Yesterday we met beleaguered Treasury Secretary Tim Geithner, the Administration’s point person on comprehensive post-catastrophe fundamental financial and regulatory reform, who having attained a position of power finds himself opposed not by his enemies but rather by his ostensible friends, his frustration boiling over as reported in the Wall Street Journal:

“You won’t like me when I’m angry”

Neal Wolin, Treasury’s deputy secretary, said Mr. Geithner told regulators “they have the prerogative to express their views, but he wanted to make sure that, since everyone had agreed on the importance of achieving reform this year, everyone stayed focused on that goal.”

From that little phrase one can deduce much about Mr. Geithner’s administrative reform strategy, and where it is foundering.  While the Journal’s article focused almost exclusively on the regulatory infighting rather than the substance, here in capsule form are the core elements:

The government’s proposal would empower the government, among other things:

[1] To take over and break up large financial companies

[2] To merge two bank regulators

[3] To toughen oversight of mortgages

Obviously Mr. Geithner convened all the lesser barons, with President Obama hovering as a looming authority figure, and swore them collectively to this vision of comprehensive financial reform (that I believe will necessarily create the Bank of Glass).  Each participating bureaucratic laird so swore, right hand figuratively upraised, left hand behind his or her back, fingers crossed.

Government officials said Mr. Geithner had expected regulators to object to parts of the plan that threatened their power or authority, but Treasury officials appeared caught off guard at how much the criticism resonated with lawmakers.

It’s called ‘lobbying’ and its mother’s milk, ‘political contributions.’

“I swear allegiance, to myself, and to my re-election chances”

Mr. Geithner wanted to tell the attendees they shouldn’t let turf battles get in the way of fixing a system that is clearly broken, Mr. Wolin said.

I’m cutting through the muck whether anyone helps me or not

He declined to comment on Mr. Geithner’s tone and language.

We’re declining comment on the language

Mr. Geithner’s tone is a consequence of the inevitability effect, and the role in which he has been cast – the driver:

 I’m not stopping until you’re all moving

When a proposal becomes conceptually inevitable, all the stakeholders instinctively migrate into one of five roles.

1. The driver(s).  The person or group compelling the activity forward.  The driver, a visionary, sees riches and demons no one else sees.  As such, he is single-minded: close. 

2. The suddenly sober.  They were joking around, playing the usual games, when suddenly the driver flung down the talisman of doom – and they realized, whoa, this is serious.  And they did the right thing.

3. The Laocoons who want to win the recriminations.  Realizing they are going to lose, they intend to make very clear they had no part of it.  They may be wrong-headed but they are honorable and direct.

4. The reluctant bargainers.  They didn’t want it, but now they realize that train has left the station.  Having lost the war, therefore, they want to win the peace, or at least get a piece of the win. 

5. The running-board scramblers.  They weren’t necessarily going to push this car out of the muck, but once the wheels start rolling, they want to throw their piece of policy luggage on board.

Within the reluctant bargainers I should have identified a further subset – the empire-builders.  Any time power is being centralized, any administrator worth her salt wants to increase her power, so if he’s in the likely centralizing agency, she’s all for standardization and consolidation, and if she’s out, it’s all about ‘checks and balances.’

With that in mind, turn with us now to Mr. Geithner’s verbal woodshed and listen for the participants’ positions to reveal themselves:

“You are talking about tremendous regulatory power being invested in whatever this entity is going to be,” Ms. Bair told the Senate Banking Committee last month. “And I think, in terms of checks and balances, it’s also helpful to have multiple views being expressed and coming to a consensus.”

When the Federal Reserve Board of Governors sets rates, that board debates and votes.  So that process already works.  When Ms. Bair, who is not on the Federal Reserve Board, speaks of “checks and balances,” one can safely read that as “I’d like a veto over Fed decisions.”

All of your decisions, that is

Officials from the Federal Reserve and the Office of the Comptroller of the Currency, meanwhile, have questioned the creation of a new federal agency to oversee consumer regulations, a move that would take away powers from both institutions.

