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The nancial crisis of 2008, as well asmany earlier crises, had an importantpolitical dimension.1 Government notonly failed to intervene to restrain a bub-ble but also directly abetted the expan-sion of the bubble. After the bubblepopped, political considerations limitedand delayed appropriate policy changes.

Both during and after bubbles, politi-cal outcomes reflect the same forces thatoperate in normal times. Such forces in-clude decision-making based on ideolo-gies: free market conservatism, egalitari-

anism, and populism. Political decisions(and non-decisions) also reflect checksand balances across branches of the fed-eral government and across layers ofgovernment in a federal system, as wellas institutional checks, such as bicamer-alism and libusters. Interests favoringcurrent arrangements benet from thestatus quo bias inherent in our politicalinstitutions. How these forces operate isgreatly influenced by how ideology has

contributed to polarization between thetwo major political parties.These forces are part of the normal

flow of politics in our democracy. Politi-cians respond to the politically activecampaign contributors and lobbyists in

particular. Policy is swayed by the self-

interest of nancial rms and, morebroadly, creditors and debtors. So-called independent regulators, includ-ing the Federal Reserve, respond notonly to their own ideology and exper-tise but also to elected ofcials withpolitical power over them.

The crisis of 2008 followed the latestin a long history of real estate bubblesin the United States. Bubbles often spillover into other sectors, so that a pop inan asset bubble frequently engenders a

banking crisis.

Before 2008, the most recent exampleof a real estate bubbles devastating ef-fect on nancial institutions was the sav-ings and loan (S&L) crisis of the 1980s.This earlier crisis differed in importantrespects from the 2008 crisis. First, thepolitical system was substantially lesspolarized than it is today. Second, theeconomic shock was much smaller.

These two factors contributed to a lesscontentious eventual resolution of thecrisis. Moreover, the crash in real estateprices at that time was much more geo-graphically concentrated than in the2000s, and the thrifts (as the rms in theS&L industry were called) were moreMain Street than Wall Street. Nonethe-less, the interaction between the nan-

Nolan McCarty, Keith T. Poole,

Thomas Romer & Howard Rosenthal

Political fortunes: on nance & its regulation

2010 by the American Academy of Arts& Sciences

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cial and the political sectors stronglyforeshadowed the events of 2008.2

Prior to the late 1970s, the S&Ls had a

specialized niche: for the most part, theytook in short-term deposits and offeredlong-term xed-rate mortgages. Troublemight arise if the interest they had to payto attract depositors rose above the rateson older mortgages, but market condi-tions and government regulation of de-posit interest rates helped S&Ls avoidthe potential losses that might resultfrom a mismatch between the short andlong terms. A serious mismatch did ariseafter the nancial innovation of moneymarket mutual funds in the 1970s; thefunds drew deposits away from S&Lsand eroded their protability.

The interest rate mismatch becamecritical as a consequence of the abruptincrease in interest rates initiated bythe Volcker Fed and the ensuing severerecession of 1981 to 1982. Real estate val-ues collapsed, especially in the Oil Patchand the Farm Belt. By 1982, more thantwo-thirds of the thrifts had become

unprotable. In the aggregate, the S&Lindustry had negative net worth by theregulatory capital standards of the time.The industrys regulator, the FederalHome Loan Bank Board (fhlbb), rec-ognized the situation; however, the de-posit insurer, the Federal Savings andLoan Insurance Corporation (fslic),had insufcient funds to shut down theinsolvent S&Ls.

The political response to the severeeconomic shocks facing the thriftswas to relax regulatory standards andexpand the scope of assets that thriftscould hold. The key elements of thelegislation affecting S&Ls in the early1980s were deregulating interest rates;allowing for adjustable-rate mortgages(arms); and permitting S&Ls to ex-pand their loan products from homemortgages to commercial real estate,

junk bonds, and other risky invest-ments.3 Moreover, the fslicwas notgranted additional funding authority,

which ensured a policy of regulatoryforbearance against failing thrifts.

The protability of some S&Ls tempo-rarily improved. But the extra risk-takingencouraged by regulatory forbearancesoon took its toll. By 1987, the magnitudeof the industrys insolvency problem hadincreased dramatically, yet political ac-tion enshrined continued regulatory for-bearance by extending the use of lenientaccounting rules and weakened capitalstandards. At the same time, legislationreafrmed the full faith and creditbacking offslic-insured deposits with-out providing the agency additional -nancing authority to act aggressivelyagainst the owners of essentially bank-rupt S&Ls.4 Equity holders and manage-ment in such insolvent rms bore vir-tually no downward risk. But, as longas they were allowed to operate, theywould benet from any success of riskygambles that restored protability.5

These zombie thrifts continued tostay open, making increasingly riskybets as they gambled for resurrection.

