An effective and stable financial system

Lane Kenworthy, The Good Society
August 2021

Finance is vital to a good society. People need to be able to borrow money to fund expensive purchases such education, homes, and cars. Entrepreneurs and firms need access to external funds in order to start up or expand a business, invest in research, and adjust to changing conditions.

What we want is a financial sector that will provide adequate funding for useful endeavors but won’t cause economic crises and won’t discourage government from doing good things.

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An effective financial system will direct funds toward any borrower that has a good shot at succeeding. Part of the genius of markets is that they facilitate unplanned but beneficial economic behavior. It’s very difficult to anticipate where such firms or sectors will come from, so the best bet is to have multiple sources of financing. Decentralized private market-based financial systems seem to work well in this regard.

One potential flaw is that biases may cause lenders to underinvest in certain types of businesses, communities, and individuals — companies with little potential for good short-run returns, low-income communities, racial or ethnic minorities, entrepreneurs aiming to challenge large monopolistic firms, worker cooperatives, and others. Here two solutions can help. One is rules that prohibit discrimination, along with active enforcement of those rules. The other is support for local financial institutions and ones dedicated to funding of less advantaged borrowers. Historically, local public, community, and cooperative banks have played an important role in ensuring that businesses don’t get underfunded because of lender biases.1

In addition, society might want to direct investment toward firms or sectors that are likely to achieve a particular social goal, such as climate stability, but may not yield much in the way of profits. Here a national funding agency can play a useful role.


Two of the biggest economic crises of the past century were driven by financial bubbles that popped and spilled over to the broader economy, wreaking havoc on the lives of hundreds of millions of people and causing not just temporary agony but also long-term financial and psychological scarring.2 Financial crises have occurred frequently in the rich democratic countries, as we see in figure 1.3

Figure 1. Share of rich democratic nations in banking crisis
The countries are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Korea (South), Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom, United States. Data source: Carmen M. Reinhart and Kenneth Rogoff, “Dates for Banking Crises, Currency Crashes, Sovereign Domestic or External Default (or Restructuring), Inflation Crises, and Stock Market Crashes (Varieties),”

This might be endemic to capitalism. It may be inevitable that a largely private financial sector will periodically overreach in search of new financial instruments and new customers, making too many risky investments and loans that eventually go bad, resulting in an economic downturn.

Then again, if we compare across the rich democratic nations, we see that over the past half century those with more of a social democratic capitalist orientation have tended to experience fewer banking crises. Figure 2 has a measure of social democratic capitalism on the horizontal axis and the number of years the country spent in a banking crisis since 1973 on the vertical axis.

Figure 2. Social democratic capitalism and banking crises
Years in banking crisis: share of years, 1973-2010. Data source: Carmen M. Reinhart and Kenneth Rogoff, “Dates for Banking Crises, Currency Crashes, Sovereign Domestic or External Default (or Restructuring), Inflation Crises, and Stock Market Crashes (Varieties),” Social democratic capitalism: average standard deviation score on four indicators: public expenditures on social programs as a share of GDP, replacement rates for major public transfer programs, public expenditures on employment-oriented services, and modest regulation of product and labor markets. The data cover the period 1980-2015. Data source: Lane Kenworthy, Social Democratic Capitalism, Oxford University Press, 2020, pp. 39-40. The line is a linear regression line. “Asl” is Australia; “Aus” is Austria.

Key to limiting financial crises is effective government regulation.4 The aim is to allow flexibility and innovation while discouraging excess. One smart choice is to break up financial firms that become “too big to fail.” If a bank or investment firm knows that policy makers will be forced to bail it out in the event it becomes insolvent, it will have little incentive to refrain from overly aggressive lending or investing. Also wise is a requirement that financial players maintain fairly large capital cushions — money on hand as a share of total loans — in case a large number of loans go bad in a short period of time, as in the 2008-09 crisis. It may be helpful to require a sharp separation between commercial banks and investment banks, as America’s Glass-Steagall law did from 1933 to 1999, though the jury is still out on this. A financial transactions tax can dampen speculation and volatility in markets for stocks and currencies.