Let me join them in shuddering.  Consumer risk exposure is not greater in banking than any other sector of the economy, nor is protection of bank consumers intrinsically a financial-oversight role.  Since banks are stores where people entrust money, bank regulation should be about assuring that money’s safety.  Consumer protection isn’t unique to banking, nor intrinsic to it.

Administration officials say they aren’t worried about the overhaul’s prospects –

What else would they say?

– adding that there is consensus on key aspects, including the regulating of over-the-counter derivatives.

That’s merely agreeing to the obvious.  Obviously we now need some levels of derivative regulation – but by itself that says nothing.  What matters is whether the regulation is disclosure, minimum capital requirements, or approval, and if so in what form and by whom, which is the enormous political-turf question.

We definitely agree there’s some manure to slice up

Treasury officials say they expected a big debate over the complex legislation.

O those seers, who are so wise in the ways of Washington.

The first piece, which addresses executive pay, passed the House Friday.

That’s just the low-hanging political fruit, and the non-contentious element.

“The industry is already back to their pre-meltdown bonuses,” said White House Chief of Staff Rahm Emanuel.

Remember, Mr. Emanuel is sound-biter-in-chief for the President.

Sound bites?  Ho hum

“We need to make sure we don’t slip back to risky behavior where the institutions have all the upside and the taxpayers have all the downside, which is why we need regulatory reform.”

That’s well said, and it’s the core issue.  When agents have upside without downside, and principals have risk, then we get bad lenders making bad loans, GSEs overlevering themselves, and a host of financial implosions.

Plenty of turf for all of us

At a House hearing last month, Mr. Geithner said it was “perfectly reasonable and understandable” that different federal agencies would balk at giving up powers. “Frankly, all arguments need to be viewed through that basic prism,” he told the House Financial Services Committee.

In many ways our current banking regulation operates like the Articles of Confederation, where each regulator is akin to a sovereign state that can safely ignore what the others are doing, and may certainly ignore the dictates of any purported central regulator.  Now what Mr. Geithner wants is to force through a new federal financial Constitution that makes the Federal Reserve the truly national supra-regulator:

The administration’s proposal would give the Fed broad discretion to supervise any major U.S. financial company and would also create a “financial services oversight council” to coordinate policy and help resolve disputes among regulators.

One ring to rule them all, one ring to bind them.

One conference table to seat them all …

How power would be balanced between the Fed and this entity has emerged as a flash point, one that administration officials debated.

Ultimately, officials felt the regulatory structure needed a single point of accountability –

Instinctively I think that’s right.  Today capital is at least national; banks are national; financial markets are wholly national.  Regulators must always have a breadth of sweep as large as the markets they seek to regulate, otherwise the markets will flow to the boundaries just outside the unfavorable regulatory environment, and will arbitrage the differences between those environments.

If only I coulda got across the state line …

– arguing that one weakness in the government’s response to the financial crisis last year was clarity over which entities were in charge.

Correct; it was.

The administration has pushed for Congress to complete the overhaul by the end of the year. House Financial Services Committee Chairman Barney Frank (D., Mass.) and Senate Banking Committee Chairman Christopher Dodd (D., Conn.) have both said that remains the goal.  Both men, however, have suggested the overhaul could change …

Translation: we’re completely with you … sort of.

The top Republicans on these committees, Sen. Richard Shelby (R., Ala.) and Rep. Spencer Bachus (R., Ala.), have also expressed skepticism over ceding too much power to the Fed.

“A rush to judgment where they basically throw these things together without any consensus is going to be a disaster,” Rep. Bachus said.

That’s never stopped us before.

And look how well it worked

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Turning slabs of excreta into regulatory fuel

In any new or emerging sector, business innovation always outpaces regulation – experimenting with giddy speed and venturing into that free libertarian space which sounds idyllic until the snakes of corruption slither in. Decadence and wild excess ensue, which is fun when it lasts, and then the world gets the mother of all risk hangovers. This financial catastrophe is the precondition to fundamental financial and regulatory reform, at which point enters the architect of new regulation – in this case, Treasury Secretary Tim Geithner, who’s been the Administration’s chief designer of a macro-level regulatory structure.

