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June 1, 1992

Taxpayers At Risk

The Moral Hazards of the New Mercantilism


Mercantilism is a system of social, political, and economic organization which today characterizes Peru, most of Latin America, and probably many Third World countries. The prevailing system in many European countries during the fifteenth to the nineteenth centuries,
mercantilism grants state privileges to favored producers and consumers by means of regulations, subsidies, taxes, and licenses.

A market economy encourages creativity and efficiency in production because competition prevails. In a mercantilist system, however, laws and regulations encourage individuals to seek privileges and to use the law to their personal advantage. My book, The Other Path, shows how mercantilist traits of the Peruvian state and economy thwart free competition and the exercise of genuine entrepreneurship by the vast majority of Peruvians.

My colleagues and I at the Institute for Liberty and Democracy are concerned with developing strategies to aid Peru in the peaceful transition to a market economy and a stable democratic society. In our work, the ILD occasionally invites experts from other countries to consult with us on ways to expand public access and participation. One of those consultants who visited us in Lima last year is Thomas Stanton, the author of this insightful paper on mercantilist financial institutions in the United States.

As quite different countries, Peru and the United States face different kinds of economic and political challenges. Nonetheless, in our mercantilist heritage, as in much else, we share common roots. While the market economy has largely replaced mercantilism in the United States, Mr. Stanton points out that some large vestiges remain, especially in the U.S. financial sector where banks, savings and loan associations, and government sponsored enterprises retain attributes of mercantilist corporations. As Mr. Stanton shows, it is not pure coincidence that many such U.S. companies -- which thrive-or fail according to government law and regulation, not only because of market forces -- are (in disarray.

Hernando de Soto
PresidentInstituto Libertad y Democracia



Mercantilism is the economic system that flourished in Europe from the l400s to the l800s, bridging the centuries between feudalism and capitalism. It is characterized by an active pursuit of the national interest through extensive regulation of private business and the chartering of business organizations for specific public purposes.

There are many mercantilist organizations in the United States today, chartered by both state and federal governments.

In banking and finance:

  • Commercial Banks
  • Savings and Loans
  • Credit Unions
  • Insurance companies
  • Farm Credit System
  • Federal National Mortgage Association -- Fannie Mae
  • Federal Home Loan Mortgage Association -- Freddie Mac
  • Student Loan Marketing Association -- Sallie Mae
  • Federal Home Loan Banks
  • Federal Reserve Banks
  • College Construction Loan Insurance Association -- Connie Lee
  • National Consumer Cooperative Bank

In commerce:

  • Comsat
  • Public utilities in transportation, communication, and energy
  • National Corporation for Housing Partnerships

These mercantilist organizations enjoy special legal privileges not extended to all business firms. Among these privileges are:

  • They are chartered by government.
  • Their activities are restricted by government.
  • They are protected against competitors by government.
  • Even if insolvent, they can go out of business only with government

Some mercantilist institutions benefit from direct or indirect government guarantees of their obligations. Deposit insurance for banks and thrifts and the government's implicit guarantee of government sponsored enterprise obligations mean that these mercantilist companies can raise money even if they fail in the marketplace.

Because of these guarantees, the new mercantilism has created an enormous moral hazard that has already cost American taxpayers hundreds of billions of dollars and threatens to cost much more. At the end of fiscal year 1991, the taxpayers faced a contingent liability of almost four trillion dollars -- $4,000,000,000,000:  

Banks   $1,942,000,000
Savings and Loans $654,000,000
Credit Unions $197,000,000
Fannie Mae $456,000,000
Freddie Mac $369,000,000
Federal Home Loan Banks $107,000,000
Farm Credit System $74,000,000
Sallie Mae $43,000,000

The new mercantilism is an unstable system. There is a pattern In the, history of mercantilist enterprises that has become apparent in the United States:

  • Establishment of the organization
  • Government protection for the new oligopoly power
  • Early political success in expanding legislated charter powers
  • Later political failure to expand charter powers because of political opposition
  • Occurrence of political and economic risk
  • Crisis that makes status quo untenable

We have already reached the last stage in this pattern of mercantilist collapse in the savings and loan industry. We appear to be in the later stages in the commercial banking industry. We must seek serious and prompt reform of the new mercantilist system. The taxpayers deserve no less.


I. Public Purposes and Private Companies: The Role of Mercantilist Institutions in the U.S. Financial System

Taxpayers have been jolted by the spectacular and expensive failure of thousands of thrift institutions and -- it increasingly appears -- hundreds of banks at a cost of hundreds of billions of dollars. It is important to understand the institutional source of this debacle so that proposals can be properly designed to reduce the rate and cost of future bank and thrift failures and to apply proper preventative lessons to other institutions with similar vulnerabilities.

Banks, savings and loans, and government-sponsored enterprises can best be understood as mercantilist institutions: They are special-purpose companies chartered and operating under federal law to serve public purposes. The special-purpose charters of mercantilist companies make them fundamentally different from other companies.[1] The creation, evolution, and decline of mercantilist companies follows a distinctive pattern that is different from that of ordinary companies whose characters are shaped more by the marketplace and less by legislative and political forces. A range of federally and state-chartered corporations have mercantilist characteristics; the most numerous and most important mercantilist companies today are financial institutions.

The new mercantilism should not be confused with privatization. Privatization is an effort to return to the market business organizations that had been created or owned by government. The defense production industries returned to private ownership after the Second World War are examples of this. Its direction of movement is from government enterprise to private enterprise. To the extent that privatization is partial, the result of this process may be a mercantilist enterprise, that is, an enterprise that mixes characteristics of both private and public enterprises. An example of a mercantilist organization created by partial privatization is Fannie Mae. If privatization is complete, it results in a business enterprise that does not enjoy special privileges or special protection from competition.