Congress and the White House optedfor forbearance for two related reasons.First, ending the S&L debacle requiredan unplanned and unbudgeted expendi-ture. The funds could come either fromassessments on the industry or fromgeneral government taxes and borrow-ing. Sick thrifts had a strong interest incontinued forbearance; the remaininghealthy thrifts resisted the additionalfees that they may have been assessedunder a recapitalized fslic. The imme-diate beneciaries of lax regulation werepolitically active. They pressed electedofcials to support their case with theregulators and in framing legislation.There was no signicant constituencyin favor of confronting the full magni-

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tude of the S&L problem when it wasstill relatively small, or of curtailingrather than extendingforbearance.

Importantly for connecting the dots tothe current crisis, these looser regula-tions remained in effect even after theS&L meltdown.

Second, incumbents of both partieswere concerned that dealing with thecrisis through a large recapitalizationoffslicwould look like a bailout andwould be unpopular with the votersin the November 1988 elections. Bothparties supported banking deregula-tion and regulatory forbearance. Eventhough experts both inside and outsidethe Beltway widely recognized the grav-ity of the S&L industrys situation, thecandidates mostly avoided discussingthe crisis during the presidential elec-tion campaign.

By early 1989, the need to shut downfailed S&Ls and to recapitalize the de-posit insurance fund could no longer beput off. Relatively rapid congressionalaction produced the Financial Institu-

tions Reform Recovery and Enforce-ment Act of 1989 (firrea), which Pres-ident Bush signed that August. firrealed to a bailout of depositors and dispos-al of the assets of failed thrifts by a newentity, the Resolution Trust Corporation(rtc). The fhlbbwas folded up and anew regulator, the Ofce of Thrift Super-vision (ots), put in place. The ots rep-resented a soft reform: by the 2000s, itwas a regulatory venue of choice for mort-gage institutions seeking to escape thestricter regulatory arm of the Fed. A con-cession to the industry in 1989, ots inmore recent years accommodated thelikes of Washington Mutual, IndyMac,and aig.6

In brief, unintended consequences ofnancial innovation and deregulationproduced a crisis; interest-group politicsand populist abhorrence of bailouts pro-

longed it. The media coverage of theS&L crisis in full bloom focused oncolorful stories of malfeasance and al-

leged political corruption (most nota-bly Charles Keating of Lincoln Savingsand Loan and his ve senators, includ-ing future presidential nominee JohnMcCain). But the true highlight tapeshould recognize that most of the S&Lgambles were completely legal actionsin the regulatory environment createdby elected ofcials responding to inter-est-group pressures and to electoralconcerns with the mass public.

The resolution of the S&L debacle didnot include tightening the looser regu-lation of interest rates and other dimen-sions of the home mortgage industry.Not surprisingly, then, nancial marketswitnessed an explosive growth of nan-cial innovation in a generally permissiveregulatory environment. Before the 2008meltdown, this nancial innovation wasgenerally seen as a positive force that de-livered real benets. The pace of innova-

tion accelerated during a period of glob-al economic growth and, in particular,the American economic ascendancy ofthe 1990s. Financial sector protabilityrose and nancial sector prots becamea much larger share of total corporateprots. Financial sector wages increasedmuch faster than wages in other sec-tors.7 Highly skilled individuals flockedto nancial engineering.

While the nancial sector often attrib-uted this innovation and growth to thevirtues of unbridled capitalism and freemarkets, the shadow of politics was nev-er far behind. First, much of this innova-tion was designed to create instrumentsthat would optimize prots around reg-ulatory constraints. Notably, banks in-vented off-balance-sheet vehicles thatcreated leverage without violating theBasel I capital requirements.8

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Second, the importance the industryplaced on maintaining a favorable po-litical environment is underscored by

a massive increase in political involve-ment. Between 1992 and 2008, politicalcampaign contributions from the nan-cial sector nearly tripled, even after ad-

justing for inflation. (Only the legal pro-fession had a faster growth rate of con-tributions.) The current magnitude ofgiving is also remarkable. Four subsec-tors of nance (securities and invest-ments, real estate, insurance, and mis-cellaneous nance) are now in the topten of all industry contributions, andtwo of them (securities and investments,real estate) have dominated the growthin contributions.9

Although Republicans and Demo-crats both have been blessed with con-tributions from the nancial sector, theimplications for the Democratic Partyhave been especially signicant. Overthe past forty years, voting behaviorand partisan identication in the Unit-ed States have become highly structured

by income. The Republican Party hasfared somewhat better among voterswith middle income and higher, whilethe Democratic Party has received themajority of the votes from those withlower incomes.10 But even as the Dem-ocrats were depending more heavilyon the votes of lower-income citizens,the party came to rely more on the -nancial resources of wealthier support-ers and interest groups. Consequently,the Democratic Party now has two dis-tinct wings: the money wing and thevotes wing. The nancial services sec-tor has become an increasingly impor-tant part of the money wing.

