When a Politician Praises “Efficiency,” Hang on to Your Wallet (Financial Reform Headfake Edition)

A fair bit of ink has been spilled on the idea that what is often called “innovation” in financial services is a fancy way of saying “extortion racket.” I was cheered when Paul Volcker put the ATM on his list of banking innovations and seemed unable to come up with anything worthwhile since then. Similarly, Martin Mayer described innovation in banking as using new technology to do that which was forbidden under the old technology.

A related bit of NewSpeak is “efficiency.” Businessmen will often argue that certain measures should be undertaken because they are more efficient. That is code for “because everything will go faster/more smoothly, we will make more money.”

Now why does this idea deserve critical scrutiny? Well, for instance, disclosure, ranging from product labels to SEC filings, is inefficient. Anything that helps public safety is inefficient. Democracy is inefficient.

Moreover, if you put on your systems design hat, too much efficiency is a VERY bad thing. A highly efficient system, as Richard Bookstaber reminded us in his A Demon of Our Own Design, suffers from “tight coupling,” which means that activities propagate through the system so rapidly that they cannot be interrupted. That in turn means it is very easy for processes to amplify and spin out of control. Systems designers give safety and stability top priority, and efficiency second.

And now we have “efficiency” possibly turning the Consumer Financial Protection Agency legislation into a Trojan horse to gut state oversight of banking. It was the states, not the Feds, that went after a host of abuses, starting with dot com stock touting to auction rate securities to dubious mortgage lending practices.

The row started when Representative Melissa Bean of Illinois, who sits on the House Financial Services Committee, added an amendment to the draft bill (which could come to a vote today, call your rep!) that would bar states from having measures tougher than the Federal standards. As Huffington Post noted (hat tip reader Barbara):

Bean is the co-chair of the pro-business New Democrat Coalition’s financial services task forced and vies for the title of Wall Street’s favorite Democrat. Bean and other New Dems are tussling with committee progressives over federal preemption. If Bean’s measure carries, states would not be allowed to enforce consumer protection laws on national banks that are stronger than those at the federal level. All banks would need to do, then, is water down regulation at the top, rather than in each state legislature.

Lisa Madigan, the Illinois Attorney General, is not taking this lying down and has fired off this salvo to Bean:

Federal regulators have maintained that national banks did not play a significant role in precipitating the crisis. That claim does not comport with the facts. The Center for Public Integrity found that 21 of the 25 largest subprime lenders during the lead-up to the crisis were financed by large banks….In contrast, in the run-up to the current crisis, many state attorneys general (including my Office) aggressively prosecuted the bad actors in the industry within our reach….

Federal laws have frequently stymied state reform efforts. These laws preempted states from regulating certain risky loan terms and features, such as prepayment penalties and negative amortization, regardless of whether a state-chartered or federally licensed entity makes the loan. It was precisely these types of features that led to widespread abuses….State attorneys general saw abuses of the prepayment penalties, which often locked borrowers into unaffordable subprime mortgages. Yet federal preemption barred states from enacting tougher laws to address these abuses, even as applied to those entities that we regulate.

National banks and thrifts claim that allowing states to enact tougher laws when necessary – as the CFPA Act would – will result in too great a burden on the system. That argument is disingenuous. Many of these lenders are multi-national companies that currently have to comply with a vast array of varying rules both inside and outside our nation’s borders. In fact, as demonstrated by the swollen docket of our nation’s foreclosure courts, national banks seem to have no problem complying with the varying state and local laws governing the foreclosure process.

And of course, the real point of this exercise is obvious. It is is much more “efficient” for banks to assert their control over the country at the Federal level, where they have already made impressive inroads, than to have to also deal with rearguard efforts from pesky and persistent state officials.

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  1. Wayne In IL

    That should probably read, Melissa Bean. It only took her 2 terms to learn the ways of Washington.

  2. DownSouth

    This issue goes to the heart of a debate that dates back to the founding of the Republic. This and another post today (regarding the ruling of the Massachusetts Land Court) speak to the same underlying dispute, and that is the separation of powers in our governments.

