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April 28, 2014

Q&A: Charles Calomiris

The SIPA professor, co-author of “Fragile by Design,” discusses the historical influence of politics on banking in different countries—and why it matters.

In Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, Charles W. Calomiris of SIPA and Columbia Business School and Stephen H. Haber of Stanford University examine the historical record in the United Kingdom, the United States, Canada, Mexico, and Brazil to show how banking has played out over time in different nations and, even more important, in different political contexts.

Calomiris and Haber find that banking crises and lack of credit are not accidents, but the product of national political frameworks that reflect the input of multiple stakeholders. They suggest that the well-being of banking systems depends on the abilities of political institutions to balance and limit how coalitions of these various groups influence government regulations.

Professor Calomiris, who is on leave this year to advise the IMF on banking policy, spoke with SIPA News about the book. An edited version of the conversation follows.

How did this book come about?

Stephen Haber and I have been working on the issues addressed in this book for 30 years. As far as the book itself is concerned, a few years ago we were invited to become part of a property rights task force at the Hoover Institution, at Stanford. They asked us to focus on the meaning of property rights in finance.

In finance, property rights issues have traditionally been discussed too narrowly, focusing on the legal rights of minority shareholders, the rights of creditors, and a lot of legalism about the efficiency of enforcement in the courts. But our shared perspective is that what’s most important from the standpoint of property rights in finance are the rights to engage in certain financial activities, the right to get favored access to credit, and the right to be insulated from financial loss.

Expropriation risk, entry barriers, chartering of banks, allocation of losses when they occur—once you understand these are all property-rights questions, the property-rights aspect of finance becomes a long and interesting subject. And, if you know the history of finance, it’s clear that those are political decisions, they’re not just decisions that are made in court related to politically neutral legal principles.

How did you develop the framework for the book, which focuses on five countries in particular?

We tried to do something new, both in terms of methodology and topics. We had written about most of these topics before in pieces for most of these countries. What is new topically is the inclusion of a broad historical experience of many countries over many years, which captures all the relevant political regime types and how they connect to banking system outcomes. What is new methodologically is the reliance on historical narrative. We argue that the best way to understand how politics and banking are linked is to start at the beginning of a country’s history and actually go through the political bargains that underlay banking system outcomes. In short, we wanted to write a coherent, sequential narrative that encompassed a lot of countries and a lot of time — 300 years — and different types of political environments over that time, and show how political pre-conditions affected banking system outcomes.

We knew it would be helpful to think of the performance of banks across two dimensions– the frequency of banking crises, defined carefully and sensibly – there are many banking crisis studies today that do not meet that standard – and the degree of credit abundance or scarcity. Stability and credit abundance are the two key performance criteria because banking crises are socially costly, and an absence of bank credit is a major obstacle to economic growth.

Once you think of measuring the consequences of banking systems along these dimensions, and know enough history to pick the right countries, it is possible to derive important general conclusions from these five countries’ histories. We did not know all of those conclusions in advance.

The book doesn’t make explicit policy recommendations. Did you have a particular goal in writing the book?

We’re trying to help people understand the process of regulation of financial systems. We want to do what professors should do – educate people to participate in their democracy more productively. Maybe people will come away from the book wanting to look more carefully at the politics that surrounds banking, and maybe they’ll be more skeptical of media stories or politicians’ speeches.

Economists who offer quick fixes for banking problems are engaged in self-delusion. Politicians aren’t waiting for a smart economist to explain things to them — they know a lot already and have decided to support particular regulations often for selfish political reasons. Banking systems in most countries aren’t unstable for a lack of ideas; failure happens because the political coalition in control doesn’t care enough whether the system is designed properly. The political coalitions that control banking outcomes want to achieve things for themselves, not just stability and availability of credit in general.

Are banks as powerful, or politically partisan for that matter, as many people think?

Bankers are components of political coalitions, but they don’t’ have enough votes or influence in a democracy to engineer outcomes without forming partnerships with others. They get power by allying themselves with a broad group of people who are sharing in the gains. And alliances that are established in populist democracies like the U.S. are not generally partisan because that doesn’t make for a very robust alliance.

In the United States over the last 30 years and especially the last 20, politicians in the banking coalition include most congressional Democrats and about half the Republicans. This makes for a coalition that has proved largely immune to electoral outcomes.

That sounds like an uphill battle for advocates of change.

One lesson of the book is that things are baked in so deeply, that existing coalitions are very hard to dislodge. But I believe that progress is possible — I can point to moments in some countries where they made constructive changes.

I’m optimistic we’re living through an age where we’re learning that protecting banks and absorbing all the losses from banks is not a sustainable process. There’s going to be a political tide that’s going to turn, but to be effective it has to be smart, not just angry. Hating the banks, blaming the banks… that’s not a constructive way out.

People don’t like to be told they’re part of the problem. But if we’re going to have a democracy that makes intelligent decisions, it’s got to be informed about the dangers that are inherent in our constitutional structure.

If people were willing to look in the mirror a bit and take responsibility for their roles in our political outcomes, what a great democracy we could have.

Going forward, will the book’s findings influence your teaching?

Yes, I’ve taught pieces of this book in my SIPA courses, including Emerging Financial Markets, over the four years we wrote it.

Banking systems are primary tools for emerging financial market economies, and instability and availability of credit are key issues. People like to talk about capital flows and stock markets because that’s what investors want to discuss, but from a developmental standpoint SIPA students should be considering a more basic question that is essential to the growth of developing economies: Why is it so hard to construct a banking system that is stable and that provides credit to all creditworthy borrowers?

The basic technology of commercial banking was established in Scotland by the mid-18th century, so how come so many poor countries today have virtually nonexistent banking systems relative to GDP? How can that be?

This is especially puzzling given the huge literature that demonstrates the importance of stable bank credit as a growth propagator. Financial inclusion is associated with all sorts of benefits not just on average, but for people at the low end of the wealth distribution. Only a political perspective can provide an answer to this question.

Any closing thoughts?

Of course there are going to be people with all sorts of political reasons to dislike our book, but we took pains not to write a book that will fuel partisanship. Mainly, we want people to understand why some countries have so much more instability than others, and why some countries have much less abundance of credit than others.

It’s a fun book to read if you have any interest in history. If you like history and you think banking wasn’t important, you’ll be surprised. We’re passionate about our topic—it’s not just static models, it’s a general framework for understanding how the world has evolved.

Read more about Fragile by Design at




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