These days it takes a medieval fantasy to help us remember why liberal democracy is worth cherishing.
A prime example of the “adhocracy” that Philip Wallach refers to in his Liberty Forum essay is presented in his book To the Edge. He there describes as “adhocracy” the response to the 2008 financial crisis by the Bush and Obama administrations. For Wallach, the government’s actions amounted to “adhocracy” because they were “an unpredictable pattern of responses” that “flowed not from deliberation of lawmakers but from hurried decisions of unelected officials deriving their authorities from obscure sources.”
Despite the federal government’s “adhocracy” in the financial crisis, To the Edge praises the federal response for preventing another Great Depression. Wallach admits, however, that the “efficacy” of the government’s bailouts did not lead to public acceptance of their “legitimacy.”
In Wallach’s view, the perceived legitimacy of government action depends on four factors: legality, democratic support, trust, and accountability. Measured by at least three of those factors, it should not be surprising that the public did not accept the legitimacy of the federal government’s rescue programs. The programs were not viewed as democratic because they displayed a shocking degree of favoritism toward “too big to fail” (TBTF) banks while providing little help to beleaguered homeowners, community banks, and small businesses. Many citizens concluded that the government was untrustworthy and unaccountable because the preferential treatment received by megabanks seemed to be a byproduct of Wall Street’s political clout.
Public anger over the bailouts generated vehement protests on the Right (the Tea Party) and the Left (Occupy Wall Street), as Wallach correctly points out. However, for the reasons discussed below, I believe that the bailouts lacked legitimacy not because of their “adhocracy” but because they were part of a broader pattern of “capture” that continues to plague our political system and financial regulatory process.
In a recent article, I described the extraordinary nature of the federal government’s bailouts for large financial institutions. Federal agencies provided more than $850 billion of financial aid to prevent the failures of Citigroup and Bank of America. The Treasury and the Fed bailed out AIG with more than $180 billion of financial assistance. AIG used half of that money to pay off 100 percent of its credit default swaps and other obligations to a group of big U.S. and foreign banks. Federal agencies also provided hundreds of billions of dollars of capital infusions and debt guarantees to large banks. The Fed extended trillions of dollars of emergency loans and also adopted zero-interest-rate and “quantitative easing” policies that were highly beneficial to big financial institutions. In February 2009, federal regulators issued the ultimate TBTF pledge when they publicly guaranteed the survival of the 19 largest U.S. banks.
In contrast to the federal government’s massive support for big banks, it gave little help to smaller banks, and more than 450 of them failed between 2008 and 2012. Unlike megabanks, community banks made very few subprime loans and bore little responsibility for the financial crisis. Yet those banks were deemed “too small to save” and were allowed to fail, along with thousands of small businesses that relied on them for credit.
The federal government’s treatment of underwater homeowners was even more appalling. Congress appropriated $45 billion to help struggling homeowners as part of the Troubled Asset Relief Program (TARP). However, according to the most recent report issued by the Special Inspector General for TARP, the Treasury spent only $16 billion of those funds.
In February 2009, the Obama administration declared that its newly-adopted Home Affordable Modification Program (HAMP) would “enable as many as 3 to 4 million at-risk homeowners to modify the terms of their mortgage to avoid foreclosure.” More than six years later, fewer than one million homeowners have obtained long-term modifications of their mortgages under HAMP. Many of those homeowners now confront a serious risk of default because the grace period on their modified loans will soon expire and their interest rates will rise sharply. Due to the shortcomings of HAMP and other housing-related programs, more than nine million homes have been lost to foreclosures, short sales, or deeds in lieu of foreclosure since the beginning of 2007.
The Obama administration rejected numerous proposals to give principal relief to deserving homeowners through mortgage “cramdowns” in bankruptcy or through refinancing programs similar to the Home Owners’ Loan Corporation of the 1930s. The administration did not approve principal reductions because it wanted “to avoid destabilizing banks by forcing mortgage losses onto them,” as Wallach points out in To the Edge. In other words, when the interests of the megabanks conflicted with those of homeowners, the administration sided with the banks.