    James Madison frames the issue as follows:

    In a single republic, all the power surrendered by the people is submitted to the administration of a single government; and the usurpations are guarded against by a division of the government into distinct and separate departments. In the compound republic of America, the power surrendered by the people is first divided between two distinct governments, and then the portion allotted to each subdivided among distinct and separate departments. Hence a double security arises to the rights of the people. The different governments will control each other, at the same time that each will be controlled by itself.

    So governmental power was to be split between the federal government and state governments, and the power of each of these was to be further split between the legislative, executive and judicial departments. This was, in theory, supposed to prevent a single interest from monopolizing governmental power.

    One must take a moment to consider the historical context in which the founding of the republic occurred. Never before had the common man been deemed capable of playing a role in government. As Hannah Arendt observed in On Revolution, up until the advent of the American Revolution, in order to participate in government,

    one had to be a ruler, a free-born man in antiquity, a member of the nobility in feudal Europe, and although there were enough words in premodern political language to describe the uprisings of subjects against a ruler, there was none which would describe a change so radical that the subjects became rulers themselves.

    So in this context, even though the Founding Fathers were committed to expanding the governing franchise, they were nevertheless leery of all the new participants that were to be so suddenly admitted into the public realm. Their fears were two-fold:

    1) They were not sure that the common man had the intellectual and moral capacities to self-govern

    2) They feared the “tyranny of the majority” or what Elbridge Gerry called “an excess of democracy.”

    These fears resulted in a Constitution that, although quite progressive for its time, is nevertheless beginning to show some cracks due to the knowledge that has accumulated over the past 220+ years.

    The first fear enumerated above resulted in a form of government in which the public representation constituted a republic as distinguished from a democracy, where “a small number of citizens…assemble and administer the government in person” to guard “against the confusion of the multitude.” The end result of this has been that, as Arendt goes on to explain,

    the age-old distinction between ruler and ruled which the Revolution had set out to abolish through the establishment of a republic has asserted itself again, once more the people are not admitted to the public realm, once more the business of government has become the privilege of the few, who alone may “exercise [their] virtuous dispositions” (as Jefferson still called men’s political talents).

    As to the second fear, Madison has certainly been proved correct in his theory that the best way to protect the rights of a minority from the tyranny of the majority is to “enlarge the sphere” of republican government. A strong federal government has been shown repeatedly to be the best remedy to the “abuses of republican liberty practiced in the states.” Probably nowhere was this better demonstrated than in the Civil Rights Movement, where the federal government stepped in to guarantee the rights of racial minorities when the states failed to do so.

    But even though a strong federal government has served the interests of racial minorities well, it is important to recognize which minority was foremost in the minds of the Founding Fathers when they drafted the Constitution. This was true regardless of the fact that the sentiments of the Founding Fathers ran the gamut from the highly aristocratic Hamilton to the egalitarian Jefferson, for one thing they all had in common is that they were wealthy patricians. As Lance Banning wrote in “Madison, the Statute, and Republican Convictions”:

    Much of the American elite shared Madison’s alarm with the “abuses of republican liberty practiced by the states.” Many, maybe most, defined the problem as a classic crisis of relationships between the many and the few, creditors and debtors, rich and poor.

    The bottom line of all this is that the advantages of an elite, wealthy minority were built into the structure of the constitution. And it is to the great credit of Jefferson that he alone, late in his life, was to recognize and write about the error that had been committed in the promulgation of the Constitution.

    The result of the advantages built into the Constitution for an elite, wealthy minority is that the history of the United States has been, all but for a few brief episodes, one of a welfare state for the rich. And any rollback or containment of the nanny-state for the rich has always been a hard-fought, uphill battle.

    A brief recounting of US history pretty much tells the story. As Jacques Barzun pointed out, in its early years the “Americans fought and cheated the Indian tribes on their borders and the southerners lived off the toil of 200,000 African slaves.”

    Kevin Phillips then picks up the sordid tale. The great railroad fortunes, to pluck one example from Phillips’ long history of government largess that has been lavished upon rich people, were all built with government subsidies. As he points out in Wealth and Democracy: ”Of the $23 million the Illinois Central had spent by 1857, most was raised from mortgages on the federal lands and only a sixth from shareholders, underscoring the centrality of the federal contributions.”

