Some people are offended if you say “happy holidays” and others are offended if you say “merry Christmas.” Some people are offended if you are offended by one greeting or another, and some people are offended by efforts to explain why some people are offended when other people are offended by one greeting or the other. Makes one’s head spin. So let’s change the subject.
Megan McArdle disagrees with “a very common” point I made in an earlier post: that banking regulation is necessary because of moral hazard that results from deposit insurance (both formal FDIC insurance and the informal insurance where authorities end up compensating creditors not covered by the FDIC program). Yes, it’s a very common point, but it turns out to be wrong, she says:
Almost everything in the world has negative and/or positive externalities. But despite this, we do not intervene to subsidize everything with good negative externalities, or punish everything with bad. That's because things with substantial negative externalities often contain sufficient punishment to deter the individual; likewise, things with positive externalities often carry enough reward to produce a socially optimal amount. For example, if I am a bus driver, the negative externality of my suddenly jerking the steering wheel to the left and driving the bus off a cliff is much higher than the cost to me--many lives against my one. But my own life is very valuable to me. The threat of its loss is enough to deter such behavior 99.9999% of the time.
The problem with this example is that in the real world the bus driver has a continuous range of options as to how much care to take. Suppose, for example, that he slept badly the night before and knows that he will not be able to drive very attentively. He may well decide to drive even though he would not if he fully internalized the risk of harm to the passengers. We have all done this, and all kinds of laws and regulations, with the tort system as an overall backstop, attempt to deter people from acting in this way. McArdle continues:
Bankers take risk in order to make money, and they control risk in order to avoid losses. But the losses they are most interested in are not to their shareholders. Rather, they are worried about the loss of their jobs. As long as the bank regulators fire any managers who put the bank in receivership, I can see no difference between an unregulated private system without deposit insurance, and a system with. That isn't to say that there is enough regulation in either situation. But if there is a problem, it is that bankers have a socially less-than-optimal risk appetite, or that the punishment for driving a bank into insolvency is insufficient. The moral hazard from deposit insurance doesn't much enter into it.
In a world with bank insurance but without regulation [corrected, thx to traveler456], I would start up a Posner bank, ask you for a deposit, and then use your money to buy lottery tickets. If I win the lottery, I pay you back; if I don’t, I dissolve the bank and you go to the government for your funds. I wouldn’t bother to hide my investment strategy from you; you wouldn’t care because you would be paid in any event. I would set up hundreds of banks and give the managers a salary that they would receive if and only if they collect deposits and use them to buy lottery tickets; otherwise, they are fired. (Corporate law junkies will point out that the government will pierce the corporate veil and go after my lottery winnings, but in the real world, with thousands of shareholders and not-lottery but still risky investment schemes that unfold over decades during which dividends are paid and the money spent, that’s not so easy.) McArdle continues:
The moral hazard for depositors may be large. But I doubt it. Most depositors are not capable of determining whether a bank is faulty or sound, and they weren't in 1830, either.
This can’t be true. In the nineteenth century, elaborate efforts were made to keep track of bank risk. Merchants discounted bank notes after consulting books that compiled risk estimates. The notes of larger and more stable banks were discounted less. Since people often made payments with bank notes, they must have had a sense of how risky different banks were, and taken the risk into account when making deposits, to say nothing of common memory about which banks have stayed in business and for how long. Today, people don’t pay attention to bank risk because of deposit insurance; but people certainly think about risk when they make uninsured investments, for example, when they buy stocks or corporate bonds or, for that matter, stereos and personal computers. She concludes:
The reason that deposit insurance requires tighter regulation is that the government wants to minimize the cost to itself--not society, for whom the losses would be the same whether the government or the bank paid them. I think this is wise, for many reasons. But not because of moral hazard.
The argument here seems to be that we should distinguish the perverse incentives of depositors and of bankers. Depositors have a perverse incentive to ignore the riskiness of a bank; ironically, the government does little to counter this incentive aside from capping the insurance payout (and not very credibly). One could imagine a different system where the government tried to regulate depositors the way insurance companies normally regulate insured parties—by demanding that the insured bear some of the risk with a copayment or deductible and take other actions to minimize the potential loss.
Instead, the government goes after the banker. This would be like an insurance company trying to regulate the activity of people who impose risks on insured parties rather than on the insured parties themselves. Imagine that I have health insurance and the insurance company tries to shut down the local polluter so as to minimize its expected insurance costs. Our system of banking regulation resembles this approach.
But moral hazard is the right term. Economists use the term moral hazard to refer to the perverse incentives that arise when a principal pays an agent to act in a certain way that benefits the principal where the agent would rather act differently, but cannot observe the agent’s action, so the agent acts in a way that ends up hurting the principal relative to a baseline of optimal behavior. There are various ways of mitigating moral hazard: one is to share risks, but another is to confine the agent’s choice set. That is what government banking regulation does. It reduces moral hazard by depriving insured depositors of the option of investing in a risky bank, which would presumably offer a high interest rate or other advantages."
If a bank is guaranteed by taxpayers, it makes sense to have it limit its risk. This is because the government should take a much more conservative approach with the taxpayer's money, which should should generally used to supply goods and services to and for the taxpayers. The benefit to society of the FDIC is limiting the dire consequences of bank runs.
I agree that for explicitly government guaranteed financial institutions, we should have regulations to minimize possible losses. Moral Hazard will apply when a case comes up of a bank becoming or getting close to being insolvent. It should immediately be seized in order to keep Moral Hazard intact. Moral Hazard needs actions, not simply words, in order to be effective.
In our current crisis, Moral Hazard played the most important role, in that it was ineffective, and applying it at the point of the crisis, as Lehman showed, would have caused a financial meltdown. Why? Because past government actions, including the S & L Crisis, showed that the government would intervene in a financial crisis. One could even include Fed actions in this brief. The investors and markets were counting on this government intervention, and invested accordingly. As well, the poor record of prosecuting fraud, etc., caused many people to ignore the laws betting that they were unlikely to be discovered or prosecuted if they were. That's Moral Hazard. And, unfortunately for us, many of the people controlling actual money would have panicked even more were the government not to intervene, causing a possible meltdown.
Now, given Bagehot's Principle, that if the Fed exists, then it will be the Lender of Last Resort, and this should be taken into account in real world decisions, there will always be some presumption of a bailout. Therefore, the government will regulate these financial concerns, not just to avoid a bailout, but to avoid a crisis, which has social as well as economic side effects that we'd rather not face. Try looking at Iceland.
And that brings us back to the idea of a Central Bank. It exists because a significant segment of society does not trust bankers. The idea that average citizens are going to research the solvency of banks is not on. The reason we have these laws is because average citizens got enough power or were enough of a threat for government to realize that its existence depended upon these banking constraints. Lost totally in this quest for private banks, a purely silly one, is any Burkean sense of the nature of Politics and Political Economy. It is much more likely, in the real world, that government would control all of the banks than regulate or control none. In light of that fact, an intelligent and effective interest in limited government would attempt to compromise in such a way as to maximize liberty. As Burke might say, God spare us theorists. Whether on the right or left, they usually end up wreaking havoc in the name of their ideas.
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