As Wallach’s book acknowledges, three prominent public officials—then-Chairman Sheila Bair of the Federal Deposit Insurance Corporation, Special Inspector General for TARP Neil Barofsky, and Congressional Oversight Panel Chair Elizabeth Warren—strongly criticized the Treasury and the Fed for bailing out TBTF banks while doing little to help struggling homeowners. Wallach concludes that Bair, Barofsky, and Warren were not effective in undermining the legitimacy of federal rescue programs because they did not show that federal officials acted in a “corrupt” manner. However, for the reasons stated above, I believe that the critique by Bair, Barofsky, and Warren resonated with many citizens.
The federal government’s blanket protection for megabanks during the financial crisis was part of a much larger and longer pattern of official largesse for our biggest financial institutions. As I pointed out in a 2013 article, Congress passed a series of measures that served the interests of big banks between 1994 and 2005, including:
- removing geographic restrictions on bank expansion, thereby authorizing the creation of huge nationwide banks;
- removing prohibitions on affiliations among banks, securities firms, and insurance companies, thereby sanctioning the emergence of massive financial conglomerates;
- exempting over-the-counter derivatives from any regulation by the federal government or the states;
- making it far more difficult for consumers to obtain relief from their debts in bankruptcy; and
- expanding the “safe harbors” in the Bankruptcy Code for derivatives and securities repurchase agreements, thereby allowing big banks and other Wall Street creditors to seize their collateral and close out their contracts when their customers fail, without any oversight by bankruptcy courts.
The foregoing laws encouraged enormous growth and excessive risk-taking within a highly leveraged, massively concentrated, and dangerously interconnected financial system, all of which took us to the brink of economic catastrophe in 2007 and 2008. Similarly, federal regulators issued numerous rulings during the 1990s and 2000s that reduced capital requirements for large banks, promoted reckless subprime lending, and preempted efforts by state officials to protect their citizens from predatory loans.
In short, the extraordinary financial help and forbearance received by megabanks during the financial crisis represented a continuation of the many legislative and regulatory concessions they had received during the credit boom of the 1990s and 2000s. The long list of legislative and regulatory favors for megabanks is, unfortunately, entirely consistent with the federal government’s abject failure to pursue criminal prosecutions or impose meaningful civil penalties against culpable senior executives of major financial institutions.
True, federal authorities have collected fines from giant banks, but those fines have been accompanied by generous waivers that are carefully designed to avoid disrupting the banks’ ongoing operations. As a result, the fines have amounted to just another cost of doing business. Meanwhile, new scandals involving money laundering, tax evasion, price-rigging, fraud, and other abuses by major banks continue to appear with distressing regularity. Little wonder that senior regulators have expressed frustration over their inability to change the culture of recklessness and impunity that pervades Wall Street, the City of London, and other large financial centers.
Considering all of this, it seems only fair to ask: adhocracy on whose behalf? It also seems logical to question whether the pattern described above is really “adhocracy” or instead represents a dangerous “capture” of our political system and financial regulatory process by large financial institutions. Those concerns continue to grow in light of the tsunami of political contributions and lobbying expenditures that the financial sector has unleashed over the past quarter century.
According to the Center for Responsive Politics, the financial sector is “far and away the largest source of campaign contributions to federal candidates and parties” and accounted for almost $4 billion of political contributions between 1990 and 2014. The financial sector also spent nearly $6.5 billion on lobbying between 1998 and 2014. In 2009 and 2010, while Congress debated the Dodd-Frank Act, the financial industry employed more than 1,400 lobbyists who were former federal employees, including 73 former members of Congress. Jamie Dimon, chairman of JPMorgan Chase, candidly referred to government relations as his bank’s “seventh line of business.”
Because of public outrage over the federal government’s bailouts and Wall Street’s culpability for the financial crisis, the financial industry could not prevent Dodd-Frank’s passage in July 2010. However, Wall Street’s lobbyists and political allies succeeded in watering down key provisions of Dodd-Frank. In addition, during the past five years the industry has undermined Dodd-Frank’s implementation through relentless lobbying and litigation. Congress recently repealed a crucial section of Dodd-Frank, and more than a third of the required implementing rules still remain unfinished.
