituency, and during the Great Depression, the rise to prominence of Keynesian economics further established a major role for the president and the central government in macroeconomic policy making.

These developments led to two additional economic governance structures. First, Congress established semi-independent regulatory agencies, such as the Securities and Exchange Commission (SEC), the Interstate Commerce Commission, the National Labor Relations Board (NLRB), and the Federal Reserve Board, to regulate basic functions of the economy. These bureaucratic agencies provide "professional expertise" as a check on the political preferences of the legislature and chief executive. The commissioners have fixed terms in office and protection from political interference. In particular, the Federal Reserve Board as the regulator of the money and financial markets has a strong institutional independence and culture of professionalism, following in the tradition of the check and balance structure of the founding fathers (Knott and Miller 2008).

Second, the economic advisory structure to the president expanded substantially, beginning with the Employment Act of 1946, which established the CEA. By the time of the Kennedy administration in 1961, an informal, interagency, advisory structure emerged, known as the "Troika," with representatives from the key economic and budget agencies: the CEA, the Office of Management and Budget (OMB), and the Department of the Treasury. The Troika operates at different levels, from cabinet-level principals to staff members responsible for economic and budget policy, and the Fed chairman and staff also participates in this process. Initially the Troika focused on immediate budget and economic issues, but as international trade, federal budget deficits, and non-interest mandatory entitlement spending grew dramatically, the Economic Report of the President and the interagency cooperation included longer-term economic assumptions and forecasts (Donihue and Kitchen 2000).

Because some of the factors in the governance of the financial industry have implications for the failure of the president and political institutions to avert the crisis, the next section of the article focuses on risk and preferences in firms and the private market. The article will then turn to the relation between the president, Congress, and the regulatory agencies, and conclude with an analysis of how these interconnected governance structures and processes interacted to contribute to the financial meltdown.

Firms and Markets

In the congressional testimony referred to in the introduction, Alan Greenspan also made the observation that, "Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets' state of balance" (Testimony before the Committee on Government Oversight and Reform, October 23, 2008 [U.S. Congress 2008a, 2008b]). The question is, why didn't managers protect shareholder value and maintain the financial markets' "state of balance?" There are at least two answers to this question that will help explain how firm governance contributed to the development of the financial crisis. The first factor is how firms allocate the "budget surplus" they generate, and the second is concerned with how firms share or avoid risk and uncertainty.

Allocating the Firm's Budget Surplus

Firms are essentially teams of employees working together with capital equipment to produce a product or service. As with all teams, firms produce a greater output than the individual members could produce working alone. This greater efficiency achieved through team production produces a surplus of revenue, and the problem is how to allocate this surplus among the workers and owners of the firm (Holmstrom 1979). Based on the principle of Pareto Efficiency, the surplus should be allocated among the members according to their individual contributions to the team effort. This allocation principle is hard to achieve in horizontal teams due to "free riding" and imperfect information among the team members about each member's contribution to the team effort. It is hard to know how hard workers are working and who makes what contribution. Workers also want to "lock in" benefits and wages that over time might not correspond to their actual contribution to the production of the product or service. Some team members end up being paid more than their individual effort warrants, and others are paid less.

One solution to the free rider problem is the imposition of a hierarchical structure in which a manager or team leader decides the allocation. The problem with this solution, however, is the principal-agent nature of the relation between the manager and the team members (Miller 1992). In reality, the shareholders are the principals who delegate the allocation problem to the managers. This arrangement faces significant obstacles. Miller has shown that managers do not always face the right incentive to allocate the surplus in an efficient manner for the firm, but rather managers confront incentives to allocate more to their own pay and benefits than is warranted. Managers are able to achieve this outcome in their own interest because of asymmetric information between them, workers, and shareholders, including a lack of transparency and accountability in the managerial tasks performed. Managers can hide profits from board members through accounting and in-kind perks.

The growing recognition of this managerial self-interest has led to a variety of solutions that seek to align managers' interests with the interests of shareholders. One solution is to pay managers stock options and bonuses in addition to salary. Indeed, many top financial managers today make much more in remuneration through these stock options than in salary. A second, related approach is to define performance contracts for middle managers. The idea here is to tie the behavior of managers with the performance of the firm. A third solution is a perfectly competitive market, which would weed out those firms that overcompensate managers. This last solution will be taken into consideration in the next section of the article.

Unfortunately, none of these solutions has worked very well in practice. Managers were given the opportunity with stock options to manipulate the purchase and sale of stock to maximize their return from the market on a short-term basis. Consequently, the interests of the managers did not align with the longer-run value and performance of the company but with short-term volatility in stock prices by which they could acquire huge gains in the short run, making them very wealthy and independent of the long-run welfare of the corporation.