It is a job both thankless and pressure-packed, leading to the frustration recently chronicled in the Wall Street Journal:

WASHINGTON — Treasury Secretary Timothy Geithner blasted top U.S. financial regulators in an expletive-laced critique last Friday as frustration grows over the Obama administration’s faltering plan to overhaul U.S. financial regulation, according to people familiar with the meeting.

‘Expletive-laced’ is a phrase few would associate with our mild-mannered Treasury Secretary. What could so fray his nerves?

Read my Anglo-Saxon, polysyllabic lips

While it may seem trivial gossip, I suspect that underlying it is a much deeper structural concern – namely, that creation of a newer holistic and coherent financial regulatory architecture is in jeopardy, not from its enemies, but from the inevitability effect on its friends.

Mantra for a reformer: beware the inevitability effect

As Dwight Eisenhower said, If a problem cannot be solved, enlarge it. Every time business expands its reach, regulation must follow. Now capital is at least national if not global, money is stored in computers not vaults, and what constitutes a financial institution has morphed beyond the capacity of post-Glass-Steagall regulators even to envision.

“Do I really have to sign this?”
President Roosevelt flanked by Glass and Steagall

In a post-physical banking world, it makes no sense whatsoever for financial entity regulation to be narrow-limited either in geography or in ecosystemic niche. Instead we must create the Bank of Glass, which I prophesied last summer:

Transparent scalable granularity

What is it and why do I want it?

Market investors want three things:

1. Transparency. If opacity leads to fragile balance sheets, then transparency creates strength. Tomorrow, the price of doing business will be an open-book acceptance that investors have the right to look anywhere they want, any time they want, and ask any question they want about the holdings.

People who bank in glass houses, know what their positions are

2. Granularity. What got Wall Street and its customers into the self-reinforcing-writedown cycle was aggregation, slicing, and the resulting loss of information.

Information is granular, in Wall Street parlance, when there is a clear and complete chain of numbers from the smallest bit of data to the largest aggregation – when, that is, aggregating entails no loss of information. This implies a ‘custody chain’ whereby all information gathered at one end of a financial structuring chain (the capital consumer) is fully accessible at the other end of the chain, the capital provider or long-term asset holder.

3. Scalability. Capital providers and capital markets demand scale, which demands standardization and consolidation.

If you want a metaphor for post-Bear reporting, imagine Google Earth.

Everything from here is just detail

Life in a glass bank

However this market chaos shakes out, when it stabilizes, there will not only be new and stricter rules from regulators, reporting requirements will render the data-opaque brick bank a thing of the past. Only via full transparency will those who want to grow their portfolios or businesses be able to regain the trust – and the money – of the capital markets.

To tap capital, we will all have to live in financial glass houses, where everything we own, everything we do, is on display all the time.

Over-arching regulation unifying all financial institutions and all financial products whether direct or derivative will require a grand unified theory of banking, observed by all banking regulators overseeing all financial institutions.

Wouldn’t it be nice if banking regulators were treed together?

This problem would be hard enough if starting from a clean slate; it is made harder for regulation because every initial regulatory framework is at best a patchwork quilt. At worst it’s a realm of feuding fiefdoms, where each established regulator enjoys its local sovereignty and zealously guards its prerogatives. Each regulator’s turf-protectiveness works against the larger goal.

You really think I’m interested in dissolving my autonomy?

Just as the Articles of Confederation proved unworkable when the newly independent nation was faced with an interstate challenge (Shay’s Rebellion), the absurdly Balkanized US financial regulatory structure was completely exploited by a dizzying pace of derivatives piled upon securities and pureed through tranches.

And in the end, who knows what it was?

The United States has a patchwork quilt of regulatory bodies, dating back to the Jeffersonian phobia of capital, and means, as I wrote nearly a year ago, that the emerging new regulatory framework must be larger and more expansive:

This story – that Congress drove us into excessive lending – is gaining wide circulation among the financial sector’s libertarian and conservative fraternities. I think it completely reverses causality – the banks betook themselves into the space in pursuit of quick profits – but its dismantling would take us away from the theme of this post.

While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.