The new mercantilism should also not be confused with contracting out. In its pure form, contracting out involves soliciting bids from private companies to perform non-policy-making tasks instead of government employees. The winning companies receive no special privileges from government in such an arrangement. Should government confer special privileges on private companies, they transform them into public utilities or other types of mercantilist organizations.

A. Introduction: Mercantilist Companies in the United States Today

In mercantilist times, national governments chartered private companies to carry out public purposes. In return for a license of royal privilege a mercantilist company accepted limits upon its permitted activities and committed itself to undertake the particular tasks specified in its royal charter.

Since mercantilist times, corporation law has progressed away from particular charters and toward the form of general-purpose corporations. While mercantilist companies were permitted to carry out only those activities specified in their charters, general purpose corporations today may undertake virtually any kind of activity unless precluded by law. While mercantilist charters were granted to a privileged few incorporators, general purpose corporations today may be formed by virtually any group of citizens desiring to do so.

Today most corporations organized under state law hold general purpose charters. A typical state law is that of the state of Delaware, that provides that a corporation may engage in virtually any legitimate activity except where restricted or precluded by law.[2]

Amidst the several million general-purpose corporations active in the United States today are a few thousand special-purpose companies created under restrictive state or federal laws. Mercantilist institutions are quasi-private entities carrying out public purposes specified by state or federal law or (as in the case of state-chartered banks and savings and loans, for example) by both state and federal law. Figure 1 provides an overview of various types of mercantilist corporations in the United States today.

Some of these corporations, especially financial institutions such as banks, savings and loans, and insurance companies, are chartered under restrictive state laws. Others include a variety of public utilities and transportation companies, and various non-profit state authorities and charitable organizations. [3]

At the federal level, there is no general purpose corporation law. All privately owned federal corporations are chartered as special purpose companies with greater or lesser flexibility under their enabling legislation. Most of these are financial institutions. Besides commercial  banks and savings and loans, these include the Federal Reserve Banks and government-sponsored  enterprises (GSEs). Government-sponsored enterprises include the Federal National Mortgage  Association (Fannie Mae), the Federal Home Loan Mortgage Association (Freddie Mac), and  the Student Loan Marketing Association (Sallie Mae). Although chartered by federal law, these  three government-sponsored enterprises are privately owned, with stock trading on the New  York Stock Exchange. Other federally chartered corporations with private ownership include  the Communications Satellite Corporation (Comsat), the College Construction Loan Insurance  Association (Connie Lee), the National Consumer Cooperative Bank, and the National  Corporation for Housing Partnerships.


From a taxpayer perspective, the most important mercantilist institutions are those  privately owned companies whose obligations are explicitly or implicitly guaranteed by  government. There are four categories of such institutions: most banks, savings and loans,  credit unions, and government-sponsored enterprises of the federal government. Some banks, savings and loans, and credit unions operate without federal deposit insurance. However, they  may benefit from state insurance funds that on occasion have resulted in taxpayer losses. The
government guarantee reinforces the mercantilist nature of such institutions: The state or federal  government protects its financial stake by fostering oligopolistic markets for institutions that  benefit from it. Policy makers fear that free competition could increase financial failures and  taxpayer losses.

As can be seen in Figure 2, the federal government provides banks, savings and loans,  and credit unions with federal deposit insurance and government-sponsored enterprises with an  implicit guarantee, together amounting to literally trillions of dollars, so that these institutions  can provide credit for the purposes specified in their charters. This study shall focus on banks,  savings and loans, and government-sponsored enterprises and highlight the special mercantilist  characteristics that give rise to their peculiar vulnerabilities, compared to the usual companies  chartered under state law.

Among the roots of bank and thrift failures is the fact that they have retained mercantilist legal characteristics that have long been eliminated from the charters of most American companies. The usual private company can change its activities to adapt to changing markets.  This ability to define and redefine lines of business is essential to strategic success, especially  over longer time periods. Examples abound of companies succeeding or failing according to  their ability to adopt new technologies and new ways of bundling their products and services to
meet changes in customer needs and the challenges of competitors.[4]

By contrast, banks and savings and loans are chartered by law to serve public purposes; their enabling legislation generally confines them to providing particular kinds of services and  to serving only those markets that are specified by law and regulation. Their distinctive legal charters limit the ability of banks and savings and loans to adapt to changing market  circumstances. Unlike ordinary companies incorporated under state law, banks and savings and  loans cannot adjust their activities and lines of business as their markets evolve. When they  come against a constraint imposed by their charter legislation, they must return to the Congress  or to state legislatures, as the case may be, to obtain relief before they can enter new lines of  business and provide different kinds of services outside the scope of their legally permitted activities. Especially in today's environment of rapidly changing technologies and financial markets, this means that the scope and extent of financial services that banks and savings and loans provide often reflect competitive forces in the political arena rather than in I the


A second, related distinction is also responsible for much of the cost of bank and thrift failures. Unlike the ordinary company, a bank or thrift does not automatically go out of business when it fails. If an ordinary company becomes insolvent and unable to pay its creditors, no one else will lend it money and it will be forced to go out of business. Also, it  can go bankrupt under the federal Bankruptcy Code. By contrast, the law provides that a failed bank or thrift can be closed only by its governmental regulator. Moreover, deposit insurance and the overnment's implicit backing of GSE obligations mean that these mercantilist companies can raise money even if they fail in the marketplace. Once again, this distinction turns a financial issue into a political one; regulators who close too many banks or savings and loans are liable to be blamed for the fact that these institutions failed. They may be accused of  causing a credit crunch and can be subjected to significant political pressure to be more lenient. [5]Figure 3 on page 7 summarizes differences between ordinary corporations and mercantilist companies.

