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Political Bubbles

Political Bubbles: Financial Crises and the Failure of American Democracy

Nolan McCarty
Keith T. Poole
Howard Rosenthal
Copyright Date: 2013
Pages: 296
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  • Book Info
    Political Bubbles
    Book Description:

    Behind every financial crisis lurks a "political bubble"--policy biases that foster market behaviors leading to financial instability. Rather than tilting against risky behavior, political bubbles--arising from a potent combination of beliefs, institutions, and interests--aid, abet, and amplify risk. Demonstrating how political bubbles helped create the real estate-generated financial bubble and the 2008 financial crisis, this book argues that similar government oversights in the aftermath of the crisis undermined Washington's response to the "popped" financial bubble, and shows how such patterns have occurred repeatedly throughout US history.

    The authors show that just as financial bubbles are an unfortunate mix of mistaken beliefs, market imperfections, and greed, political bubbles are the product of rigid ideologies, unresponsive and ineffective government institutions, and special interests. Financial market innovations--including adjustable-rate mortgages, mortgage-backed securities, and credit default swaps--become subject to legislated leniency and regulatory failure, increasing hazardous practices. The authors shed important light on the politics that blinds regulators to the economic weaknesses that create the conditions for economic bubbles and recommend simple, focused rules that should help avoid such crises in the future.

    The first full accounting of how politics produces financial ruptures,Political Bubblesoffers timely lessons that all sectors would do well to heed.

    eISBN: 978-1-4008-4639-9
    Subjects: Political Science, Economics

Table of Contents

    (pp. 1-24)

    One of us was unfortunate enough to be caught up in the housing bubble in southern California. He was relocating to the San Diego area in late 2004. He and his wife had owned four homes in three states over the previous twenty-seven years. Typically, the couple would negotiate with sellers over price and then seek financing from a bank. They would also initiate contact with lenders for refinancing.

    The couple went house hunting when the North San Diego County real estate market was frenetic. Their agent advised them to carry cell phones at all times because if anything came...

  2. PART I: The Political Bubble: Why Washington Allows Financial Crises to Occur

    • [PART I Introduction]
      (pp. 25-30)

      At first glance, the financial crisis of 2008 appears to be the result of egregious, greedy actions in the private economy. The miscreants include the top management of financial firms, including Countrywide Financial, Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, American International Group, and Fannie Mae and of credit rating firms such as Moody’s, Fitch, and Standard & Poor’s. The scandalous behavior involved the misuse of innovations such as “sliced and diced” collateralized debt obligations, credit default swaps, and financially “engineered” strategies embedded in mathematical models. At the same time credit agencies with conflicts of interest issued misleading ratings...

    • CHAPTER 1 Bubble Expectations
      (pp. 31-37)

      An economist defines a “bubble” as any situation in which the price of an asset exceeds its “fundamental” value.¹ Therefore, bubbles pose a puzzle for standard economic theory. Why would investors continue to purchase assets at prices for which they are certain to lose money when the asset’s price returns to normal? Why wouldn’t the market be flooded by offers to sell the asset at the inflated price?

      The “no-duh” answer is simple: investors believe that the fundamental value of the asset has increased. But where do such beliefs come from, and how are they propagated? How do the beliefs...

    • CHAPTER 2 Ideology
      (pp. 38-70)

      Although bubble expectations are important for generating the public and private sector behavior that leads to financial crises, there is another more important source of the beliefs that influence the government response to the bubble and its collapse: ideology. An ideology is a set of basic beliefs about how the world works and about what is right or wrong. We distinguish ideologies from bubble expectations primarily in terms of the rigidity of the beliefs. Because they are deeply held and often rooted in basic principles, ideological beliefs are much less responsive to new information, persuasion, or context. Consequently, we distinguish...

    • CHAPTER 3 Interests
      (pp. 71-89)

      In the epigraphs given here, Presidents Roosevelt, Bush, and Obama were doing their best to reassure financial markets when miscreants were in full public view. Roosevelt’s remarks came just after the unraveling of the corner on United Copper and three weeks before the suicide of the banker Charles Barney, who was caught up in the scandal. Bush’s radio address came the week before WorldCom’s recently resigned CEO Bernard Ebbers was to testify before the House Financial Services Committee. (“Bad actor” Ebbers is now serving a twenty-five-year sentence in a federal prison.) Obama was speaking at the time of a widespread...

