Well Said, Jeff
My freedom-loving friend Jeff E. Jared is a frequent writer of letters to the editor. His latest published letter is well worth a read:
Daniel Bennet believes that the cause of our economic woes “was the institutions which had never had any regulations to begin with†and the repeal of the Glass-Steagall Act (3-25). He couldn’t be more wrong.
Banking is heavily regulated. There’s the Federal Reserve (which controls interest rates and the money supply), the SEC (which enforces regulations), the Glass-Steagall Acts (1932-33), Federal Deposit Insurance (FDIC), capital requirements, reserve requirements, financial reporting and disclosure requirements, credit rating requirements, large exposure restrictions, related party restrictions, affiliation restrictions and payment system requirements. Money is the most regulated thing in America.
Mr. Bennet cited the repeal of the Glass-Steagall as a cause of the crises. But remember, only part of Glass-Steagall was repealed in 1999, the part barring investment banks from combining with regular banks. It kept deposit insurance (FDIC) backed by the government. Thus, the risk was socialized (because FDIC would bail out bad banks) while profit was privatized (now being able to combine, get big and diversify). This is corporate socialism.
Further, the institutions that failed, Bear Stearns and Lehman Brothers, were investment banks that didn’t combine with commercial banks. They were bought by banks that had combined under deregulation to become stronger: B of A and JPMorganChase. So without the repeal, the crises might be worse.
The root problem is that previous government bailouts, like the S & L crises of the 1980’s, were always looming in the background to encourage risky behavior. It doesn’t make sense to forbid banks to diversify their product line to limit risk, while at the same time guaranteeing their deposits–which increases risk. So the repeal of Glass-Steagall didn’t go far enough.
Liberals who support regulation often fall into this trap. They see a problem, and–failing to understand that we don’t have unfettered capitalism and that there are pages and pages of regulations already—they mistakenly demand more regulations, rather than repealing the excessive ones we already have.
The American economy is not a free market. It might have been in 1880, but since FDR and the New Deal 1930’s, we haven’t been close. The key is to deregulate by abolishing the Federal Reserve and ending subsidized insurance to the banking industry, and repealing the rest of Glass-Steagall.
Without the FDIC, banks would be tuned into any potential panics and runs and reel in their loans accordingly when public anxiety rose, like a kind of shock absorber. Subsidies and regulations disable this natural self-regulation of the market.
Jeff E. Jared, Kirkland
April 9th, 2009 at 04:43:15 pm
It’s good that someone has faith in the benevolence of my colleagues across the isle.
As for the last bit, I’m afraid Jeff simply doesn’t understand how banks work very well.
All modern banks lend long and borrow short, keeping the difference in interest rates as profit less some usually negligible default costs.
The very nature of banks prevents them from “reel[ing] in their loans accordingly” in response to a panic. Of course, narrow or full reserve banking is possible in such an environment, but that is an entire blog post.
April 10th, 2009 at 01:52:15 pm
Regardless of how banks truly work, the principles are still the same: When banks suffer for their bad behavior, they have an incentive to behave well. When they are rewarded for their bad behavior, they have an incentive to behave poorly. Even if banks, reacting to present incentives, tend to behave poorly, without the perverse incentives of the FDIC and numerous historical and present bailouts, the fallout of a failure would be localized and self-correcting.
April 10th, 2009 at 04:14:41 pm
Fair enough.
One brief thing to consider: FDIC makes M2 currency. As you can see in the following chart, the government has been doing the functional equivalent of revving up the printing presses. It is not a simple matter of shutting off the printing presses – there are structural forces present in the government and in society which benefit from the current arrangement and are quite non-functional when the situation changes (the current recession, etc.)
http://en.wikipedia.org/wiki/File:Components_of_the_United_States_money_supply2.svg
April 16th, 2009 at 09:06:43 pm
Jeff really has two arguments and tries to show causality where there is none. He identifies a problem, banks have found a way to create what Krugman calls a “Heads I win, Tails you lose” outcome. On this point, I agree something must be done, wiping out the shareholders and a portion of the bondholders or all of the bondholders if necessary to restore solvency would be nice.
But the flaw comes in trying to link this to regulation and specifically Glass-Steagal, the Federal Reserve, and FDIC. Although I tend to be fairly Laissez-Faire in my approach to the market, I think regulation can serve a valuable purpose.
First point. Furthermore, the Government can use it’s extremely strong credit position to create a stable operating environment for the “real economy” by keeping interest rates stable. It is critical for the functioning of an economy to have a stable price and interest rate environment. If you don’t believe me that the government through FDIC and FOMC operation has provided this environment, then I would invite you to view the following graphical data:
http://voxeu.org/files/image/diShrtAnnPct.PNG
Second point. Jeff claims that banks without the FDIC “would be tuned into any potential panics and runs and reel in their loans accordingly when public anxiety rose”. What Jeff fails to understand is that the fundamental problem with “reeling in loans” is that the nature of the loans are such that they cannot be “reeled in”, in other words mortgages and other loan based debt instruments are not “callable”. You can’t simply loan someone $200k for a house and demand it back at a moment’s notice. The fundamental problem is that deposits (liabilities) and assets (mortgages loans) are of a vastly different duration. So sorry, I have to disagree with Jeff, FDIC does prevent banks runs quite effectively and solves the duration problem.