These institutional features might be arcane and uninteresting but for the fact that they have cost the American taxpayer hundreds of billions of dollars. For that reason alone, it is worth examining them in greater detail.

B. Attributes of mercantilist companies

Banks, savings and loans, and government-sponsored enterprises are vestiges of an earlier period in the development of western legal institutions. The government has chartered them to fulfill a public purpose. Their limited corporate charters resemble those granted by monarchs and parliaments in the mercantilist period of history of western Europe, which extended in England roughly from the late 1400s into the 1800s. Similar to companies chartered in  mercantilist times -- such as the Bank of England, the Hudson's Bay Company, and the East  India Company -- these privately owned enterprises legally are instrumentalities of the government. They benefit from privileges that are usually not available to other kinds of private competitors. As were the earlier mercantilist companies, banks, savings and loans and  government-sponsored enterprises can perform valuable services to people and the nation; also like early mercantilist companies (and here one thinks of the financial debacle caused by the.  collapse of the South Sea Company in 1720) they can cause substantial damage if they fail. The important fact to keep in mind is that today's mercantilist companies are based upon a fundamentally different institutional structure than ordinary companies. Consequently they may require fundamentally different kinds of institutions and processes to assure oversight and accountability and to protect the taxpayer


C. The public purposes of banks, savings and loans, and government-
sponsored enterprises

Banks, savings and loans, and government-sponsored enterprises provide advantages to the U.S. government that are similar to those traditionally provided by mercantilist companies to the sovereign. In particular, these private institutions are able to conduct their activities on a more businesslike basis than might be permitted to a governmental body staffed by government officials and owned by the government. To take but one instance, within two years of being sold into the private sector, Fannie Mae had greatly streamlined the staff required to conduct the corporation's business. More significantly, a number of the GSEs have demonstrated financial prowess that has not always been evident in federal government agencies serving similar specialized credit purposes.

These institutions serve a variety of public purposes. The first and second Banks of the United States were chartered for the purpose of rendering fiscal services to the federal government. National banks were chartered to facilitate a stable national currency and to support some activities of the Treasury Department. Many state-chartered banks became members of the Federal Reserve System and obtained deposit insurance from the Federal Deposit Insurance Corporation, and thereby became federal instrumentalities as well.

The public purposes of savings and loans and government-sponsored enterprises relate to the functions of specialized lenders. By providing preferential access to credit, through deposit insurance or an implicit government guarantee of borrowings, and a variety of tax and other benefits, the federal government can encourage the flow of funds into a mercantilist company. When the mercantilist company is limited in its powers to serving a specialized financial market -- the residential mortgage market in the case of savings and loans traditionally and Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System, or agriculture in the case of the Farm Credit System and Farmer Mac, or student loans in the case of Sallie Mae -- then the government can attempt to assure that these institutions pass on some of their federally bestowed benefits to support a designated public purpose.

Many of these specialized institutions in their own way have made demonstrable contributions to the markets they are" supposed to serve. Indeed, some economists would contend that some of the earlier government-sponsored enterprises, the Farm Credit System and Fannie Mae in particular, have contributed to overcoming serious market imperfections that were impeding the proper flow of funds to agriculture and housing respectively.

The extent of such contribution changes over time. New technologies and changing markets alter the public benefits of enterprise lending. Fannie Mae, for instance, made an important contribution to mortgage finance in its first thirty to forty years of operation, when the presence of significant market imperfections restricted the availability of mortgage money in the growing central and western states, as compared to those in the East. Today, those market imperfections have been overcome, and many competing financial institutions are available to channel mortgage money across the fifty states. This means that the potential contribution of Fannie Mae today is measurably less than it was previously. Similarly, in 1932,  the Federal Home Loan Bank System (FHLBS) may have been an important means of restoring  financial vitality to the thrift industry devastated by the Great Depression; today, it is not at all clear how provision of credit to a shrinking number of profitable savings and loans serves a  significant public purpose. (The FHLBS does not lend to shaky thrift institutions except with very high collateral requirements or unless the federal government guarantees repayment of the loan.)

Finally, the public benefits of mercantilist financial institutions have been diluted by the considerable expansion of federal credit in recent years. Over one-third of all non federal borrowing today is subsidized by the federal government, directly or indirectly. Increasingly, ad hoc changes in the enabling laws of specialized lenders such as savings and loans and GSEs have meant that the public benefits of the federal credit support they provide are diffuse and poorly directed; at the same time, the ability of federal credit to give selected borrowers an advantage is weakened.

A federal credit advantage for everyone means an economic advantage for no one. This raises questions about the extent to which all federal credit subsidies, including those provided through specialized mercantilist institutions, are properly focused to assure that they serve high- priority credit needs and do not offset each other. Vigilance is needed to assure that changing markets and changing public needs do not diminish the benefits provided by mercantilist institutions, as well as that they do not increase the potential taxpayer costs.

