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Friday, October 31, 2008

"Financial Crises and Democracy"

James Kwak on "the role of democratic politics in responding to the financial crisis":

Financial Crises and Democracy, James Kwak: Lorenzo Bini Smaghi, a member of the Executive Board of the European Central Bank, gave a thought-provoking speech in Milan last week. In particular, he focused on the role of democratic politics in responding to the financial crisis and, more broadly, in how governments manage their economies. Smaghi begins with the premise that it was a mistake to let Lehman fail in mid-September (not everyone agrees with this, but many people do), thereby triggering the acute phase of the credit crisis. He then asks why this happened.

As subsequent events have shown,... when the first rescue package was rejected by the US Congress, opposition to providing the financial sector with public funds came not only from within the government, but also from parliament. The Members of the US Congress, many of whom face voters at the beginning of November, feared that such a decision would compromise their re-election. There was opposition to rescuing Lehman Brothers, therefore, not only from within the Administration, but also from Congress and, more broadly, from public opinion. In other words, the decision was largely the result of a democratic process.

For Smaghi (and for many others), however, the systemic importance of the financial sector meant that it was actually in the interests of US citizens to bail out Lehman and, later, much of the financial sector. ...

Smaghi continues by investigating why the public is opposed to a rescue of the financial system that is actually in its own interests.

My opinion is that this doesn’t require investigation, as there is little reason to expect people to vote in their own economic interests since, in most cases, thick screens of political rhetoric make it extremely difficult for them to identify where their interests lie. To take the most obvious example of the moment: According to the non-partisan Tax Policy Center, Barack Obama’s tax plan will be better for the bottom four quintiles of the income distribution, and John McCain’s plan will only be better for the top quintile (see the figure on page 41); yet more Americans think that Obama will raise their taxes than that McCain will (50% to 46%), thanks to the constant repetition of the “spreading the wealth” sound bite (note how the numbers have reversed in just the last two weeks). If governments make the right economic choices on occasion, it is sometimes in spite of popular opinion but, most often, because the public does not have a strong opinion on the topic. (How many people get worked up about the Fed Funds rate, at least in normal times?)

In some respects, it may actually be good that the economy is being overseen by a lame-duck administration that is largely free to ignore public sentiment, and therefore has been able to ditch its vocal anti-regulatory ideology in favor of a series of pragmatic steps that, collectively, constitute the largest direct government intervention into the economy in my lifetime. There are certainly aspects of the intervention that reflect the free-market instincts of the players concerned, such as the outsourcing of TARP to banks and asset management firms and the relatively gentle recapitalization program. But on the whole, it is an exercise of government power in the economy that until a few months ago was anathema to the conservatives in the administration. ...

We will need to decide how much of the power to respond to financial crises we want concentrated in the hands of an independent Federal Reserve who can react with less concern for the political consequences of their actions, and how much of the power we want in the hands of congress so that policy choices are subject to legislative debate and procedures, and there is accountability to voters. We've seen that too much concentration of power can be risky - the original Paulson bailout plan showed us that we shouldn't trust all that power in the hands of one person, and we were fortunate that checks and balances led to modification of the plan into something more acceptable. Even so, my own preference is to put quite a bit of the authority in the hands of the Fed even when it involves actions such as the purchase of risky securities that put taxpayer money at risk (but I should acknowledge that view does not appear to be a widely held).

Putting the power in the hands of a single individual gives us the ability to respond quickly to any financial crisis, but this represents too much concentration of power and is risky for that reason. But congress is overly deliberative and can be too slow to react to problems, it is subject to myopic political concerns that can come at the expense of the long-run health of the economy, and members of congress often lack the knowledge needed to understand the full implications of alternative policy choices. So perhaps the Fed represents a workable medium between these extremes that offers relatively speedy action, deliberation among the board memebers, bank presidents, and staff, implicit oversight from congress, and shared consent for policy choices that gives us, on average, better and less costly policy outcomes.

    Posted by on Friday, October 31, 2008 at 05:40 PM in Economics, Financial System, Politics | Permalink  TrackBack (0)  Comments (28)

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