Recent events suggest that market-oriented financial reform is gaining new traction on the right. See, for example, the address of Dallas Federal Reserve Bank president Richard Fisher at CPAC and the ongoing legislative collaboration between Senators David Vitter (R., La.) and Sherrod Brown (D., Ohio) on financial reform. Many center-right pundits have been calling for an end to Too Big to Fail and for breaking up various megabanks for a while, and now it looks like some of those serving in Washington are beginning to appreciate the wisdom of this cause.
Conservatives have an opportunity here to argue on behalf of a financial federalism that would attempt to ward off the dangers of asset concentration, revise limits on leverage for a variety of institutions, and draw clearer lines between various banking activities. Just as the political doctrine of federalism entails a broad distribution of government power (in federal, state, and local entities), financial federalism would put in place a financial system in which systemic risk is lessened through a broad distribution of capital and a variety of capital flows. Financial federalism would undo the distortions of Too Big to Fail. There are various economic, policy, and political reasons for Republicans to move toward market-oriented financial reform.
The influence of the financial system on the American economy is growing. According to recent numbers
from the U.S. census, the financial and insurance sector accounted for a bit more than 8.4 percent of GDP in 2010 (and that number does not include various sectors heavily influenced by finance, such as real estate and management). This is a huge change from the golden days of postwar prosperity. Throughout the 1950s, ’60s, and ’70s, the contribution of the financial and insurance system to GDP never rose above 5 percent
. According to census data, only manufacturing and real estate contribute more to private-sector GDP than finance does.
Not only is finance bigger than ever, it’s also more concentrated. According to the Dallas Fed, the five largest banks held 17 percent of total market assets in 1970. In 2010, that figure was 52 percent. This is an astonishing climb in market concentration and market instability. Now, the failure of one megabank could unleash the Four Horsemen on the economy, and thus the federal government has a strong incentive to intervene on behalf of any megabank that seems on the verge of failure. The existence of such a concentration in banking assets could lead to a vicious circle of market vitiation: The continued existence of Too Big to Fail banks could encourage further federal subsidies of them, which in turn would strengthen the market position of such banks and make them even bigger. Critics of Dodd-Frank and the post-bailout financial system point out that such a perverse feedback loop already exists. Fisher and others argue that as long as any bank is Too Big to Fail, the banking sector will remain at best a hugely distorted market, one that favors the politically connected and encourages foolish risks.
As an antidote to these problems, Republicans and conservatives should advance a plan for federalism for the financial system, applying the principles of constitutional federalism to the marketplace; just as the American body politic is strengthened by having a variety of competing interests (at the local, state, and federal levels), the American financial system would benefit from a proliferation of competition. The Founders were skeptical about both an overriding singular federal authority and a few large states joining together to form a combine that could control the rest of the nation. Likewise, we should be concerned about a few large, interconnected financial institutions having disproportionate sway over the market and over government regulators. Breaking up big banks and establishing a financial regulatory system that draws clearer lines between different kinds of banking activity could accomplish a few goals that are amenable to conservative aims. Such reform would reestablish in banking a market where all institutions are small and separate enough to fail. Too Big to Fail has empowered a few select banks, giving them exaggerated influence in the marketplace. Breaking up these banks or placing new capital limits on them could eliminate this market-destroying risk.
Establishing clearer limits between different kinds of banking activity would allow for a proliferation of interest groups. The repeal of Glass-Steagall (a 1933 law separating investment banking from commercial banking) in 1999 possibly helped spur the increasing consolidation of banking assets and banking activities. Since Glass-Steagall’s repeal, finance has witnessed an intensified concentration of banking interests, with problematic results for the free market. As Luigi Zingales of the University of Chicago argues in his recent book A Capitalism for the People, the increasing consolidation of the financial industry gives it a more unified voice for influencing Congress. This influence helped shape the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which significantly increased the power of creditors. A provision of this law gave extra-special protections to the holders of derivatives and led to increased confusion in the frantic days of the 2008 financial crisis. In an earlier era, Zingales argues, the banking industry would have been splintered into a variety of interests, which would have balanced each other out and thereby prevented large market-subverting measures from being passed. Whereas now a few monolithic forces influence government regulation, the financial system should be broken up into a set of competing interests. The competition could weaken the ability of a few political actors to influence regulation and wring disproportionate benefits from the government. A proliferation of interests could ensure that financial-industry regulations would at once be more limited and more conducive to the interests of the broader American economy.