Small-yet-broad is beautiful (or why it is good to have been British)

By Lorenzo

The central purpose of Calomiris & Haber’s Fragile by Design: the Political Origins of Banking Crises is to explain to Americans why their banking system does not perform as well as other countries–particularly compared to that of their neighbour, Canada. In chapter 14, the authors put the matter quite starkly:

… if a highly stable banking system is defined as one that has been crisis-free since 1970, then only six out of 117 countries–Australia, Canada, Hong Kong, Malta, New Zealand, and Singapore–meet the threshold for being both credit abundant and crisis free.

As the authors note, all six were part of the British Empire. Three (Hong Kong, Malta and Singapore) are city-states. The other three (Australia, Canada and New Zealand) are among the world’s most stable and long-lived democracies. The authors argue that these latter three countries also have something else in common:

… the structures and political histories of these three countries tended to mitigate the ability of populists and bankers to form coalitions that disadvantage everyone else.

Something that is very clear, is that “de-regulation” is a term empty of explanatory power. All successful six have liberalised financial markets–Australia and New Zealand, for example, were leaders in financial “de-regulation”. If someone starts trying to blame the Global Financial Crisis (GFC) on “de-regulation”, you can stop reading, they have nothing useful to say.

It is very much the point of Calomiris & Haber’s Fragile by Design to look at these issues comparatively and historically, which gets in the way of all sorts of congenial ideological narratives. Their final chapter (Chapter 15) is entitled “Reality is a Plague on Many Houses” just to make that point–particularly that Americans need to look outside their own history for answers.

Playing the game
In Chapter 2, The Game of Bank Bargains, they make it quite explicit that the question is always the actual structure of financial regulation:

… the normal functioning of banks depends on three sets of property rights that only government can provide. Banks need powerful governments. But power may not be wielded in the interests of bankers unless bankers can convince the group in control of the government to partner with them.

Hence the game of bank bargains. Hence also the political origins of banking crises. Or, as they say:

… our goal is to explore why banking is all about politics–and always has been.

It is inherent in the nature of banking given that:

Any enterprise whose inputs and outputs consist primarily of promises to repay debts is inherently unstable and risky.

Banks have to deal with credit risk and liquidity risk. Hence banks are pioneers of limited liability laws:

… in the vast majority of countries, the first enterprises to seek charters granting their shareholders a limit on liability were banks: the special limited-liability acts for banks typically antedated general incorporation laws by decades.

Which brings the government into the heart of banking.

A bank cannot simply declare that its shareholders have limited liability or other legal protections. Only the government can offer these. It does so by granting privileges–through bank charters–and enforcing them in courts. A charter is not just a license; it is a contract between the bank and the government.

To have an effective bank bargain, (1) bank assets have to be protected from government expropriation, (2) minority shareholders and depositors have to be able to stop bank insiders expropriating their assets or else be compensated for accepting the risk of expropriation by bank insiders, and (3) there has to be mechanisms to protect bank insiders, minority shareholders and depositors from expropriation by borrowers or else be compensated for accepting the risk of expropriation by borrowers.

Since 1970, six jurisdictions have managed to do all that. Why so few jurisdictions? Because governments face conflicts of interest in managing the game of bank bargains. They regulate banks, but borrow from them. They discipline debtors, but often rely on them for political support. They allocates losses among creditors in cases of bank failures, but may simultaneously look to them for political support. The constant temptation is to shift the game of bank bargains to benefit those who usefully notice at the cost of those who do not; the arsonists in charge of the fire brigade problem, with government having, as Calomiris & Haber put it “multiple opportunities to behave opportunistically”.

Most governments fail this test. Hence only 6 out of 117 jurisdictions managing the game of bank bargains so as to provide abundant credit but avoiding bank crises.

If the standard is set so as to include countries that have avoided a crisis since 1970, but are only required to have a level of credit to GDP equal to the mean across all countries, we get all the way to 13 jurisdictions out of 117: the “successful six” are joined by the Bahamas, Bahrain, Barbados, Belize, Macao, Mauritius and South Africa. All are former parts of the British Empire, except Macao, and all achieved independence peacefully.

Out of the 13, all but 3 are small islands or city-states. While, like Australia and New Zealand, South Africa (since the 1997 constitution was a brokered deal with the white minority) has institutions which:

… make it hard to populist movements to form coalitions with banks to enact regulatory policies that benefit them at the expense of everyone else.