Like many corporate contributors, thenancial sector tends to shift its campaigncontributions based on which party con-trols Congress. From 1987 to 1994, a ma-

jority of the money went to the Demo-

cratic Party, which had majorities inboth the House and the Senate. Follow-ing the 1994 elections, there was a large

shift in contributions to the newly em-powered Republicans. Following theDemocratic takeover of Congress in2006, the money switched back toabout where it was in the early 1990s.

But even during the period when ithad relatively little power in Washing-ton, the Democratic Party did well withthe securities and real estate industries.From the partys perspective, nancemakes an almost ideal money wing(almost as good as Hollywood). Unlikemany other industries with potentialclaims on political attention, nancialsector rms do not pollute the environ-ment (at least not directly) and do nothave especially contentious labor rela-tions. During normal times and duringeconomic booms, these facts make formuch less conflict with other Democrat-ic constituencies like environmentalistsand labor unions. Of course, an idealalliance in good times is not necessarily

one that can survive a bust.

In a Washington epitomized by AlanGreenspans nearly nineteen-year tenureas Fed chairman, regulatory constraintswere viewed in a dim light. There waseither bipartisan support for a hands-offpolicy or lack of a winning coalition thatwould revamp regulation to address anew and highly complex environment.Indeed, a considerable amount of nan-cial deregulation occurred through agen-cy decisions and legislation during theClinton administration. In 1998, Brook-sley Born, Clintons appointee as chairof the Commodity Futures Trading Com-mission (cftc), proposed regulatingoff-exchange trades in swaps and otherderivatives. Her initiative was shot downby Greenspan, Treasury Secretary RobertRubin, Deputy Secretary Larry Summers,

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and Securities and Exchange Commis-sion (sec) Chairman Arthur Levitt.The Commodity Futures Moderniza-

tion Act of 2000 (cfma)passed byan overwhelming 377 to 4 roll-call votein the House and a voice vote in the Sen-atecodied the marginal role of thecftc and facilitated active expansionof over-the-counter derivatives markets.

Previous executive and deregulatorymeasures of the nancial sector culmi-nated in the Financial Services Modern-ization Act of 1999, which also passedwith large bipartisan majorities.11 It re-pealed the Glass-Steagall Act of 1933,which had separated commercial banks,investment banks, and insurance com-panies; it also explicitly prohibited thesec from regulating securities-basedswap agreements. During the decadeswhen these boundaries were contested,commercial banks, investment banks,and insurance companies were frequent-ly on different sides of disputes over -nancial regulation. The eventual ero-sion of legal and regulatory boundaries

between segments of the nancial sec-tor also removed some of the politicalconflicts over economic turf within thesector. As deregulation took these is-sues off the table, previously separatedparts of the sector now had more close-ly aligned interests.12

The turn of the century was not with-out warning that deregulated nancialmarkets posed dangers. The collapse ofthe hedge fund ltcm in 1998 revealedthe potential for global contagion andsystemic risk. A second warning shotwas red in 2001 with the failure of En-ron, WorldCom, and other rms withaccounting scandals. It became apparentthat the specics of deregulation weredesigned to benet nancial and corpo-rate interestssuch as the Enron loop-hole in the cfma.13 There was also evi-dence that deregulations fundamental

premisethat accounting rms, WallStreet analysts, and rating agencies wouldprovide unbiased and transparent infor-

mation to investorswas false. None-theless, the spirit of deregulation contin-ued relatively unabated. Much like fir-rea, the Sarbanes-Oxley Act (2002) didnot address forms of accounting arbi-trage, such as off-balance-sheet vehiclesthat avoided capital requirements, em-ployed by nancial institutions as theymarched toward the 2008 crisis. Duringthe George W. Bush administration, thesec essentially eliminated its capacityto inspect investment banks and weak-ened its enforcement.14 Ignoring thewarning signals of the turn of the centu-ry was facilitated by continued econom-ic growth. The crisis of 2008 arrived inan environment where most nancialtransactions were unregulated and reg-ulated activities were largely unmoni-tored.

By 2000, the foundation had been laidfor a housing market bubble that would

reflect the alignment of two disparateideologies: free market conservatismand redistributive egalitarianism. Thefoundation consisted of a crazy quiltof legislative, executive, and judicial de-cisions in the 1980s and 1990s that areoverwhelming in their details. A briefrecap would note that (1) a variety of -nancial institutions were permitted en-try into various loan and insurance mar-kets, (2) usury laws were stripped away,and (3) the ability of states to regulatenancial products, like credit cards, of-fered by out-of-state rms was largelyeliminated while other features, suchas loan-to-value limits, remained withthe states. States could also compete inthe chartering of banks. The result wasthe expansion of predatory lending prac-tices, loans that would be quickly under-water if housing prices declined, and

