Who Governs?
Market problems such as monopoly, fraud, speculation, and/or manipulation are perceived, the legislature passes a law to correct them, a bureaucracy is assigned to interpret and enforce the law, buyers and sellers comply, and the problems are solved or at least lessened. Markets are remedied along the lines of officialsâ understanding of the publicâs welfare. Or are they? Are the promises of politicians, the powers of regulators, and the stories of textbooks believable?
This is a lot to ask because we have learned from hard experience that mistaken legislatorsâ perceptions and/or the inability or unwillingness of bureaucracies to enforce the law or the public to comply are also possible. All are subject to complex and changeable influences. In addition, the market interests believed to have been a source of the problems may persist along with incentives to obstruct the law or bend it to their own advantages. To the extent that markets continue to have their often inscrutable and unpredictable ways, legislatures and bureaucracies are undermined and government is by private interests.
This approach resembles the âiron triangleâ theory of government consisting of congressional committees, the bureaucracy, and interest groups, except that, more generally, it begins with the making of the law and also considers markets of which private interests are parts (Adams 1981). There is no simple general pattern of these interactions because the laws have different origins and the distributions of power between the groups are variable and changing. For example, the massive securities losses of the Great Depression of 1929â33 led to the securities acts of the New Deal that were intended to correct the secrecy and greed of financial firms by means of enforced transparency and limits on such suspect practices as short selling and margin trading.
An alternative explanation is that typical securities issues of the 1920s were honest and transparent, with good prospects, but lost their values after 1929 with the disappearing profits of issuers, a cause which should be laid at the door of monetary policy rather than corporate greed. A more logical official response to such a crisis would have been reform of the monetary authority in the interest of price stability.
A similar story applies to the creation of the Federal Reserve in 1913. The country had experienced several financial crises, and the Panic of 1907, with the help of the Progressive movement and the presidency of Woodrow Wilson, sparked the establishment of a powerful public bank to deliver an elastic currency and profitable banks. Unfortunately, during the next twenty years, American finance experienced the greatest fluctuations in its history because it was used by the government to finance a major war followed by its unthinking submission to gold-reserve restraints which inhibited it from moderating the ensuing deflation.
In fact, the chief cause of the fragility of the American banking system had been overregulation, particularly state prohibitions of branching that resulted in a plethora (30,000 in 1920 and 13,000 after the failures of the 1920s and the Great Depression) of mainly small undiversified banks, as well as rigid reserve requirements that discouraged crisis lending by the money-center banks. Most failures were of small agricultural banks unable to survive the post-World War I falls in the prices of agricultural products.
Added to the sometimes misdirection of laws has been their hasty emotional constructions by temporary political majorities on the heels of crises. Should we necessarily conclude that the plethora of laws enacted during President Franklin Rooseveltâs famous first 100 days were evidences of legislative achievement when we realize that crises, reactions to them, and the distribution of political powers are transient? A law and its enforcement might endure because of persistent economic and political conditions, aided by inertia, or they might not. The Securities and Exchange Commission, created in 1934, still exists along with its reporting requirements. On the other hand, several of the provisions of the Securities Exchange Act of 1934 directed at risks and monopolies have yet to be applied, and the SEC was moribund from the time the supporting administrationâs attention turned elsewhere in the mid-1930s until the 1960s, and its efforts continue to be uneven.
Bureaucraciesâ responsibilities have expanded with lawmakersâ ambitions relative to their knowledge. So-called laws often in fact mostly consist of general directions to make and enforce rules (which are the effective laws) such as those pertaining to bank risk, required capital, leverage, and liquidity in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. Nor is this approach to lawmaking an innovation. The originators of the 1934 Securities Exchange Act wanted substantial changes to what they deemed too risky and too monopolistic exchange trading practices, but to get the Act passed, had to settle for Securities and Exchange Commission studies which decades later have still been unable to move the interests involved.
The other agency that we consider, the Federal Reserve System, soon deviated from the purposes specified by its founding 1913 Actâamong which were currency stabilization and maintenance of the gold standardâas it monetized the governmentâs World War I deficits and failed to deal with the subsequent deflations.
The question remains: Who or what governs the financial markets in our more-or-less competitive economy? Do the legislatureâs rules as implemented matter? Even pertinent laws and competent bureaucracies are faced with formidable tasks in their attempts to modify the behavior of often recalcitrant market participants. There are general influences on regulationâincluding private interests, Congress, and bureaucratic preferencesâbut no simple general result. Bureaucracies are less systematic and predictable than is sometimes supposed (Niskanen 1971; Moe 1997). They desire large budgets, of course, but their behavior is also affected by changing ideologies, political pressures, and private interests.
