Wednesday, December 21, 2016

American Banking Shifts Across Financial History

This post will be about how the structure of American banking throughout the history of the United States. This post'll be split into several sections:
1. Introduction
2. Oligopoly Banking
3. "Regulated", Decentralized Banking
4. Conclusion

1. Introduction:
I'll start off by first referencing an old post that I did on the initial design of the American banking system and then move on to the two "extremes" of banking that we've had in the history of American finance. The former is what's effectively a banking oligopoly wherein financial power is centered out of a few large banks that control the entire system. The latter financial system is one of decentralized finance that's largely locally determined. Throughout most of US history, the systems have been somewhere in between.

The first extreme is closest to what the US currently has. In this instance, financial markets are relatively "deregulated". In order to deal with this terminology, I first need to clearly communicate what I mean by "regulated" and "deregulated". Within the case of the United States, the term "regulated"--as I will use it--implies 4 key constraints on banking:
1. To cross state lines
2. Limits on branch banking
3. Limits on corporate consolidation
4. Limits on asset-backed securitization
Note: These constraints are often packaged together and they may or may not overlap.

2. Oligopoly Banking:
Most importantly, the oligopoly style of banking system is relatively, or totally, deregulated in the 4 key constraints above. In this kind of a system, banks often cross state lines with no real way to stop them. Branch banking across various states is easy. Corporate consolidation isn't just easy, but also common, so if banks find themselves in trouble they usually just get taken over another financial institution. Another key aspect is asset-backed securitization that allows for banks to take smaller and more local assets, package those assets into a security, and sell them to various financial institutions across the world.

It's commonly thought that the first asset-backed security in US history was created in 1980, but it was really created in 1790 (as I've written before). It's also thought that the first collateralized debt obligation (CDO) was created in 1980 in the United States. This is also patently false. The first CDO was created in 1851 to finance the production of railroads across the Union (the result was a rail network by 1860 larger than the rest of the world combined). So clearly, the US has a long history of "deregulated" financial markets.

In the oligopoly based banking system, the idea is for private capital to use the federal government as a tool to impose a system by which there's long-term investment, centrally directed, while still allowing for a decentralized consumption base (it's also a goal of the more decentralized private banking system as well, but it's accomplished by differing means). So the direction of investment comes from private-public partnerships and requires an oligopoly on banking.

In this kind of a financial system, you end up having serious deflationary pressure, if not outright deflation. Inflation becomes very difficult to come by because the link between money supply and inflation is severed, as I've previously written. If there's any sort of issue with smaller banks, they get absorbed by larger banks in corporate takeovers. So if there's a lot of smaller banks, those banks usually end up either failing or being absorbed into corporate conglomerates.

Also note that due to the fact that the vast majority of financial assets are owned by a few large financial institutions, it makes corporate consolidation easier for other firms who can use the large banks to broker such deals. So in essence, the oligopoly style banking system I'm describing makes it rather simple for all firms to take advantage of economies of scale. To put simply, this kind of a banking system doesn't just foster scaling effects in banking, but in virtually all kinds of firms ranging from industry to technology to services to any industry that has economic advantages by economies of scale.

The oligopoly type of banking system in the US has a history of concentrating financial, political, and economic power in the hands of a few. In effect, this kind of a banking system has had a historical tendency to exacerbate income and wealth inequality. It is economically efficient, but this kind of financial system is ruthless in terms of social costs. It can place very difficult financial circumstances upon communities of all kinds.

3. "Regulated", Decentralized Banking:
The second extreme of banking is the decentralized form of banking. This type of banking has its roots in the old Jacksonian era of American politics. It's built on the idea that banks and concentrated financial power are dangerous to republican institutions due to the way they can impose social costs upon a community against their will. The Jacksonians view the centralization of power as a real threat to republican institutions and a real cause of disillusionment and fear among common populations.

In order to regenerate republican institutions, the Jacksonians generally call for a rapid reduction of federal financial power by effectively letting states put up barriers to interstate banking. They did this by "free banking" where each state would have its own banking laws, making it difficult or prohibitively costly for banks to be more than regional (maybe they'd cross state lines, but it was tough to go across regions due to having to deal with state by state regulation).

So the idea of the Jacksonians was to leave the policy of banking to the states. Later on, the progressives picked up many of these same policy positions and ideas that they'd run on. These ideas primarily involved a banking system that's totally dependent on local and community banking. Eventually, this view was imposed by strict regulation on the use of financial derivatives.

One of the key aspects of a "regulated" and decentralized banking system was that it decentralized the power and decision making of finance to local communities and states. Due to this fundamental aspect, this kind of banking system has the tendency to be inflationary--especially during given conditions and time periods--since households have a lot of power, can vote themselves purchasing power, and then demand surges at key points. In other words, the losses of a recession are borne with higher inflation instead of higher unemployment or lower wages because workers and households have more control and influence over the factors of production.

The "regulated" and decentralized banking systems have also had a history of high rates of bank failure because all banking is local. If a bank fails, it just goes out of business instead of being consolidated into a larger network. So either the depositors get hit or there's deposit insurance. The Jacksonians never pushed for deposit insurance, but the progressives did to offset the losses to depositors. You can have either or, but it doesn't change the underlying structure of the financial system.

The Jacksonians went to more of a "free banking" style of a decentralized and "regulated" financial system, but the progressives took a more top-down approach. They decided everything would center from the Fed and the Treasury. The progressives also decided that it'd be a good idea to place branching restrictions on banks in an order to prevent them from crossing state lines. That way, banking couldn't have an oligopoly by the very nature of the system.

4. Conclusion:
Throughout US history, we've gone back and forth in between these two extremes. Currently, we're living under the oligopoly extreme of the financial system. Personally, I do not like the "regulated" and decentralized style of banking that's favored by the progressives and Jacksonians. At my core, I'm a Hamiltonian who prefers a strong base and power center in the political and financial system for private capital that often supersedes the power of the larger populace at large.

As I've written before, Hamilton created a financial system that ended up being much closer to the oligopoly style of banking after the birth of the Republic. Eventually, Andrew Jackson totally shook this system up to impose a more decentralized and "regulated" financial system (albeit the consideration by many libertarians as "less regulated", although it's important to note that what we consider as 'libertarian economics' has a historical track record of going along with Jacksonian political economy in the United States) after his successful attempt in destroying the Second Bank of the United States. Then, the first CDO was created in 1851 and the resolution of the 1857 crisis started to push this country more and more toward the oligopoly style of banking system.

As we approached the Civil War, the political divides were fundamentally economic and financial divides built around the banking system and the power of private capital. Private capital was on the side of the Union, which's why Lincoln ended up being the man who forged a Union. However, this banking system led to a gross amount of income and wealth inequality in the Gilded Age (quite similar to social environment we've got now). So over time, the progressives realized they could win elections by running against the banks.

Eventually, it took the Great Depression for the progressives to impose their kind of banking system (even though they got the reasons for the Great Depression entirely wrong and they actually worsened it due to Woodrow Wilson's terrible economic and foreign policy), which they did. So for the next ~40-50 years this kind of a banking system held until the inflation in the 70's. So over time, such restraints on the banking system were loosened. And here we are now.

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