Second, the growing market and price increases in real estate investment trusts led senior managers to impose unrealistic performance targets on fund managers, sometimes of 10% a year or more in growth (interview with Stan Ross, former senior partner with Ernst and Young, September, 2009). These aggressive performance targets made sense initially, but they could not be sustained in the longer run. Eventually managers had an incentive to make riskier investment decisions in order to maintain the high target levels of growth each year. Many fund managers faced a loss of bonus or even dismissal if they did not reach these increasingly unrealistic performance targets.

Added to this increasingly risky behavior by senior managers and fund managers was the practice by rating agencies to rate real estate securities as more creditworthy than in hindsight was the case. To understand this kind of surprisingly risky behavior requires a more direct analysis of risk and decision making among firms.

Risk and Interfirm Decision Making

Firms take three basic approaches to reducing risk. The first is a set of control strategies. Under a vertical integration strategy, firms purchase competitors, suppliers, and distributors to control the economic chain from production to delivery to the customer (Pindyck and Rubinfeld 2005). A second control strategy is to negotiate favorable contracts with suppliers and distributors that reduce risk to the firm. And the third control strategy is exercised through mergers with competitors to gain market share or other market advantages.

The second general approach to reducing risk among firms is to shift the risk onto other firms or to insurance companies (Crozier 1964). Shifting risk can be achieved through passing the risk quickly onto another firm before the risk can detrimentally affect the original firm. An example is when a mortgage broker, such as Countrywide, sells mortgages to another bank within a few weeks after selling mortgages to individual home purchasers. This bank will then turn the mortgage over to a third-party investment firm. Credit default swaps serve a similar purpose of shifting risk through the purchase of insurance against default of portions of the real estate portfolio.

Third, firms take a portfolio approach (Markovitz 1959) to risk by developing financial or economic instruments that spread the risk among several different firms through securitization and insurance arrangements. Blending mortgages of differing risk factors into a real estate investment trust spreads the risk throughout a large investment instrument. In pursuing this strategy, investment firms have hired mathematical modelers to minimize risk to the individual firm (Manganelli and Engle 2001).

Unfortunately, distance between borrowers, lenders, and investors increases moral hazard and asymmetric information problems. Thinking that the risk is passed on quickly or diffused across several investment instruments creates incentives for individual brokers, lenders, and investors to take on riskier practices that threaten the system as a whole. Senior managers also failed to fully understand the mathematical models used to spread risk, and investment banks had too limited knowledge about on-the-ground real estate markets. Rating agencies came to believe that the individual risks are low and that the system is the sum of the parts, failing to understand the risk building in the system as a whole. As Paul Wilmott, states, "The more sophisticated your tool, the greater the potential for pretending there's no risk" (quoted in Wall Street Journal, November 23, 2009).

Economic and Financial Innovation and Change

Experimental economics has demonstrated that these kinds of risk-taking market behaviors are exacerbated in times of economic change and financial innovation. In simulated economic markets played with student participants, the results show that price bubbles occur naturally. In repeated games with the same instruments and market rules and same (increasingly sophisticated) players, bubbles eventually disappear, as the student participants become experienced in recognizing when prices are becoming overheated. Some participants start selling and bidding lower, averting the development of a bubble. However, when the experimenters introduce new financial instruments and changes in the rules of the simulated market, bubbles reappear, even with experienced players in repeated games (Hussam, Porter, and Smith 2008; Plott 2008; Haruvy, Lahav, and Noussair 2007; a Noussair and Powell 2010). Players are uncertain when they are reaching a price level that is too inflated to be sustained, until it is too late, and the bubble bursts.

These analyses of incentives and institutional relationships in the economy in the past decade help to explain in part the private market failure that led economic actors to engage in increasingly risky behavior. Experimental economics also shows why the dramatic economic changes and financial innovations during this period may have added to risk taking and the failure in the market.

The question is, why didn't the president and Congress, working with regulatory agencies responsible for sound banking and finance and for protecting the money supply, recognize these risks and try to counter them through policy and regulatory actions or proposals? What was the nature of the public governance failure that contributed to the crisis?

The President, Congress, and the Supply and Demand for Regulation

In order to better understand the role of regulation in the complex set of economic activities involved in the financial crisis, it is helpful to focus initially on the supply and demand for regulation. The system for regulating banking, mortgages, and investments is exceedingly complex and involves the interaction among a number of different economic activities, including banking, securities and investments, accounting practices, and mortgage loans and housing policies.

Supply and Demand for Regulation

The demand for regulation stems from several factors. One important factor is the political ideology of the president and the major political parties. Ideas about the role of government in the economy, the size of government, and the effect of regulation on economic efficiency influence presidential and party ideologies. In general, Republican presidents and the Republican Party have emphasized small government, deregulation, and reliance on allowing market forces to govern economic activity, while Democratic presidents and the Democratic Party have favored more active government intervention and regulation of the economy, including regulations for social, health, and environmental goals. As will be argued below, however, despite a growing rancor and political incivility in partisan relationships, the two parties had converged substantially in their attitudes toward economic regulation and privatization over the past two decades.