D. The changing nature of corporate charters

1. Mercantilist charters

Some sense of historical development is useful here to show the evolution of corporate charters and the nature of the mercantilist vestiges today. In the early mercantilist period, corporate charters were bestowed by the monarchy. The mercantilist state itself was incapable of undertaking a range of activities that were considered important, including trade, manufacturing, mining, and -- especially -- banking, and turned instead to the private sector. Business corporations were seen essentially as agencies of the government.[6]  Incorporation generally involved the grant of monopoly powers, including the power to regulate business activities in the company's designated economic sector.[7]

Merchants with ideas for new ventures would seek an advocate at the royal court to present a plea for a charter. If granted, the charter would specify permitted activities and special privileges of the new corporation and would provide for some form of commitment that the monarch would be appropriately compensated for the privileges bestowed. In England, as the British Parliament gained in strength, it began to confer an increasing proportion of such charters. Eventually, the Parliament rather than the monarch decided when to bestow corporate charters for new ventures. As before, the charter specified the public purpose of the company, its permitted activities and privileges, and the remuneration to be provided to the state. Corporate charters often had a limited life; they might expire upon occurrence of specified events or passage of a prescribed number of years.[8] 

2. Early American charters

The first American corporations were chartered by the colonies and states, the Continental Congress, and the United States Congress in much the same way. In America, there has been an intermittent tradition of strong antagonism against mercantilist companies. The early corporations. were seen as monopolies and beneficiaries of special privilege.[9] The Continental Congress chartered the Bank of North America in 1781; because of questions about the authority of the Continental Congress to charter a bank, the bank also obtained a charter from the State of Pennsylvania. Within a few years, political opposition to the bank's monopoly powers forced the repeal of its state charter and then limited the terms of a new charter granted by the State of Pennsylvania. [10]

Alexander Hamilton, Secretary of the Treasury, proposed creation of the first Bank of the United States and the Congress enacted the legislation in 1791. The bank was patterned upon the Bank of England that had been chartered in 1694. The charter of the Bank of the United States, limited to a term of twenty years, specified the powers and privileges of the company. Under the charter, the U.S. government was a minority shareholder. When Congress failed to extend the charter, the Bank expired in 1811. 

State legislatures continued to charter banks. Aaron Burr obtained a perpetual bank charter from the New York State lepislature in 1799. The legislature chartered the new company, the Manhattan Company, to provide a supply of pure water for the City of New York. Burr used his political skill and influence to obtain a special provision of the charter authorizing the company to use any profits for any purpose not prohibited by the Constitution or laws of the United States or the State of New York. Under this provision, Burr established the Manhattan Bank that later merged into The Chase Manhattan Bank. [11]

In 1816, the federal government enacted legislation to charter a second Bank of the United States, again with the government as a minority shareholder. The twenty year charter again prescribed the authorized activities of the bank. It also provided that the majority of the directors would be elected by the private shareholders but that five out of the twenty directors of the bank would be appointed by the President of the United States. The government eventually sold its stock at a profit, but continued to have representation on the Board of Directors. The federal charter of the Bank of the United States expired in 1836 after President Andrew Jackson's Bank War in which he vetoed legislation that would have provided for renewal for another twenty years. As with the first "Bank War" over the Bank of North America, this opposition was fueled by the popular objection to monopoly and privileges bestowed on a favored few shareholders.

In 1862, the federal government chartered a railroad corporation, the Union Pacific Railroad Company, to help build the first transcontinental railway. The federal government subsequently chartered other railroads and also provided financial support to railroad companies operating under state charters.

Meanwhile, state legislatures began an evolution of their corporation laws away from the mercantilist model. New York permitted incorporation under a general law for some business purposes in 1811. However, the state continued to require some special purpose charters, such as for establishment of banks. In 1837, the State of Michigan enacted the first free banking act, providing that a bank could be incorporated by any group without need for special legislation. However, even free banking laws continued to limit the activities permitted to banks under their charters. [12] By the early twentieth century, state legislatures had removed virtually all restrictions on general purpose companies and their ability to obtain corporate charters. Nevertheless, certain activities, including the business of banking, continued to be subject to special charter provisions and, usually, supervision by state government agencies.

3. Federal bank legislation

In 1863 and 1864 the federal government, under financial pressure from the Civil War, re-entered the business of chartering banks. This time, however, the National Bank Act reflected the forces of democracy that had manifested themselves in the struggle over the Bank of the United States. The new law was based upon the pattern of state free banking laws. Instead of a monopolistic charter, extending benefits to a privileged few bank shareholders and incorporators, the new national bank system offered opportunity to any group of incorporators that could satisfy statutory and regulatory requirements for starting a bank.

Nonetheless, both the national bank system and state banking laws continued to exhibit the mercantilist feature of defining and limiting the activities that could be engaged in by a federally or state-chartered bank. The laws also continued to provide special privileges and to permit federally chartered institutions to engage in specified activities, notably the provision of checking facilities and the taking of demand deposits, that were denied to non-bank competitors. With passage of the Federal Reserve Act of 1913, the federal government imposed upon many state-chartered banks -- those that chose to join the Federal Reserve System -- additional requirements specified in federal law and also provided special new benefits of membership in the Federal Reserve System. In 1980, those benefits and regulations were extended to all banks, whether they were members of the Federal Reserve System or not, by the Depository Institutions Deregulation and Monetary Control Act.

4. Thrift institutions

Early thrift institutions included cooperative savings and loan associations that operated on a voluntary and unincorporated basis. In 1875, New York imposed requirements that savings and loan associations submit annual financial reports to the state banking department. By 1930 most states had enacted legislation prescribing standards and, with greater or lesser degrees of restriction, the eligible activities for savings and loan associations. One of the most important of such restrictions was the requirement of federal law, and most state laws, that savings and loan associations be limited in their activities to making mortgage loans and to serving local market areas.

5. Deposit insurance and increased federal protection

The 1930s saw a significant increase in government involvement with banks and thrift
institutions. In 1933 and 1934 the federal government created systems of federal deposit
insurance for banks and thrift institutions, respectively.

