It's time to challenge Wall Street from the supply side
Big banks insist they need high-risk leverage to provide access to credit. The new supply siders can expose the humbug.
Today we are taking a break from our forum on the politics of abundance to return to back to the abundance policy agenda, with an essay of mine that links to our previous forum on our still-unfixed problem of bank regulation.
The burgeoning movement for an “abundance agenda” is focused on dislodging the special interests that block the production of more goods and services in sectors including housing, transportation, energy, health care, and intellectual property. But so far, abundance advocates have had little to say about finance, the sector that must underwrite the growth they hope to unleash.
That void is being filled by megabanks, which are currently fighting tooth and nail against regulations that would slightly reduce their reliance on borrowing. A scare campaign warns that the new rules would make "loans, utilities, and groceries more expensive” and that “no one stands to lose more than hardworking Americans.”
This is, to quote L. Frank Baum, “a Great and Terrible humbug.” It is one thing to recognize that, at some point, there may be trade-offs between ensuring financial stability and other economic goals. It is quite another to warn that any change will kneecap the common man while ignoring the economic (and political) carnage that another major financial crisis would unleash.
The burgeoning abundance movement is well-positioned to deflate the nonsense and reset the debate. Its cross-ideological strands—supply-side progressivism on the left and state-capacity libertarianism on the right—and its growth-oriented bona fides provide credibility. Its progress in dismantling shibboleths in the devilishly complex arenas of housing and energy suggests a capacity to take on the tangled world of finance. And its connection to young professionals in financial centers like New York, Boston, and San Francisco gives it a powerful audience.
But for an emerging coalition that already has a full plate, the question may be: Why bother?
A new supply-side economics can’t ignore finance
Nothing happens without financing, and abundance advocates should have their own story to tell about ensuring the economy’s supply of lifeblood. Here’s why:
Banking is central: For much of American history, banking policy was a central topic of political debate. Andrew Jackson waged epic battles against the Bank of the United States; the Populist movement and its prophet, William Jennings Bryan, derided tight money supply as a “cross of gold”; FDR decried “reckless banking” and rebuilt the economy around a new model of consumer credit.
At the level of theory, figures from Alexander Hamilton through Milton Friedman integrated analysis of the financial sector into their broader prescriptions for the economy, with profound influence. The rise of Friedman’s monetary theory overlapped with the original “supply side economics,” which posited that liberating capital through lower taxation and deregulation would drive growth and efficient resource allocation. But it turns out the choice in banking is not between more or less regulation — it’s between better and worse, simpler and more complex, prophylactics and life support.
Now, as Kathryn Judge put it in a recent Yale Law Journal essay, “Banking law is an integral component of the broader conceptual effort underway to reconsider the aims, tools, and assumptions animating economic policymaking more generally.”
Banking is captured: The problems plaguing banking should be familiar to thinkers gathering under the banner of abundance. These advocates know that incumbents who enjoy government protection often argue that their privileges are all for the greater good. In housing, they say that limiting supply will maintain “neighborhood character” and ward off ruinous increases in traffic or school enrollment. In health care, they claim to defend the patient-doctor relationship or preserve high standards of care. In energy, they claim to provide the most secure resources or to protect consumers from high costs.
In banking, the capture revolves around equity requirements — rules about how much shareholder investment (as opposed to debt) should be backing banks’ loans and other assets. The biggest firms argue that requiring more equity will constrict their ability to lend to worthy borrowers because “equity is expensive.” But if shareholders require higher returns than lenders to give banks their money, it is because they face a different risk profile. The difference is that while lenders can expect a government bailout to rescue them if things go sideways, shareholders cannot. This is because stock prices adjust automatically, and a blow to shareholders poses much less of a contagion risk. The upshot is that higher equity requirements make it more costly to take on high-risk investments by design.
However, the nature of this cost is widely misunderstood. It is often falsely explained as “setting aside” money. This fundamental confusion conflates funds raised from shareholders with reserves, which are registered on the other side of the balance sheet. This is the language used to argue that the new regulatory proposal slightly raising equity will limit credit to worthy borrowers such as needy homebuyers and green energy projects, for example. (And while bankers are making such causes the face of their lobbying, the biggest impact of the contemplated rule would be on capital-market activities and fees from services like brokerage, according to the Congressional Research Service.)