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another round of zombie banking thatencompassed institutions largeWash-ington Mutual, for exampleand small,

including forty Georgia banks eventuallyforced into receivership by the fdic.15

A Republican twist to free market cap-italism was a belief in the political ad-vantages of the ownership society.In brief, homeowners were thought tobe more likely to vote Republican thanrenters.16 The post-1980 support forlow- and moderate-income housing byRepublicans represented a historicalshift. In 1977, conservatives, supportedby lenders, had mustered considerablebacking for a Senate amendment thatunsuccessfully sought to delete TitleVIII, the Community RedevelopmentAct, from the housing bill that passedthat year. The later shift away from par-tisanship on housing policies came afterthe deregulation of the 1980s and 1990screated a protable market in loans tolow-income families.17 By the adminis-tration of George H.W. Bush, there wasbipartisan support for legislation such

as the National Affordable Housing Act(1990), which included a variety of initia-tives directly aimed at expanding home-ownership among low-income house-holds, and the Federal Housing Enter-prises Financial Safety and SoundnessAct (1992), which set minimum percent-age-of-business targets for Fannie Maeand Freddie Mac purchases of mortgagesissued to low-income households.

On the Democratic side, redistributiveegalitarianism sought to increase home-ownership among the poor and minori-ties. Fannie Mae stated in its 2003 Annu-al Report, [A]s long as there is a gap inminority and non-minority homeowner-ship rates, Fannie Mae and Countrywidewill continue to make sure all Americanshave the chance to realize the dream ofhomeownership. While it was not polit-ically feasible to make homeownership

an entitlement like food stamps andMedicare, political pressure and eco-nomic incentives encouraged lenders

in the mortgage market to accomplishegalitarian goals. Promoting egalitari-anism through a market led by govern-ment-guaranteed enterprises FannieMae and Freddie Mac appealed notonly to the Democratic base but alsoto highly compensated Democrats. Theceo of Fannie Mae from 1991 to 1998was James Johnson, an executive assis-tant to Vice President Walter Mondale,member of the John Kerry vice presiden-tial selection team, and cashiered mem-ber of the Obama vice presidential se-lection team.18 From 1998 to 2004, Fan-nie Mae was headed by former directorof the Ofce of Management and Bud-get during the Clinton administration,Franklin Raines.19 Raines presided overFannie Mae during a major accountingscandal; his executive compensationhas been extensively criticized.20

Housing policy was one area largelydevoid of partisan conflict in an era

characterized by highly polarized poli-tics.21 The American Homeownershipand Economic Opportunity Act of 2000directed at easing the nancing of mort-gages, including reverse mortgages, andincreasing nancial assistance for home-ownership by the poor, elderly, and dis-abledwas passed by voice vote in theHouse and unanimous consent in theSenate. The American Dream Downpay-ment Act of 2003 was passed by unani-mous consent in the Senate and withoutobjection in the House.22 President Bushenthusiastically signed the act into law,as a measure that would build the own-ership society by providing $200 mil-lion per year in down payment assistanceto at least 40,000 low-income families.23

Both American acts relaxed standardsfor lenders. In contrast to these measuresdirected at expanding homeownership,

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from 2000 to 2006 only one of sixteenlegislative bills aimed at curbing pred-atory lending and enforcing other as-

pects of consumer protection passedthe House; none passed the Senate; and,of course, none became law. Lobbyingagainst these bills came disproportion-ately from riskier lenders that originat-ed mortgages with high loan-to-incomeratios, used securitized instruments, andhad fast-growing mortgage loan portfo-lios.24 As in the S&L asco, lenders inthe weakest economic condition weremost likely to lobby against regulatoryconstraints.25

The What, me worry? approach toregulation had been made possible bythe agreement of free market capitalistsand redistributive egalitarians on policyin the mortgage market. This coalitionwas blown apart by the unraveling of thehousing bubble that preceded the nan-cial crisis. Housing prices started to fallin 2006, subprime mortgage bonds plum-meted in early 2007, and residential fore-

closures accelerated. Dealing with theforeclosure problem meant moving fromthe win-win scenario of the pumped-up housing market to the hard choicesinvolving helping borrowers through anon-budget bailout or forcing lenders totake a haircut via a moratorium or animposed reduction in either principalor interest.

Making these choices took place in afar more polarized political environmentthan was present at the time firrea re-solved the S&L crisis. Partisan blamegame politics prevailed over any grandcrisis coalition in the national interest.The rst move in this game was the Amer-ican Housing Rescue and ForeclosurePrevention Act (ahrfpa), signed intolaw by George W. Bush in July 2008, afterhe had threatened to veto an earlier billpassed by the House in May. The July

vote on nal passage in the House showeda sharp ideological split, with unanimoussupport from Democrats, support from

more moderate Republicans, and oppo-sition from conservative Republicans.Salient local issues can at times trumpideology, lobbying, and contributionsfrom out-of-constituency interests. Inthe ahrfpa case, Republican Housemembers also proved sensitive to theextent of foreclosures in their districts,especially foreclosures in Republicanvoting areas of the districts.26 ahrfpa,however, left so much discretion to lend-ers that it did little to avoid foreclosures.