Before the advent of deposit insurance, banks and savings and loans had retained a major
mercantilist characteristic: Even if they were insolvent, they did not formally go out of business
until the government terminated their charters. Without deposit insurance, this often remained

a technicality. A failing bank or thrift could not raise money; this meant that it ceased to be
able to do business even though its charter might continue in formal existence.

Deposit insurance changed this feature from a technicality to a fundamental distinction.

Federal deposit insurance gave failing banks and savings and loans access to potentially
unlimited funds from depositors. This meant much greater taxpayer exposure in the event that
they became insolvent. While the marketplace would force closure of the ordinary company,
federal deposit insurance meant that banks and savings and loans could continue operating
indefinitely, even though they had failed financially. They went out of business only when their
regulator closed them down. 

The Great Depression also brought other significant changes to the laws governing banks
and savings and loans. Laws were enacted to enforce a sharp separation between commercial
and investment banking, to cap interest rates that banks (and, after 1966, savings and loans)
could pay on deposits, and to limit the entry of new banks and savings and loans to compete
with established institutions.

In summary, the enabling legislation governing most general business corporations
reflects the workings of the forces of democracy in response to events over the past two hundred
years. Today groups of incorporators can form and dissolve most companies with relative ease.
However, amidst the large majority of corporations chartered under general corporation laws of
the states, there remains a minority of companies chartered with distinctive privileges and
restricted activities and powers, created under state or federal law , that retain many of the old
mercantilist attributes.

II. Mercantilist Financial Institutions as Instruments of Federal Policy

A. The role of federal law in providing privileges and defining permitted activities of banks, savings and loans, and government-sponsored enterprises

Similar to the royal charters of mercantilist companies, federal law today provides special
privileges and benefits and defines the permitted activities of banks, savings and loans, and
government-sponsored enterprises. Especially important to mercantilist companies was the
exclusive nature of their charters. Federal law and requirements of federal law implemented by
relevant federal regulatory agencies create special privileges for today's mercantilist financial
institutions by imposing barriers to entry by potential competitors. This situation is most
pronounced for government-sponsored enterprises because of the inability of competitors to
obtain similar federal charters and thereby obtain the same benefits and privileges as existing
enterprises. [13] Banks and savings and loans for many years have benefitted from, special
privileges. Under their enabling legislation, they were sheltered from the rigors of open
competition. This protection precluded non-banks or non-thrifts from providing certain services
on equal terms with banks and savings and loans, and also limited the amount of competition
from other banks and savings and loans and from new entrants in any particular geographic

Federal law has provided other generous benefits as well. Thrift institutions, for
example, benefitted from a federal income tax exemption for many years. Some government-
sponsored enterprises, including some institutions of the Farm Credit System and the Federal
Home Loan Banks today have federal income tax exemptions, as did Freddie Mac until recently.
Federal law continues to limit the amount of taxes that states and localities may impose upon
banks, savings and loans, and government-sponsored enterprises. [14]

Federal law also pre-empts state laws and restrictions that may apply to state-chartered
private competitors of banks, savings and loans, and government-sponsored enterprises. For
example, government-sponsored enterprises are free to serve national markets without being
subject to the doing-business laws of the individual states or state securities requirements
applicable to competitors. [15]

For years, banks, savings and loans, and government-sponsored enterprises have been
able to use their governmental privileges to serve their legally restricted markets and to make
generous profits for their private owners. As was the original mercantilist system in Europe,
this state of affairs is stable until changing markets and technologies and new forms of
competition outrun the ability of the government to legislate wisely or effectively, and especially
until they outrun the ability of government to maintain the oligopoly or monopoly profits for its
mercantilist institutions.

B.  Rewards and risks for mercantilist companies

1. Rewards

There are many rewards for being an institution permitted to operate in a federally
protected market niche. The thrift business for years was known as a "three-six-three" business:

The thrift executive paid three percent on passbook deposits, made mortgage loans at six
percent, and was on the golf course every day by three o'clock in the afternoon. The term
"banker's hours" conveys much the same concept. Federal and state laws gave banks, says
Lowell L. Bryan, "the benefits of operating within a very profitable cartel.[16]  Today, a
number of government-sponsored enterprises are reaping oligopoly profits in their federally
protected markets.

Take banks first. Federaland state laws have provided many privileges to national banks
and other commercial banks. Most importantly, they were given the. exclusive authority to
provide check clearing services and checking accounts and (along with savings and loans and
credit unions) to provide federally insured deposit accounts. Together these provisions
traditionally have meant that a large amount of money was forced through the banking system.

Federal law also limits competition from other types of financial service companies. For
instance, the Glass-Steagall Act of 1933 provided that securities firms could not engage in
commercial banking functions. The Bank Holding Company Act, a federal law, limited the
ability of commercial and industrial companies to enter the business of banking through bank affiliates. Finally, federal and state laws also limited the amount of competition among banking institutions themselves by limiting branching within states and across state lines.

Together, these restrictions in recent decades permitted banks to reap oligopoly profits
in the local markets that they served. Although the United States possessed thousands of banks,
the overlay of federal and state laws assured that they would not all be able to compete for the
same customers.