The US, by contrast, not so much.

Small islands and city-states dominate the list of the successful players of the game of bank bargains because they are simply much more likely to have broadly-based bargains. (Though Iceland is a salutary reminder that success is not guaranteed from being small.)

As for the worst performers, setting the criteria as having at least two bank crises since 1970 and credit to GDP ratio at or below average gives us: Chad, the Democratic Republic of Congo, Argentina, Bolivia, Brazil, Cameroon, the Central African Republic, Colombia, Costa Rica, Ecuador, Kenya, Mexico, Nigeria, the Philippines, Turkey and Uruguay. (Kenya is clearly letting the British-is-better side down, though its path to independence was marred by violence. [Nigeria is also letting the British-is-better side down, but it is really a mistake as a single country.]) Basically, as the authors point out, autocracies, new democracies or democracies whose institutions provide few barriers to rent-seeking.

Broadening the question

Flag_of_Barbados_(1870–1966)When we look at lists of per capita GDP on a purchasing price parity (PPP) basis, we can see that the US is the only large country in the top 10 persistently included: the others being small (less than 10 million in population) as well as oil-rich, monarchical or democratic (or some combination thereof–looking at you Norway). So, clearly the US continues to do something right.

Of course, since the US is seriously a federation, it could be argued it is really a bunch of small countries operating in close formation. That what is by far the largest state by population (California) is also something of a public-policy mess adds plausibility to the claim. As does the only two countries with populations of over 10 million to get into any of the lists being Canada and Australia (also federations).

Clearly, the trick is to have responsive states. With smaller being generally better, as information flows more easily and more inclusively. It is generally just harder to stick it to folks (either by what you do or what you don’t do) in a way that doesn’t get noticed in smaller jurisdictions. (Unless jurisdictions are so small they fly under the media radar but are big enough to be semi-anonymous–urban local government in Oz has a bit of a problem there.)

There is an important caveat though, which Calomiris & Haber identify in discussing why Canada’s “bank bargain” has consistently worked so much better than the US’s–forcing policy bargaining to be at a broad level is less likely to generate nasty externalities. The Canadian “game of bank bargains” was played at a national level in a parliamentary-and-imperial system, so created a stable, interests-encompassing bargain more sensitive to long-term consequences.

The US “game of bank bargains” was played at State and Federal levels in coalitions built by adding individual constituencies together in congressional systems, creating unstable, interests-excluding bargains less sensitive to long-term consequences. (Since banking is all about risks across time, long term consequences are a particular problem for bank bargains.) But that is not actually an argument for bigger-being-better (Canada was always a much less populous jurisdiction than the US). It is an argument for more broadly-based being better. And broader is easier if smaller.

Still, that politicians are going to be looking to craft useful (to them) externalities means we can only expect politicians to deal with awkwardly visible negative externalities, not be a general solution to the problem of externalities. And we should also be sceptical of public policy mechanisms well set up to generate politically useful externalities. My nominations:

Public ownership.
Bureaucratic approval systems. (Unconstitutional in Germany, and good on them–they get their reward in much more rational housing markets.)
Complex tax rules.
Low visibility regulations. (Which would be most of them.)

17 Comments

  1. Nigel Davies
    Posted June 1, 2014 at 3:40 pm | Permalink

    Kenya is not the only ‘British’ failure on that list. Nigeria belongs there too. (And a few others would be not too far off…)

    On the other hand the list of ‘British’ successes have other things in common. Educated and literate voters with a strong tradition of property rights and a clear commitment to rule of law for instance.

    In fact is would be fair to suggest that British colonies, dependencies and protecorates that were already well established and literate trading nations before annexation, (or were at the very least under British administration for over a century and developed some competence at administration law and eduction if not), are almost universally successful. Whereas any British colony granted ‘independence’ without those qualifications is almost guaranteed not to be.

  2. Posted June 1, 2014 at 6:26 pm | Permalink

    [email protected] Oops about Nigeria, fixed that. The length and “depth” of British administration is an important factor.

  3. conrad
    Posted June 2, 2014 at 5:51 am | Permalink

    I think this is entirely biased — Australian banks almost did go broke about two and half decades. You could have picked up Westpac shares for $2 each. So it isn’t the case that the system was always especially stable.

    Alternatively, this is probably one of the reasons Australian banks got through the most recent problems (and hence the factors are thus quite idiosyncratic) — they managed to learn from it all and were simply more conservative than previously.