    And so the pattern has continued, right on down to today, when the most flagrant abuse of the welfare state for the rich entails massive subsidies for the finance industry.

    1. DownSouth

      That last paragraph reads better as follows:

      And so the pattern has continued, right on down to today, when the most flagrant abuse of the welfare state for the rich entails a reckless and recalcitrant finance industry, its snout buried deeply into the public trough.

    2. Anonymous Jones

      Of course, it’s difficult to protect some minorities and not others, especially when the class of minorities you’re not interested in protecting has the power of wealth and a disproportionate effect on the making of the protections. I’m definitely on your side, but with the caveat that issues like “equal treatment” are intractable. Ask a few people whether equality is treating different people the same or different people differently based on their unique circumstances. You will not find a consensus. It is not difficult to find fact sets that blow apart anyone’s neat and tidy definition of “equal treatment.”

      I’m interested in reading Jefferson’s mea culpa. Can you kindly point the way?

      1. DownSouth

        Anonymous Jones,

        Hannah Arendt was very much in awe of the Founding Fathers, and especially Jefferson. She believes it was Jefferson who may have hit upon the solution to the grave political problems that now so deeply plague our nation, but unfortunately too late in his lifetime for it to make a difference.

        Arendt devotes almost the entire final chapter–“The Revolutionary Tradition and its Lost Treasure”–of her book On Revolution to this subject. In his younger days, Jefferson believed that a new constitution should be promulgated every couple of generations or so. As Arendt observes: “His occasional, and sometimes violent, antagonism against the Constitution and particularly against those who ‘look at constitutions with sanctimonious reverence, and deem them like the ark of the covenant, too sacred to be touched’, was motivated by a feeling of outrage about the injustice that only his generation should have it in their power ‘to begin the world over again’.”

        Violent revolution was Jefferson’s preferred manner of bringing a new Constitution about. Of recent Tea Party fame is this oft repeated slogan by Jefferson: For “the tree of liberty must be refreshed, from time to time, with the blood of patriots and tyrants. It is its natural manure.”

        After the French Revolution, however, Jefferson was to recant this earlier belief, as Arendt explains:

        Jefferson, therefore, when he had learned his lesson from the catastrophes of the French Revolution, where the violence of liberation had frustrated all attempts at founding a secure space for freedom, shifted from his earlier identification of action with rebellion and tearing down to an identification with founding anew and building up.

        What he came up with in the stead of violent revolt was his injunction to “divide the counties into wards,” as again Arendt explains:

        Jefferson himself knew well enough that what he proposed as the ‘salvation of the republic’ actually was the salvation of the revolutionary spirit through the republic. His expositions of the ward system always began with a reminder of how ‘the vigour given to our revolution in its commencement’ was due to the ‘little republics’, how they had ‘thrown the whole nation into energetic action’, and how, at a later occasion, he had felt the foundations of the government shaken under [his] feet by the New England townships’, ‘the energy of this organization’ being so great that ‘there was not an individual in their States whose body was not thrown with all its momentum into action’. Hence, he expected the wards to permit the citizens to continue to do what they had been able to do during the years of revolution, namely, to act on their own and thus to participate in public business as it was being transacted from day to day.

        And as Arendt goes on to explain:

        It is perhaps noteworthy that we find no mention of the ward system in any of Jefferson’s formal works, and it may be even more important that the few letters in which he wrote of it with such emphatic insistence all date from the last period of his life. It is true, at one time he hoped that Virginia, because it was ‘the first of the nations of the earth which assembled its wise men peaceably together to form a fundamental constitution’, would also be the first ‘to adopt the subdivision of our counties into wards’, but the point of the matter is that the whole idea seems to have occurred to him only at a time when he himself was retired from public life and when he had withdrawn from the affairs of state.


        The Bill of Rights in the American Constitution forms the last, and the most exhaustive, legal bulwark for the private realm against public power, and Jefferson’s preoccupation with the dangers of public power and this remedy against them is sufficiently well known. However, under conditions, not of prosperity as such, but of rapid and constant economic growth, that is, of a constantly increasing expansion of the private realm—and these were of course the conditions of the modern age—the dangers of corruption and perversion were much more likely to arise from private interests than from public power. And it speaks for the high caliber of Jefferson’s statesmanship that he was able to perceive this danger despite his preoccupation with the older and better-known threats of corruption in bodies politic.