State and federal laws similarly protected thrift institutions from the rigors of
competition. Starting in the 1930s, with the advent of deposit insurance, banks and later savings
and loans were subject to interest rate restrictions on the amount they were permitted to pay on
deposit accounts. Starting in 1966, the law permitted savings and loans to pay their depositors
one-quarter of one percent higher interest than could banks. With some exceptions at times of
so-called "disintermediation," this assured a strong flow of savings from depositors into thrift

Under the relevant federal and state laws, savings and loans were generally limited to
making home mortgage loans. Moreover, they were expressly limited to making mortgage loans
within local market areas. Once again, the government created thousands of institutions
organized into a series of local oligopolies that could reap above-average profits from their
legally protected market. Virtually all of this protection came from laws that were enacted at
the behest of the protected thrift industry itself. [17]

A third kind of mercantilist company, the government-sponsored enterprise, benefitted
from even more explicit restrictions on competition than were available to banks and savings and
loans. Fannie Mae, Freddie Mac, Sallie Mae, and a newer enterprise called Farmer Mac (the
Federal Agricultural Mortgage Corporation) operate under unique federal charters that are not
available to others that might want to compete on similar terms. The Federal Home Loan Banks
and Farm Credit System Institutions are chartered by their federal regulators; those regulators
are in turn limited in the number of banks they are permitted to charter. Instead of deposit
insurance, government-sponsored enterprises benefit from an implicit federal guarantee that
lowers their borrowing costs and enhances the value of the mortgage-backed securities that they
issue. [18]

2. Risks

There are also risks, and especially political risks, involved with being a mercantilist company. One risk is that the government will try to change the terms of the mercantilist contract to gain greater public benefits than the companies' stockholders are willing to share.  The federal government frequently amends the law governing mercantilist companies. The  federal government changed the terms of the contract with thrift institutions and Freddie Mac, for example, when it subjected them to federal income taxation.

Sometimes, legislation may change a mercantilist contract to the advantage of
shareholders and then back again. Thus, in 1981 the Congress greatly expanded Sallie Mae's
charter act to permit the company to engage in "any ... activity the Board of Directors of the
Association determines to be in furtherance of the programs of insured student loans [or
uninsured student loans] authorized under this part or will otherwise support the credit needs of
students.[19] , When Sallie Mae used this provision to purchase a thrift institution, banks and
savi,ngs and loans objected to this new competition. The Congress thereupon passed new
legislation restricting Sallie Mae's authority and expressly providing that Sallie Mae could not
own or operate a depository institution.[20]

The second kind of political risk involves the possibility that the federal government will
enact legislation greatly diminishing the value of a corporate charter. To take a recent example,
community banks actively fought the Bush Administration's legislative proposals to expand the
authority of banks to branch across state lines. Such expansion would mean that larger banks
could enter local markets and compete against local community banks. The Treasury
Department argued that relaxing bank branching restrictions would reduce excess bank capacity
in many markets and thus enhance the safety and soundness of banks, and would provide
important consumer benefits and increase the efficiency of bank operations.[21] The community
banks saw a threat to their market position. They prevailed and the 1991 banking legislation
omitted the proposed expansion of geographic powers of banks.

Another example comes from Sallie Mae. In 1991 Sallie Mae stock dropped in value
when Congress and the Bush Administration considered replacing the system of federally
guaranteed private student loans with direct federal loans to students. Under .its federal charter,
Sallie Mae is the single largest participant in the student loan market. Such a change would
affect all lenders to the extent that they hold small portfolios of student loans; by contrast, the
change could impair all of Sallie Mae's business at once. As one stock analyst warned, "In light
of our recent findings regarding political risks, we view the company's prospects as more
speculative than we had previously. Developments in the political arena could lead us to quickly alter our investment recommendations either upward or. .. downward .... [22]

Moreover, legislative threats can come from state as well as federal governments. In the
Great Depression, for example, states enacted moratoria on the ability of mortgage lenders --
primarily thrift institutions at that time -- to foreclose on defaulting borrowers. Unless a
mercantilist company can use the fact of pre-emption of such legislation by federal law as
protection, such changes may survive judicial scrutiny.[23]

To take an earlier example involving federally assisted railroads including the Union
Pacific Railroad Company, the U.S. Pacific Railway Commission observed in 1887 that,

the great variety of bills introduced for the purpose of controlling the business of
the railroads, imposing arbitrary rates of freight, limiting their powers, enacting
stringent liabilities for accidents, forbidding the exercise of the right of eminent
domain, and imposing unequal taxes made it almost impossible for the railroad
companies to avoid expending considerable sums of money in causing their
interests to be properly represented. Many of these bills doubtless had their
origin in the perfectly just belief that the business of the railroads ought to be
subjected 'to supervision and control. Other bills were totally impracticable, and
would have inflicted immense loss on the companies affected thereby. [24]

A third kind of risk to mercantilist institutions is much more subtle than the other two,
but potentially devastating. The governmentally protected market for a mercantilist company
may be profitable for years. Inevitably, however, markets and technologies change. If they
change enough, the federally protected niche can become a death trap. Non-mercantilist
competitors may drain away customers -- borrowers or depositors -- with packages of services
that the mercantilist companies are legally precluded from providing. This is the subject of
Section III below.

The various mercantilist companies today are situated at various points along the
continuum of this political risk. After the disaster of the late 1970s and 1980s, savings and
loans may well be dying out as a distinctive kind of financial institution; banks meanwhile are
beginning to fail in serious numbers as they find themselves confined by provisions of their
enabling legislation that do not constrain non-bank competitors. Finally, some of the
government-sponsored enterprises remain in the happy period of recouping super-normal profits
even as the limits of their enabling legislation begin to become apparent.


III. The Role of Politics and Markets in Shaping the Activities of Mercantilist Financial Institutions

Like any profit-oriented company, a bank, a thrift, or a government-sponsored enterprise
must pay attention to its customers and its markets. However, this orientation is somewhat
different from that of a company facing vigorous competition because the mercantilist company
can have the opportunity to earn oligopoly profits and essentially to dominate its legally
protected market niche.