There are also strong interest group pressures demanding regulation. Some industries have actively sought government regulation to reduce the risk of ruinous price competition, especially in large industries such as airlines, trucking, and telecommunications. These industries face incentives to form economic cartels due in part to economies of scale and the large capital investment required for efficiency. Since cartels are inherently unstable because of the prospects of cheating on the cooperative cartel agreement, firms in these industries have sought government regulations to enforce the features of the cartel, including regulations that prevent entry into the industry and price competition (Hammond and Knott 1988). A similar form of interest group pressure arises through the potential for achieving economic rents through regulation such as in the sugar and milk industries and the housing industry.

A third factor leading to a demand for regulation is political response to economic crises. The collapse of Enron and WorldCom in 2001 led to the Sarbanes-Oxley Act of 2002, which established new regulations for mark-to market or fair market value rules, uncompetitive and costly reporting, and extensive data gathering. Often these regulatory laws are passed in reaction to the last crisis, sometimes introducing regulations and rules that can worsen the next crisis, which is arguably the case with the fair market value rules adopted under Sarbanes-Oxley. These rules hastened the price readjustment downward during the financial meltdown, reducing bank assets, and thereby accelerated banks' financial vulnerability. The government felt unable to revise these fair market value rules during the crisis, fearing widespread uncertainty over how to value assets (private conversation with Christopher Cox, former SEC chairman, during the Financial Meltdown, October 2010).

Powerful political and economic ideas played an important role in the demand to deregulate the economy, starting in the 1970s (Derthick and Quirk 1985). Although historically, Republicans have favored deregulation more than Democrats, over the past few decades presidents and congressional leaders of both political parties have pushed for deregulation, including such prominent Democrats as Ted Kennedy, Jimmy Carter, and Bill Clinton, and Republican presidents such as Gerald Ford, Ronald Reagan, and George H. W. and George W. Bush. A key impetus for this convergence of thought on deregulation came from the stagflation in the 1970s and the growing economic research that showed how regulation of price and entry in several industries caused both economic inefficiency and inflation (Peltzman 1976). Here was a culprit that the presidents of both parties could attack for the high unemployment and high inflation of that period.

But the story of deregulation is more complicated. When Presidents Ford and Carter used their executive power through appointments to the Federal Trade Commission (FTC) and other commissions to administratively force deregulation, these actions created a dynamic in the economy that gained momentum like a snowball going downhill. Significant technological changes in telecommunications and banking allowed upstart companies to establish footholds outside the existing regulatory framework. Established companies also sought to compete with these new entrants into the market through getting around the regulations. ATM machines, for example, were easily placed across state lines, but were these new technical innovations in banking covered by the regulatory ban on inter-state banking established under the Glass-Steagall Act (Banking Act of 1933) ? Companies such as MCI introduced new types of telephone services and innovative hand-held devices that fell outside the standard regulatory framework. These companies demanded deregulation in order to be able to compete on a more equal playing field with the regulated established companies (Hammond and Knott 1988).

In the governance process of the federal government, it was easier to block new legislation than to propose and pass new legislation. Blocking legislation simply entailed keeping the proposed new bill from leaving the congressional committee. But presidents from Ford through Clinton appointed commissioners who took administrative action to deregulate industries, requiring new legislation to reverse these activities. The specialized congressional committee, which oversaw the regulatory agencies and established industries, found it very difficult to draw up new legislation to counter these administrative rules. To become law, such new legislation would have to pass the relevant committees in both houses of Congress, the votes on the floors of both houses, and a threat of presidential veto. Consequently, unable to turn back the clock, Congress eventually passed legislation in several industries that codified into law the executive-initiated, deregulatory actions under way. This political dynamic, which was led by the president, reinforced the economic dynamic toward greater deregulation over the past four decades (Hammond and Knott 1988).

Deregulation of Banking and Investment

Over the course of the 1980s and 1990s, Presidents Reagan, Bush, and Clinton promoted and Congress passed several laws deregulating banking and investment. The political and economic pressures pushing these laws followed the kind of dynamic described above for deregulation in other industries. Banking differed from airlines and trucking, however, in that it was regulated heavily following the Great Depression in the 1930s under the Banking Act of 1933, which established the Federal Deposit Insurance Corporation and restricted banks from operating in more than one state (geographic regulation), regulated prices banks could charge for interest on deposits (price regulation), and separated commercial and investment banking (economic function regulation).

Following administrative actions taken by President Carter, in 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act (DIDMCA), deregulating prices banks could charge for interest and allowing banks to set interest rates on deposits according to market supply and demand. This change was driven in part by the huge growth in depositors in money market mutual funds (MMMF) established by companies such as Merrill Lynch, which operated outside the banking industry's regulatory rules on deposits. In the 1970s, driven by high inflation, depositors were abandoning banks and moving billions of dollars in deposits to MMMFs with investment firms, threatening the stability of the traditional banking system. It was in this economic context that Congress passed the DIDMCA.

