------------ EH.NET BOOK REVIEW --------------
Published by EH.NET (July 2007)
Philip T. Hoffman, Gilles Postel-Vinay and Jean-Laurent Rosenthal,
_Surviving Large Losses: Financial Crises, the Middle Class, and the
Development of Financial Markets_. Cambridge, MA: Harvard University
Press, 2007. viii + 263 pp. $28 (hardcover), ISBN: 978-0-674-02469-4.
Reviewed for EH.NET by Howard Bodenhorn, Department of Economics,
Lafayette College.
Those of us who knew some financial history were not surprised by the
Enron and WorldCom collapses in 2001 and 2002. We may have been taken
aback by the magnitude of the losses and empathized with Enron
employees who saw comfortable retirements evaporate before their
eyes, but I can recall more than one dire prediction as Y2K
approached and not because anyone really believed that confused
computers would turn out the lights. Rather, some of us had genuine
concerns that the equity market mania in 1999 resembled that of 1929
and hoped that the Fed would get it right the second time around.
Optimism reigned at cocktail parties, however, and statements about
unsustainably high equity prices were casually dismissed as just one
more example of economists' collectively predicting 11 of the past 10
recessions. History warned us that the collapse was not a matter of
"if." It was a matter of "when." While this sense of inevitability
now sounds like so much "I-told-you-so" hindsight, _Surviving Large
Losses_ makes a case that the then minority opinion was reasonable.
The book makes the case that financial crises are inevitable. What is
not inevitable is how societies respond as the pieces are picked up
after the crisis.
Philip T. Hoffman (Caltech), Gilles Postel-Vinay (?cole des Hautes
?tudes en Sciences Sociales) and Jean-Laurent Rosenthal (Caltech)
recognize their debts to the finance-growth literature, exemplified
by Ross Levine's many and influential cross-country studies, and the
equally influential La Porta, Lopez-de-Silanes, Shleifer and Vishny
(LLSV) "law and finance" literature, which holds that a country's
financial system is heavily influenced by the legal protections
offered to equity and debt holders.[1] As influential as the related
Levine and LLSV literatures are, cross-country analyses labor under
two fundamental shortcomings. First, they ignore the powerful
historical forces that shape a country's financial institutions and
infrastructure, the "colonial origins" argument at the center of LLSV
notwithstanding. For a host of reasons, many of which are explored in
this book, countries become prisoners of their own pasts, but the
story is far more complex than colonial origins. Second, both
literatures identify, but cannot explain a growth nexus, though some
progress on that front has recently appeared.[2] That is, the size
and structure of a country's financial system matters for long-run
growth, but the analyses fail to explain why and how they matter and,
more importantly, why and how they change. If success can be had by
simply copying the successful, why have so many economies failed to
do so? The short answer, of course, is that institutional change is
not costless. No matter how inefficient an existing financial system,
its costs and benefits are capitalized by economic actors who will
resist change absent some outside impetus that alters the calculus.
_Surviving Large Losses_ provides an original and provocative
hypothesis that offers an interpretation of financial reform:
historically, one of the most important moving forces behind
financial evolution has been the financial crisis. It is a fact that
financial crises are virtually inevitable in modern economies -- a
source of sleepless nights, if not outright dread, for even the most
sophisticated, well-hedged investor. Despite the enormous human costs
of financial crises, "they often prove to be turning points in the
evolution of financial markets and long-term economic growth" (p. 2).
Because crises are followed by searches for culprits and insistent
calls for change, they afford politically opportune moments to reform
financial institutions. In the U.S., for example, the Federal Reserve
System and the Federal Deposit Insurance Corporation, two fundamental
building blocks of the twentieth century U.S. banking edifice,
emerged as post-crisis reforms. These reforms demonstrate that
something new and functional can be built on the ashes of the old and
broken.
Although the authors offer a political economy model of post-crisis
financial reform, they do not arrive at their conclusions by
analyzing historical data -- though they have performed such analyses
elsewhere. Instead, they take a decidedly low-tech, narrative
approach to appeal to the widest possible audience. After providing a
verbal explanation of their political economy model, the authors rely
on their extensive historical knowledge of about four centuries of
financial crises to support their interpretations.