Also similar to other major private companies, mercantilist companies must pay attention
to the Congress, state legislatures, and relevant governmental regulators. Again, however,
mercantilist companies tend to be different. Unlike the ordinary company, the success or failure
of a mercantilist institution rests even more with its success in the political arena than with its
success in the marketplace. Only a favored few ordinary companies can obtain governmental
support when they falter or fail financially; by contrast, a few changes in enabling legislation
of a mercantilist company can revitalize -- at least temporarily -- even the most moribund

A. The role of markets

Mercantilist institutions can and do fail. Indeed, it was the widespread failure of banks
and thrift institutions in the Great Depression that led to deposit insurance and many of the laws
and regulations that have shaped the role of banks and savings and loans in subsequent decades.
In the good times since the Great Depression, most banks and savings and loans did not fail.
Instead, they served their protected market niches and reaped protected profits. This profitability
was possible because laws and regulations essentially entrapped two groups of customers who
paid much more for banking and thrift services than was justified by the cost of providing those
services. First, federal interest rate ceilings meant that depositors in banks and thrift institutions
did not receive full value for their deposits. Second, high-quality corporate borrowers paid
commercial banks much more for their loans than their risks would have indicated. Lowell L.
Bryan reports a McKinsey and Company study indicating that in the high-inflation environment
of the late 1970s the real return on investment to bank and thrift depositors was actually
negative. Such depositors were effectively subsidizing banks and savings and loans by tens of
billions of dollars a year. [25]

On the lending side, banks showed their acumen at protecting their customer base of
high-quality borrowers. Federal law prevented institutions other than banks from offering
checking accounts and prevented banks from charging interest on such accounts. This essentially
forced most funds in the economy to flow through depository institutions and gave banks
leverage over their borrowers. Banks used this leverage to require their borrowers, and even
their high-quality corporate borrowers, to maintain large compensating (and interest-free) deposit
balances. This cross-subsidy in turn enabled banks to keep their stated interest rates relatively
low on loans, and thereby helped to exclude non-bank lenders like finance companies from
competition for good credit borrowers. On the deposit side, banks tried to compete with service.
They added branches, automated teller machines, and even cash management services for their
corporate customers.

For thrift institutions, it was much the same. So long as savings and loans had a
protected source of low-cost deposits, they could afford to make local mortgage loans and hold
these mortgages in their portfolios. As were banks, savings and loans were barred from direct
price competition in attracting depositors. Like banks, savings and loans also resorted to
unregulated methods of competition. When high interest rates caused an outflow of deposits --
technically known as disintermediation -- savings and loans would offer inducements such as the
proverbial toaster and other non-price benefits for depositors to continue to keep their money
in accounts subject to the legally imposed interest rate ceilings. Some savings and loans used
their relationships with real estate settlement service providers, such as settlement attorneys and
title companies, to provide added profits on their mortgage lending activities, again in markets
that were protected from the rigors of full competition.

Federal laws and regulations dampened competition, but could not eliminate it. Because
of the restrictions on bank and thrift branching, the United States came to have thousands of
banks and thrift institutions serving protected local markets. Banks began to adopt distinctive
competitive strategies. Larger banks used the bank holding company device to avoid some bank
branching restrictions and serve the largest institutional customers, and also to provide a greater
range of services than could be offered by an insured bank itself; regional banks grew to serve
regional markets; and local banks actively solicited high-quality small business customers for
their loans.

Government-sponsored enterprises have retained the original mercantilist form of
privileged charter. They have no competition from others with similar corporate privileges and
requirements. While other completely private companies can grow by diversifying into a wide
range of markets, government-sponsored enterprises are limited to serving their designated
markets. Supported by their ability to borrow large amounts of money on favorable terms, and
limited to serving their designated economic market segments (but free to serve large geographic
areas) government-sponsored enterprises can be expected to direct their energies to trying to
grow within their permitted markets. If the permitted markets are large enough, government-
sponsored enterprises can become huge institutions. In 1991 alone, for example, Fannie Mae
grew by over $85 billion dollars. The single company now funds, in portfolio or- mortgage-
backed securities, over one half-trillion dollars of home mortgages.

 As they grow in dominance in their permitted lines of business, enterprises also playa
major role in shaping their markets. Fannie Mae and Freddie Mac have had a major impact on
the residential mortgage market. Almost all mortgage lenders now use standard mortgage
instruments drafted by Fannie Mae and Freddie Mac for their residential loans. Fannie Mae and
Freddie Mac have helped to increase national uniformity in contracts and procedures for sales
and servicing of mortgages. They have helped to increase market efficiency and reduce
transaction costs, compared to earlier days when variations among states and regions kept the
mortgage market segmented into geographic areas. Finally, along with Ginnie Mae, Fannie Mae
and Freddie Mac have helped to pioneer standard terms and conditions related to mortgage-
backed securities. Mortgage-backed securities benefit from economies of scale, and their
standardization has been important in producing a homogenization of terms for such securities
so that such economies can be realized.

Fannie Mae and Freddie Mac have also helped to displace thrift institutions in their role
as portfolio lenders. To the extent that Fannie Mae and Freddie Mac pass on some of their
borrowing advantages and economies of scale to home buyers, the reduction in mortgage rates
has tended to squeeze less efficient competitors including many thrift institutions. As economists
increasingly agree, the growth of the mortgage-backed securities business ultimately appears to
spell the displacement of thrift institutions from the business of holding mortgages in
portfolio. [26]

B. The role of politic

While success in the marketplace is important to mercantilist companies, success in the
political arena is vital. A mercantilist company that begins to fail in the market can turn to the
political process for redemption. [27]

1. Political risk and the demise of the thrift industry

This happened to thrift institutions in the early 1980s. Ultimately, federal laws and
regulations could not stop the emergence in the marketplace of new technologies that facilitated
the development of powerful new competitors to banks and savings and loans. The growth of
money market mutual funds in the 1970's finally provided borrowers an escape from the
artificially low interest rates paid on their captive deposits. Then political risks suddenly
materialized in deadly form for the thrift industry. In 1979 Federal Reserve Chairman Paul
Volcker and the Federal Reserve Board attempted to squeeze out rising inflation by increasing
the level of interest rates dramatically. 