The inadequate and multiply-provincial regulatory system we now have must be superseded by an integrated new framework, which requires a principal designer, for which position Secretary Geithner has already been chosen:

The proposed regulatory revamp is one of President Barack Obama’s top domestic priorities. But since it was unveiled in June, the plan has been criticized by the financial-services industry, as well as by financial regulators wary of encroachment on their turf.

It would take too much time (for me to figure out and for you to read) to dissect the particulars of each proposal, many of which will change anyhow before they are implemented.

No point in dissecting it if it’s dead on arrival?

Instead, keep your eye on the macro principles, which are these:

1. Everyone is a bank. By any other name – even a Wal-Mart ATM in a grocery store – if it takes deposit-like inflows and provides credit-like outflows, then it is a bank.

2. Everything is a financial instrument. If you buy or sell it in the money store, it’s a financial instrument.

3. Everyone is a Bank of Glass. You get up to hijinks between closed doors, you lose your privacy privileges. All financial institutions depend, directly or implicitly on the state’s balance sheet to backstop their actions. The state having discovered that even unregulated entities can make gargantuan horribly overleveraged bets, the state will now insist that everybody sleep with the lights on.

4. All banks and all financial instruments are capital-charged with the originator having hard equity at risk. I’ve pointed out before the concentrating effect of having hard equity at risk. The way to compel this is via capital charge. (The parallel here is with regulation of psychotropic drugs. When they were naturally grown, they were free and legal; as they became more refined, poppies into opium into heroin, they became first regulated and then criminalized. The same goes for psychedelic financial instruments, man; far out.)

Wow, man, derivative

Nothing sobers up a risk-taker like having his own money permanently in the transaction. Expect heavy capital charges – probably excessively weighted for a while, but that will be better than the unbearable lightness of B-piecing.

5. All professionals are licensed. So we license the mortgage brokers; we intermediate the home appraisers. We’ll clamp down on originators, standardize disclosure documents, improve consumer protection (via disclosure, not a new super-agency, please), and generally put everyone through a series of road tests.

Secretary Geithner has to know all this; he’s known it at least for a year, probably for several years. Now, having migrated form the relative obscurity of the New York Fed to the spotlights of Treasury, he must have expected that his control over the levers of power would enable him to force through logical change.

No such luck.

Can’t find your way out of committee?

Larry Summers, who preceded Mr. Geithner as Treasury Secretary and who now glowers in friends-close proximity to the President, was massively unable to pull Harvard together out of its entrenched fiefdoms. He failed because each graduate school faculty has its own budget and endowment and donor base. That money power enabled them cordially to invite the Harvard President to go pound sand. Unable to compel, and likewise unable to require, Mr. Summers was emotionally incapable of persuading.

Mr. Geithner, who is smoother, has evidently been trying the route of persuasive pressure, only to find that appointed officials have a similar power of veto:

Mr. Geithner told the regulators Friday that “enough is enough,” said one person familiar with the meeting. Mr. Geithner said regulators had been given a chance to air their concerns, but that it was time to stop, this person said.

Oooh, I love it when you talk ultimatum.

Whom was he lecturing?

Among those gathered in the Treasury conference room were:

Federal Reserve Chairman Ben Bernanke

Securities and Exchange Commission Chairman Mary Schapiro

Federal Deposit Insurance Corp. Chairman Sheila Bair.

Grasping? Turf conscious? Me?

In addition to Mr. Bernanke, Ms. Bair and Ms. Schapiro, other attendees at Friday’s meeting were:

Fed Governor Daniel Tarullo

Comptroller of the Currency John Dugan

Commodity Futures Trading Commission Chairman Gary Gensler

Office of Thrift Supervision Acting Director John Bowman.

Regulate him, not me

Spokespeople for all regulatory agencies represented at the meeting declined to comment.

There being no upside whatsoever in doing so …

Friday’s roughly hour-long meeting was described as unusual, not only because of Mr. Geithner’s repeated use of obscenities, but because of the aggressive posture he took with officials from federal agencies generally considered independent of the White House.

See, that’s the problem – they are independent of the White House, and have always been. Independence of central bankers is a cornerstone of modern economic policy, so much so that promptly upon Gordon Brown’s becoming Chancellor of the Exchequer, he immediately granted independence to the Bank of England.