The bubble denitively popped withthe failure of Lehman Brothers in Sep-tember 2008. Political circumstancesstrongly influence how the executiveand regulatory branches handle a pop.TheS&L crisis did not endanger the en-tire economy; for electoral considera-tions, both the Reagan administrationand the Democrat-controlled Congresschose to sweep the crisis under the rugin 19871988. It is instructive to com-

pare the 2008 crash with the stock mar-ket crash of October 1929 that occurred

just seven months into the four-yearterm of Herbert Hoover. His adminis-tration, largely personied by TreasurySecretary Andrew Mellon, respondedpassively. In a European parliamentarysystem, Hoover would not have beenexpected to survive for four years. TheAmerican institution of four-year termsmay well have contributed to the sever-ity of that crisis. (The Democrats didcapture the House in the 1930 midtermelections.)

In contrast to the setting of the Depres-sion, the crisis of 2008 occurred less thantwo months before an election and lessthan four months before the inaugura-tion of the new president. Not only wasthe incumbent president a lame duck,his presidency was tarnished by Iraq

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and other events. Bush had very limitedsway over Republicans in a Democrat-controlled Congress. In the push for the

nancial reform bill that passed in July2010, President Obama was out front,with Treasury Secretary Geithner in asupporting role and Fed Chairman Ber-nanke largely off-stage. But when thehousing bubble popped, Treasury Secre-tary Henry Paulson and Bernanke werefront and center. In the absence of pres-idential leadership, Paulson and Bernan-ke were especially concerned that theiractions be legitimated by Congressorat least not overly attacked. The nancialmarkets response to the initial failure ofthe Troubled Asset Relief Program bill(tarp, the bank bailout) showed thatthose markets could be roiled by eitherthe capitalist right, xated on moral haz-ard, or by the progressive left, botheredby the distributional implications of abailout.

Opposition from both extremes of theliberal-conservative spectrum, reelec-tion concerns, and a proposal from a Re-

publican administration facing a Demo-cratic Congress combined to blur ideo-logical voting on the tarp bill in Fall2008. When the auto bailout bill wasvoted on in December, there was strongideological polarization, a pattern thatreached perfection when the stimulusbill was considered early in the Obamaadministration. In the House, there wasperfect party separation, except for six,nonpivotal Democrats who were al-lowed to defect. In the Senate, therewas perfect ideological separation; theadministration made just enough con-cessions to buy the votes of the threeleast conservative Republicans: ArlenSpecter, Olympia Snowe, and SusanCollins. This pattern, likely to reappearon all aspects of nancial reform, wasagain manifest when Edward Kennedysreplacement, moderate Republican

Scott Brown, demanded and obtainedmodications to the conference reporton the 2010 reform bill. The modica-

tions beneted such nancial institu-tions as State Street Corporation andFidelity Investments, headquartered inBrowns home state of Massachusetts.27

Not only is polarization problematic ininitial reform efforts, the gridlock it pro-duces impedes the routine legislativemaintenance required for a robust regu-latory environment.28 Any reform legis-lation that may be forthcoming will un-doubtedly need such future ne-tuning.

Ideally, regulators would have the re-sources and expertise to monitor close-ly developments in the regulated sectorand the incentive to promulgate and im-plement policies that are in the publicsinterests. The conditions for such regu-latory performance are hard to meet inany domain, but the problem of regula-tory capacity is particularly acute in thecase of nancial regulation.

The most obvious difculty stems

from the complexity of modern nance.Armies of rocket scientists are employedto develop and implement increasinglycomplicated nancial products and trad-ing strategies. Many of the products arenot well understood by Wall Street ex-ecutives, much less outside regulators.This problem might be mitigated some-what if the regulatory agencies couldeasily draw from the same talent pool asWall Street. But the salary differentialsmake this difcult. The highest paid -nancial regulators (the president of theNew York Fed and the chairman of theFed) make a fraction of a middling trad-ers annual bonus. Even where regulato-ry agencies can hire individuals with thebackground to understand the intrica-cies of modern nance, such individualsare usually on their way from or theirway back to Wall Street. Such a revolving

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door undermines the autonomy of regu-latory agencies from the industry theyare supposed to regulate. Even if such

regulators are not motivated by a futureWall Street payout, they may still be in-clined to share Wall Streets worldview.

The most direct implication of low reg-ulatory capacity is that it will be hardto sustain a regulatory regime that de-pends too heavily on the delegation ofdiscretionary power to regulators. Thisconcern speaks directly to the debateabout whether a council of super-regula-tors can monitor the nancial sector foremerging systemic risks and react effec-tively with new capital requirements,leverage limits, or conversion of contin-gent bonds. Such a system requires thatregulators have very high levels of infor-mation and expertise as well as the in-centive to act in ways that may be ad-verse to the nancial services industry.The recognition of low capacity arguesagainst sophisticated discretionary regu-latory management of the industry andin favor of blunter approaches such as

banning the most systematically danger-ous products and practices or cappingthe size of nancial institutions. Blunter,less complex, and less lengthy legislationwould not only reduce opportunities fornancial innovators to nd loopholesbut also focus the attention of regulators.

