Governance and the Financial Meltdown: The Implications of Madisonian Checks and Balances for Regulatory Reform

Abstract

This paper is concerned with the critical role of governance institutions in bringing about the financial meltdown. The basic argument is that the build-in checks and balances in the U.S. governance system failed to provide a counterweight, and instead reinforced the excessive optimisms in the financial markets. This optimism was created through dramatic changes in globalization of liquidity, Internet speed of transactions, and sophisticated new financial instruments.

Work in the economics of regulation and in experimental economics shows that changes in financial instruments and the structure of the market can give market participants wrong signals about the formation of bubbles in the market. The “dotcom” bubble was caused in part by the excessive optimism by market participants that the Internet had changed the way the market works to such a degree that old rules of the business cycle were obsolete. The globalization of financial markets with its gigantic liquidity worldwide and rapid movement combined with sophisticated new financial and securities instruments created similar overly-confident expectations of unparalleled growth.

At the same time, major changes in regulatory and legislative governance reinforced this overly optimistic view of the financial markets. The political parties failed to check each other on the regulation of financial markets. Instead, the economic views of both political parties in the Congress and the presidency shifted over the past twenty years toward a greater reliance on market forces and limited regulations as the path to continued economic growth and prosperity. Legislative interest group politics also reinforced this political party and ideological orientation through large scale campaign contributions from investment, real estate, mortgage, and construction firms, as well as from Fannie Mae and Freddie Mac. The Federal Reserve, which might have acted as a counterweight to this political orientation, instead increasing adopted the professional view that less regulation and more liquidity would allow private markets to sustain growth and prosperity.

In corporate governance, professional managers might have acted as a counterweight to the excessive optimism of shareholders, who were seeing massive gains in stock prices and profits. However, over the past twenty-five years senior managers were increasingly compensated and rewarded for short-term profits and stock prices, and thereby, their self interest coincided with the shareholders’ short term and excessive expectations of unlimited growth. Managers in turn placed similar short-term rewards and punishments on fund managers toward continued high growth.

The conclusion of the analysis is that the established checks and balances between political parties, the two houses of Congress, interest groups, and corporate boards not only failed to act as a counterweight to the excessive optimism of the financial bubble but rather contributed to and reinforced this development.

Keywords: financial crisis, governance, economic regulation