As with many areas of policy, regulation of the financial industry should proceed in a trial-and-error fashion, using incremental learning to try to move steadily toward a “just right” — not too light, not too heavy — regulatory approach. In the past half century the trend has been toward less regulation of finance, as we see in figure 3. (The appendix has a separate graph for each country.) This may need to change.

Figure 3. Financial regulation
Higher values indicate more regulation. The index is constructed by combining seven dimensions of financial regulation: (1) Credit controls: capture restrictions on the amounts of bank lending to specific sectors or ceiling on overall credit extended by banks. (2) Interest rate controls: capture the degree to which banks are restricted in setting rates (whether floor or ceiling interest rates exist and/or bind). (3) Entry barriers: capture barriers to entry into the financial system which may take the form of restrictions on the participation of foreign banks; restrictions on the scope of banks’ activities; restrictions on the geographic area where banks can operate; or excessively restrictive licensing requirements. (4) Privatization: captures the degree to which the government is not involved directly in financial services (using thresholds of 50%, 25%, and 10% of state ownership to differentiate between full state control and full liberalization, respectively). (5) Capital account restrictions: capture having multiple exchange rates for various transactions, as well as transactions taxes or outright restrictions on inflows and/or outflows. (6) Securities market development captures policies that governments use to encourage development of securities markets; these include auctioning of government securities, establishment of debt and equity markets and policies to encourage development of these markets (such as tax incentives or development of depository and settlement systems), and policies to promote the openness of securities markets to foreign investors. (7) Prudential regulation and supervision: captures whether a country adopted risk‐based capital adequacy ratios based on the Basle I capital accord, and whether the banking supervisory agency is independent from the executive’s influence and has sufficient legal power. Each index originally ranges from 0 to 3, where 3 indicates the most restrictive regulations, except in 7, where 0 indicates the most restrictive regulation. The deregulation index is the sum of indices 1 to 6 minus index 7. Data source: Thomas Philippon and Ariell Reshef, “An International Look at the Growth of Modern Finance,” Journal of Economic Perspectives, 2013, online appendix, figure A4, using data from Abiad, Detragiache, and Tressel, “A New Database of Financial Reforms,” International Monetary Fund Working Paper 08/266, 2008.

An increasingly prominent notion is that capitalism causes financial crises because it generates high levels of income inequality.5 There are at least three potential pathways. First, households with stagnant incomes increase borrowing in order to sustain consumption growth, and their debt levels eventually become unsustainable. Second, as the rich get a larger and larger portion of the income, they end up with excess savings, which fuels speculative investment and financial bubbles. Third, the rich use their money and consequent political influence to press policy makers to loosen regulations on finance, and this too leads to bubbles.

Anthony Atkinson and Salvatore Morelli have done the most comprehensive study of financial crises across countries and over time. They conclude that “The history of systemic banking crises in different countries around the world does not suggest that either rising or high inequality is a significant causal factor.”6

What about the 2008-09 crisis in particular? We probably don’t yet have the final story on the Great Recession’s causes, but there are grounds for skepticism about income inequality’s contribution.7 Growing demand for loans by middle- and low-income households may have been driven more by the rising cost of homes and college, along with relaxed lending standards and the availability of home equity loans, than by slow household income growth. Risky lending may have been spurred by the creation of new financial instruments that appeared to spread risk and by rising pressure for profits in publicly owned investment firms. Finally, the Federal Reserve could have quashed the housing bubble, the proximate precipitant of the crisis, had it wanted to. That it chose not to do so arguably owed more to Fed Chair Alan Greenspan’s ideological predilections than to the political influence of America’s rich.8


An influential adage, often attributed to Karl Marx, holds that the government in a capitalist society is structurally dependent on capital.9 Policy makers need the economy to perform well, in part because this is good for people and in part because it boosts politicians’ likelihood of getting reelected. This dependence enables businesses to exert significant influence on policy choices by withholding investment or threatening to move to another country. Providers of finance are especially powerful, because money is more mobile than factories and offices and because finance feeds every sector of the economy. In modern economies, international finance also can influence policy makers by increasing a government’s cost of borrowing in the bond market.10 James Carville, an advisor to President Bill Clinton, once said “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”11

