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.
On the right, the biggest objection to financial reform has been informed by politics, not policy: Wall Street donors, a key GOP constituency (and Democratic constituency, too), will, the argument goes, turn on Republicans if they start to offer real financial reform. But two rejoinders could be made. The first is that an increasing number of those in the financial community are waking up to the fact that real reforms are needed to make the financial system as a whole functional. Former Citigroup CEO Sandy Weill, for example, made headlines last year when he argued for a return to Glass-Steagall provisions. Better regulations and the opportunity to fail will encourage banks to invest prudently and will lessen the likelihood of a financial crisis, whereas the continued existence of Too Big to Fail and an unreformed Dodd-Frank could risk setting up the U.S. economy and the global financial system for another crisis. The current financial system subverts market interests and encourages asset bubbles. It’s a ticking time bomb, which brings us to the second rejoinder.
It’s in Wall Street’s best interest to ensure that another crisis does not occur (or at least is deferred as long as possible). If Too Big to Fail continues and another crisis hits, Washington is likely to single out another sacrificial lamb before bailing out the rest of the big banks — and who wants to be the next Lehman Brothers, left to twist in the wind while its rivals receive generous bailouts? Moreover, an increasing concentration of financial assets will increase the likelihood that the federal government will attempt to socialize the financial system further. Up to now, this socialization has taken the form of protecting certain politically connected big banks, but there is no guarantee that this socialization will not be pushed further, to the point that the government starts to control these banks, and their executives, more directly. If the Masters of the Universe want to keep raking in free-market money, it is in their own interest to ensure that finance remains a free (and thereby fallible) market.
Republicans can expect a political benefit if they take on financial reform. It changes the playing field. As the national economic debate currently stands, Republicans often find themselves arguing from a position of weakness or reaction. Republicans too often content themselves with arguing against what Democrats are proposing (on increasing the minimum wage, say, or extending health-care coverage to the poor and middle class). If the GOP remains simply the Party of No, it risks surrendering policy direction to the Democrats. A refusal to advance a more positive agenda hurts Republicans’ standing with the general public. While talk of a “debt crisis” may rally the party faithful, that fear seems remote to a large part of the broader public, all too many of whom find themselves treading water. And tax cuts, the Republican answer to Democratic promises of new spending, have also lost their luster for many Americans (in part because their federal tax burden has decreased substantially over the past 20 years).
Pivoting to financial reform could be a way for Republicans to rally around an affirmative policy measure. Financial reform that ends Too Big to Fail and encourages prudence in the financial system could unify the party base and reach out to those in the center. Rather than splintering the party or making it seem deaf to the needs of the middle — as debates over the budget and immigration, for example, have sometimes done — financial reform could point the Republican way forward for a set of policies that at once embodies market imperatives, improves the national economy, and speaks to the needs of the vast majority of Americans.
Republicans are presented here with a real opportunity, as financial reform is an issue where conservative interests overlap with those of the sensible Left. Senate Republicans could work to craft a financial-reform deal or series of deals with Democrats such as Sherrod Brown and Elizabeth Warren (yes, Elizabeth Warren). Republicans in the House can pass a financial-reform bill, negotiate a compromise with the Senate version, and send the reconciled bill to President Obama. If he vetoes it, that is a popular win for Republicans. If he signs it, Republicans can share in the credit for passing a much-needed and popular reform for the financial system. By taking an assertive position on financial reform now, Republicans can position themselves not as followers of Democratic demands but as equal partners in the task of governance. Just as welfare reform helped redeem the Democratic party in the eyes of many in the middle, financial reform could help wash away some of the stigmas currently troubling the Republican brand. Financial reform would also, like welfare reform, accomplish a fundamentally conservative end.
Only by opening the financial sector up to failure can we also open it up to enduring market success. The risk of failure encourages prudence. A financial sector that operated as a free and legal market would have a variety of interests and viewpoints, which would weaken the ability of a few mega-corporations to influence Congress and subvert the market. Without a functioning and sensible financial system, the U.S. economy faces dim prospects for a recovery. The current extended stagnation has numerous sources, but one wonders whether the dysfunctional financial system has a significant role here. The success of small government in the United States seems closely connected to a vibrant economy, and anything that restores the vitality of the economy could have positive implications for small-government aims.
The precise policies of a conservative approach to financial reform should remain part of an evolving discussion, and now is certainly not the time to close that off. For now, conservatives should agree to restore the long-term vitality of the financial system by moving it toward the principles of market pluralism and diffusion of interests, which would go far toward restoring both the Republican party and the U.S. economy.
— Fred Bauer is a writer from New England. He blogs at A Certain Enthusiasm, and his work has been featured in numerous publications.