An open access publication of the American Academy of Arts & Sciences
Fall 2010

Political fortunes: on finance & its regulation

Nolan McCarty, Keith T. Poole, Thomas Romer, and Howard Lewis Rosenthal

Nolan McCarty, a Fellow of the American Academy since 2010, is the Susan Dod Brown Professor of Politics and Public Affairs and Associate Dean at the Woodrow Wilson School of Public and International Affairs at Princeton University. His publications include Political Game Theory (with Adam Meirowitz, 2006), Polarized America: The Dance of Ideology and Unequal Riches (with Keith T. Poole and Howard Rosenthal, 2006), and The Realignment of National Politics and the Income Distribution (with Keith T. Poole and Howard Rosenthal, 1997).

Keith T. Poole, a Fellow of the American Academy since 2006, is the Philip H. Alston, Jr. Distinguished Chair in the Department of Political Science, School of Public and International Affairs, at the University of Georgia. His publications include Ideology & Congress (with Howard Rosenthal; second revised edition, 2007), Polarized America: The Dance of Ideology and Unequal Riches (with Nolan McCarty and Howard Rosenthal, 2006), and Spatial Models of Parliamentary Voting (2005).

Thomas Romer is Professor of Politics and Public Affairs and Director of the Research Program in Political Economy at the Woodrow Wilson School of Public and International Affairs at Princeton University. His publications include “An Empirical Investigation of the Dynamics of pac Contributions” (with James Snyder), American Journal of Political Science (1994); “Interjurisdictional Sorting and Majority Rule: An Empirical Analysis” (with Dennis Epple and Holger Sieg), Econometrica (2001); and “Parties in Elections, Parties in Government, and Partisan Bias” (with K. Krehbiel and A. Meirowitz), Political Analysis (2005).

Howard Rosenthal, a Fellow of the American Academy since 1992, is Professor of Politics at New York University. He edited What Do We Owe Each Other?: Rights and Obligations in Contemporary American Society (with David J. Rothman, 2008) and is the author, most recently, of Ideology & Congress (with Keith T. Poole; second revised edition, 2007) and Polarized America: The Dance of Ideology and Unequal Riches (with Nolan McCarty and Keith T. Poole, 2006).

The financial crisis of 2008, as well as many earlier crises, had an important political dimension.1  Government not only failed to intervene to restrain a bubble but also directly abetted the expansion of the bubble. After the bubble popped, political considerations limited and delayed appropriate policy changes.

Both during and after bubbles, political outcomes reflect the same forces that operate in normal times. Such forces include decision-making based on ideologies: free market conservatism, egalitarianism, and populism. Political decisions (and non-decisions) also reflect checks and balances across branches of the federal government and across layers of government in a federal system, as well as institutional checks, such as bicameralism and filibusters. Interests favoring current arrangements benefit from the status quo bias inherent in our political institutions. How these forces operate is greatly influenced by how ideology has contributed to polarization between the two major political parties.

These forces are part of the normal flow of politics in our democracy. Politicians respond to the politically active– campaign contributors and lobbyists in particular. Policy is swayed by the self-interest of financial firms and, more broadly, creditors and debtors. So-called independent regulators, including the Federal Reserve, respond not only to their own ideology and expertise but also to elected officials with political power over them.

The crisis of 2008 followed the latest in a long history of real estate bubbles in the United States. Bubbles often spill over into other sectors, so that a pop in an asset bubble frequently engenders a banking crisis.

Before 2008, the most recent example of a real estate bubble’s devastating effect on financial institutions was the savings and loan (S&L) crisis of the 1980s. This earlier crisis differed in important respects from the 2008 crisis. First, the political system was substantially less polarized than it is today. Second, the economic shock was much smaller. These two factors contributed to a less contentious eventual resolution of the crisis. Moreover, the crash in real estate prices at that time was much more geographically concentrated than in the 2000s, and the thrifts (as the firms in the S&L industry were called) were more Main Street than Wall Street. Nonetheless, the interaction between the financial and the political sectors strongly foreshadowed the events of 2008.2

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  • 1Poole thanks his colleagues at the University of Georgia for offering many helpful comments. Romer is grateful to the United States Studies Centre at the University of Sydney, where he was on sabbatical leave during the North American winter months of 2010, for its gracious hospitality. It was an excellent environment for stimulating conversations about the global financial crisis. Rosenthal thanks his colleagues at the California Institute of Technology in the spring quarter of 2010, especially Peter Bossaerts and Jean-Laurent Rosenthal, for discussion and comments, as well as participants in conferences at Columbia University and Università Cattolica del Sacro Cuore.
  • 2Our summary of the politics of the S&L crisis is based on Thomas Romer and Barry R. Weingast, “Political Foundations of the Thrift Debacle,” in Politics and Economics in the 1980s, ed. Alberto Alesina and Geoffrey Carliner (Chicago: University of Chicago Press, 1991).
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