Affordable Housing Institute : US

Chaos ensues when an enterprise’s span of activity is greater than the span of judicial or regulatory consistency. That, at least, is the plausible hypothesis behind the emergence of the FBI, brought into being to chase Bonnie and Clyde across state lines; and Interpol, created to pursue criminals throughout Europe.

Eliot Ness, 1929: you need a police force whose jurisdiction is at least as big as Al Capone’s

The principle applies equally well to networks (railroads achieve huge scale only after track gauge was standardized; the Internet boomed only after the Internet Standard Protocol). It applies particularly to financial markets, starting with currency (among the great Roman innovations was uniform and reliable coinage) –

Roman coins, just as good as money as Yogi Berra would say)

– and continuing through the regulation of banks. Because capital is the quickest asset there is, if it spans multiple regulatory jurisdictions, it can reside wherever it’s most comfortable (hello, tax havens like the Isle of Man, the Netherlands Antilles, and Guernsey!), and take advantage of quirks in laws regarding privacy, taxation, disclosure requirements, and shareholder rights.

To this list of balkanized financial regulatory jurisdictions we must add, with some embarrassment, the United States, where banks are governed by an overlapping and inconsistent set of charters, as explicated in a fascinating Wall Street Journal op-ed by banking historian and essayist/ fulminator John Steele Gordon:

A beard that thick means he’s an academic

A Short Banking History of the United States

Why our system is prone to panics

We are now [October 10, 2008 – Ed.] in the midst of a major financial panic. This is not a unique occurrence in American history. Indeed, we’ve had one roughly every 20 years: in 1819, 1836, 1857, 1873, 1893, 1907, 1929, 1987 and now 2008. Many of these marked the beginning of an extended period of economic depression.

Each one typically also results in a fundamental financial reform, usually expanding the scope of regulated or legally obligated entities.

From my IUHF talk

How could the richest and most productive economy the world has ever known have a financial system so prone to periodic and catastrophic break down? One answer is the baleful influence of Thomas Jefferson.

Baleful? Moi?

Perhaps no president has suffered as much over the last score of years from reappraisal as Jefferson. From the apparent philandering with Sally Jennings in Paris to his petty feuds with Alexander Hamilton, much of his luster has been tarnished. Still, he bought Louisiana and gave us, among other powerful imprints, the Jeffersonian section.

The next time you’re flying across the Great Plains on a sunny day, look down. That graph-paper grid you’ll see, often with irrigated green circles inside, is America, divided into 40-, 80-, and 160-acre rectangular and square sections according to a plan first designed by Thomas Jefferson.

Jefferson’s early imprinting of America, a virgin continent divided into meridians and latitudes, endures today. So does his antipathy to banking.

Jefferson, to be sure, was a genius and fully deserves his place on Mt. Rushmore. But he was also a quintessential intellectual who was often insulated from the real world. He hated commerce, he hated speculators, he hated the grubby business of getting and spending (except his own spending, of course, which eventually bankrupted him). Most of all, he hated banks, the symbol for him of concentrated economic power. Because he was the founder of an enduring political movement, his influence has been strongly felt to the present day.

They didn’t put him on Mount Rushmore for his banking expertise

Like many of the other Framers of the Constitution, Jefferson also was deeply skeptical of any central power. Aside from his vision of an agrarian plutocracy presiding as philosopher kings over a sylvan paradise, he wanted to keep power small and local.

Consider central banking. A central bank’s most important jobs are to guard the money supply — regulating the economy thereby — and to act as a lender of last resort to regular banks in times of financial distress.

Central banks are, by their nature, very large and powerful institutions. They need to be.

Jefferson’s chief political rival, Alexander Hamilton, had grown up almost literally in a counting house, in the West Indian island of St. Croix, managing the place by the time he was in his middle teens. He had a profound and practical understanding of markets and how they work, an understanding that Jefferson, born a landed aristocrat who lived off the labor of slaves, utterly lacked.

Political parties emerged out of their philosophical and personality clash

It’s no surprise that, when the parties formed after Washington, one led by Hamilton became known as the Federalists, the other led by Jefferson becoming the Democratic-Republicans.

Hamilton wanted to establish a central bank modeled on the Bank of England. The government would own 20% of the stock, have two seats on the board, and the right to inspect the books at any time. But, like the Bank of England then, it would otherwise be owned by its stockholders.

Not so different in principle from Treasury’s conservatorship of Fannie and Freddie (although today’s private RTC version is an emergency seizure that will eventually end).

To Jefferson, who may not have understood the concept of central banking, Hamilton’s idea was what today might be called “a giveaway to the rich.” He fought it tooth and nail, but Hamilton won the battle and the Bank of the United States was established in 1792.

Ironically, Jefferson had no problem deploying Federal power in the national interest. He grabbed the Louisiana Purchase, which, if memory serves, he negotiated without any legal authority to undertake, and committed the government to purchase when it had neither money to pay the price, nor taxing ability to raise the funds. Later he sent the American fleet after the Barbary Pirates.

Stephen Decatur against the Barbary pirates

It was a big success and its stockholders did very well. It also provided the country with a regular money supply with its own banknotes, and a coherent, disciplined banking system.

But as the Federalists lost power and the Jeffersonians became the dominant party, the bank’s charter was not renewed in 1811.

Sounds like Fannie and Freddie, who both have Congressional charters, benefited from the Federal protection (explicit and implicit), grew large and powerful, and used that for political influence (among other things).

The near-disaster of the War of 1812 caused President James Madison to realize the virtues of a central bank and a second bank was established in 1816. But President Andrew Jackson, a Jeffersonian to his core, killed it and the country had no central bank for the next 73 years.

President Andrew Jackson destroying the Bank of the United States. Lithograph, 1828.

We paid a heavy price for the Jeffersonian aversion to central banking. Without a central bank there was no way to inject liquidity into the banking system to stem a panic.

Intertwined here are two distinct ideas for dealing with financial crunches:

1. In a financial crunch, liquidity is an essential ingredient. Prices collapse when everybody suddenly needs cash, and can obtain it only by selling assets. Alternatively, when there is a credible lending source, people can borrow against their assets, not selling them. (The 1929 Crash turned into the Great Depression in part because banks pulled all their credit instead of extending it.)

No small part of the reason that an ordinary recession that began in the spring of 1929 turned into the calamity of the Great Depression was the inability of the Federal Reserve to do its job.

2. In a financial crunch, confidence is an essential ingredient. Panic is not only contagious, it’s irrational. Unreason overwhelms reason. Curiously, we see this now, in the rising dollar exchange rate.

The dollar’s rising because money has more confidence in the US than in Europe

As a result, the panics of the 19th century were far worse here than in Europe and precipitated longer and deeper depressions. In 1907, J.P. Morgan, probably the most powerful private banker who ever lived, acted as the central bank to end the panic that year.

When you’re rich, you both need and can provide liquidity

It’s entirely likely, in fact, that Europe’s downturn will be more severe and protracted than the US’s, because our financial and housing ecosystems are more widely diversified and therefore more robust. The downturn is going to stress post-Maastricht monetary union in unprecedented ways.

Even Jefferson’s political heirs realized after 1907 that what was now the largest economy in the world could not do without a central bank.

Europe has a central bank, but not a central government. Will both survive what’s coming?

[Continued tomorrow in Part 2.]

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