Surviving Large Losses: Financial Crises, the Middle Class, and the Development of Financial Markets

Published by EH.NET (July 2007)

Philip T. Hoffman, Gilles Postel-Vinay and Jean-Laurent Rosenthal, Surviving Large Losses: Financial Crises, the Middle Class, and the Development of Financial Markets. Cambridge, MA: Harvard University Press, 2007. viii + 263 pp. $28 (hardcover), ISBN: 978-0-674-02469-4.

Reviewed for EH.NET by Howard Bodenhorn, Department of Economics, Lafayette College.

Those of us who knew some financial history were not surprised by the Enron and WorldCom collapses in 2001 and 2002. We may have been taken aback by the magnitude of the losses and empathized with Enron employees who saw comfortable retirements evaporate before their eyes, but I can recall more than one dire prediction as Y2K approached and not because anyone really believed that confused computers would turn out the lights. Rather, some of us had genuine concerns that the equity market mania in 1999 resembled that of 1929 and hoped that the Fed would get it right the second time around. Optimism reigned at cocktail parties, however, and statements about unsustainably high equity prices were casually dismissed as just one more example of economists’ collectively predicting 11 of the past 10 recessions. History warned us that the collapse was not a matter of “if.” It was a matter of “when.” While this sense of inevitability now sounds like so much “I-told-you-so” hindsight, Surviving Large Losses makes a case that the then minority opinion was reasonable. The book makes the case that financial crises are inevitable. What is not inevitable is how societies respond as the pieces are picked up after the crisis.

Philip T. Hoffman (Caltech), Gilles Postel-Vinay (?cole des Hautes ?tudes en Sciences Sociales) and Jean-Laurent Rosenthal (Caltech) recognize their debts to the finance-growth literature, exemplified by Ross Levine’s many and influential cross-country studies, and the equally influential La Porta, Lopez-de-Silanes, Shleifer and Vishny (LLSV) “law and finance” literature, which holds that a country’s financial system is heavily influenced by the legal protections offered to equity and debt holders.[1] As influential as the related Levine and LLSV literatures are, cross-country analyses labor under two fundamental shortcomings. First, they ignore the powerful historical forces that shape a country’s financial institutions and infrastructure, the “colonial origins” argument at the center of LLSV notwithstanding. For a host of reasons, many of which are explored in this book, countries become prisoners of their own pasts, but the story is far more complex than colonial origins. Second, both literatures identify, but cannot explain a growth nexus, though some progress on that front has recently appeared.[2] That is, the size and structure of a country’s financial system matters for long-run growth, but the analyses fail to explain why and how they matter and, more importantly, why and how they change. If success can be had by simply copying the successful, why have so many economies failed to do so? The short answer, of course, is that institutional change is not costless. No matter how inefficient an existing financial system, its costs and benefits are capitalized by economic actors who will resist change absent some outside impetus that alters the calculus.

Surviving Large Losses provides an original and provocative hypothesis that offers an interpretation of financial reform: historically, one of the most important moving forces behind financial evolution has been the financial crisis. It is a fact that financial crises are virtually inevitable in modern economies ? a source of sleepless nights, if not outright dread, for even the most sophisticated, well-hedged investor. Despite the enormous human costs of financial crises, “they often prove to be turning points in the evolution of financial markets and long-term economic growth” (p. 2). Because crises are followed by searches for culprits and insistent calls for change, they afford politically opportune moments to reform financial institutions. In the U.S., for example, the Federal Reserve System and the Federal Deposit Insurance Corporation, two fundamental building blocks of the twentieth century U.S. banking edifice, emerged as post-crisis reforms. These reforms demonstrate that something new and functional can be built on the ashes of the old and broken.

Although the authors offer a political economy model of post-crisis financial reform, they do not arrive at their conclusions by analyzing historical data ? though they have performed such analyses elsewhere. Instead, they take a decidedly low-tech, narrative approach to appeal to the widest possible audience. After providing a verbal explanation of their political economy model, the authors rely on their extensive historical knowledge of about four centuries of financial crises to support their interpretations.

The substantive chapters of the book open with a fundamental question: Why is it that some states protect savers and investors while others plunder? Every state, no matter how wealthy or democratic is capable of plunder, but those that resist grow over the long term. What increases the probability of plunder is the size of the public debt relative to the state’s ability to service it. Countries with small debts and low taxes relative to GDP are less likely to prey on financial markets (p. 12-13). Countries mired in public debt and with already heavy tax burdens have few politically viable options during a crisis other than default or confiscation. In many societies, preying on the military or a hungry electorate instead of the rentiers is a sure ticket for a short reign (p. 14-15).

In issuing public debt the state plays a critical role at the extremes. At one extreme is the state whose issuance of debt leads to the emergence of debt markets with institutions suitable to and organizations capable of trading private claims. So long as the state restrains itself, an entrepreneurial class gains access to an expanding web of finance with positive consequences for long-term economic development.[3] At the other extreme is the state that piles up enormous debts and pays for them by preying on financial markets. To avoid the predator, investment capital hides or flees with obvious negative consequences for long-term growth.

How do crises matter in this process? Financial markets shrink during a crisis and investors call for change in the aftermath. Whether change occurs, how change is initiated, and who initiates it ? government or private actors ? are issues determined through the interaction of political economy and historical accident. Part of the answer depends on who demands post-crisis change and whether the demands for change are translated into productive and efficient institutions (the preferred outcome) or whether losers use the political system to confiscate from winners however defined (the undesirable outcome) or something in between.