Beyond the technical problems thatplague low-capacity agencies, there isimportant political feedback. Low ca-pacity makes it harder to hold agenciesaccountable to congressional and presi-dential oversight because it is harder todistinguish between bad policies andpoor implementation. This may causeelected leaders to be reluctant to endowagencies they cannot control with sub-stantial discretionary power.

Recently enacted legislation strives tomitigate these problems by strengthen-ing the informational capabilities of reg-

ulators (such as the creation of the Ofceof Financial Research in Treasury) andby enhancing accountability mechanisms

(especially those relating to the FederalReserve, including presidential appoint-ment of the head of the New York Fedand restriction of the Feds emergencylending authority with increased over-sight by the Government Accountabili-ty Ofce). But there are strong reasonsto believe that these reforms by them-selves will not signicantly improve -nancial regulation. Better informationand policy analysis can go only so far ifagencies lack the resources to act effec-tively on that information and analysis.The lack of expertise and informationalso reduces the value of increasing regu-latory capacity. Why increase the abilityof an agency to implement uninformedpolicies? Expertise and capacity are com-plements; this creates a bureaucraticreform trap.29

A reform trap also exists with respectto improving oversight and account-ability. Investing in greater oversight of

agency decisions is most valuable whenthe links between agency policy and out-comes are the most transparent, becauseit is then easier to detect policies Con-gress does not approve of. Since low ca-pacity distorts the relationship betweenpolicies and outcomes, more oversight isnot very helpful. Conversely, when over-sight mechanisms are poor, raising ca-pacity is not very valuable since the po-litical overseers do not benet from theincreased transparency of the policy-outcome link. Reforms, therefore, mightwell consider restrictions on rm behav-ior that would simplify rather than ex-pand regulatory authority. For example,a relatively limited (and visible) menuof exchange-traded derivatives mightbe preferable to a giant (but semi-secret)smorgasbord of over-the-counter spe-cial orders. Similarly, bank supervision

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might benet from the Volcker Rule,which, among other things, would pro-hibit banks from running private-equity

and hedge funds.

Although the current economic situ-ation is much more complex than thatof the S&L crisis, there are some simi-larities. There is conflict between largeand small banks and between intereststhat were cashiered (Lehman Brothers,Washington Mutual) and those thatwere rescued (Citicorp, Bank of Ameri-ca). Both crises were influenced by regu-latory venue shopping. Existing regula-tors have fought to maintain their turf,without regard to competency. Bothcrises were influenced by zombie seek-ing of high returns without due regardto risk. The reluctance to deal with theS&L crisis when the 1988 elections wereon the horizon appears to be paralleledby a failure to address reform of FannieMae and Freddie Mac before the 2010elections. More generally, the inadequa-cy of the S&L reforms gives pause as to

the effectiveness of the recently passedDodd-Frank Wall Street Reform andConsumer Protection Act.

There are several difculties in thepolitical process and in a regulatory-nancial complex that present severehurdles to effective regulation of the -nancial sector. First, we should keep inmind an observation made by the polit-ical scientist E. E. Schattschneider: innormal times, policy reflects the balanceof political clout among moneyed inter-ests; but if an issue becomes broadly sa-lient, as after an economic crisis, thenall bets are off. Politicians care about be-ing reelected, so if the folks get upsetthe politicians will cater to their wishes(or at least what the politicians perceivethese to be). Once an issue sinks backbelow the surface, the moneyed interestsreassert themselves.30 With the new reg-

ulatory reform legislation, many of thekey decisions will be made by regulatorsmonths and years afterwardwhen -

nancial regulation is not nearly so salientand therefore can be expected to bemuch more deferential to the industrythan the spirit of the legislation.

Second, because political polarizationappears to decline and rise with incomeinequality,31 and income inequality inturn partly reflects the strong increasein nancial sector prots and income,32

future efforts at dealing with U.S. nan-cial crises are likely to continue to occurin a highly polarized environment. Po-larization inhibits timely and effectiveresponses, both by causing legislativegridlock and by increasing the willing-ness of those out of power to block allchange until they get back in, ratherthan compromise on centrist policies.Intensive lobbying from affected inter-ests further reinforces ideological op-position.

Third, nancial markets are nowextremely complex, with myriad prod-

ucts. Regulatory incentives, staffs, andbudgets are not aligned toward success-ful monitoring and enforcement.33 Con-sequently, even if nancial products arelimited and regulated, private partieswill continue to innovate within theconstraints of existing regulation. Tech-nological change, as in data processingand mathematical models, will bringforth innovations. Regulators, in con-trast, are unlikely to be proactive withrespect to innovations.

