24 April 2020
The Wealth Effect:
How the great expectations of the middle class have changed the politics of banking crises
Jeffrey M Chwieroth and Andrew Walter
2019, Cambridge University Press, 596 pages,
Reviewer: William Allen
Why did governments bail out distressed banks in 2008? The obvious explanation is because they thought that the systemic consequences of letting the banks fail would be worse than bearing the costs of the bailouts. Economic historians understood that bank failures, and the absence of deposit insurance, were the main reason why the depression of the 1930s was so bad, and were therefore partly responsible for its catastrophic consequences. Politicians understood that, too. President Obama, when nominating Ben Bernanke for a second term as Chairman of the Federal Reserve, referred explicitly to Bernanke’s understanding of the causes of the Great Depression
Chwieroth and Walter reject the obvious explanation, which they find ‘unsatisfying’. Their preferred explanation is that the increase in voters’ wealth, by which they mean financial wealth, over the past 200 years or so has made them increasingly supportive of bailouts and that politicians, who need to get elected, do what voters want.
They identify three sub-periods since the early 19th century. In the first era – ‘low expectations’ – ‘most voters had a limited stake in financial stabilization and did not see governments as responsible for preventing crises and mitigating their impact.’ That era lasted until 1945. In the second era, which they call ‘the Bretton Woods years’, severe banking crises were rare. It was in the third era, ‘when banking crises returned with a vengeance’, that voters’ expectations kicked in. ‘Our key argument’, they say, ‘is that this middle voter bloc [in the middle of the income and wealth distribution] has moved from a soft Bagehot stance towards a strong bailout stance over the course of a century or more.’ (p 27)
The argument lacks understanding of the historical context and does not stand up to close examination. In the first era, the experience of financial crises in the 1820s and 1830s led to the Bank Charter Act of 1844, which, it was hoped, would prevent future crises. It failed to do so, and the Bank of England took on the role of lender of last resort in 1847, 1857, 1866 and 1890. It was pressed to acknowledge a permanent responsibility for last-resort lending, to solvent banks, notably by Walter Bagehot, the editor of The Economist, and it ultimately did so. The authors’ claim that ‘newspaper opinion exonerated [public sector actors] from responsibility for financial instability’ (p 149) is therefore not entirely accurate; but to the extent that it is accurate, it only demonstrates the irrelevance of newspaper opinion. And the first era was one in which voters showed a keen interest in personal financial stabilisation, which led to the Liberal Party’s social reforms of 1906 – 1914, and to the commitment made to full employment in 1944.
The other important development of the first era in the United Kingdom was the concentration of the banking system. Between 1870 and 1920, a long series of takeovers and mergers ended with the dominance of the ‘Big Five’ London clearing banks. These banks were initially conservatively managed, but even then they were too big to fail, as the Bank of England recognised in the 1920s, just as the building societies were judged too important to fail in 1939 when the legality of some their assets was questioned. This, it seems to me, was the crucial change which made bailouts of large distressed banks unavoidable.
Financial conditions in Britain in the second era, after 1945, were overshadowed initially by the enormous debts that the government had run up in wartime, and later by post-war governments’ unrealistic expectations of the country’s productive capacity. There was no alternative to financial repression as an instrument of macro-economic policy, and it was tested to destruction. The government solved its debt problems by inflation. In doing so it helped the banks, which paid no interest on current account deposits, being protected from competition as a necessary quid pro quo for complying with official restrictions on their lending. It’s not surprising that there were no severe bank failures.
The third era began after the conflict between financial repression and inflationary macro-economic policies had erupted. The former became unsustainable; unfortunately the latter continued for quite a while. Out of that chaos came the ascendancy of free-market politics in the 1980s. The authors talk a lot about financialisation, which can perhaps be thought of as a rising proportion of financial assets to total wealth. Certainly financialisation has happened, on a grand scale, as they show. To some extent, it is the result of policy choices – e.g. the decisions of the British monetary authorities, beginning in the 1960s, to promote London as a global financial centre, to abolish exchange controls in 1979, and to deregulate securities trading in 1986. But to a large extent, financialisation is a by-product of other developments. Above all, increased life-spans and much longer retirements have created a demand for assets to finance pensions. And the rise of owner-occupation in housing (30% of houses were occupied by their owners in 1951, 63% in 2017) has led to rising demand for mortgages. The banks’ behaviour became egregious in the early 21st century, and the government and its agents in the Bank of England and the Financial Services Authority knew that they were too big to fail. But they too were caught up in the optimism of the time, and did far too little to protect the public from the risks of a financial collapse.
The Bank of England failed to act in accordance with Bagehot’s precept as lender of last resort to Northern Rock in 2007, even though the latter’s regulator, the FSA, said that it was solvent. That failure, and the consequent run on Northern Rock, caused great alarm worldwide, the effects of which are unmeasurable. When other banks got into distress in 2008, assessing their solvency was very difficult, because of the opacity and unmarketability of many of their assets. Lehman Brothers was allowed to fail, because the Fed, deeming it to be insolvent and following Bagehot, declined to support it. In the ensuing panic, governments felt compelled to bail most other banks out for fear of a new Great Depression. They were surely right to do so, just as the authors are surely wrong in suggesting that voters supported bailouts, whatever newspapers said. In the United States, the TARP (Troubled Assets Relief Program) was initially rejected by the Congress because so many voters made their representatives aware of their hostility to financial bailouts. And, as the authors note, the governing parties in the USA and the UK both lost the next elections after the financial crisis.
I can’t understand why Chwieroth and Walter reject the obvious explanation of the bailouts of 2008. Nevertheless, they are surely right to draw attention to the threat that financial instability poses to political stability. The continued existence of too-big-to fail banks has been addressed by heavier and more intrusive bank regulation, but it remains to be seen whether this will prevent future failures, and whether it is having unwanted and unintended side-effects.