The fact of structural dependence is not in dispute. There are plenty of examples, from France’s Mitterrand government feeling compelled to retreat from its nationalization and government spending plans in the early 1980s to pressure on the governments of all rich democracies to reduce tax rates to particular policies that have been blocked or abandoned due to worry about capital flight or a negative reaction from the bond market.12

Countries can reduce the threat of capital flight by adopting capital controls, and governments in most of the rich democratic nations did so in the 1950s, 1960s, and 1970s.13 Since then, they have tended to judge that the benefits of access to international financial markets outweigh the damage incurred from capital flight.

How big a problem is the threat of capital flight in the typical affluent democratic nation? Some analysts contend that it is much smaller than the conventional image holds. Domestic providers of finance can in principle move their money wherever they like. But most of the time they don’t leave, because they can make money by lending to firms and individuals in these nations, and most of those firms stay put because they, in turn, can make money by utilizing the employee skills, network ties, and high-quality infrastructure in these countries. Torben Iversen and David Soskice put the point as follows14:

“Advanced capital is geographically embedded in the advanced nation-state rather than footloose…. The value added of advanced companies is geographically embedded in their skilled workforces, via skill clusters, social networks, the need for colocation of workforces, and skills cospecific across workers and the implicit nature of a large proportion of skills. The nature and pattern of industrial organization has changed substantially through the century but the insight of economic geographers that competences are geographically embedded has not. Thus, while advanced companies may be powerful in the marketplace, advanced capitalism has little structural power.”

Rather than capital flight, it is conservative political parties that have tended to be the chief obstacle to enactment of progressive policies. The Republican Party in the United States, for instance, favors low taxes, limited regulation, and a weak welfare state not just because of pressure from the financial sector or other business interests, but because this has become a core element of its political ideology.15


The appendix has additional data.