Mr. Geithner reminded attendees that the administration and Congress set policy, not the regulatory agencies.

“Remember, I’ve been appointed already, your appointment’s still coming up”

Dangerous ground there, and an inflammatory statement. Independent agencies have their freedom for a policy reason – not to kowtow to the current prevailing winds is intrinsic to their value. Contradicting that premise could easily offend listeners and harden their skepticism into opposition.

Mr. Geithner, without singling out officials, raised concerns about regulators who questioned the wisdom of giving the Federal Reserve more power to oversee the financial system. Ms. Schapiro and Ms. Bair, among others, have argued that more authority should be shared among a council of regulators.

I think it was Abraham Lincoln who remarked that he never posed strategic questions to a council of generals, because their consensus bias led them always to counsel caution. Shared authority is divided authority – good, maybe, for deliberative bodies (like a Congress); bad for executive and administrative ones.

“If you need my consent, baby, you’ll wait until I’m ready”

[Continued tomorrow in Part 2]

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[Continued from yesterday's Part 1.]

In yesterday’s post, exploring the US’s banking history via a well-reasoned and opinionated Wall Street Journal op-ed by banking historian and essayist/ fulminator John Steele Gordon, we had reached the stage of circling liquidity injections and confidence injections as essential responses to financial crises. 

Hold still for the liquidity and confidence

It’s no surprise, and a great comfort, that Messrs. Bernanke and Paulson, who know both the history and the market dynamics through and through, have pressed all these liquidity/ confidence buttons continuously since last march, when they first banked on value.  As I wrote at the time:

Ten days ago, the Federal Reserve made a bet that economic students will be studying for decades.  Under Ben Bernanke, the Fed pushed $200 billion – that’s your money and my money – into the global capital markets pot, in effect making a bet that assets the market won’t buy have the value their originators say they do. 

These tickets are valuable

Important for this post’s purposes is that Bernanke and Paulson were in a position to make such a bet. 

From my IUHF talk: the Paulson principles

Their predecessors weren’t, because they had no Federal reserve system.

The Federal Reserve was created in 1913. But, again, they fought to make it weaker rather than stronger. Instead of one central bank, they created 12 separate banks located across the country and only weakly coordinated.

After the 1929 crash, the system failed, and propelled us into the Great Depression.  Out of that financial catastrophe came the SEC and FDIC, two integral creatures in our modern ecosystem.

[The Fed] was completely reorganized in 1934 and the U.S. finally had a central bank with the powers it needed to function. That is a principal reason there was no panic for nearly 60 years after 1929 and the crash of 1987 had no lasting effect on the American economy.

The date was Monday, October 19, 1987.  As Wikipedia describes it, with commendable factuality and minimal speculation:

In financial markets, Black Monday refers to Monday, October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short period. The crash began in Hong Kong, spread west through international time zones to Europe, hitting the United States after other markets had already declined by a significant margin.

London fell first …

The Dow Jones Industrial Average (DJIA) dropped by 508 points to 1739 (22.6%).

New York fell later that same day …

By the end of October, stock markets in Hong Kong had fallen 45.8%, Australia 41.8%, Spain 31%, the United Kingdom 26.4%, the United States 22.68%, and Canada 22.5%.

The Black Monday decline was the largest one-day percentage decline in stock market history.  A degree of mystery is associated with the 1987 crash, and it has been labeled as a black swan event. 

It recovered … but nobody knows why

Important assumptions concerning human rationality, the efficient market hypothesis, and economic equilibrium were brought into question by the event. Debate as to the cause of the crash still continues many years after the event, with no firm conclusions reached.

Whatever else we’ve learned through events like these, it’s the need for continuous credible liquidity, and a source of unshakable confidence.  That is largely a role for central banks.  So is the standardization of money.

While the Constitution gives the federal government control of the money supply, it is silent on the control of banks, which create money. In the early days they created money both through making loans and by issuing banknotes and today do so by extending credit. Had Hamilton’s Bank of the United States been allowed to survive, it might well have evolved the uniform regulatory regime a banking system needs to flourish.

Counterfactual hypotheses are always tough to refute, but this one is quite plausible.  Remarkably, throughout most of the nineteenth century, we had dozens of different banknotes.

