Monday, September 30, 2013

Bank Bailouts Are Healthy And Necessary

As readers know, I am a Tea Party libertarian, at least up to a point. I get off the bus when it comes to monetary and financial policy. I like having a central bank, a lender of last resort, and a financial safety net. Why? Because I don't want the American people to experience another Depression.

There is strong sentiment on the Right (and the Left) to break up the big banks, and to prohibit future bank bailouts. Indeed, there is a push for a Constitutional Amendment to outlaw future financial bailouts (I haven't seen the wording). The view is that, had Paulson and Bernanke allowed Wall Street go bankrupt in October of 2008, excesses would have been squeezed out, and market discipline would have been restored. That, of course, is Mellonism.

Please note that the Great Recession was not caused by the existence of the financial safety net: it was cause by Paulson's inexplicable withdrawal of the net under Lehman. The past five years would have been quite different if the safety net did not have a Lehman-sized hole in it.

Breaking up the big banks is a stupid idea that goes in the wrong direction. Most countries have a few very large banks that are TBTF. The US is unique in that, because of prairie populism, it has thousands of small regional banks that are not TBTF, and a handful of big banks that need to be TBTF. The best run banking systems (Canada, Australia) consist of a few, well-regulated national banks that are subject to strict regulation and which are not permitted to default upon their senior debt or uninsured deposits. That is called "financial stability", which is a predicate for prosperity. (Note also that the "securities firm" is also a dangerous American invention.)

The US experimented with a fragmented banking system with no safety net for 150 years until 1934. Financial stability was not a hallmark of those 15 decades. There were decennial banking panics and decennial depressions, culminating in the Big One. Go back and read an account of the mid-1890s; it wasn't pretty unless you were rich.

Financial capitalism is prone to cycles and panics, as Hyman Minsky has shown. There is a constant repeating of the credit cycle: prosperity, overconfidence, overleverage, panic, collapse, depression, recovery. This cycle may be prophylactic in some Darwinian sense, but it creates a lot of unnecessary suffering, as well as undesirable political consequences. It cannot be legislated out of existence, and it cannot be prevented by repetition.

Market discipline doesn't work because the credit markets have a memory of at most two years. Markets do not learn. How many traders at Goldman have read Friedman's monetary history of the US? How about none. How many traders at Goldman remember LTCM? A handful at most. The Masters of the Universe tend to be about 30 years old and are lucky to remember who Bill Clinton was.

The credit market in general and the banking system in particular need to be protected from themselves. That requires three pillars:
1. High capital requirements for the systemically-significant.
2. Intrusive prudential regulation with an emphasis on risk management and risk tolerance. (London Whales should be punished.)
3. A reliable safety net, such that panics do not occur. That means no more Lehmans, not no more bailouts. It means financial stability.

Let's not relearn the lessons of the 1930s.

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