Financial Crises and Democracy

Lorenzo Bini Smaghi, a member of the Executive Board of the European Central Bank, gave a thought-provoking speech in Milan last week. In particular, he focused on the role of democratic politics in responding to the financial crisis and, more broadly, in how governments manage their economies. Smaghi begins with the premise that it was a mistake to let Lehman fail in mid-September (not everyone agrees with this, but many people do), thereby triggering the acute phase of the credit crisis. He then asks why this happened.

As subsequent events have shown, in particular when the first rescue package was rejected by the US Congress, opposition to providing the financial sector with public funds came not only from within the government, but also from parliament. The Members of the US Congress, many of whom face voters at the beginning of November, feared that such a decision would compromise their re-election. There was opposition to rescuing Lehman Brothers, therefore, not only from within the Administration, but also from Congress and, more broadly, from public opinion. In other words, the decision was largely the result of a democratic process.

For Smaghi (and for many others), however, the systemic importance of the financial sector meant that it was actually in the interests of US citizens to bail out Lehman and, later, much of the financial sector.

The financial sector is different from other sectors, precisely owing to the systemic and contagion effects that a crisis would have on all the other sectors. It is thus in the interests of the individual citizen to support the decision to rescue a bank in difficulty, as the individual interest coincides with the public interest.

Smaghi continues by investigating why the public is opposed to a rescue of the financial system that is actually in its own interests.

My opinion is that this doesn’t require investigation, as there is little reason to expect people to vote in their own economic interests since, in most cases, thick screens of political rhetoric make it extremely difficult for them to identify where their interests lie. To take the most obvious example of the moment: According to the non-partison Tax Policy Center, Barack Obama’s tax plan will be better for the bottom four quintiles of the income distribution, and John McCain’s plan will only be better for the top quintile (see the figure on page 41); yet more Americans think that Obama will raise their taxes than that McCain will (50% to 46%), thanks to the constant repetition of the “spreading the wealth” sound bite (note how the numbers have reversed in just the last two weeks). If governments make the right economic choices on occasion, it is sometimes in spite of popular opinion but, most often, because the public does not have a strong opinion on the topic. (How many people get worked up about the Fed Funds rate, at least in normal times?)

In some respects, it may actually be good that the economy is being overseen by a lame-duck administration that is largely free to ignore public sentiment, and therefore has been able to ditch its vocal anti-regulatory ideology in favor of a series of pragmatic steps that, collectively, constitute the largest direct government intervention into the economy in my lifetime. There are certainly aspects of the intervention that reflect the free-market instincts of the players concerned, such as the outsourcing of TARP to banks and asset management firms and the relatively gentle recapitalization program. But on the whole, it is an exercise of government power in the economy that until a few months ago was anathema to the conservatives in the administration.

This lurch to the center has also been profoundly disorienting for the McCain campaign, which has tried to straddle the field by, on the right hand, arguing that the answer to the crisis is cutting earmarks and reducing spending, while, on the left hand, proposing an even more aggressive intervention in which the government would buy up and refinance mortgages directly. The conventional wisdom is that the financial crisis has helped Obama because “the economy” is a traditionally Democratic issue. But another interpretation is that, in a time of economic crisis, Americans are looking for pragmatic, centrist, even technocratic policies from their leaders, which Paulson and Bernanke have been trying to provide; in this environment, McCain’s brand – the warrior, the maverick – tends to work against him.

Update: On the topic of reducing spending, it turns out that the Obama campaign has been far better than the McCain campaign at controlling its own costs. Coming from a company that is fanatical about keeping costs down, I’m impressed.

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