Bank Bailouts Are Inevitable


One of the difficulties in discussing banking policy is that many otherwise well-informed people tend to retreat into misplaced ideological thinking.

On the one hand, you've got the liberals, who tend to favor almost anything that can reasonably be called regulation. Believe it or not, it is extremely difficult to convince many liberals that the unintended costs of a regulation may far outweigh the benefits.

There's a tendency to just assert that all the costs can be dealt with by more regulation. A good example of this are the various approaches liberals have offered to credit ratings agencies, almost all of which would just further cartelize credit ratings and make the agencies even more immune to competitive pressure.

On the other hand, you've got the conservatives. They tend to look at every regulation as an interference with the free market. The problem here is that this assumes the pre-existence of a free-market. It's like the joke about economists stuck on an island with cans of tuna but no way of opening them. "We assume a can-opener," one economist proposes. Conservatives look at new regulations, balk at government intervention into the market. But when asked where the free market was before the regulation, it turns out they were just assuming one.

A bit more on this point. In a system of fiat money controlled by a central bank, with fractional reserve banks backed by deposit insurance, characterized by enormous mega-banks that have grown so large primarily because of concentration-inducing regulation, there is no pre-existing free market into which the government can intervene.

When we talk about bank regulation, we're really attempting to guess how institutions and individuals will react to a change in the type of intervention—not to the introduction to government intervention.

One thing that is especially unhelpful when discussing banking policy is the insistence, which we actually hear from both the right and the left, that we have a new policy against bailouts. This simply isn't true. We had a policy against bailouts before the bailouts. Treasury Secretary Hank Paulson genuinely believed he lacked the authority to rescue Lehman Brothers. The Federal Reserve did not believe it could extend a loan to AIG. But those beliefs changed when the crisis hit.

Left leaning New York Times columnist Paul Krugman writes:

Finally, even if you persuade yourself that the moral hazard created by financial firefighting outweighs the benefits of avoiding a 1931-style cascading crisis, the fact is that policy makers will intervene. Hank Paulson set out to make Lehman an example; two days later he was staring into the abyss.

So the only feasible strategy is guarantees and a financial safety net plus regulation to limit the abuse of those guarantees. It’s imperfect; it faces the constant threat of regulatory capture; but it has worked in the past, and it’s the only game in town.

Krugman still tends to have too much faith in the efficacy of regulation, neglecting the likely market reactions to things attended to limit the abuse of government support. But he is right: this is the only game in town.

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