Deposit insurance without restricting banks

Last year the New York Times ran several articles about the end of capitalism. Others picked up the theme and reinforced it with claims that greedy bankers and deregulated financial markets had brought the world to the brink of another Great Depression. Allegedly we were saved by timely, forceful, and intelligent government actions. And the next phase had to be more government regulation of... [more]

Last year the New York Times ran several articles about the end of capitalism. Others picked up the theme and reinforced it with claims that greedy bankers and deregulated financial markets had brought the world to the brink of another Great Depression. Allegedly we were saved by timely, forceful, and intelligent government actions. And the next phase had to be more government regulation of financial and economic life. Unbelievable! Certainly there were many mistakes in the financial sector and a massive response by the Federal Reserve. Left out is the government's disastrous mortgage and housing policy. Without the policies followed by Fannie Mae, Freddie Mac, and the destructive changes in government housing and mortgage policies, the crisis would not have happened. Also, without warning, a 30 year policy changed when Lehman Brothers failed, followed by a hesitant and uncertain lead from Treasury Secretary Paulson. These actions converted a garden-variety recession into a world-wide crisis. The Federal Reserve acted forcefully and determinedly to lessen the fallout from its Lehman error, but much damage was done. Let's not overlook government failure. Let's try to prevent more of the same. Would bankers have made so many errors if there had never been a too-big-to-fail policy? Not all bankers overinvested in mortgages but some "got up to dance" believing that they would profit and the rest of us would pay to prevent failures. Has the government learned from its mistakes by closing Fannie and Freddie and agreeing to put any housing subsidy on the budget, as a proper policy would require? Do you hear the president, the Treasury, or the Federal Reserve insisting on an end to too-big-to-fail? This is the age of Madoff, Stanford, AIG, and many others. Regulation failed in all these instances. Failure is not unusual. Regulation often fails either because regulators are better at announcing rules than at enforcing them or because the regulated circumvent the regulations. The Basel Accord was supposed to reduce banking risk. Financial markets circumvented it. Unusual? Not at all. In 1991 Congress passed the FDIC Improvement Act that authorized regulators to close banks before they lost all their capital. Regulators ignored it. Unusual? Not at all. Regulation is static and markets are dynamic. If markets don't circumvent costly regulation at first, they will find a way later. Congress should recall these failures before passing new regulations. It should choose regulations that give the regulated incentives for compliance. During the Great Depression Congress authorized section 13 (3) that told the Federal Reserve to lend directly to small and medium sized firms that could not get accommodation from the banks. In this crisis, Section 13(3) was used to lend to AIG. This stretched the original purpose beyond any reasonable interpretataion. Congress should remove this authority. It is now a source of large loans to failing enterprises, an undesirable extension of too-big-to-fail and a misuse of the intent of 13(3). We cannot have deposit insurance without restricting what banks can do. The right answer is to use regulation to change incentives--making the bankers and their shareholders bear the losses. Beyond some minimum size, perhaps $10 billion of assets, Congress should require banks to increase their capital more than in proportion to the increase in their assets. Let the bankers choose their size and asset composition. Trust stockholders' incentives not regulators rules. Incentives are not perfect, but they are better. Secretaries Geithner and Paulson told the AIG hearing that they faced a choice--a bailout or another Great Depression. Not true. Classical central banking offered a better alternative, used many times in the past. Classical policy called for letting AIG fail and lending to counterparties against good collateral. That policy supports the prudent and lets the failures fail. I have watched and at times participated in discussions of crisis policy. The issue is almost always decided by those who tell the Treasury Secretary that without a bailout, crisis is likely, and the crisis will go into the history books with his name on it. The result: we make the taxpayers, your constituents, pay the cost of bankers' errors of judgment. And we invite some to choose imprudent behavior knowing they are too-big-to-fail. The market is not perfect. It is run by humans, who make mistakes. They should pay for them. But the same humans run government where they make different, often more costly mistakes for which the public pays. At the moment, we see excessive spending and promises to spend that cannot be kept. This is a major problem in California and Greece but soon to be followed by others including the federal government. At all levels of government, promises to pay state and local pensions, old age retirement, and to provide healthcare far outstrip capacity to pay. The Congressional Budget Office and many others have been warning for years about the $50 or $60 trillion dollars of unfunded liability. Government's answer--offer an expensive drug benefit followed currently by a more expensive "reform" that increases the unfunded medicare-medicaid liability. Dissemble about the real costs. [less]