The increase in interest rates was fatal for many savings and loans. Locked into
portfolios of low-yielding 30-year fixed mortgages, they could not survive in a high-interest rate
environment. By contrast, banks tended to make adjustable rate commercial loans tied to the
prime rate; with some exceptions such as rural banks whose borrowers were driven out of
business by the high interest rates, this helped to protect them from the immediate consequences
of the Federal Reserve Board's actions.

Facing unanticipated disaster in its legally restricted lines of business, the thrift industry
once again turned to Washington for relief. In 1980 legislation, savings and loans and banks
obtained deregulation of interest rates and an expansion of federal deposit insurance, from
$40,000 per account to $100,000 per account. The first provision permitted savings and loans
and banks to pay market rates of interest to help keep their depositors from fleeing to money
market funds; the second provision expanded the federal safety net for banks and savings and
loans and encouraged the large scale flow of brokered deposits into institutions that offered the
highest rates.

This was not enough. Locked into their low-yielding portfolios, savings and loans could
not afford to pay market rates to depositors for any length of time. By 1981 it is estimated that
the thrift industry" had lost its entire net worth. In 1982, savings and loans sought and received
additional benefits in the Garn-St Germain Act. The 1982 law expanded the lines of business
available to thrift institutions, permitted them to make commercial loans up to specified limits
and removed loan-to-value limits on real estate loans. Finally, the industry exerted continuing
pressure on members of Congress, the Reagan Administration and the Federal Home Loan Bank. Board to assure that government would not close many savings and loans when they failed.

The combination of impaired capital and negligent federal oversight gave managers of
failed savings and loans the incentive to make large-scale financial gambles. The expanded
powers and privileges gave them new ways to roll the dice. As economist R. Dan Brumbaugh
puts it, the savings and loans were gambling for resurrection. If a gamble succeeded, it could
save an institution; if it failed, the institution felt that nothing had been lost. The institution's
demise had been assured after 1979 when the Fed had implemented its new policies and driven
up interest rates. Only the government and taxpayer stood to lose when the gambles failed and
the losses of failing savings and loans were compounded, sometimes by billions of dollars.

Even as late as 1986, savings and loans continued to rely upon their political strength.Their major trade association, the U.S. League of Savings Institutions, successfully blocked
legislation in 1986 to provide funds to recapitalize the insolvent Federal Savings and Loan
Insurance Corporation (FSLIC) Fund. The industry argued that most failed institutions deserved
the chance to remain in business until the return of better times. In 1987 the Reagan
Administration and Congress overcame strong political opposition and finally legislated $10.8
billion in funds to close insolvent savings and loans. That was far too little money to close the
number offailed institutions that continued to gamble with taxpayer money.

By 1987 the Federal Home Loan Bank Board (FHLBB), the nominal thrift regulator, was also trying to restore the quality of regulatory oversight lacking in previous decades. Finally,  after the 1988 election, the Bush Administration and Congress enacted strong legislation  abolishing the FHLBB, creating a new financial regulator, the Office of Thrift Supervision, and  providing that regulator with strengthened powers and resources. The new legislation, and legislation in subsequent years, also provided tens of billions of dollars in additional resources
to help pay for the closure of insolvent institutions. It is estimated that the final cost of the thrift  debacle will be upward of $150-$200 billion to American taxpayers once all failed institutions  (and those expected to fail in coming years) are closed. [28]

The experience of the savings and loans shows the dangers of expanding the legal powers
of mercantilist institutions. Regulators are forced to evaluate risks of new financial products and
services that they may not understand. Moreover, expanding powers without limiting deposit
insurance may cause an uncontrolled spread of federally supported credit into new sectors of the
economy that may not need it. The multitudes of see-through office buildings funded by failing
savings and loans are but one manifestation of the problems of excessive federal credit caused
by broadened powers and inadequate federal oversight,

2. Political risk and the decline of banks

The case of banks provides an interesting contrast to the thrift story because it illustrates
the other horn of the dilemma and shows what happens when mercantilist institutions fail to
obtain continuing expansions of their legal powers. Banks as well as savings and loans lost
depositors to the burgeoning money market funds starting in the 1970's. By itself, this might
have been a manageable difficulty, if banks could have retained their captive high-quality
borrowers. Unfortunately for banks, the market changed in that regard as well. Technological
developments in information processing permitted the emergence of the commercial paper
market. - Large- and medium-size high-quality corporate borrowers began to raise money more
cheaply in the commercial paper market than they could from banks. Once the new competition
was viable, it grew rapidly. Figure 4 on page 24 shows the growth of the commercial paper
market. It shows the rapidly declining ratio of bank commercial and industrial loans to
commercial paper outstanding in just 20 years. To give some sense of the underlying numbers,
at the end of 1960 commercial paper issued by non-financial corporations and finance companies
amounted to only $4.5 billion. Within fifteen years, that figure had multiplied more than 40-
fold, to over $200 billion. By contrast, bank lending for commercial and industrial purposes
increased by only ll-fold in the same period from $43 billion to $494 billion.[29]