Hoffman, Postel-Vinay and Rosenthal argue that the outcome turns on the behavior of three actors ? the middle class, financial intermediaries, and the government. Casual observers might think that the wealthy would be the driving force behind post-crisis reform. But, as the authors note, it is a broad, relatively egalitarian middle that drives financial development, as well as the political economy of reform. Entrepreneurs tend to emerge from the middle. The middle has collateral. The middle relies on local financial institutions. The middle is most vulnerable to crises.

Although the middle’s favored short-term post-crisis strategy might be a bailout and redistribution, enough members of the group usually recognize that institutional reforms that strengthen the financial system and insulate it from transient shocks are the preferable long-term strategy. A more vibrant, more efficient financial system benefits them directly (diversification) and indirectly (spurring macroeconomic growth). Whether the middle class realizes their calls for reform depends on its size and its political clout relative to the wealthy. Egalitarian societies with a broad middle are most likely to initiate useful reform because the benefits of confiscation are small ? mostly because the middle will be confiscating from itself ? and because the benefits of crisis-averting innovation are large.

Whether the middle succeeds depends on the objectives of the second principal player: financial intermediaries. It is in this arena that a society’s wealthy play an important role. Because the wealthy have (very nearly by definition) large portfolios, they are able to spread the fixed costs of innovative new products across a raft of customized financial products. But once financial intermediaries have designed products for the wealthy, it is only a matter of time before they are made available to consecutively less wealthy investors until they are eventually redesigned to suit the needs of the middle. A recent example of increasing regulatory concern is the growing upper-middle class fascination with hedge funds.

Crises, as Hoffman, Postel-Vinay and Rosenthal note, have many causes, including government predation, herd behavior, asymmetric information, and inadequate diversification. If intermediaries see post-crisis profit opportunities and can expect governmental or legal support for reforms and new products that reduce the negative consequences of information asymmetries (i.e., new reporting requirements imposed by stock exchanges for listing companies) and enhance diversification (i.e., mutual funds), they will push for reform.

Government is the third principal player in the drama. Government differs from private actors because a private actor must realize a profit from any innovation or it will be driven from the market. Governments face no such constraint and can, in fact, impose taxes and other regulatory costs to pursue the changes it deems appropriate. Government has a prominent role in financial markets ? from enforcing contracts to subsidizing deposit insurance to overcoming some types of market failures ? but there is a constant fear of governmental overreach, predation, and the encouragement of rent seeking. Governmental intervention is successful when the net social benefits of a proposed reform outweigh its costs and when the rents created are small relative to the benefits of resolving the market failure (p. 169).

What is the authors’ interpretation of massive state intervention in financial markets in modern Western-style economies? They argue that it was an outgrowth of the bloody and tumultuous twentieth century. Governments intervened on a modern scale during the First World War when national survival seemingly demanded planning boards, rationing and conscription of men and materiel, including middle-class savings. The Great Depression induced a second wave of massive intervention and regulation. The Second World War, post-war reconstruction and the Cold War elicited even greater government intervention. Thus, the period between 1914 and 1990 was one of massive and increasing governmental regulation.

How did the Western-style economies realize their remarkable rates of growth in the twentieth century if financial markets labored under the ever increasing weight of government regulations? The authors argue that these countries “got away with it” because, as the century opened, they already had good institutions in place and governments, while highly regulatory, were rarely predatory. Low-income and low-growth developing countries that copied, or tried to copy, the regulatory structures of the West failed because they did not begin with the same pro-growth institutions.

In the end, then, Surviving Large Losses, while more historically nuanced than the finance-growth and law-and-finance literatures from which it springs leaves us in much the same place. Political economy takes us only so far. A large part of the story of good finance is historical contingency, which makes for a less parsimonious tale than that offered by LLSV and others, but one more satisfying to economic historians. Nevertheless, we are left to wonder how the financial institutions that matter emerge and thrive. The authors’ explanation hangs mostly on the existence of a middle class but that, too, depends on a preexisting set of “good” social, political, economic and governmental institutions. Surviving Large Losses is, therefore, probably best viewed as a low-tech contribution to the literature attempting to unbundle institutions. It is certainly thought provoking and leaves as many questions as answers. Before its interpretations carry the day, however, much more theoretical and empirical work will need to be done. Although the conclusions drawn from many historical episodes will appeal to economic historians and general readers, I suspect that mainstream banking and finance types will withhold judgment until many more formal tests are provided. I look forward to seeing those tests and expect the authors of Surviving to be notable contributors.

Notes: 1. See Ross Levine, “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature 35:2 (June 1997), 688-726 and Ross Levine and Thorsten Beck, “Stock Markets, Banks and Growth: Panel Evidence,” Journal of Banking and Finance 28:3 (March 2004), 423-42; Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert W. Vishny, “Law and Finance,” Journal of Political Economy 106:6 (December 1998), 1113-55.

2. Thorsten Beck, Asli Demirguc-Kunt, and Ross Levine, “Law and Finance: Why Does Legal Origin Matter?” Journal of Comparative Economics 31:4 (December 2003), 653-75; and Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, “What Works in Securities Laws,” Journal of Finance 61:1 (February 2006), 1-32.

3. Richard Sylla, “U.S. Securities Markets and the Banking System, 1790-1840,” Federal Reserve Bank of St. Louis Review 80:3 (May 1998), 83-98 makes the case for the early U.S.

Howard Bodenhorn, professor of economics at Lafayette College and Research Associate at NBER, has written extensively on banking history. Among his recent articles is “Usury Ceilings, Relationships and Bank Lending Behavior: Evidence from the Nineteenth Century,” Explorations in Economic History (2007).