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Finance and constitutions

Most economists would agree that the global financial and economic crisis was at least partly caused by a failure in the regulation of the financial sector. While regulatory reform is now being debated throughout the world, critics argue that it is only a matter of time before any new regulations are removed by powerful interest groups. This column asks whether prompt corrective action belongs in constitutions.

In his 2009 book, The Regulatory Response to the Financial Crisis, Charles Goodhart discusses the financial crisis, what went wrong, and what needs to be done (Goodhart 2009). The standing assumption is that regulatory reforms will rest at their current level of law, namely regulatory bodies and rules approved by lawmakers. But, as I explore in this column, perhaps prompt corrective action belongs in constitutions.

To date – presumably in the interest of efficiency and flexibility in financial markets – no country has, to my knowledge, built such firewalls into its constitution, on the grounds that laws and regulations are enough. But given the frequency and massive social and economic costs of crises, it is worth questioning this received wisdom.

Does financial regulation belong in constitutions?

Imagine the US’s massive post-Great Depression reforms aimed at reducing the likelihood and scope of future financial crises1 had taken the form of a constitutional amendment. If it had been, the deliberate, some would say reckless, deregulation of US banking and finance after 1980 would have been more difficult. Perhaps the demise of Lehman Brothers in 2008 and the ensuing international financial crisis would have been averted.

Admittedly, this trail of thought is complicated by the fact that, north of the border, only a few small banks failed in the 1930s. Canada’s financial system has remained strong, even during the current global crisis. Yet, unlike US banks under Glass-Steagall, Canadian banks have always been universal, offering commercial and investment banking services side by side without incident. For this reason, the separation of commercial and investment banking along the lines of Glass-Steagall has not been thought necessary in Canada and Europe has followed suit.

In view of Europe’s recent banking problems, however, perhaps Europe needed Glass-Steagall all along. But Canada is clean. The erection of legal firewalls to separate commercial banking from investment banking cannot, therefore, be viewed as a universal remedy against recurrent financial crises. Even so, the fact that Canada has never felt the need for such firewalls in its laws does not, by itself, undermine the argument for building such firewalls into the constitutions of countries such as the US with a history of recurrent financial crises.

Iceland: From crash to constitution

The level-of-law question is especially pertinent in a country such as Iceland, which recently suffered one of the worst financial crashes on record. In Iceland, though, bankers were not solely responsible for the crash of 2008. They simply went as far as they could with the permission of politicians. The root cause of the crash was the incestuous relationship between politicians and the owners and managers of the banks and other big firms.

  • Bankers everywhere usually go as far as they can within the limits imposed on them by politicians through laws and regulations, and sometimes farther.
  • Politicians usually go as far as they can in the pursuit of their objectives by making laws and executing them subject to the restraints imposed by the constitution, and sometimes also by public opinion.

This is why it is common practice around the world to specify – in the constitution – the division of responsibility and power among the three main branches of government – along with checks and balances. Lawmaking is then tasked with developing specific provisions concerning day-to-day government, including its regulation of banks and other financial institutions.

The Constitutional Bill before the Icelandic parliament awaiting a national referendum is in this spirit. The bill, passed unanimously on 27 July 2011 by a nationally elected constituent assembly, aims to sharpen the division of power among the legislative, executive, and judicial branches of government. The articles concerning the right to information, freedom of the media, appointments to public office, the independence of key state agencies, and parliamentary investigation committees are, inter alia, intended to reduce the likelihood that the banks can again outgrow the government’s ability to protect the people against the banks.

Would the proposed Icelandic constitutional provisions prevent another crash?

The answer, in my view, is simply “No”. All that a constitution can be expected to do – or the law, for that matter – is to lower the probability of yet another crash.

