The New Political Bubble

by Nolan McCarty on June 25, 2013 · 2 comments

in Political Economy

At the end of this summer, the world will mark the fifth anniversary of the beginning of the worst financial crisis since the Great Depression.  Some commentators will undoubtedly tout the many lessons learned and the progress made towards financial reform.  After all, Congress passed the Dodd-Frank Financial Reform bill to lower the risk financial instability and to better deal with its consequences.  To end the “Too-Big-Too-Fail” (TBTF) dynamic, regulators were given new authority to monitor and regulate systemically important financial institutions and to liquidate, rather than bailout, those that get in trouble.  Markets for complex derivative securities such as credit default swaps were to be made more transparent by requiring more standardization and trading over exchanges.  Finally, a new agency, the Consumer Financial Protection Bureau (CFPB), was created to protect consumers from manipulative credit products.

Despite these reforms, the evidence continues to mount that Crisis of 2008 was a crisis wasted.  Consider the following:

  1.  Since the financial crisis and Dodd-Frank, the largest banks have only gotten larger.  JPMorgan Chase’s London Whale reveals that these firms continue to take very risky bets.

  2. Large financial firms appear to continue to benefit from lower credit costs because investors believe that the government will once again come to the rescue should a systemically financial institution get in trouble.  Until we are in the midst of the next financial crisis, there is no way of knowing whether these beliefs are wrong.

  3. Many of the efforts to regulate derivatives and other financial products have been delayed or diluted.   According to the law firm Davis Polk, more than 60% of the regulatory rules required by Dodd-Frank have yet to be finalized – and more than 35% have not even been proposed.

  4. The rulemaking of the CFPB is in legal limbo because President Obama was forced by Republican opposition to appoint its director during a very brief Senate recess.

  5. The financial regulatory agencies have not been given budgets sufficient to carry out the tasks they were delegated in Dodd-Frank.

  6. And despite all of the shortcomings of the reform effort, there is a growing bipartisan movement in the House to repeal much of Dodd-Frank.

Why has financial reform unraveled so dramatically?  It is because the reform efforts were too focused on the proximate economic causes of the crisis and completely ignored the more fundamental political causes.  In our new book, Political Bubbles:  Financial Crisis and the Failure of American Democracy,  Keith Poole, Howard Rosenthal, and I argue that behind each financial crisis lurks a “political bubble” — a set political biases that foster market behaviors leading to financial instability. Rather than tilting against risky behavior, in political bubbles politicians and regulators aid, abet, and amplify the risks created in financial markets.  These biases are deeply embedded in the constellation of ideology, institutions, and interests that define the American political system.  We not only trace how a political bubble led to the U.S. deregulatory and monetary policies propped up the asset bubbles that generated the 2008 crisis, but how similar dynamics have played out in the recurrent financial crises in U.S. history.

Unfortunately, little has happened over the past five to eliminate the ingredients of the political bubble.  The Republican Party and much of the Democratic Party remain ideologically committed to financial deregulation.   Congress remains polarized, gridlocked, and dysfunctional.  Fragmented regulatory agencies remain under-resourced, yet authorized to formulate and enforce hopelessly complex rules for hopelessly complex markets.  And most importantly, the political clout of the financial sector has scarcely diminished.

Let’s hope this new political bubble doesn’t pop as violently as the last.

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