Fourth, there is a taboo against rigor-ous enforcement. In his remarks at thePittsburgh G20 meeting in 2009, Presi-dent Obama spoke of the nancial cri-sis as the result of the reckless few.After Enron and WorldCom, PresidentBush claimed a few bad actors can tar-nish our entire economic system. Andfollowing the Panic of 1907, President

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Roosevelt comforted the public by de-claring, Dishonest dealing and specu-lative enterprise are merely the occasion-

al incidents of our real prosperity.34Once the immediate crisis has passed,there is little continued political payoffin either stating or acting on the premisethat most of those in the nancial sectorwill, at best, bend the rules as much asthey can and push politicians to get ridof the rules when the rules are incon-venient.

Finally, not only have nancial mar-kets become more interconnected, sohave the worlds of nance, politics, phi-lanthropy, and academia. For example,the outside directors ofaig between2005 and 2008 included Obama andClinton diplomat Richard Holbrooke,Clinton Defense Secretary William

Cohen, Reagan White House advisorand Harvard economist Martin Feld-stein, Ford Housing and Urban Devel-

opment Secretary and Bush trade rep-resentative Carla Hills, Ford energyczar Frank Zarb, American Museumof Natural History President Ellen Fut-ter, and public television executiveGeorge Miles. Feldstein, Futter, Hol-brooke, Miles, and Zarb served on theboard for all or part of the years 2005to 2008. Over that period, their individ-ual compensation as director rangedfrom $792,000 to $1,136,000.35 Again,once the crisis is past, criticism of thenancial sector from government, aca-demia, and nonprots is likely to bemuted. We appear to be stuck with theregulatory-nancial complex.

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endnotes

1 Poole thanks his colleagues at the University of Georgia for offering many helpful com-ments. Romer is grateful to the United States Studies Centre at the University of Sydney,where he was on sabbatical leave during the North American winter months of 2010,

for its gracious hospitality. It was an excellent environment for stimulating conversationsabout the global nancial crisis. Rosenthal thanks his colleagues at the California Instituteof Technology in the spring quarter of 2010, especially Peter Bossaerts and Jean-LaurentRosenthal, for discussion and comments, as well as participants in conferences at Colum-bia University and Universit Cattolica del Sacro Cuore.

2 Our summary of the politics of the S&L crisis is based on Thomas Romer and Barry R.Weingast, Political Foundations of the Thrift Debacle, in Politics and Economics in the1980s, ed. Alberto Alesina and Geoffrey Carliner (Chicago: University of Chicago Press,1991).

3 The two principal pieces of legislation were the Depository Institutions Deregulation andMonetary Control Act of 1980 and the Garn-St. Germain Depository Institutions Act of1982.

4Competitive Equality Banking Act of 1987.5 See David H. Pyle, The U.S. Savings and Loan Crisis, in Handbooks in Operations Researchand Management Science, vol. 9, Finance, ed. Robert A. Jarrow et al. (Amsterdam: Elsevier,1995).

6 The rtc is now generally thought to have done a good job, though it had some rockyyears. In disposing of the assets of failed thrifts, the rtc faced conflicting political man-dates (including social policy objectives such as minority contracting and affordable hous-ing, as well as getting the highest value for the assets). See Lee Davison, The ResolutionTrust Corporation and Congress, 19891993. Part II: 19911993, fdicBanking Review(2006), http://www.fdic.gov/bank/analytical/banking/2007apr/article1/index.html.


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7 Thomas Philippon and Ariell Reshef, Wages and Human Capital in the U.S. FinancialIndustry: 19092006, nberworking paper 14644 (National Bureau of EconomicResearch, 2009).

8See Markus K. Brunnermeier, Deciphering the Liquidity and Credit Crunch 200708,Journal of Economic Perspectives (Winter 2009).

9 Lawyers and law rms, considered a separate industry, contributed $126 million in 2008.Many of these contributors may also have had interests in nancial sector regulation.

10 See Nolan McCarty, Keith T. Poole, and Howard Rosenthal, Polarized America: The Danceof Ideology and Unequal Riches (Cambridge, Mass.: mit Press, 2006).

11 The law is more commonly known as the Gramm-Leach-Bliley Act, after its three Repub-lican cosponsors.

12 See Luigi Zingales, Capitalism After the Crisis, National Affairs (Fall 2009): 3031.

13 Certain energy derivatives contracts were exempt from regulation by the cftc. One ofthese exemptions was for trades conducted over electronic trading platforms such as theone developed by Enron; hence, the Enron loophole. See Mark Jickling, The EnronLoophole, report RS22912 (Congressional Research Service, 2008).

14 Ross Levine, An Autopsy of the U.S. Financial System, nberworking paper (NationalBureau of Economic Research, April 2010).