On the other hand, there seem to be some regularities in financial institutionsâ defensive responses to legislation. Effective prudential legislation is exceedingly difficult. The future is uncertain and wide open. Prohibitions or requirements regarding specific activities, which is the approach typically taken in financial legislation and regulation, can have little effect on the risk exposures of institutions with an infinity of choices among activities and portfolios. Such laws and their bureaucracies may enjoy long and busy lives, and even good reputations, with little inconvenience to market participants.
Regulations seek predictable behavior which is typically unobtainable (and perhaps undesirable) in developing environments in which discretion and adaptation are fundamental. This is nowhere truer than with respect to the disclosure requirements of the 1930s securities acts, which presume that reputations and expected results are less dependent on past performances than on standardized promises.
The Federal Reserve has also sometimes conformed more closely to traditional practices than to modern legislation. The ancient principal (though often denied) practice of central banks has been more to monetize government deficits, although sometimes restrained by the publicâs aversion to inflation, than to pursue their advertised goal of monetary stability. How they actually behave during any particular time period depends on executive, congressional, and private pressures as well as the ideologies existing within the agencyâleading in the 1960s to a contest between the needy executive and a cautious agency. Guess who won.
This book looks at the outcomes of two experiences of government stimulated by the securities acts of the 1930s and the post-World War II monetary-policy responsibilities of the Federal Reserve. Similarities in our stories are furthered by the involvement of William McChesney Martin, Jr., in both, as president of the New York Stock Exchange, that is, a representative of the financial industry, in the 1930s, and as chairman of the Federal Reserve Board, a government agency, from 1951 to 1970. It is interesting that Martinâs conservative, free-market, ideology influenced events in both situations even though it came from a private interest group in one case and a government agency in the other.
Born in 1906 into a St. Louis family with a history of finance and public serviceâhis father was president of the Federal Reserve Bank of St. LouisâMartin was educated before the coming of Keynesian economics and the New Deal, although the Progressive (government interventionist) movement was already part of American politics. Martinâs experiences revealed not only the interplay of Congress, bureaucracy, and market interests but also the Old Schoolâs mixture of resistance and accommodations to regulation. As president of the NYSE (1938â40), he was caught between the reforming pressures of government and the resistance of members of the Exchange struggling for profits and even survival, and second, as chairman of the Federal Reserve (1951â70), between the Fedâs official mandate of financial stability and political and intellectual pressures for easy money. He showed similar economic views in the two cases as well as substantial bureaucratic skills. In the first case, he held off the reformers, with mixed success, until his goodwill had been exhausted. His record as chairman of the Fed is well-known: low inflation for a dozen years followed by as much resistance as he could manage consistent with the Fedâs survival to presidentsâ easy-money pressures during the remainder.
Legislationâs probable influences are often complex and uncertain when adopted, and might or might not become more straightforward with time. We might expect a law to diminish in effectiveness over time as technology and political conditions change. On the other hand, market adaptations could as easily, in principle, strengthen as weaken the effectiveness of laws. We will look at the practical development of the securities and Federal Reserve acts and compare them with subsequent related legislation, such as Dodd-Frank, which was inspired by the 2008 financial crisis, and is the most recent substantial effort to improve the financial system by legislation.
This book builds on the many excellent studies of the Securities Acts of the 1930s and the Federal Reserve Act of 1913, by examining their changing effectiveness over time as they respond to developing political, bureaucratic, and market pressures. Histories of the Acts are alive with personalities and their interactions with the private and political conditions of their times. New to the financial center, the young Martin, for example, was thrust into a prominent position with conflicting obligations to the bureaucracy and the stock market. The directions of his efforts were affected by the political climate, first emphasizing the reforms of the Exchange envisioned by the Securities Exchange Act of 1934, but also subject to traditional profit-seeking practices under pressure from the Exchange as administration pressures turned elsewhere.
Similarly, although as Chairman of the Fed, Martinâs stable-price preference had not changed, his efforts were affected by political pressures. Observations of Martin at the New York Stock Exchange and the Federal Reserve allow us to study the interactions and relative importance of private interests, laws, bureaucracies, and ideologies. General theories of legislatures or government bureaucracies are difficult, but examinations of them in the contexts of particular conditions and personnel may improve our understanding of them a little, even if only to find that their importance may sometimes be exaggerated.
A Background of Crises and Financial Regulation
Financial crises and government reactions have been with us for centuries, e...