For Future Reference

Milton Friedman used to say that the businessman supports free markets EXCEPT for his particular industry. His industry is important or special for reason X, and must be protected in some way or receive special treatment/aid from the government.

I may have commented on this before on this blog, but I think it's relevant to this post too: do economists think the financial sector is special because it is "our industry"?

Like many economists, I believe the financial sector has some special properties. Grad students like me were fed a steady diet of papers making this case. Bernanke himself has written several of them.

Since the bailouts I have been asking myself: is the financial sector REALLY special (i.e. special enough for this or even a moderate level of government intervention), or are we somehow dubiously convinced?

What's weird about finance is that banks are like nodes in a network. If one goes down and the network is sufficiently big enough, the payments system can quickly bypass the dead node and the real economy is relatively unaffected.

But if the node coveys a lot of information (i.e. payments and counterparty transactions) or lots of nodes similarly located, then a wipeout can disrupt the payments systems sufficiently to disrupt the real economy. The suddenous of it happening doesn't allow enough time for participants to substitute away. The leverage of these institutions means that death is sudden, not a long forseen event like GM.

Also, financial instituations, especially banks, are holding wealth, not providing consumption goods. Thus, when they fail, the externalities are quite different than if GM fails. Losing the opportunity to buy a GM car is not a big deal. To lose $100,000 in a bank account or $10,000,000 on a swap transaction is another thing.

I know I keep recommending him, but I think you'll truly enjoy Michael Lewis's new article at Portfolio magazine.

http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom#page9

As much as I enjoy Megan McArdle, she seems more like a village gossip when compared to Lewis.

This is a very erudite obvservation.

I would say telecommunications, specifically the Internet, is more tightly coupled than finance and affects more other industries (or if it doesn't now, it will in a decade).

I'm not sure weird is the right term. How about "Banks and Finance are part of the financial infrastructure that allow businesses to function. We bail them out the same way we would bail out the electricity business if it were failing."

Megan does identify the upcoming dilemma, though: At some point a line will be drawn, and an industry that employs thousands of people Will NOT be bailed out, and there will be political winners and losers in the bailout game. If needed, would the tobacco or firearms industries get bailout money? Probably not, much to North Carolina and Connecticut's chagrin.

And while we're at it, what about the United States Postal Service? They are poised to lay off a significant portion of their (unionized) work force and perform forced buyouts of senior employees. Should they get a bailout? I would argue that yes they should, and it can be performed fairly innocuously, without really delving in to the bailout money, and in a way that would be as fair to competitors as, say, bailing out the makers of the Hummer and the 2009 Dodge Challenger, which probably gets 12 MPG.

Is finance special? Maybe. But even if it is, that only matters if the whole industry, rather than just some individual players within it, were going under. Many banks are not in trouble, and would take market share from the weak giants if only those giants weren't being heavily subsidized by the Fed and the Treasury.