From a Maine bank, 1851

From a Connecticut bank, 1850’s

Confederate dollar, 1862 – don’t take that one!

Without it, banking regulation was left to the states. Some states provided firm regulation, others hardly any. Many states, influenced by Jeffersonian notions of the evils of powerful banks, made sure they remained small by forbidding branching. In banking, small means weak.

An important principle.

There were about a thousand banks in the country by 1840, but that does not convey the whole story. Half the banks that opened between 1810 and 1820 had failed by 1825, as did half those founded in the 1830s by 1845.

Recall that a bank is a money store, and like any other store, it can go out of business.  When that  happens, its creditors — ordinary Americans call them ‘depositors’ – are left out in the cold, having lost their savings.  Bank failures were endemic globally in the nineteenth century, particularly in times of war.

Many “wildcat banks,” so called because they were headquartered “out among the wildcats,” were simple frauds, issuing as many banknotes as they could before disappearing.

By dressing up a fraud as a ‘bank,’ one could print money backed by nothing.

By the 1840s there were thousands of issues of banknotes in circulation and publishers did a brisk business in “banknote detectors” to help catch frauds.

Balkanized systems always have, at a minimum, staggering inefficiency, which takes a huge toll on commerce.

The Civil War ended this monetary chaos when Congress passed the National Bank Act, offering federal charters to banks that had enough capital and would submit to strict regulation. Banknotes issued by national banks had to be uniform in design and backed by substantial reserves invested in federal bonds.  

In effect, Congress forced banks to backstop their paper.  This is quite similar to the dynamics now at play to regulate naked short selling (large bets without capital behind them, in effect financial bluffs), and the inevitable emergence of collateral requirements for complex derivative instruments.

Meanwhile Congress got the state banks out of the banknote business by putting a 10% tax on their issuance.

An interesting example of a patient legislative workaround fix.  Rather than bar state banks outright from issuing notes, which presumably would have faced a legal and political challenge, Congress imposed a tax, probably using the entirely reasonable argument that banks need to provide security for their paper.

Unfortunately state banks did not disappear, but proliferated as never before. By 1920, there were almost 30,000 banks in the U.S., more than the rest of the world put together.

Overwhelmingly they were small, “unitary” banks with capital under $1 million. As each of these unitary banks was tied to a local economy, if that economy went south, the bank often failed. As depression began to spread through American agriculture in the 1920s, bank failures averaged over 550 a year. With the Great Depression, a tsunami of bank failures threatened the collapse of the system.

Hence the FSLIC, the FDIC, and a slew of other New Deal programs.

From my IUHF talk: once the government is in, it’s never out

But national banks could not branch if their state did not allow it and could not branch across state lines.

Modern readers who never experienced it will find it incomprehensible that the US prohibited interstate banking, even as we had interstate commerce, interstate credit cards, interstate markets. 

The system was stable in the prosperous postwar years, but when inflation took off in the late 1960s, it began to break down. S&Ls, small and local but with disproportionate political influence, should have been forced to merge or liquidate when they could not compete in the new financial environment.  

Capital always scales up, particularly as technology advances.  Blocking mergers prevented – or, more precisely, deferred for thirty years – a natural consolidation that would have and did benefit consumers (particularly when leavened with the Community Reinvestment Act, the logical consequence of allowing multi-branch banks).

In the 1990s interstate banking was finally allowed, creating nationwide banks of unprecedented size.

But Congress’s attempt to force banks to make home loans to people who had limited creditworthiness, while encouraging Fannie Mae and Freddie Mac to take these dubious loans off their hands so that the banks could make still more of them, created another crisis in the banking system that is now playing out.

This story – that Congress drove us into excessive lending – is gaining wide circulation among the financial sector’s libertarian and conservative fraternities.  I think it completely reverses causality – the banks betook themselves into the space in pursuit of quick profits – but its dismantling would take us away from the theme of this post.

While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.

From my IUHF talk: everyone’s a bank, everyone’s a bank of glass

I buy all of that except the last, wishful modifying clause.  One man’s undue influence is another man’s free expression.

“Money is the mother’s milk of politics” – Jesse Unruh

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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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