The globalization of banking in the 1980s created political and economic pressures to deregulate the geography of banking as well as price. Until 1994, the establishment of all bank holding companies had to be approved by the Federal Reserve Board of Governors. Banks headquartered in one state were prohibited from acquiring banks in other states. With the strong support of President Clinton, Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which deregulated cross-state mergers for banks. This legislation codified into law the existing reach of banks through electronic teller machines across state lines and opened the doors for the rapid concentration of American banking nationally and globally.

By the end of the 1990s, the president and Congress faced bipartisan political support for deregulation of function. The Gramm-Bleach-Biley Act of 1999 allowed banks to engage in commercial and investment activities and for banks to merge with investment firms. This act was followed by the Commodity Futures Modernization Act of 2000, which deregulated derivatives and futures contracts. Along this path to deregulation, Congress also passed the Private Securities Litigation Act of 1995, which reduced "frivolous" litigation securities lawsuits, which was passed over President Clinton's veto.

In general, the deregulatory dynamic began in the 1970s, driven by technological and financial changes in the banking industry and "stagflation." This deregulatory momentum accelerated with the political support by presidents of the idea that regulation causes inefficiency and inflation in the economy, based on over a decade of economic research. The presidential administrations of Ford and Carter undertook aggressive administrative actions, including using appointment powers and administrative rules to deregulate banking, trucking, airlines, and telecommunications (Hammond and Knott 1988). Congressional committees close to the regulated, established industries attempted to reverse these executive deregulatory actions but were unable to gain the necessary political support in Congress as a whole to pass new legislation that would either reverse the actions or extend regulations to the new upstart firms and activities.

As deregulation proceeded, economic and political pressures mounted for further deregulation. The established firms joined in the rush to the new technology and new competition; without regulatory protections they had little choice. In some fields, such as airlines, deregulation led to fierce competition and the wholesale restructuring of the industry, with old flagship airlines going bankrupt. In banking, small hometown banks, which had enjoyed a local monopoly for decades, were swallowed up by larger interstate and global banks. Giant mega investment/banking firms emerged that competed in the global financial markets. These developments spurred further innovation in financial instruments to package risk and leverage for expanding the industry.

While these developments produced economic growth and productivity for the economy initially, they also eventually increased economic and financial risks and weakened the checks and balances in economic governance that undergird our democratic system. The next section focuses on the role of professional expertise and politically independent economic agencies in economic governance and its implications for the failure to avert the financial crisis.

The Trustee Model of Democratic Accountability

In contemporary democratic theory in political science, bureaucratic agency interactions with the president and Congress are often defined by a principal-agent model of accountability. To achieve government policy in the public interest depends on strict adherence by the agents (bureaucrats) to the principals (elected officials) who represent the democratic will of the citizenry (McCubbins, Noll, and Weingast 1987; Weingast 1981). These models assume that the preferences of the elected officials accurately reflect the preferences of voters. Consequently the main problem of accountability becomes one of making sure that the bureaucrats accurately carry out the statutes and authority given them by Congress and overseen by the president.

There are several problems with the principal-agent model of accountability in pursuing economic policies. Elected leaders face major political incentives and opportunities to act in ways that do not promote efficiency in the economy. Congressional majority voting is subject to instability and cycling (Arrow 1951). The partisan ideological biases of the political parties influence stances on economic issues that are not evidence based. Coalition politics of the president and Congress also produces suboptimal decision making that allocates government contracts and subsidies based on the geography of the representatives' districts or on broad coalitional interest group support for the president rather than on the priority investments for economic growth. Given their influence over regulations, statutes, and the government budget, elected officials face political moral hazard. They have incentives to collude with private interests for mutual gain. This kind of rent-seeking behavior causes major harm to the common economic benefit for society (Knott and Miller 2006, 2008).

North and Weingast (1989) argue that historically this kind of rent-seeking government interference in the economy hindered economic growth. For markets to flourish, governments had to make a credible commitment to enforce private contracts, the rights of private property, and the rules governing the exchange of goods and services. They examine the case of the British Parliament, which eventually gained the power to check the king's ability (and propensity) to appropriate private property at will and the favorable effects of this parliamentary authority on investment and the growth in the private market. A system of checks and balances contributed to the development of credible commitment; the Parliament checked the power of the king.

Following the logic of this historical role for checks on political authority, Knott and Miller (2008) use the term "trustee" model of accountability, in which agents are expected to not always follow the preferences of the president or members of Congress. The logic of this model flows from the Madisonian idea of checks and balances and introduces a professional expert check on the propensity to political moral hazard of elected politicians. It is called a trustee model as an analogy to the system of trusts and trustees set up in the financial sector to protect parents' children from misusing their inheritance, to protect assets from legal suits by divorced couples or other creditors, and many other similar uses. These trusts and trustees often keep the principals from following their preferences, and becoming their own worst enemy, which in the longer run actually works in favor of the interests of the principals.

