Thursday, September 30, 2010

Reconciling libertarianism and financial stability

Earlier this year, Daniel Stern posted the following (abridged) comment:

What I want to hear more about is reconciling, as a policy matter, the libertarian impulse and the admission that some of our institutions are "too big to fail."
The essence of libertarianism is responsibility for the consequences of one's actions.
Once we agree that certain institutions are absolved from those consequences, we're no longer libertarians. We're simply capitalist corporatists, and the only question is who gets the money.

Banks (and frankly, all financial institutions) are special. The state has a legitimate interest in financial stability, the money supply and credit creation. I would argue that the state has a more compelling interest in the stability and functioning of the financial system than in any other realm besides national security and domestic tranquility.

Constitutionally, the federal government is empowered to mint coins. It is not empowered to print paper currency or to regulate or, God forbid, bail out banks. But since the Republicans passed the National Banking Act in 1862 (the Democrats having left the legislature to form their own government in Richmond), the federal government has arrogated to itself the right to do whatever it wants in money and banking. Further federalization included the Federal Reserve Act of 1913 and the myriad legislation of the New Deal, most notably the FDIC. While unconstitutional, in my opinion this legislation was essential to prosperity and financial stability.

The history of the US banking system under state regulation before the Civil War was not pretty. Anyone could get a charter (“wildcat banking”) and any bank could issue bank notes (and then dishonor them). It was a Ron Paul Disneyland. Which was fine, so long as you weren’t actually living in the United States at the time. 
Banking panics were routine, and depressions (yes, depressions) were common, and the money supply was volatile and uncontrolled.

But even after the passage of the NBA and the FRA, there was still no concept of TBTF or the realization at the policy level that bank failures were catastrophic for the real economy. Hoover allowed large banks (in New York and Detroit) to fail, wiping out their depositors’ money and sparking a run on the entire financial system. Under Hoover, M2 shrank by something like a third, bringing prices down with it (M2 x velocity = price level x GDP). M2 goes down, NGDP goes down. This is not negotiable.

This carnage was brought to an end by FDR, who (1) ended the deflationary fetish of the "gold drain" so that the Fed could focus on credit growth; and (2) ended bank runs with the bank holiday and deposit insurance.

Other than the US, there is no major country on earth which has allowed a major financial institution to default on its debts. Ireland is now spending over a third of its GDP bailing out its banks (some of whom one might not have thought were TBTF).

I do not believe that the Constitution or sound policy allows the federal government to regulate chickens, eggs, toys, cigarettes, gas mileage, wages, prices, light bulbs, shower heads or toilets. 

But because the government must protect and maintain financial stability, it must regulate the financial system and do whatever is necessary to maintain stability, including bailouts. (Which is why it must regulate banks and TBTF nonbanks.)
In a bailout, shareholders must lose everything, and management must be fired. But creditors (esp. depositors) must be protected. There is no alternative.

So my answer to Dan’s query is that rational libertarianism presumes the existence of a powerful state which can defend its legitimate (but limited) interests.

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