Toward “Deep” Financial Reform: The U.S. as a Developmental Finance State

Following a familiar historical pattern, policy responses to the latest global financial crisis and subsequent economic and political dysfunction can be divided into three sequenced but overlapping phases. The first phase was a period of “wartime”-style emergency measures hastily fashioned by legislators and regulators working to place a floor beneath sinking markets and stave off further collapse. Next came a protracted, although never quite settled, debate over what actually had happened in 2008 and how best to prevent a recurrence. This second phase saw the enactment of Dodd-Frank and adoption of Basel III, two of the most significant finance-regulatory reform efforts in recent decades.

Now, just over six years after the fateful Lehman Brothers bankruptcy and nearly five years after the contentious passage of Dodd-Frank, the crisis-provoked policy debate is gradually shifting into a deeper, more “soul-searching” mode. In this third phase, a growing number of observers of financial, monetary, and macroeconomic phenomena are raising more fundamental questions concerning the social function of the financial system and its effects on both the real economy and the political process. Behind continuing debates over the advantages and disadvantages of stress testing, methods of calculating credit exposure, and criteria for designating systemically important firms, a broader conversation is taking shape – and the search for a more comprehensive and programmatically developed vision of the proper balance among state, finance, and economy finally is getting underway.

In a new article, we take a first step toward formulating such a vision. Ambitious though it might be, our approach is both rooted in history and evolutionary. We work to recover a venerable American policy tradition that reaches back to the Founders’ era but seems to have been lost in more recent decades. This programmatic vision – captured in what we call a “developmental finance state” – is founded on three propositions: (1) that the “real” economy should be understood in terms of economic and social development, explicitly recognized as a continuing national priority and ongoing process of self-conscious, forward-looking change; (2) that the modalities of finance are, and always have been, the most potent means of fueling economic and social development thus conceived; and (3) that the state, as the nation’s ultimate collective agent and most potent financial actor, both must and often imperceptibly does pursue national developmental goals by acting endogenously, as a direct participant in private financial markets – rather than merely exogenously, as a source of externally imposed regulatory command and control.

In short, we define a developmental finance state as a state that pursues specific developmental goals through direct participation in private financial markets as a public market actor. This is a proactive and confident state that, in its many institutional incarnations, creates and shapes private financial markets in pursuit of broader public goals. It is also a state that was envisioned and planned by the nation’s first Treasury Secretary, Alexander Hamilton, as springboard both for the American Republic’s long-term economic and political independence and for continuous self-renewal thereafter.

Hamilton’s “game-changing” vision explicitly put the federal government, as the nation’s primary collective agent, in a guiding role in the development of America’s financial system, infrastructure, industry, and trade – all while preserving important roles for the publicly influenced private sector. The new debt securities issued by Hamilton’s Treasury, for example, formed the foundation of the nation’s financial system and enabled the federal government to modulate the national money supply – as they continue to do to this day. Hamilton’s First Bank of the U.S., for its part, combined public with private money under joint public-private direction to mobilize capital to fund national development projects. And Hamilton’s Society for the Promotion of Useful Manufactures and associated “enterprise zone” in Patterson, New Jersey were the first modern instance of combined public-private venture-capital support for industrially useful research and development.

This early Hamiltonian model of a developmental finance state fundamentally shaped the subsequent economic trajectory of the U.S., as well as the trajectories of those European and East Asian nations – notably Germany, Japan, and Korea – that explicitly adopted the Hamiltonian model to jumpstart their own economic “miracles” in the 19th and 20th centuries. It is accordingly ironic in the extreme that this crucial and influential American policy tradition is now almost completely absent from our political discourse, which seems to assume that ours is a pure-form, genetically encoded laissez-faire state.

How can we recover this strangely forgotten tradition? What would – or will – a 21st-century American developmental finance state look like? Our article aims to answer these questions systematically. We start by showing that, despite the dominance of neoliberal thinking in American policy circles over the past several decades, many elements of the developmental finance state model remain alive, well, and fully operative today, albeit still hidden in plain sight. We show how public instrumentalities currently perform many important roles as direct participants in U.S. financial markets. In particular, we identify and discuss four categories of such market-actor roles: what we call “market-making,” “market-moving,” “market-levering,” and “market-preserving.”

For example, government-sponsored enterprises (“GSEs”) like Fannie Mae and Sallie Mae historically “made” secondary markets in home mortgage and higher education loans, thereby successfully enabling millions of Americans to become homeowners and college graduates (before these GSEs were privatized and got into trouble). By way of another example, the trading desk of the Federal Reserve Bank of New York “moves” prevailing interest rates daily by purchasing and selling Treasury securities, in so doing maintaining the stability of a systemically critical “money rental” price. By insuring private banks’ deposit liabilities, in turn, the FDIC “levers” an inherently risk- and run-prone deposit-taking business into a far more reliable national system of commercial banking. And by way of one final example, in 2008-09 the U.S. Treasury, FDIC, and Federal Reserve “preserved” the nation’s financial markets from collapse through strategic purchases of assets and extensions of insurance coverage.

In all of these cases, federal instrumentalities act just like private market actors do: they buy, sell, lend, borrow, insure, and securitize. Yet they fundamentally differ from private actors in two crucial respects: (1) they are all very large actors with significant funding advantages, backed as they are by the full faith and credit of the United States; and (2) their actions are not driven – or, therefore, constrained – by private profit considerations, hence they are able to act as market contrarians in taking privately unpalatable risks with a view to generating systemic public benefits. These benefits, moreover, often are broader and more consequential than what orthodox economists traditionally have in mind when speaking of the provision of “public goods” or the correction of “market failures.” It is this proactively systemic focus and broader transformative potential, not captured in the familiar idiom of orthodox economic theory, which our taxonomy of existing governmental market-actor roles aims to uncover and elucidate.

In addition to providing a conceptual framework for tracking and understanding the significance of various functions that public actors currently perform in private financial markets, our taxonomy enables us to envision many possible extensions of existing modalities – extensions we believe would look familiar to latter-day Hamiltonians. The proposals we make in this vein aim to foster the emergence, from practices already familiar and well underway, of a much more ambitiously proactive and effective developmental finance state that can consciously pursue a much bolder normative agenda than most such agendas currently under consideration.

Under the categories of market-making and market-moving, for example, we consider the possible extension of Federal Reserve open market operations from interest rates to a broader set of systemically important financial asset prices and even the price of labor. Under the market-levering heading, in turn, we propose extensions from familiar GSE operations and “infrastructure bank” proposals to a more ambitious National Capital Management Corporation (“Nicky Mac”), organized as a public-private equity fund proactively investing in new, potentially transformative productive and infrastructural modalities. And under the heading of market-preserving, we elaborate a “golden share” mechanism pursuant to which public authorities take a contingent equity stake in systemically important financial institutions – stakes that confer internal control rights when particular institutions get into trouble and come to require navigation by a public “manager of last resort.”

At this stage, our proposals are more in the nature of thought-experiments than ready-to-use, off-the-rack legislative blueprints. They do not pretend to be immune to critique. On the contrary, these proposals are bound to generate disagreements and require further elaboration. But we believe pushing our collective imagination beyond the narrow confines of now-familiar technical debates is a necessary first step toward reclaiming a once-familiar form of programmatic policy vision – as well as a truly public-minded finance.

The preceding post comes to us from Robert C. Hockett, the Edward Cornell Professor of Law at Cornell University Law School, and Saule Omarova, Professor of Law at Cornell University Law School.  The post is based on their recent article, which is entitled “Public Actors in Private Markets: Toward a Developmental Finance State” and available here.