    This doesn’t seem to happen as much in the US presumably in large part because at the individual level it doesn’t matter if the bank you work for goes broke in the long term, and because they know the government will bail them out anyway. The first of these is also true of Australia (so perhaps this is just a cultural difference, or perhaps there are rules that help alleviate it), but the second is possibly not, because we simply may not have the money since the banks are now too big to save (although historically that wasn’t true).

  4. John Turner
    Posted June 2, 2014 at 6:45 am | Permalink

    I suggest the author should read the comments of Associate Professor William K Black on control fraud. The author appears not to have heard of Gresham’s Law; a law which simply states that competent enforced regulation is essential otherwise entities with no or poor ethics drive the other entities out of the market.
    The author also does not appear to know that on 15/16th September, 2008, when Lehman Bros went to the wall, all Australian banks had to be rescued because they were, in effect, bankrupt.
    I took the author’s advice and stopped reading when he suggested someone with my understanding of economics do so.

  5. John Turner
    Posted June 2, 2014 at 8:50 am | Permalink

    The article at the link below arrived just after I made my first comment.
    Maybe if the author read and understood the article at the link, and a few others at that blog written by Black, or Dr Stephanie Kelton, or J D Alt he might write more sensibly on economic matters.
    http://neweconomicperspectives.org/2014/06/spains-stimulus-plan-oxymoron-crafted-regular-morons.html#more-8288

  6. George Gell
    Posted June 2, 2014 at 11:24 am | Permalink

    Although I do not agree with John Turner that the article is entirely biased. He is correct that Westpac was in trouble in the late 1980s. An issue at $3 failed. The mismanagement of its subsidiary AGC was the main problem.
    Also Whitlam created a near collapse situation in his chaotic 3 years of power. I was able to assemble from clients a package of $500,000 to secure 25 % p.a. interest for a fixed three months from Westpac, then Bank of NSW.
    We have had some close calls.
    The 2007 so called crisis was all in the muddled head of a muddled Australian Government. With a fiat currency, a history of budget surplus, a strong trading relationship with China and a concentrated strong banking sector, a government guarantee of bank deposits was all that was needed–completely useless refund of tax, school building, and pink bats were totally a panic fuelled nonsense..

  7. Posted June 2, 2014 at 6:36 pm | Permalink

    Folks, “crises-free” does not mean no bank ever fails (or comes close to failing), it means there is no systemic crisis. If close-calls occur, but do not become crises, then that suggests the “game of bank bargains” is being played, well, better than most places do.

    [email protected] Westpac had problems, that is not a systemic crisis. Also, the US experienced a massive failure of prudential regulation, we didn’t. Their regulatory structure encouraged excessive risk-taking, ours didn’t–that’s the point.

    [email protected] I have heard of Gresham’s Law, you have apparently not, because that is not what it says. The folk version is “good money drives out bad”, but Robert Mundell has a more complete explanation, which I can highly recommend.

    Australian banks were not bankrupt (i.e. insolvent), there was some liquidity concerns. They were dealt with, so no crisis.

    [email protected] The linked article has nothing to do with anything discussed in the post. Perhaps you should have kept reading.

    [email protected] Crises averted count as not having a crisis, surely. Agree about the utterly unnecessary 2007 fiscal stimulus. The RBA had that side of things (keeping aggregate spending up) well in hand.

  8. conrad
    Posted June 3, 2014 at 6:11 am | Permalink

    Lorenzo — Australian banks got very close to broke (especially Westpac – but all the banks were flogged, they just wern’t so close). That would have triggered a systematic crisis (just look at what the tiny Pyramid building society did). We were just lucky (and lucky twice over because it’s probably one of the reasons they didn’t crazy the second time around, like the US banks did).

    A quick search around gives this interview they are talking about in passing: http://www.abc.net.au/money/vault/programs/prog3.htm

  9. conrad
    Posted June 3, 2014 at 6:12 am | Permalink

    where they are talking about it in..

  10. John Turner
    Posted June 3, 2014 at 11:38 am | Permalink

    It would have been better had I used the term a Gresham Dynamic. The former investigator in the US savings and loans crisis, Associate Professor W K Black, uses the concept in regard to business ethics in many of his posts at neweconomicsperspectives.org and in his book The Best Way to Rob a Bank is to Own One.
    Quantitative Easing in the USA has been the US Reserve swapping good paper for bad with US financial institutions banks. The banking crisis in the USA and elsewhere gave rise to the term too big to fail. That really meant the banks were so big that they could not be allowed to fail – they would have taken down too many other businesses.
    In 2007/8 the Australian Banks had massive short term loans denominated in foreign currencies. They could not meet calls on those loans. They were faced with trading while insolvent and the Australian Government took responsibility for their overseas borrowing. To me that is a bank failure situation.