        The only remedies against the misuse of public power by private individuals lie in the public realm itself, in the light which exhibits each deed enacted within its boundaries, in the very visibility to which it exposes all those who enter it. Jefferson, though the secret vote was still unknown at the time, had at least a foreboding of how dangerous it might be to allow the people a share in public power without providing them at the same time with more public space than the ballot box and with more opportunity to make their voices heard in public than election day. What he perceived to be the mortal danger to the republic was that the Constitution had given all power to the citizens, without giving them the opportunity of being republicans and of acting as citizens. In other words, the danger was that all power had been given to the people in their private capacity and that there was no space established for them in their capacity of being citizens….

        Hence, according to Jefferson, it was the very principle of republican government to demand ‘the subdivision of the counties into wards’, namely, the creation of ‘small republics’ through which ‘every man n the State’ could become ‘an acting member of the Common government, transacting in person a great portion of its rights and duties, subordinate indeed, yet important, and entirely within his competence’. It was ‘these little republics [that] would be the main strength of the great one’; for inasmuch as the republican government of the Union was based on the assumption that the scat of power was in the people, the very condition for its proper functioning lay in a scheme ‘to divide [government] among the many, distributing to every one exactly the functions he [was] competent to’. Without this, the very principle of republican government could never be actualized, and the government of the United States would be republican in name only.

        I know that’s mostly just a bunch of quotes, Anonymous Jones, but I hope it helps clarify what I was talking about.

        1. Anonymous Jones

          Thank you. The quotes are in fact enlightening. I have always been a bit fearful of what I perceived as Jefferson’s excessive stance against the powers of federal government. As I age, I see more merit to his views. My trepidation initially came from the absurd “tyranny of the majority” seen in the social sphere from the southern states in the second half of the 20th century. I always felt as if the federal government (and the Warren Court in particular) served as a bulwark against backwardness (regardless of whether such assessment was fair or not (or correct or not)). I still have trepidation about the idea of wards in a world of free mobility and economic interconnectedness. The issue of sovereignty seems far more complex than it was in Jefferson’s day, but I’m not sure about that. We see governing units of all shapes and sizes in a “race to the bottom” to lure businesses and sports teams. I’m not sure how these issues would be resolved, especially given the various leverage that might develop in “power center” wards, without the guiding hand of a strong central government. Alas, it is, for the most part, all too complicated for me.

  3. Peripheral Visionary

    Yves, I’ve got some bad news for you: I think the phrase “hang on to your wallet” is in fact a trademark of the Republican Party, and you may be on the hook for $0.02 in royalties to that organization. :D

  4. DoctoRx

    Thanks, Yves

    An important post, to the point. The political point is that there is an Establishment with two wings that teeter-totter up and down w/o real change on matters financial. There was no way the Establishment was going to let an FDR and Pecora Commission happen. It only took an 89% decline in the Dow and an over 30% unemp rate among non-farm workers plus all the 1933 bank closures to get reform. It wasn’t in the cards nowadays.

  5. gordon

    Elinor Ostrom, recently co-recipient of an economics quasi-Nobel, might be expected to line up in opposition to a single, monolithic regulator. Her work has (summarising brutally) been about the value of distributed, grass-roots regulation and rule-making. This is a quote from an article she co-authored in Science (SCIENCE VOL 302 12 DECEMBER 2003)

    “Governance should employ mixtures of institutional types (e.g., hierarchies, markets, and community selfgovernance) that employ a variety of decision rules to change incentives, increase information, monitor use, and induce compliance (6, 63, 117). Innovative rule evaders can have more trouble with a multiplicity of rules than
    with a single type of rule”.

    (Note: .pdf)

    I’m waiting for some interviewer to burrow into the implications of her work for the Federal/State controversy, and for regulatory capture in general. She might have some interesting things to say.

  6. gordon

    P.S. to my previous comment…

    Jared Diamond listed several of Elinor Ostrom’s works in the Further Readings section to Ch. 14 of his popular book “Collapse”

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