In my view it is unreasonable to expect the government not to act in response to the ongoing financial crisis. Under the present conditions any administration, Democratic or Republican, would act. It’s a political necessity.
It’s reasonable to question just what sort of intervention is necessary or would be the most effective. The responsible critics who favor a more incremental approach to addressing the problem than the proposal that’s on the table need to explain why the incremental steps taken to date won’t resolve the problem and why the incremental steps they prefer will. So, for example, when Sebastian Mallaby in the Washington Post follows Raghuram Rajan and Luigi Zingales in saying that the government should require banks to cancel dividend payments and issue new equity or Charles Calomiris and Douglas Elmendorf in saying that the government should buy equity stakes in the banks they need to flesh out a little more for us why these steps will have the desired effect when the measures taken to date haven’t. Yes, I know that they suggest a few possibilities. Under the circumstances, that’s not enough. Criticisms of a failure to act and, particularly, a failure to act on a timely basis are commonplace; criticisms that too much action has been taken too quickly are much rarer. The last time I can recall that was in the National Recovery Administration more than 70 years ago.
I agree with critics like Arnold Kling who note that economic resources have been misallocated to the financial sector and that the sector needs to shrink. Where I disagree is in how it should shrink, I think because I differ from Dr. Kling in the reasons that the misallocation occurred.
I believe that the sector has grown, not because of the lack of regulation, but because of regulation. The financial sector is highly regulated and there are substantial barriers to entry. The industries that have prospered most over the last 25 years are those who’ve been able to prevent competition, particularly competition from overseas. That includes banking, insurance, and healthcare.
In recent weeks there’s been a rising chorus of those advocating increased regulation of the financial sector to prevent future financial turmoil. I believe that we and they need to think long and hard about exactly what sort of regulation, if any, would have the desired effect. In particular the advocates of increased regulation need to connect the dots a little more between what’s happening and the regulations that they prefer. I don’t see a clear connection between deregulation or lack of appropriate regulations and the present financial crisis although I’m willing to listen to those who think that’s the case. Propose your reforms and make the connections.
I do, however, see a connection between ever larger financial institutions, reduced competition, and the willingness to take increased risks, secure in the belief, fully justified by the government’s recent responses, that once they’ve achieved great size they’ll be too large to be allowed to fail. I’ve asked the question before: how do we function in today’s global economy, dominated by enormous, frequently government-sponsored institutions, without enormous institutions of our own, the commensurate lack of competition, and being at the mercy of speculators immune to market discipline?