The “revolving door” between Wall Street and Washington provides further evidence of the financial industry’s far-reaching influence over legislative and regulatory policies. Robert Rubin, Lawrence Summers, Timothy Geithner, Henry Paulson, Annette Nazareth, Peter Orszag, Jacob Lew, William Dudley, and Mary Jo White are recent examples of the steady stream of senior officials that flows continuously between the commanding heights of Wall Street and top positions in the Treasury, Fed, and other financial regulatory agencies.
Regulatory “capture” occurs when senior financial regulators align their policies with the views of their Wall Street peers due to an extensive network of professional relationships and social friendships. As James Kwak has explained, this type of “cultural capture” operates through a set of shared understandings, which ultimately produce “regulatory actions that serve the ends of industry.” Shared understandings are forged not only through revolving-door employment opportunities given to regulators who accept the industry’s viewpoint, but also through ostracism of other regulators who refuse to accept the Washington-Wall Street “consensus.”
Financial industry leaders and their regulatory allies repeatedly marginalized opponents of financial deregulation during the 1990s and 2000s by claiming that those critics “did not understand the bright new world of modern finance,” as Simon Johnson and James Kwak have explained in 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (2011). In one well-known example, Alan Greenspan, Rubin, and Summers silenced Brooksley Born, a chairman of the Commodity Futures Trading Commission who dared to suggest in 1998 that the federal government should adopt stronger regulations for derivatives.
In 2011, the Independent Evaluation Office of the International Monetary Fund published a revealing report on the reasons for the IMF’s failure to identify or respond to the reckless behavior and financial abuses that caused the financial crisis. Its conclusion:
IMF’s ability to identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, [and] a general mindset that a major financial crisis in large advanced countries was unlikely.
The report further explained that a financial crisis was deemed “unlikely” because the IMF’s leadership believed that “market discipline and self-regulation would be sufficient to stave off serious problems in financial institutions,” and “‘sophisticated’ financial markets could thrive with minimal regulation.”
The IMF’s report confirms that “groupthink” and “intellectual capture” contributed to the lack of effective action by regulators during the period leading up to the financial crisis. After the crisis hit, the federal government’s massive support for megabanks and its failure to hold senior executives accountable for misconduct have reinforced public cynicism about the financial industry’s influence over legislative and regulatory policies. Until Washington demonstrates that it has regained independence from and control over Wall Street, the public will continue to view our financial regulatory policies as lacking in legitimacy.
To regain such independence and control, Washington must discard the pro-megabank policies advocated by Rubin, Summers, and Geithner. All three insist, along with other big bank supporters, that we must tolerate the enormous risks associated with TBTF banks because only financial giants can provide the services needed by multinational corporations. There is little empirical support for that argument, and any possible benefits for multinational firms are far outweighed by the social costs of systemic financial crises created by megabanks.
When financiers made similar claims a century ago, Louis Brandeis persuasively rebutted them. Wall Street’s leaders argued in the early 1900s that the “great banking houses” were needed to “perform efficiently the country’s business.” In response, Brandeis demonstrated (in his 1914 book, Other People’s Money and How the Bankers Use It) that “banker-management” had caused great injury to the public through “financial recklessness,” pervasive conflicts of interest, mismanagement, and suppression of competition. Brandeis warned, “We must break the Money Trust, or it will break us.” His warnings were ultimately heeded in 1933, when Congress passed the Glass-Steagall Act to break up the giant financial conglomerates that helped to promote the speculative boom of the 1920s.
Support for Glass-Steagall eroded after decades of criticism by big banks and other advocates of deregulation. Even so, that statute provided the basis for a stable and successful financial system that endured for almost 50 years without a serious financial crisis. In contrast, after big banks convinced regulators to open loopholes in Glass-Steagall during the 1980s, and ultimately persuaded Congress to repeal it in 1999, we again suffered through a devastating boom-and-bust cycle comparable to the period between 1921 and 1933. It is long past time for Washington to take effective action, once again, to remove the economic and political dangers created by megabanks.