  1. Richard Deeg, Finance Capital Unveiled, University of Michigan Press, 1999; Marc Schneiberg, “Toward an Organizationally Diverse American Capitalism? Cooperative, Mutual, and Local, State-Owned Enterprise,” Seattle University Law Review, 2011. 
  2. Lisa Kahn, “The Long-Term Labor Market Consequences of Graduating from College in a Bad Economy,” Labour Economics, 2010; P. Oreopoulos, T. von Wachter, and A. Heisz, “The Short- and Long-Term Career Effects of Graduating in a Recession: Hysteresis and Heterogeneity in the Market for College Graduates,” American Economic Journal: Applied Economics, 2012; Paola Giuliano and Antonio Spilimbergo, “Growing Up in a Recession,” Review of Economic Studies, 2014. 
  3. See also Anthony B. Atkinson and Salvatore Morelli, “Inequality and Banking Crises: A First Look,” Report for the International Labour Organization (ILO), 2010; Anthony B. Atkinson and Salvatore Morelli, “Chartbook of Economic Inequality,” 2014. 
  4. Dani Rodrik, “The Tobin Tax Lives Again,” Project Syndicate, 2009; Paul Krugman, “Six Doctrines in Search of a Policy Regime,” New York Times: The Conscience of a Liberal, 2010; Alan Blinder, “Financial Collapse: A Twelve-Step Recovery Plan,” New York Times, 2013; Simon Johnson, “Resurrecting Glass-Steagall,” Project Syndicate, 2015; Mike Konczal, “Structural Reform Beyond Glass-Steagall,” Next New Deal, 2015; Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World, Penguin, 2018. 
  5. Branko Milanovic, “Income Inequality and Speculative Investment by the Rich and Poor in America Led to the Financial Meltdown,” Yale Global Online, 2009; Joseph E. Stiglitz, “Drunk Driving on the US’s Road to Recovery,” Real Clear Politics, 2009; Raghuram G. Rajan, Fault Lines, Princeton University Press, 2010; Robert B. Reich, Aftershock, Knopf, 2010; Anant C. Thaker and Elizabeth C. Williamson, “Unequal and Unstable: The Relationship between Inequality and Financial Crises,” New America Foundation, 2012; Barry Z. Cynamon and Steven M. Fazzari, “Inequality, the Great Recession, and Slow Recovery,” 2014; Michael Kumhof, Romain Ranciere, and Pablo Winant, “Inequality, Leverage, and Crises,” American Economic Review, 2015. 
  6. Atkinson and Morelli, “Inequality and Banking Crises: A First Look”; Atkinson and Morelli, “Chartbook of Economic Inequality.” See also Michael D. Bordo and Christopher M. Meissner, “Does Inequality Lead to a Financial Crisis?,” Working Paper 17896, National Bureau of Economic Research, 2012. 
  7. Edward Glaeser, “Does Economic Inequality Cause Crises?,” New York Times: Economix, 2010; Bordo and Meissner, “Does Inequality Lead to a Financial Crisis?”; Atif Mian and Amir Sufi, House of Debt, University of Chicago Press, 2014. 
  8. Lawrence R. Jacobs and Desmond King, Fed Power: How Finance Wins, Oxford University Press, 2016, p. 22. 
  9. Fred Block, “The Ruling Class Does Not Rule: Notes on the Marxist Theory of the State,” Socialist Revolution, 1977; Charles E. Lindblom, “The Privileged Position of Business,” in Politics and Markets, Basic Books, 1977; Goran Therborn, What Does the Ruling Class Do When It Rules?, Verso, 1978; Adam Przeworski and Michael Wallerstein, “Structural Dependence of the State on Capital,” American Political Science Review, 1988; Leo Panitch, “Europe’s Left Has Seen How Capitalism Can Bite Back,” The Guardian, 2014; Leo Panitch, “The Long Shot of Democratic Socialism Is Our Only Shot,” Interview with Bhaskar Sunkara, Jacobin, 2020. 
  10. Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton, 2009; Paul Krugman, End This Depression Now!, W.W. Norton, 2012; Mark Blyth, Austerity: The History of a Dangerous Idea, Oxford University Press, 2013. 
  11. James Carville, “The Bond Vigilantes,” Wall Street Journal, 1993. 
  12. Peter A. Hall, Governing the Economy, Oxford University Press, 1986; Philipp Genschel, “Globalization, Tax Competition, and the Welfare State,” Politics and Society, 2002; Dani Rodrik, The Globalization Paradox, W.W. Norton, 2010; Kevin A. Young, Tarun Banerjee, and Michael Schwartz, “Capital Strikes as a Corporate Political Strategy: The Structural Power of Business in the Obama Era,” Politics and Society, 2018. 
  13. Fred Block, “Capitalism Without Class Power,” Politics and Society, 1992; Tom Malleson, After Occupy: Economic Democracy for the 21st Century, Oxford University Press, 2014. 
  14. Torben Iversen and David Soskice, Democracy and Prosperity, Princeton University Press, 2019, Preface. See also Joel Rogers and Satya Rhodes-Conway, Cities at Work: Progressive Local Policies to Rebuild the Middle Class, Center for American Progress Action Fund, 2014; Torben M. Andersen et al, Nordic Economic Policy Review: Whither the Nordic Welfare Model?, Norden, 2015, ch. 5. 
  15. Thomas E. Mann and Norman J. Ornstein, It’s Even Worse Than It Looks, Basic Books, 2012; Monica Prasad, Starving the Beast: Ronald Reagan and the Tax Cut Revolution, Russell Sage Foundation, 2018. In a recent book, Fred Block offers a different take: “In tracing out the linkages between financial interests and establishment politicians, the most useful idea is that of ‘cognitive capture.’ It is not just personal connections and campaign contributions that make political leaders beholden to financial interests. The core problem is that most politicians … have adopted the same beliefs about how the economy works as the financial community. It is as though they all went to school together and read the same books, so they share the same belief system.” Block, Capitalism: The Future of an Illusion, University of California Press, 2018, pp. 7-8.