The Great Recession Five Years Later: How Washington Made Things Worse

Nolan McCarty (AB ’90) is the Chair of the Department of Politics at Princeton University and the Susuan Dod Brown Professor of Politics and Public Affairs at the Woodrow Wilson School of Public and International Affairs. Professor McCarty’s research focuses on American politics, democratic political institutions, and political game theory. He has written extensively on a variety of topics including polarization and, most recently, on the political underpinnings of the Great Recession.

Your book, Political Bubbles: Financial Crises and the Failure of American Democracy, asserts that political forces like rigid ideology, ineffective institutions, and special interests work to amplify risk and therefore the propensity for bubbles and crises. How did this play out in the years leading up to the financial crisis?

As we detail in the book, these factors that you mention (ideology, the structure of our policymaking institutions, and interest group politics) played a very important role in creating public policies that were more conducive to financial risk-taking. These policies included things like deregulation of derivative markets, more lax enforcement of existing regulations, and very little attempt to intervene in mortgage markets as evidence mounted that things were going wrong in terms of mortgage markets. So, this combination of the ideology that markets are best left alone, other ideological considerations that favored housing as a policy goal, as well as the unique structure of our legislative and regulatory institutions create an environment where, as the crisis was building, there wasn’t a political will or capacity to intervene until the crisis was full-blown.

You propose breaking up the banks to avoid “too big to fail”. Interestingly, the first bank to fail, Bear Stearns, was one-sixth the size of Bank of America today. Could you respond to that critique?

Sure, some have made a couple of points to this effect. One is that some of the first institutions to fail were not the largest. Some smaller institutions failed so it was interconnectedness and not size. Another was the example of the Canadian banks, which are all quite large and allegedly weathered the storm quite well.

On the first point, these things are all systematically related. The institutions were interrelated both financially and also, as we point out in the book, politically. So the counterfactual that I would focus on is not the fact that Bear Stearns was small, but would they have treated Bear Stearns and Lehman differently if there weren’t large institutions that could be brought down by their failures? So my arguments about “too big to fail” aren’t really about the total risk associated with very large financial institutions. That’s not to say that small institutions can’t fail and that small institutions failing because of their interconnectedness has consequences, but those problems are really magnified when the small firms fail and they are interconnected with large firms whose failure would be extremely costly.

The other point is that in some sense, too big to fail is not purely an economic or financial problem; it’s a political problem that undermines the accountability of these firms. I discuss that in terms of what I call the bad apples approach; that there has been a real hesitance to investigate and prosecute financial crimes because the costs of harming a very large financial firm are just very large. So too big to fail has this political effect on accountability.

In the case of Canadian banks, they are really highly regulated, so perhaps one could give up on our suggestion for downsizing big financial firms if one were willing to take Canadian levels of regulation. But we’re in a situation where our banks are big, and they’re not regulated in the same way that Canadian banks are. There’s also a lot of evidence that Canadian banks suffered a lot more during the crisis than we think they did. They got a lot of support from the Canadian government and from the US Federal Reserve to keep running.

Now, some have said that there was just a liquidity problem, but I’ve seen reports that there were actually insolvency problems in Canadian banks, which implies that these funds were used to bail out Canadian banks in the same way that American banks were bailed out. So I think size, especially in the American context, is very risky. Although I concede the point that Bear Stearns is a much smaller institution. One of the reasons we worried about Bear Stearns was because its failure could affect these very large firms. In fact, we did see the failure of Lehman have big impacts on huge financial institutions, including insurance companies like AIG. So I still maintain that controlling the size of financial firms is very important, both for these economic reasons, but especially for these political reasons.

In a 2010 interview with the New Yorker, recent Nobel Laureate Eugene Fama argued that if people had known there was a credit bubble, they would have shorted the market and there wouldn’t have been a bubble. Do you think a similar argument could be made about political bubbles in that these regulations and institutions look great until something goes wrong?

On the political side, maybe the analogy to that point isn’t quite as strong. People knew that there were problems in the fragmented regulatory structure, so the information about the politics was good. Now, I guess you could say they may have underestimated the costs. So some might argue that the fact that regulators were fighting with one another prevented them from regulating the markets more strongly. That may have led to de facto deregulation, and if you believe that most of these financial developments were positive ones, then that could be a good thing. That argument could recognize the objective fact about the politics and then not understand the political ramifications.

I guess I’m not really sure how to answer the question in that the statement about how hard it is to detect economic bubbles holds for political bubbles. In the same way that people were complaining in the early 2000s about what was going on in the housing market but were unpersuasive would also be true with the criticism about the politics. A lot of people were screaming about the political influence of Fannie and Freddie, yet reform didn’t happen. So I concede the point that a big part of what’s going on, whether it’s politics or economics, is that when things are going well, most people believe they’re going well for a reason, and it becomes very hard to change them.

One of the things that is interesting about the shorting argument against political bubbles is that people were trying to short the market. Famously, John Paulson did make a lot of money. Of course, unlike politics, where when you disagree with what’s going on you have all kinds of incentives to voice those concerns, if you believe that there’s a bubble and you’re going to go short, you have very strong incentives to keep quiet about that. So the diffusion of information – when people see that things are going wrong in these economic markets – people don’t have incentives to share that information. In fact, they want the bubble to grow as big as possible before you short.

So the argument that you’re always going to get that market efficiency through shorting really depends on the market being very transparent. You lack that transparency in these particular markets, especially in these over-the-counter derivative markets where they’re not being traded on exchanges. You can’t see the flow of orders. Then you have these problems with Paulson basically designing the securities that he wanted to short, and you have the incentive problems with the rating agencies, etc.  So I do think, structurally, there’s a lot of market inefficiency there in these crises.  But I think the political problem and the economic problem is just the same in that the people who are concerned about a bubble forming are, almost by definition, a minority, and both the economic pressures and the democratic pressures move in a pro-cyclical direction.

Feature Photo: cc/(Poster Boy NYC)