Third point. Jeff rebukes the importance of Glass-Steagal, “Further, the institutions that failed, Bear Stearns and Lehman Brothers, were investment banks that didn’t combine with commercial banks.” The failure of Bear and Lehman are explicit failures, bankruptcy, but what about all of the other major banks that are solvent only because of the implicit support of the government. If the Federal government announced tomorrow withdrawal of further support, most of the major banks would be delisted the same day. If one actually puts down ideology for a moment and looks at the industry organization of large U.S. banks one quickly realizes that the functionally distinct lines of business are not combined under one organization for economies of scales or scope but to make a more powerful organization for political influence. Furthermore, many of the lines of business representing under the same organization have terrible conflicts of interest. One prime example of this is the commercial banking, investment banking and brokerage incestuous triangle. A bank underwrites a stock (the company it underwrites is a client), the brokerage business is not supposed to unbiasedly rate that stock and make buy/sell recommendations to other clients, and if the underwritten company needs additional capital now has to decide (again without bias) whether the company is credit worthy and decide what interest rate to charge. Glass-Steagal was design to prevent these abuses from taking place.
Ok, but Jeff says Bear and Lehman would not have been aided by a strick enforcement of Glass-Steagal. It is hard to say because there is still such opacity as to what actually happened and what is happening, but from some accounts the fact that Lehman having both commercial banking and investment banking under the same balance sheet actually did lead to the failure. The account goes that after some initial turbulence nervous commercial banking clients started withdrawing their payroll accounts and taking them elsewhere. This cause short term liquidity problems which normally could have been dealt with by borrowing at the LIBOR rate, except that the TED spread had recently grown to almost 5%. Ok, but that is just one example, but what about AIG, similar story hedge fund attached to an insurance company. The point is that if these banks were monoline that there would be no “workout problems”, they could be allowed to fail. It is there entrenched entanglements that prevent being able to allow them to fail without cause system problems. But please maybe there is a counterargument as to why banks need to integrate retail banking, commercial banking, credit cards, investment banking, hedge fund operations, credit rating, brokerage and trading operations, institutional lending, insurance, 401k retirement and pension planning, and more lines of business.
I have more I want to write, but no time, I’ll just leave it at this, stop lights are a form of regulation, maybe it helps society work together more effectively, or maybe we should remove them too.
April 17th, 2009 at 01:02:46 pm
In reply to Scott:
1) The graphic is interesting-looking, but I’m not sure what it means. It looks like “something” is less volatile after a bunch of regulations were passed, but that doesn’t equate to good in my mind, necessarily.
I think you’re right that the FDIC works to avoid bank runs with the way the banking system currently works. I’m not convinced the way the bank system currently works is very good, though, so I’m not very interested in helping the current system stay stable. That’s one of the reasons I’m all for eliminating the FDIC. It certainly would make me more careful about where I leave my money in the future (I had most of my money in WaMu when it collapsed).
I have struggled for a long time to figure out why regulations are so popular. I think I’ve finally discovered a significant chunk of the reason. It is quite simply that regulations work — they usually do provide real short-term, discernible gains. The pernicious part of it all is that I strongly believe that regulations come at an enormous long-term hidden cost. I can think of only a few that might have positive long-term effects.
The reason for this, I believe, is that regulations correct perceived imperfections in the present, with little to no knowledge or insight into what the future holds. Certainly, breaking up AT&T’s monopoly was good in the short-term, but did it drastically delay mobile phones because suddenly land lines were “good enough” again? I think this is very likely. As another pertinent example, the FDIC certainly makes bank runs less likely today, but is it also causing alternatives to the current banking system to have no chance because the traditional banking system is effectively heavily subsidized by the taxpayer? I think this is true. I don’t know for sure what a better banking system is, but I’ll bet there are people out there who have good ideas who can’t try them out because the deck is so stacked for the types of banking institutions that already exist.
It is not that regulations don’t work — they often do. It is what regulations preclude that bothers me.
April 20th, 2009 at 04:01:02 am
The image Scott shows is a measure of the short term interest rate. Think of it as the cost of money. A volatile short term interest rate means that there are lots of bubbles that are forming and popping frequently.
I look at the FDIC and the Federal Reserve much the way most people look at early fire fighters who suppressed all forest fires. When viewed over a long period of time, the buildup of brush and undergrowth is a dangerous phenomenon – one that leads (eventually) to particularly hot and dangerous fires.