  11. Posted June 5, 2014 at 5:18 pm | Permalink

    [email protected] Westpac ran close, but did not go bust and the other banks did not run as close and did not go bust either. That is a long way from systemic crises. A bank failure is only a systemic crisis if it generates a contagion effect. The problem with Pyramid was a mishandling of both the prudential regulation in Victoria (NSW refused to let it enter their market, because it was judged not to be up to scratch) and mishandling it when it ran into problems. The claim is not that the polities which did well never had any bank failures, but that they never actually had systemic crises.

    And the “we were just lucky” explanation gets way over-used. Our prudential regulation works better, and for reasons.

    [email protected] In 2007/8 the Australian Banks had massive short term loans denominated in foreign currencies. They could not meet calls on those loans. They were faced with trading while insolvent and the Australian Government took responsibility for their overseas borrowing. To me that is a bank failure situation. You are not describing insolvency but a liquidity crisis, which is why systems have lenders of last resorts. The claim is not that there never will be, nor were, shocks to the financial system, merely that the shocks will be successfully managed, which they were.

    “Gresham’s Dynamic” is an overblown claim misusing the original concept, which relies on the idea that the one thing (coins) have different values in different situations.

    QE is a whole different matter to the subject of this post.

    Too big to fail is rather older than the GFC (dating back to at least 1984) and, indeed, helped feed into said crisis.

    Your level of (mis)understanding is not a recommendation for the websites you keep recommending.

  12. Posted June 6, 2014 at 10:19 am | Permalink

    Our big banks are living on the edge, benefit from an uneven playing field and are massively subsidised by the taxpayer.

    The big banks ran to the Government during the GFC and the Government saved them. Lorenzo uses the following weasel words to describe the situation:

    Australian banks were not bankrupt (i.e. insolvent), there was some liquidity concerns. They were dealt with, so no crisis.

    These two http://www.theaustralian.com.au/business/opinion/how-taxpayers-cosset-the-banks/story-fnc2jivw-1226377855248articles are worth reading.

  13. Posted June 6, 2014 at 1:02 pm | Permalink

    [email protected] Your link does not work.

    And if you cannot work out the difference between being insolvent (i.e. assets are less than liabilities) and having liquidity problems (your current holdings of cash are not enough to meet current demands), you really cannot talk about financial crisis, shocks, etc usefully.

    Yes, the Big Four get supported, not denying that. But the trade-off is stricter prudential regulation. (The whole point of Calomiris & Haber’s book is, after all, that banks are always, and inevitably, specifically regulated.)

    Again, the claim is not that there are never any financial shocks, nor never any liquidity issues, etc, nor that the Australian government does not provide lender of last resort capacities. The point is that the above was enough to be deal with the financial shock, so no actual systemic crises (as distinct from a merely possible one).

    Or, to put it another way, our Game of Bank Bargains works rather better than other folks’–particularly the US’s.

  14. Posted June 6, 2014 at 2:02 pm | Permalink

    Sorry. Links are here and here.

    Usually Creighton is full of crap but there is some substance to his claims in this case, I think.

  15. Posted June 6, 2014 at 7:57 pm | Permalink

    [email protected] Yes, there is a guarantee to Oz banks. Yes, that reduces their capital costs. Yes, that is why managing effective prudential regulation is the necessary corollary. This was the biggest single failure in the US: the failure to do so.

    Part of the difference here is that our mortgages are serious–you retain the debt no matter what happens to the house.

  16. Nigel Davies
    Posted June 13, 2014 at 6:39 pm | Permalink

    Amazing, a great article to challenge people’s thinking about stability in political structures, and the nit-picking is all about definition of obscure terms.

    The point of the article was British style structures vs non British style? Anyone want to make a useful comment on that?

    How about if I stir by stating that constitutional monarchies are always going to be more stable and secure and enduring than republics? Any response?

  17. Mel
    Posted June 13, 2014 at 8:59 pm | Permalink

    Nigel:

    Any response?

    You’re an idiot.

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