Tyler Cowen has a new variation of the too-big-to-fail story. He quotes Anna Schwartz to the effect that insolvent banks need to be shut down. Tyler replies
This is almost certainly true if the number of "problem banks" is sufficiently small. It works less well if the number of problem banks is very large.
I disagree with Tyler on this. To me, the more potential problem banks there are, the higher should be the priority of shutting down weak banks.
Suppose you have a banking system that consists of 100 banks, and only 25 are healthy. Policy (a) is to try to stabilize all 100 banks. Policy (b) is to close the bottom 25 banks as soon as possible.
It seems to me that under policy (b), the middle 50 banks may be able to survive, with fewer competitors and lower risk premium on inter-bank lending. Under policy (a), all the banks survive for a while, but every bank becomes fundamentally weaker as a result.
Tyler's assessment of current policy is that it is a reasonable response to a potential catastrophe in the banking system. My assessment is that it is an attempt, as in Japan in the 1990's, to prop up a failed industrial policy. In the U.S., the locus of industrial policy has been the housing and mortgage industries. In Japan, it was the manufacturing export sector and an inefficient domestic retail sector. In both Japan and the U.S., the financial sector was used as a government tool to sustain the industrial policy. In both countries, the refusal to back out of the failed industrial policy is a recipe for stagnation.
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