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?

5 comments… add one
  • Eh, your hypotheses re barrier to entry strikes me as naive as you’re only looking at the Mega Banks.

    While there is something to be said for the Regulatory argument regarding concentration in the financial industry, capital needs and globalisation of financial services in key areas, like I Banking (in particular the capital markets operations of I banks) are at least as strong in my opinion.

    Further, it would appear that the worst issues have arisen where financial sector regulation was non-existant or weak, notably:
    (i) Low end, in mortgage markets, where poor national and state level regulation of the non-bank area (mortgage brokers, non-bank lenders, etc) opened the door for fraud and degeneration of lending standards. & nota bene, this area had, by most standards, rather loose barriers to entry, not at all in the manner of the standards required of deposit takers, proper banks. I find it hard to give credit to an argument calling for less Supervision in this area. Bad money drives out good; barriers should exist in these instances as the con men can ruin the confidence game that is lending rather easily.
    (ii) High end, derivatives markets in the increasingly exotic high finance world. Here again for derivatives markets, esp. the truly fun Cred. Def. swaps, MBS, etc., there is rather little regulation (indeed of course it is open to question if anyone understood the risks), and the market actors are /were Qualified Investors – big boys w/o need for adult supervision like Joe Depositor. Here the question becomes a little more complicated as risk management regulation in my view has gotten dangerously naive in opting for modeling in areas where no proven model on risk exists; the lesson being bad regulation can do a world of harm. However, it strikes me as idiotic to argue this area does not need regulation or that barriers to entry caused issues as such. Search for return, lowering standards and the utter failure of portfolio theory risk modeling caused the issues. Tighter regulation of bank exposure to this risk is clearly needed – although the highest net worth should be free to play in the Hedges once proper concentration safeguards are up.

  • I was thinking of the mega-banks since those are the ones that are “too big to allow to fail”.

    I don’t have any opposition to increased regulation in the abstract; I’m just concerned that whatever regulation is induced be targeted at solving problems that actually exist rather than just punishing perceived miscreants.

    Unfortunately, our legislators are lawyers, most have never taken either an economics or business course, haven’t taken a mathematics course since they were in high school, and probably have only the haziest notion of the difference between a million and a billion.

  • Larry Link

    I don’t think we’ve come close to understanding just what has happened except to realize that the risk are too high to do nothing. To bail or not to bail…it is no longer a simple matter of a large bank or financial institution
    going under, it’s about the little guy, those small retirement funds that 50% or so of Americans have invested in for their retirements..I’m not an economist, a banker, I’m just an American worker who has had to invest in the Free Market in order to have some kind of retirement, we have placed a great deal of trust in those who are suppose to know about those things…we are angry at the risk that has been taken with our hard earned dollar…I personally want to see Government working at understanding the problem and then correcting the regulation by adding new, or changing the old but that something needs to be done…if we can’t trust the system, who will we be able to trust in the future…?

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