Recognizing its political moral hazard problem, Congress has taken actions to establish semi-independent regulatory commissions to oversee the contract enforcement and rules of the game for the economy. The most obvious example of this type of action is the creation of the Federal Reserve Board, with long, fixed terms in office, a separate personnel system, and a set of rules that gives the central bank independence from political interference. The presidential system of economic advisors was also established in part as a professional expert check and balance, albeit weak and only advisory, on the macroeconomic policies and preferences of the president. For the most part, the Council of Economic Advisers' membership has consisted of academic economists of substantial professional standing in the profession (Stein 1996). Comparative governance studies show that this role for independent expertise in decision making on economic policy increasingly characterizes the regulatory structures of European countries (Majone 1997), and comparative international empirical studies have shown that countries with independent central banks protect the value of money better than countries without such institutions (Jensen 1997; Keefer and Stasavage 2003; Mosher 1999).

Why, then, didn't this trustee system of professional expertise work better to guard financial stability in the run-up to the meltdown? Over the past couple of decades, two interrelated developments have weakened this system of checks and balances for the economy. The major development was a growing convergence of views between professional economics and partisan ideology in favor of deregulation, privatization, home ownership, and monetary policy. These macroeconomic and policy ideas started out as economically rational in a prior historical period but became integrated into political ideologies and public policies much less appropriate and eventually harmful in more recent and different economic times. The ideas also grew into a political ideology of the more the better; if a little deregulation is good, more deregulation is better.

Part of the explanation is that macroeconomic ideas and political ideologies change much more slowly than the dynamics of the economy, similar to the failure of students in the economic experiments to recognize financial bubbles when economic conditions were changed. But these ideas and ideologies were reinforced by and led to the development of a powerful and growing political moral hazard of policies and practices by presidential administrations and congressional oversight committees relative to the activities of the SEC, FTC, Fannie Mae and Freddie Mac, and the U.S. Department of Housing and Urban Development (HUD) to provide ever more favorable deregulation and subsidies to the financial, housing, and banking industries.

Professional and Partisan Ideological Convergence

In the 1950s and 1960s, presidential candidate Barry Goldwater and the right wing of the Republican Party advocated for privatization of government services and deregulation of the economy based on a strong belief in the superiority of private enterprise and the market over government delivery of services. While not initially part of the political mainstream, these ideas began to make a broader impact in the 1970s. As the economy experienced high inflation and unemployment, a growing body of empirical evidence in economics showed that the regulation of price and entry of major sectors of the American economy from telecommunications to trucking slowed productivity and increased inflation. In the 1970s, Presidents Gerald Ford and Jimmy Carter made deregulation a part of their political campaigns and presidential policy, and in the 1980s President Ronald Reagan promoted these ideas further, as deregulation and privatization came into the mainstream. Both parties' presidents supported deregulation of trucking, telecommunications, airlines, and banking (Hammond and Knott 1988), and deregulation and privatization became part of the George H. W. Bush and Bill Clinton presidencies, with relatively little change from the Reagan era.

At the same time, Keynesian economics and macroeconomics in general gradually faded in significance compared to the role of microeconomics and monetary policy in the thinking about and understanding of the workings of the national economy. Indeed, the drastic reversal of the role of the federal government in rescuing and now stimulating the economy over the past three years stands in stark contrast to the prior three decades. The Republican Party came to base its fiscal policy on the Laffer curve, introduced during the Reagan administration. Named after economist Arthur Laffer, the Laffer curve illustrates that increasing tax rates beyond a certain equilibrium point will have a negative effect on tax revenue because of the decreasing incentive for participating in economic activity. This analysis over time served as the basis for a political ideology that cutting taxes is the only way to grow the economy and assure long-term financial stability of the federal budget. For the most part, however, the presidents of both parties have left macroeconomic policy to the monetary side, and thus, in the hands of the Fed.

Alan Greenspan chaired the Federal Reserve Board during much of this period. In testimony before the congressional oversight committee referred to above, he stated, "There was a flaw in the model of how the financial world worked. The model that had worked for decades suddenly stopped working." He also asserted that, "I was partially wrong on the benefits of deregulating derivatives... While I favor self-regulation, the rating by the rating agencies made derivatives appear less risky than they were" (U.S. Congress 2008a, 2008b). Greenspan also supported very low interest rates following the calamity of the 9/11 terrorist attacks on New York and Washington as the primary means for reviving a faltering economy. These low interest rates stayed in place into the latter part of the 2000s, even as the housing price bubble grew larger in 2006-08. There was a strong belief that the scale of the global financial market and the sophisticated unbundling of financial risks through derivatives and default credit swaps provided sufficient safety for continued economic growth.

