Why Banking Systems Succeed -- And Fail

The Politics Behind Financial Institutions

Partially printed new $20 bills at the Bureau of Engraving and Printing in Washington, October 23, 2006. Jim Young / Courtesy Reuters

People routinely blame politics for outcomes they don’t like, often with good reason: when the dolt in the cubicle down the hall gets a promotion because he plays golf with the boss, when a powerful senator delivers pork-barrel spending to his home state, when a well-connected entrepreneur obtains millions of dollars in government subsidies to build factories that will probably never become competitive enterprises. Yet conventional wisdom holds that politics is not at fault when it comes to banking crises and that such crises instead result from unforeseen and extraordinary circumstances.

In the wake of banking meltdowns, one can rely on central bankers, Treasury officials, and many business journalists and pundits to peddle this view, explaining that well-intentioned and highly skilled people do the best they can to create effective financial institutions, allocate credit efficiently, and manage problems as they arise but that these Masters of the Universe are not really omnipotent. After all, powerful regulators and financial executives cannot foresee every possible contingency and sometimes find themselves subjected to strings of bad luck. Supposed economic shocks that could not possibly have been anticipated destabilize an otherwise smoothly running system. According to this view, banking crises are like Tolstoy’s unhappy families: each is unhappy in its own way.

This conventional view is deeply misleading. In reality, the same kinds of politics that influence other aspects of society also help explain why some countries, such as the United States, suffer repeated banking crises, while others, such as Canada, avoid them altogether. In this context, “politics” refers not to temporary, idiosyncratic alliances among individuals but rather to the way a society’s fundamental governing institutions shape the incentives of officials, bankers, bank shareholders, depositors, debtors, and taxpayers to form coalitions with one another in order to shape laws, policies, and regulations in their favor -- often at the expense of everyone else. A country does not choose its banking system; it gets the banking system it deserves, one consistent with the

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