Arnold Kling  

Too Many Bad Banks to Fail?

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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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The author at PrestoPundit in a related article titled HOW DUMB ARE TYLER COWEN AND PAUL KRUGMAN? writes:
    When it comes to Hayekian econ and macroeconomics, the answer is very, very dumb.  This is an excellent article, and I recommend you read the whole thing.The fallacies of Cowen and Krugman are of the most basic sort -- errors... [Tracked on October 20, 2008 1:16 PM]
COMMENTS (5 to date)
Steve Sailer writes:

Good analysis.

You can add to that a failed human capital policy. Considering a large majority of the defaulted mortgage dollars are in just four states -- California, Nevada, Arizona, and Florida -- it's clear that importing millions of blue collar workers at the same time we were exporting factory jobs to China meant that there was nothing for them to do except build houses, houses that they could never earn enough to pay for, and whose presence made the neighborhoods decline in value.

If we had wanted to import millions of under-educated blue collar workers, we should have kept up tariffs to provide factory jobs for the newcomers. At least that policy would have a certain amount of logic behind it.

Methinks writes:

I have the hearings on right now. Bernanke read his testimony and is now responding to questions. Is it me or is everybody trying to re-inflate this housing bubble? If we successfully inflate some bubble (maybe it'll be a different bubble - this one is going to be hard to re-inflate), don't we risk a worse crash next time?

El Presidente writes:

I agree with you in sentiment. But I can't get over the idea that consumers do not readily distinguish between closing 25% of the banks and loss of their own personal wealth. Do we know how many banks are potentially in trouble? Would existing banks be able to discriminate and effectively close shaky banks out of the lending loop if it was easy to determine which ones were good and which were not? If even 10% of banks were shuttered, consumers would recoil in fear. Shutting them down one at a time might help. That way it would be a slow bleed and people would have time to adjust to the concept of banks closing while not destroying their wealth.

My fear is that an anxious public would create unnecessary collateral damage in response to such a move. How would you address that? Oh, wait. I know. You'd let the market fix it.

E. Barandiaran writes:

Arnold,
You're closer to be righ than Tyler, but still far away. Please read again Anna's interview: she doesn't say that problem banks have to be shut down. Her support of the initial Paulson-Bernanke plan is based on the same idea that I have been suggesting in comments to your posts for the past four weeks: define the terms and conditions of the purchase of assets in such a way that problem banks--and only problem banks--have an incentive to participate in the plan.

AJ writes:

Brilliant analogy to Japan mfg export sector (wish I'd thought of that!). Is there any academic or informative article somewhere making this comparison or is there some article documenting the amount of housing mortgage repackaging industry that is oversized and needs to contract?

Allen

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