The professional, theoretical bias in economics as represented in the Fed's and CEA's models of how the economy worked increasingly converged with the policy and political ideological preferences of the presidents of the two major political parties and members of Congress. The Fed accommodated both the strong political party interest in expanding home ownership through low interest rates and low entry requirements for mortgages and also the political party interest in limited government regulation and noninterference in the economy, which was believed to have become sophisticated enough through risk unbundling instruments, investment risk insurance, and global financial market scale to "correct" itself without government playing much of a regulatory or macro-economic policy role.

The problem with this convergence of ideas is that professional and political ideas that emerged in the 1970s during a time of stagflation and excessive regulation of the economy continued to drive thinking and policy into the 1990s and 2000s, when economic conditions and the structure of the economy were much different. One factor that reinforced these ideas beyond their appropriateness for the economic time period was a growing political moral hazard that supported the ideology and, in turn, was supported by the ideology.

Political Moral Hazard

Political moral hazard by Congress to collude with private industry to mutual benefit has reduced efforts by regulatory agencies to provide sound regulation of the banking, housing, and investment industries. From 1987 to 1989, five senators, known as the Keating Five, sought to prevent the SEC from regulating the savings and loan industry in Arizona and Texas. The five senators involved were accused of intervening on behalf of Charles H. Keating Jr., chairman of the Lincoln Savings and Loan Association and the subject of a Federal Home Loan Bank Board regulatory investigation. The senators played different roles in helping Keating, including calling bank regulators to encourage them to take actions favorable to Keating. The senators' campaigns or groups they supported received $1.3 million in donations from Keating and the Lincoln Savings and Loan Association (Berke 1990)

At the time of the firm's collapse, the Enron Corporation was the largest contributor to the campaign of Phil Gramm, the chair of the Senate Banking Committee. His wife, Wendy Gramm, served as the chair of the Commodities Futures Trading Commission, and she sought to exempt Enron from energy swap regulations. After leaving government, Wendy Gramm served on Enron's board with an annual compensation close to $1 million. During this period, the SEC staff proposed regulations to reduce the conflict of interest between accounting services and consulting, often performed by the same firm, but the staff were rebuffed by the Senate Banking Committee. In 2007, Christopher Cox, appointed by President George W. Bush as SEC Commission chair, proposed an administrative rule, supported by the commissioners, that SEC staff members must get authorization from the commissioners before taking actions on sanctions. This rule created delays, demoralized officials, and caused many officials to leave, reducing sanctions by 51%.

Despite President Bush' efforts to propose legislation to more strictly regulate the government-sponsored housing mortgage companies, Fannie Mae and Freddie Mac, these companies engaged in several activities to influence congressional oversight committees and regulatory agencies (Koppell 2001). There was very weak regulation of housing finance by the Office of Federal Housing Enterprise Oversight in HUD, with no director for over three years in the late 1990s. Both companies were investigated by the U.S. Department of Justice between 2003 and 2006 for excessive spending on lobbying activity. The Fannie Mae Foundation spent $650 million opening offices in congressional districts, and the two mortgage companies also spent $170 million in lobbying activities from 1998 to 2008, more than the American Medical Association. In 2006, Freddie Mac agreed to pay a $3.8 million fine to settle allegations that it made illegal campaign contributions. In 2003 and for the next five years, company managers underestimated their earning (Associated Press 2006).

Fannie Mae and Freddie Mac also faced growing competition for market share in the 2000s. Rapidly growing companies such as Countrywide offered subprime mortgages and other risky mortgage packages to low-income buyers, thereby gaining a greater share of the low-end mortgage market, an important focus for Fannie Mae and Freddie Mac. The situation developed similarly to the National Aeronautics and Space Administration (NASA) Space Shuttle program in the 1980s, when NASA faced competition from the European Ariane rockets. The shuttle program speeded up flight schedules and reduced safety procedures to meet market competition, resulting in the tragic 1986 shuttle Challenger failure (Willford 1986; Heimann 1997). The two government-sponsored mortgage companies faced political and economic pressures to maintain and grow their market share at a time when the housing market was booming and when both political parties favored low-interest mortgages to encourage home ownership by low-income families. To do so, the companies aggressively entered the low-end market with risky loans to match those in the private marketplace, thus contributing to the eventual collapse of this market.

In addition, many people working in the financial industry had once served in the government. There are 73 previous members of Congress who are now working as Wall Street lobbyists, 17 of whom served on the congressional banking committees. This list includes Michael Oxley, one of the two coauthors of Sarbanes-Oxley, who is now a senior advisor to the board of directors of NASDAQ. There are also 66 registered financial lobbyists who previously worked as staffers on either a House or Senate banking committee, and 82 staffers worked for members of Congress who sat on one of the banking committees. Another 42 served in the Treasury Department, and 7 served in the Office of the Comptroller of the Currency (Lovely 2010).