The substantive chapters of the book open with a fundamental
question: Why is it that some states protect savers and investors
while others plunder? Every state, no matter how wealthy or
democratic is capable of plunder, but those that resist grow over the
long term. What increases the probability of plunder is the size of
the public debt relative to the state's ability to service it.
Countries with small debts and low taxes relative to GDP are less
likely to prey on financial markets (p. 12-13). Countries mired in
public debt and with already heavy tax burdens have few politically
viable options during a crisis other than default or confiscation. In
many societies, preying on the military or a hungry electorate
instead of the rentiers is a sure ticket for a short reign (p. 14-15).
In issuing public debt the state plays a critical role at the
extremes. At one extreme is the state whose issuance of debt leads to
the emergence of debt markets with institutions suitable to and
organizations capable of trading private claims. So long as the state
restrains itself, an entrepreneurial class gains access to an
expanding web of finance with positive consequences for long-term
economic development.[3] At the other extreme is the state that piles
up enormous debts and pays for them by preying on financial markets.
To avoid the predator, investment capital hides or flees with obvious
negative consequences for long-term growth.
How do crises matter in this process? Financial markets shrink during
a crisis and investors call for change in the aftermath. Whether
change occurs, how change is initiated, and who initiates it --
government or private actors -- are issues determined through the
interaction of political economy and historical accident. Part of the
answer depends on who demands post-crisis change and whether the
demands for change are translated into productive and efficient
institutions (the preferred outcome) or whether losers use the
political system to confiscate from winners however defined (the
undesirable outcome) or something in between.
Hoffman, Postel-Vinay and Rosenthal argue that the outcome turns on
the behavior of three actors -- the middle class, financial
intermediaries, and the government. Casual observers might think that
the wealthy would be the driving force behind post-crisis reform.
But, as the authors note, it is a broad, relatively egalitarian
middle that drives financial development, as well as the political
economy of reform. Entrepreneurs tend to emerge from the middle. The
middle has collateral. The middle relies on local financial
institutions. The middle is most vulnerable to crises.
Although the middle's favored short-term post-crisis strategy might
be a bailout and redistribution, enough members of the group usually
recognize that institutional reforms that strengthen the financial
system and insulate it from transient shocks are the preferable
long-term strategy. A more vibrant, more efficient financial system
benefits them directly (diversification) and indirectly (spurring
macroeconomic growth). Whether the middle class realizes their calls
for reform depends on its size and its political clout relative to
the wealthy. Egalitarian societies with a broad middle are most
likely to initiate useful reform because the benefits of confiscation
are small -- mostly because the middle will be confiscating from
itself -- and because the benefits of crisis-averting innovation are
large.
Whether the middle succeeds depends on the objectives of the second
principal player: financial intermediaries. It is in this arena that
a society's wealthy play an important role. Because the wealthy have
(very nearly by definition) large portfolios, they are able to spread
the fixed costs of innovative new products across a raft of
customized financial products. But once financial intermediaries have
designed products for the wealthy, it is only a matter of time before
they are made available to consecutively less wealthy investors until
they are eventually redesigned to suit the needs of the middle. A
recent example of increasing regulatory concern is the growing
upper-middle class fascination with hedge funds.
Crises, as Hoffman, Postel-Vinay and Rosenthal note, have many
causes, including government predation, herd behavior, asymmetric
information, and inadequate diversification. If intermediaries see
post-crisis profit opportunities and can expect governmental or legal
support for reforms and new products that reduce the negative
consequences of information asymmetries (i.e., new reporting
requirements imposed by stock exchanges for listing companies) and
enhance diversification (i.e., mutual funds), they will push for
reform.
Government is the third principal player in the drama. Government
differs from private actors because a private actor must realize a
profit from any innovation or it will be driven from the market.
Governments face no such constraint and can, in fact, impose taxes
and other regulatory costs to pursue the changes it deems
appropriate. Government has a prominent role in financial markets --
from enforcing contracts to subsidizing deposit insurance to
overcoming some types of market failures -- but there is a constant
fear of governmental overreach, predation, and the encouragement of
rent seeking. Governmental intervention is successful when the net
social benefits of a proposed reform outweigh its costs and when the
rents created are small relative to the benefits of resolving the
market failure (p. 169).