It’s a politics of high scarcity and low state capacity: To be sure, even once it is understood that equity standards do not require anyone to “hold” or “set aside” capital, it is possible that various sectors may be disadvantaged when the bar is raised — but abundance advocates have an answer there, too.
To see why, you have to get through some background. Equity requirements — as they work today — are “risk-weighted,” and go up or down depending on where a bank puts its money. If a given investment is classified as higher risk, it raises the equity-to-debt ratio a bank must operate with. But bankers prefer debt because it comes with implicit guarantees of government bailouts. That is why, whenever regulators touch equity rules, they kick over a hornet’s nest of interest groups that seek to be classified as low-risk — including those backing worthy causes such as low-income housing.
One way to lower the temperature is to point out that for those who seek more green energy or housing for low-income Americans, the abundance agenda offers far more direct answers: make it easy to build more and do it more cheaply. In other words, the fact that some mortgages could become less appealing to issue matters much less if the underlying price of low-income housing is driven down. The fact that green energy investments might look less attractive from a financial engineering perspective is unimportant if they become much more likely to survive permitting hurdles. Fighting over risk weights is a game for people who can’t grow the pie.
But the best way to get out of this tangle is to eliminate bankers’ preference for debt by persuading markets that bailouts really are a thing of the past—and that can only be done with a steep hike in equity requirements. Even if bailouts weren’t an issue, the current method is bound to perpetually keep the government a step behind. The risk-weighting approach assumes that regulators can parse the balance sheets of trillion-dollar institutions and understand which investments fit into different tiers of risk. One way to increase state capacity, of course, is to ensure a well-staffed and expert bureaucracy. But often, the straightforward solution is to reduce the burdens on that bureaucracy. Regulators’ lives would be much simpler if their first line of defense were a high equity ratio, period — not a guess about how risky this or that investment could become.
Abundant faith
Taking on bank regulation may seem unexciting compared to the abundance movement’s other targets. It’s largely a matter of playing defense, in that a better equity standard for banks won’t set off a flowering of new housing or high-capacity transmission lines. By the same token, the cost of poor bank regulation is largely invisible at the moment. Any future reckoning is not keeping anyone poor right now.
But if it comes, a new financial crisis could prove even more devastating than the last, with its sharp drop in GDP, feeble recovery, and political instability. Abundance economics requires a mindset of optimism—a faith that an interest group that makes concessions today will be rewarded through the growth that results. That spirit is difficult to summon in a time of widespread austerity.
The return of interest-rate reality only makes the problem more acute. While rates would drop in a recession, it seems unlikely we will return to the days of virtually free borrowing. Meanwhile, the history of American savings and loans and the recent bungling at Silicon Valley Bank should remind us to be wary of financiers’ ability to safely navigate a world where rates move across a much broader spectrum.
All this is only a sketch of the challenges finance poses to abundance advocates. Even if the emerging coalition can agree on some first principles — and given its ideological diversity, that is not obvious — the specific remedies will prove difficult to hammer out. Just how much equity should banks be required to raise? How should nonbank lenders and the “shadow banking” system be managed?
But movement building, like economic progress, requires the vision and patience to think far into the future. If abundance advocates have any advantage over the barons of Wall Street, it’s that.
David Dagan is director of editorial and academic affairs at the Niskanen Center. He covered banks at the Central Penn Business Journal from 2004-2009. (Twitter: @daviddagan)
Read more:
Can democracy take stock of Wall Street? (Editor’s note)
Capital confusion - by Anat Admati and Martin Hellwig
Bailouts forever - by Anat Admati and Martin Hellwig
The myths that fuel the megabanks - by Thomas Hoenig
Giving power to truth - by Colleen P. Eren
Image: https://commons.wikimedia.org/wiki/File:Wizard_Oz_Humbug.jpg