Conclusion: Governance and the Financial Crisis

Whether different policy tactics during the crisis might have mitigated the damage, the fact is that the country through a series of developments approached the brink of financial collapse. Characterizing the role of the president in these developments is difficult because federal policy reflects a multi-institutional governance process involving several agencies, processes, and advisors (Hammond and Knott 1996). From the foregoing analysis, there are two, interrelated economic governance factors that contributed to the outcome. These factors, in turn, were exacerbated by important financial innovations that masked, for many participants in the public and private sectors, that the country and the world were facing such eminent risk.

Convergence of Preferences in Economic Regulation

The first governance factor was the growing convergence of preferences over the past three decades between the two parties and the president and the two houses of Congress with respect to deregulation and privatization. Tom Hammond and Christopher Butler (2003) have shown in a careful international comparison that while institutions matter, when preferences are uniform, they matter much less than might be predicted. In Federalist Number 10, James Madison clearly lays out the argument for a republican form of government based on the assumption that each separate house of Congress, the judiciary, and chief executive would represent a different set of political/ economic interests (Madison, Jay, and Hamilton 1787). But if preferences converge, these institutional checks and balances work less effectively.

In the period prior to the financial crisis, the political ideologies of the presidents and professional biases of the economic agencies converged on the approach to regulation and the market. The Federal Reserve, which is the primary regulator of the financial and monetary aspects of the economy, came to reflect the same biases in its models of the economy as dominated the two political parties. The CEA and the Treasury Department also shared these views. The trustee model is less effective when the trustee has the same policy preferences as those who set up the trust.

Financial and Economic Innovations and Policy Change

Just as the students in the economic experiments with simulated markets had difficulty recognizing bubbles, so did the actual participants in the financial and mortgage markets over the past two decades have difficulty understanding how their actions were creating huge risks to the system, what Chairman Greenspan has termed "irrational exuberance" (Greenspan 1996). This private sector failure to recognize changing market and financial conditions, however, was not counteracted by the institutions of democratic governance.

The ability of presidential administrations to accurately assess the economic situation and pursue effective policies depends on the interplay of several factors, including the economic political ideology of the president, the system of economic advisors and agencies (Weatherford 1987), and the political moral hazard of the president and Congress. Consequently, presidential administrations have an inconsistent record of adjusting their policies to the realities of evolving market and economic conditions.

Despite changed economic conditions, presidents often promote economic political ideologies developed by previous political leaders, and professional economists in the federal government can hold to economic theories and economic thinking that lags or does not fully understand the innovations and adaptations in the economy. While the Kennedy tax cut, for example, was hailed as the right policy at the right time, the Nixon administration operated under the same assumption as the Johnson-Kennedy administrations that there is a direct trade-off between employment and inflation. The administration initially set a target of 6% unemployment as a means to bringing down inflation. As both inflation and unemployment soared above 6%, President Nixon departed from the advice of his national CEA to impose wage and price controls (Stein 1996).

Against the advice of his advisors and most economists, President George W. Bush pursued tax cut policies for upper-income brackets that were very close to the policies of the Reagan administration. In the early 1980s, high inflation was pushing middle-class Americans into higher tax brackets and, given the greater progressivity of the tax system, dampening economic demand and investment. Reducing rates and adjusting the brackets made economic sense at the time and helped stimulate the economy. In the early 2000s, economic conditions were much different, with a growing inequality of income and low inflation.

During the period prior to the financial crisis, the globalization of financial markets and the development of sophisticated financial instruments for mitigating and spreading risks led to the belief in the private market and at the Fed and the U.S. Treasury that the economy no longer operated under the same potential for collapse that occurred during the Great Depression. If the government kept regulation low and liquidity high, the economy and the housing market would continue to grow, with the market making necessary price and supply and demand corrections along the way. These economic ideas appealed politically to presidents and congressional leaders of both parties for different reasons.

Ideas, Political Moral Hazard, and Economic Governance

The American democratic system adopts and implements political and economic ideas more readily if they are reinforced by advocacy groups or special economic interests. As argued above, on the supply and demand for regulation, powerful ideas in favor of deregulation depended on the support of a broad presidential coalition and the news media but also the economic self-interest of innovative firms outside the regulatory structure and newly deregulated firms. As initial deregulatory policies succeeded in the 1970s and 1980s, innovative firms in the finance, banking, and housing mortgage industries created highly profitable new investment, finance, and real estate products. They also formed political alliances and lobbying relationships with political parties, candidates, and congressional committees to push for further deregulation and to block the extension of banking regulation to these new financial instruments and real estate trusts.

While deregulation and privatization have produced large benefits for the overall growth and productivity of the economy, the moral hazard of economically inefficient yet lucrative and mutually beneficial ties between firms and Congress increasingly influenced regulations and economic policies toward the finance, mortgage, and banking industries. Presidential administrations did oppose some deregulatory legislation and, in limited cases, supported stricter regulations, but in general, presidents continued to favor further deregulation and privatization through appointments to leadership and management positions in the independent economic regulatory agencies that reflected the ideological bias toward deregulation, privatization, and market solutions. The Fed chairman and the Treasury secretaries also pursued policies favorable to free markets and lack of regulation in the finance and banking industries, including support for low interest rates and housing policies. This political moral hazard between the president, Fed chairman, Treasury secretaries, and congressional committees over time weakened the role of professional expertise and the role of independent regulatory agencies in the development and implementation of federal banking and finance policies, and contributed to the causes of the periodic financial crises over the past three decades.

