March 23, 2014 7:09 pm

‘Fragile by Design’, by Charles Calomiris and Stephen Haber

An analysis of close ties between governments and bankers is a fine addition to standard economic models but leaves questions hanging

Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, by Charles Calomiris and Stephen Haber, Princeton University Press, RRP$35/£24.95

One reason why economists did not see the financial crisis coming is that the models most macro and financial economists deal in are free of politics. Fragile by Design offers a much-needed supplement. This sweeping account of how banking and politics have always been intertwined spans three centuries and five countries: the UK, the US, Canada, Mexico and Brazil.

Charles Calomiris and Stephen Haber, academics at Columbia and Stanford universities, analyse the rules and institutions that have shaped banking as the outcomes of a “game of bank bargains” where politicians – the real kind, not the apolitical social planners of standard economic models – are central and powerful players. Crucially, however, they are not all-powerful.

Governments typically need banks when they are running out of money (historically, usually when they were fighting wars) and are forced to bargain with private financiers. These financiers obtain concessions in return for funding a bank to channel credit to the government or to politically popular causes, such as mortgage lending in recent decades. The concessions typically come in the form of monopoly rights or other privileges; in the last US bubble, they consisted of allowing megabank mergers. In the authors’ analysis, banking develops as a rent-seeking racket where the politically powerful divide with bankers the spoils extracted from those outside of this political “coalition”.

The authors’ approach is at times fascinating. They shed light, for example, on the oligopoly in the UK banking market that emerged over a century ago: “The government saw a highly concentrated banking system as one with which it could more easily negotiate.”

More provocatively, given today’s banking debates, their analysis leads Calomiris and Haber to challenge a conventional view of the 1930s reforms in the US. The New Deal’s adoption of deposit insurance, mortgage guarantees and the Glass-Steagall act that split commercial and investment banking are usually taken to have transformed banking. Haber and Calomiris instead see continuity.


In their view, the US tradition of thousands of single-branch “unit” banks was in fact on its way to extinction because of its own instability – when along came deposit insurance to save it. This was a bad thing, they say, because insurance protects bankers “from the discipline of the deposit market” and has retarded the consolidation of banks into larger, more diversified and stable groups.

It is an inconvenient fact, gamely admitted by the authors, that a half-century of stability followed the introduction of deposit insurance, drawn to a close by the savings and loans crisis of the 1980s. They argue that the old, inefficient system was stable only while low inflation prevailed. As price rises gathered speed from the late 1960s on, a legal ceiling on deposit rates encouraged savers to opt for money market funds, undermining the funding of depositary unit banks.

But if so, it is more natural to blame the rate ceiling or poor macroeconomic management, not deposit insurance. Haber and Calomiris’s desire to disparage the 1930s reforms – and conversely to applaud the 1990s consolidation – smacks of scapegoating.

As for the 2000s crisis, they blame another political “coalition”, this time between activist groups for the poor and minorities (and their political representatives, including above all former US president Bill Clinton) and megabanks. In return for political support of mergers, banks committed vast amounts of credit to poor borrowers. Activists lobbied for weaker underwriting standards at the government-sponsored mortgage insurers to encourage yet more lending. The subprime mortgage bubble followed.

Those on the left, and in Europe, tend to close their ears to this story, filing it under Republican disingenuity. But it deserves to be appreciated in the fullness of its horrors.

For all its reach, the book remains frustrating in one respect. Haber and Calomiris stop short of applying their analysis to the deep changes US and European banking systems are undergoing today. There is a short, mostly sceptical section on US Dodd-Frank banking reforms, and no mention of the bail-in mechanisms and banking union being created in Europe.

“It remains unclear,” they write, “whether the depth of the banking crisis in Britain [is] an aberration or [showed that] banks expect to be protected and are thus able to undertake risk at the taxpayers’ expense.” Many British observers would beg to differ.

Nonetheless, the book helps identify the right questions to ask in today’s banking policy debates. But readers will have to find the answers by themselves.

The writer is a Financial Times journalist

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