Would it have been better to include in the bill an article aimed at tying the hands of the banks? This could have been done by, for example, stipulating quantitative limits on the ratio of foreign debt to GDP or on the ratio of the foreign exchange reserves of the central bank to the short-term foreign liabilities of the banking system. The latter ratio, by the Giudotti-Greenspan rule, must never be allowed to fall below unity lest the currency be exposed to ‘heads-I-win-tails-you-lose’ speculative attacks. Few countries have written such quantitative requirements into law.

In US law, ‘prompt corrective action’ mandates progressive penalties against banks that exhibit progressively deteriorating capital ratios (Goodhart 2009). In this vein, would an article protecting and extending ‘prompt corrective action’ by enabling the authorities to take over banks before their legal insolvency, thus infringing on property rights to safeguard society, have belonged in the Iceland bill? In the end, it was decided to let it suffice to extend the article on the right of ownership currently in force by adding the words “Ownership rights entail obligations as well as restrictions in accordance with law” without granting the state explicit constitutionally protected authority to take over troubled banks.

Why economic provisions rarely make it into constitutions

Quantitative economic provisions are uncommon in constitutions for three main reasons.

  • First, the desire for durability through flexibility is inclined against constitutional clauses involving economic variables.
  • Second, such rules are easy to circumvent by adjusting statistical definitions.

This, by the way, is also why the Icelandic bill does not contain provisions specifying limits on the government budget deficit or on public debt. Germany, badly burnt by hyperinflation in the interwar period, was until recently the only European country with such a provision in its constitution from 1949. The Hungarian constitution of 2012 stipulates that “Parliament may not adopt a State Budget Act which allows state debt to exceed half of the GDP.” However, it goes on to add that “Any deviation ... shall only be possible during a special legal order, to the extent required for mitigating the consequences of the causes, and if there is a significant and enduring national economic recession, to the extent required for redressing the balance of the national economy.“

  • Third, quantitative constitutional provisions, or even only legal ones, related to, for example, GDP would need to be accompanied by special rules concerning adjustment to a contraction of GDP, tempting the government to keep GDP in money terms artificially high and thus imparting an inflationary bias to the economy.

The idea of including a fiscal provision in the Icelandic Constitutional Bill was ultimately rejected. Aviation provides a useful analogy.

  • An aircraft’s auto-pilot is useful in good weather, but every pilot wants to be able to overrule the aircraft’s computer if emergencies arise.
  • This fundamental principle applies to constitutional economics no less than to aviation.

The human mind must always have the last word.

Besides, it is easy to bypass such regulations by moving selected public expenditure items outside the government budget or simply to break the rules. Even France and Germany have violated the Maastricht criteria with impunity. Easily breakable rules do not belong in constitutions.

Living constitutions

Interestingly, Germany’s constitution does not impose similar restraints on monetary policy as on fiscal policy. The constitution stipulates that the Bundesbank’s “tasks and powers can, in the context of the EU, be transferred to the European Central Bank which is independent and primarily bound by the purpose of securing stability of prices.“ Here the German constitution is flexible as constitutions ought to be.

Justice Oliver Wendell Holmes made the case for a living constitution: “A Constitution is not intended to embody a particular economic theory . . . It is made for people of fundamentally differing views, and the accident of our finding certain opinions natural and familiar, or novel, and even shocking, ought not to conclude our judgment upon the question whether statutes embodying them conflict with the Constitution of the US. ... The interpretation of constitutional principles must not be too literal. We must remember that the machinery of government would not work if it were not allowed a little play in its joints.“

Goodhart, Charles A (2009), The Regulatory Response to the Financial Crisis, Edward Elgar.
Gylfason, Thorvaldur (2012), “From Collapse to Constitution: The Case of Iceland,” CESifo Working paper 3770, March.
Iceland Constitutional Bill (2011), delivered by Constitutional Council to Parliament 29 July.


1 Establishment of the Securities and Exchange Commission in 1934, the 1933 Glass-Steagall Act separating commercial banking from investment banking activities to increase the safety of depositors, etc.

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