What is the authors' interpretation of massive state intervention in
financial markets in modern Western-style economies? They argue that
it was an outgrowth of the bloody and tumultuous twentieth century.
Governments intervened on a modern scale during the First World War
when national survival seemingly demanded planning boards, rationing
and conscription of men and materiel, including middle-class savings.
The Great Depression induced a second wave of massive intervention
and regulation. The Second World War, post-war reconstruction and the
Cold War elicited even greater government intervention. Thus, the
period between 1914 and 1990 was one of massive and increasing
governmental regulation.
How did the Western-style economies realize their remarkable rates of
growth in the twentieth century if financial markets labored under
the ever increasing weight of government regulations? The authors
argue that these countries "got away with it" because, as the century
opened, they already had good institutions in place and governments,
while highly regulatory, were rarely predatory. Low-income and
low-growth developing countries that copied, or tried to copy, the
regulatory structures of the West failed because they did not begin
with the same pro-growth institutions.
In the end, then, _Surviving Large Losses_, while more historically
nuanced than the finance-growth and law-and-finance literatures from
which it springs leaves us in much the same place. Political economy
takes us only so far. A large part of the story of good finance is
historical contingency, which makes for a less parsimonious tale than
that offered by LLSV and others, but one more satisfying to economic
historians. Nevertheless, we are left to wonder how the financial
institutions that matter emerge and thrive. The authors' explanation
hangs mostly on the existence of a middle class but that, too,
depends on a preexisting set of "good" social, political, economic
and governmental institutions. _Surviving Large Losses_ is,
therefore, probably best viewed as a low-tech contribution to the
literature attempting to unbundle institutions. It is certainly
thought provoking and leaves as many questions as answers. Before its
interpretations carry the day, however, much more theoretical and
empirical work will need to be done. Although the conclusions drawn
from many historical episodes will appeal to economic historians and
general readers, I suspect that mainstream banking and finance types
will withhold judgment until many more formal tests are provided. I
look forward to seeing those tests and expect the authors of
_Surviving_ to be notable contributors.
Notes:
1. See Ross Levine, "Financial Development and Economic Growth: Views
and Agenda," _Journal of Economic Literature_ 35:2 (June 1997),
688-726 and Ross Levine and Thorsten Beck, "Stock Markets, Banks and
Growth: Panel Evidence," _Journal of Banking and Finance_ 28:3 (March
2004), 423-42; Rafael La Porta, Florencio Lopez-de-Silanes, Andrei
Shleifer and Robert W. Vishny, "Law and Finance," _Journal of
Political Economy_ 106:6 (December 1998), 1113-55.
2. Thorsten Beck, Asli Demirguc-Kunt, and Ross Levine, "Law and
Finance: Why Does Legal Origin Matter?" _Journal of Comparative
Economics_ 31:4 (December 2003), 653-75; and Rafael La Porta,
Florencio Lopez-de-Silanes, and Andrei Shleifer, "What Works in
Securities Laws," _Journal of Finance_ 61:1 (February 2006), 1-32.
3. Richard Sylla, "U.S. Securities Markets and the Banking System,
1790-1840," _Federal Reserve Bank of St. Louis Review_ 80:3 (May
1998), 83-98 makes the case for the early U.S.
Howard Bodenhorn, professor of economics at Lafayette College and
Research Associate at NBER, has written extensively on banking
history. Among his recent articles is "Usury Ceilings, Relationships
and Bank Lending Behavior: Evidence from the Nineteenth Century,"
_Explorations in Economic History_ (2007).
Copyright (c) 2007 by EH.Net. All rights reserved. This work may be
copied for non-profit educational uses if proper credit is given to
the author and the list. For other permission, please contact the
EH.Net Administrator ([log in to unmask]; Telephone: 513-529-2229).
Published by EH.Net (July 2007). All EH.Net reviews are archived at
http://www.eh.net/BookReview.
-------------- FOOTER TO EH.NET BOOK REVIEW --------------
EH.Net-Review mailing list
[log in to unmask]
http://eh.net/mailman/listinfo/eh.net-review
|