    • CHAPTER 4 Institutions
      (pp. 90-116)

      The final prong of our explanation is the shortcomings of America’s policy-making institutions. We have already discussed howinterestswork to impede adequate and efficient regulation of financial markets. Legislators and regulators are susceptible to special-interest appeals from the financial services industry. Moreover, the industry benefits from information asymmetries with the government. Butinterestsare far from the only roadblocks. Indeed, even if campaigns were publicly financed and all regulators and congressional staffers held PhDs in financial engineering, the American political system would still have considerable difficulty establishing and maintaining the sort of financial regulatory structure that would prevent the...

    • CHAPTER 5 The Political Bubble of the Crisis of 2008
      (pp. 117-148)

      TheThree I’ s— ideology, institutions, and interests— combined to inflate the bubble that led to the financial crisis of 2008 and the ensuing Great Recession. The caldron was stirred for forty years, going back to the privatization of Fannie Mae in 1968. The last major ingredient was the 2000 addition of the Commodity Futures Modernization Act. We now recount how theThree I’sresulted in errors of commission in the form of deregulation and poor regulatory structures, and errors of omission in the form of failure to regulate new products and to enforce existing law. We emphasize that the...

  3. PART II: Pops: Why Washington Delays in Solving Financial Crises

    • [PART II Introduction]
      (pp. 149-152)

      As we saw in part I, government rarely acts to keep a bubble from getting out of hand. But surely when the bubble ultimately pops, governments do better? If only they did.

      Many observers, including us, have been dismayed at how little and how poorly the financial system has been reorganized in the aftermath of the crash of 2008. Ideology, interests, and institutions all moved in the wrong direction.

      As we show in chapter 7, the ideological positions of members of Congress elected before 2008 went virtually unchanged. The midterm elections of 2010 brought about not only a Republican majority...

    • CHAPTER 6 Historical Lessons of the Responses to Pops
      (pp. 153-183)

      American history suggests four common characteristics of government responses to pops:

      1. Legislative responses to financial crises and economic downturns have generally been limited and delayed.

      2. The response often awaits a transition in political power. This partisan delay reflects the idea that the cause of the crisis is generally rooted in the ideology of the incumbent party.

      3. Future change in political power often reverses the initial legislative response. The reversal contributes to the next crisis. This point is central to the inevitability of future financial crises.

      4. Short-term reelection concerns undermine the search for longer-term solutions.

      All these...

    • CHAPTER 7 The Pop of 2008
      (pp. 184-227)

      We have seen that, historically, responses to pops have been limited and delayed. This pattern continued in the recent crisis. Housing prices began to slide in 2006 and market bubbles began popping in 2007 but serious government intervention through legislation was delayed until American International Group (AIG) collapsed the day after Lehman Brothers fell in September 2008. In April of that year Treasury officials Neel Kashkari and Phillip Swagel had developed a plan to recapitalize the banks in the event of a meltdown.¹ Before AIG collapsed, giving the force of legislation to such a plan was unthinkable. Congress was populated...

    • CHAPTER 8 “Pop”ulism
      (pp. 228-250)

      A striking puzzle of the 2008 financial crisis and the ensuing Great Recession is the very restrained and short-lived public outrage against the financial sector. The absence of public outrage explains why we have focused on theThree I’s—ideology, institutions, and interests—up to this point. The fact that the public did not press for reforms contributed, in our view, to the failure of American democracy in the financial crisis. True, outrage was expressed over the bailouts in 2008. Outrage over his membership in “the friends of Angelo,” a group that benefited from very favorable mortages from Countrywide Financial...

    • CHAPTER 9 How to Waste a Crisis
      (pp. 251-274)

      Rahm Emanuel was not alone in believing that the financial crisis of 2008 and the Great Recession would usher in an era of fundamental reform. Liberals were certain that the crisis had proven them right about the inherent dangers of unregulated financial capitalism and that the voters would finally see things their way. A charismatic new leader and progressive legislative majorities would lead the country toward a newer and fairer deal. Not only would the financial system be restructured but the tax system would be made more progressive, there would be health care for all, there would be immigration reform,...

  4. Epilogue Kicking the Can
    (pp. 275-282)

    In the fall of 2012, Americans once again had an opportunity to elect a president and change Congress. But those who hoped that the election would provide an opportunity for the nation and its leaders to engage in a discussion about the unfinished business of financial reform must surely be disappointed.

    President Obama and his opponent Mitt Romney avoided the topic of financial regulation. The topic drew just one brief engagement in the three presidential debates. When pressed in the first debate by moderator Jim Lehrer to name examples of excessive regulation, Governor Romney blamed Dodd-Frank for perpetuating banks’ too-big-to-fail...