The President, Congress, and Economic Governance Reform

President Obama proposed legislation that formed the basis for the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which made significant changes in the regulation of finance and banking. It addresses important aspects of consumer protection through the creation of a new consumer protection agency housed at the Fed, extends regulation to derivatives and other financial instruments, restricts the range of activities in which banks can engage, streamlines the organization and processes of bank regulation, gives corporate boards and investors more transparency and some say over compensation, and creates a Financial Stability and Oversight Council that has the responsibility for monitoring "system risk." It also establishes an orderly process for failing financial institutions to avoid government emergency bailouts.

While the breadth and complexity of this legislation is too great to address here, there are a few key issues related to the argument of this article. In the reform of private firm governance, the act does not address the need for higher capital requirements for banks or provide enough countervailing governance to the bonus and compensation management practices of banks and investment firms. It also does not restructure Fannie Mae and Freddie Mac, the major sources of mortgages in today's mortgage market. Fannie Mae and Freddie Mac continue to pose significant risk for the political economy. As is now under way, reform should focus on restructuring these government-sponsored enterprises (GSEs) into completely private enterprises, or to eliminating them altogether over time, with social goals for housing written into regulations covering private housing investment and lending institutions. Less dramatic would be reform that revised the rules of accountability for GSEs along the lines of countries in Europe (Bertelli 2008).

On the public governance side, a key issue is the future structure and process for economic regulation and macroeconomic decision making. In the aftermath of the crisis, there were some political efforts to reduce or eliminate the professional independence of the Fed and the SEC, and bring these agencies more under the political control of Congress and the president. This political motivation to attack the Fed's independence was understandable, especially given the failure of the central bank to avert the crisis. However, this type of reform would go in the wrong direction for the future stability of the money supply and the financial system. More important is to safeguard the independence of the Fed and the SEC, and to examine ways to assure a balance of expertise in their leadership in monetary policy and regulation of the financial industry.

The Dodd-Frank Act strengthens the Fed by giving it key responsibility for the Financial Stability and Oversight Council, which will coordinate the monitoring of "system risk." An alternative lesson might be learned from the Canadian banking and housing mortgage finance systems, which fared much better and emerged stronger than in the United States. While this international comparison is inevitably complex, what is relevant to the argument here is that the only bank regulator, the Office of the Superintendent of Financial Institutions (OSFI) operated with strong professional norms and principles focused on safety, soundness, and risk management, and acted as a counterweight to the self-interest in greater deregulation and acquisition proposed by the banking industry and the central bank. Unlike in the United States, OSFI oversees all banking functions and regulations, making it harder for the industry to avoid regulation or ally with legislative committees to mitigate regulation. Second, banking regulation is separate from monetary policy, housing policy, and other policy and political goals of the federal government. The distinctive norms of soundness and safety continued to have an institutionally prominent role in the Canadian federal government policy toward the economy and financial system (Durocher 2008; Laeven and Levine 2008; and Porter 2010).

In contrast, in the U.S. economic governance, banking and finance regulation became part of broader political goals for housing, deregulation, and market approaches to economic growth. In this regard it is interesting to note that in his recent memoir, Dick Cheney makes the point that the chairman of the Fed and the Secretary of the Treasury were close in thinking and politics to the administration and played insider roles in the White House. His advice is a greater distance from presidential politics for the Fed chairman and a strong finance professional for Secretary of the Treasury (Cheney 2011).

Whether the new regulations and regulatory agencies in the United States will produce a beneficial result for the stability and growth of the economy is yet to be determined. Bureaucratic agencies also face significant political moral hazard problems with powerful interest groups as well as ideological motivations. A positive result will depend on the ability of professional regulatory agencies to defend against political moral hazard, which depends on the balance of interests in the process. Checks on the behavior of these agencies require transparency, administrative due process, and fairness in regulatory processes, as achieved by the NLRB, for example. It also depends on strong media scrutiny and public awareness of their activities. There is a fine line between the goal of safety and the potential for stifling the innovation and risk-taking by firms and individuals necessary to a dynamic economy. While not always getting this trade-off exactly right in practice, a Madisonian check and balance remains the kind of regulatory reform that we should strive to achieve.

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JACK H. KNOTT

University of Southern California

Jack H. Knott is the C. Erwin and lone L. Piper Dean and Professor of the Sol Price School of Public Policy at the University of Southern California. His work focuses on political institutions, public policy, and public management.

AUTHOR'S NOTE: Thanks Jennifer Connolly and David Gastwirth, Ph.D. students at the USC Sol Price School of Public Policy, for their excellent assistance with the research for this article.
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