15 http://www.fdic.gov/bank/individual/failed/banklist.html (accessed July 21, 2010).

16 This belief extended to support for self-directed dened contribution pension plans andprivatization of Social Security.

17 See Edward M. Gramlich, Subprime Mortgages: Americas Latest Boom and Bust (Washing-ton, D.C.: The Urban Institute Press, 2007), 5.

18Johnson resigned his position on the selection committee after it was revealed that he re-ceived a loan on very favorable terms from Countrywide Financial Corporation, FannieMaes largest mortgage provider and a key player in the subprime lending crisis. See John

M. Broder and Leslie Wayne, Obama Aide Quits Under Fire for His Business Ties, TheNew York Times, June 12, 2008.

19 Clinton also named former Arizona Senator Dennis DeConcini to the Freddie Mac board,where he served from 1995 to 1999. DeConcini was one of the Keating Five and was for-mally criticized in 1991 by the Senate Ethics Committee for improperly interceding withthe fhlbb on Charles Keatings behalf.

20 See Lucian A. Bebchuk and Jesse M. Fried, Executive Compensation at Fannie Mae: ACase Study of Perverse Incentives, Nonperformance Pay and Camouflage, The Journal ofCorporation Law (2005).

21 See McCarty, Poole, and Rosenthal, Polarized America.

22 Some conservative groups, such as the Heritage Foundation, opposed the bill as scallyirresponsible. See http://www.heritage.org/Research/Reports/2003/12/American-Dream

-Downpayment-Act-Fiscally-Irresponsible-and-Redundant-to-Existing-Homeownership-Programs (accessed April 22, 2010).

23 See remarks of President George W. Bush, December 16, 2003, http://www.presidency.ucsb.edu/ws/index.php?pid=64935 (accessed April 22, 2010).

24 See Deniz Igan, Prachi Mishra, and Thierry Tressel, A Fistful of Dollars: Lobbying andthe Financial Crisis, working paper 09/287 (International Monetary Fund, 2009).

25 The development of the subprime mortgage market can also be traced back to the deregu-lation of the early 1980s. Subprime mortgages were based on charging higher interest ratesand offering arms to risky, often low-income and minority, borrowers. If borrowers had


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been informed of the risks, then allowing for the freedom to choose among a wider va-riety of mortgage products would make sense. Instead, naive borrowers were faced withpredatory, fraudulent, and unsupervised mortgage originators. See Gramlich, SubprimeMortgages.

26 Conservative Republicans, ideologically opposed to government intervention, were lesslikely to be swayed by economic conditions in their districts than were their more moder-ate colleagues. See Atif Mian, Amir Su, and Francesco Trebbi, The Political Economyof the U.S. Mortgage Default Crisis, American Economic Review (forthcoming).

27 Damian Paletta, Finance Bill Close to Passage in Senate, The Wall Street Journal, July 13,2010.

28 For example, although Glass-Steagall is now often hailed as instrumental in maintainingnancial stability through the 1980s, the regulatory regime it created needed to be patchedand extended by other important pieces of legislation, such as the Public Utility HoldingCompany Act of 1935, the Investment Act of 1940, and the 1956 Banking Act.

29John Huber and Nolan McCarty, Bureaucratic Capacity, Delegation, and Political Re-form,American Political Science Review (2004).

30 Elmer Eric Schattschneider, The Semisovereign People: A Realists View of Democracy inAmerica (New York: Holt, Rinehart and Winston, 1960).

31 McCarty, Poole, and Rosenthal, Polarized America.

32 Philippon and Resheff, Wages and Human Capital in the U.S. Financial Industry.

33 In the context of investigating the one thousand-point plunge of the Dow Industrial Aver-age on May 6, 2010, sec Chairman Mary Schapiro stated that the technology for collect-ing data and surveilling our markets is . . . as much as two decades behind the technologycurrently used by those we regulate. See Warp-speed Trades Outpace sec, Politico.com, June 1, 2010.

34 President Barack Obama, press conference, September 25, 2009, http://www.whitehouse.gov/the-press-ofce/remarks-president-g20-closing-press-conference; President

George W. Bush, weekly radio address, June 29, 2002, http://www.whitehouse.gov/news/releases/2002/06/20020629.html; President Theodore Roosevelt, October 24,1907, in The Letters of Theodore Roosevelt, vols. 18, ed. Elting E. Morison (Cambridge,Mass.: Harvard University Press, 1952), 839, cited in Robert F. Bruner and Sean D. Carr,The Panic of 1907: Lessons Learned from the Markets Perfect Storm (Hoboken, N.J.: Wiley,2007).

35 From aigs DEF14A lings, available at http://www.sec.gov. For 2006, 2007, and 2008we used aigs pricing of the value of stock grants and options. For 2005, we priced stockgrants at the closing price on December 30, 2005. We did not include a value for 2005stock options. Much of the value of stock awards was erased in the nancial crisis.

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07 Political Situation