Arnold Kling  

With All Due Respect

The Political Scene... Reply to DeLong...

Tyler Cowen writes,

You might wish to go back to "old banking" but according to Gorton that stopped being profitable during the 1980s. There's always an uninsured place to put your money, regulation can't stop that, and such money can find its way back to help fund the banking system, right?

With all due respect*, one should ask why "old banking" became unprofitable in the 1980's. I would suggest that the Basel capital accords made it so, and this was a bootleggers and baptists story. The baptists were regulators who wanted to avoid another savings and loan crisis. The bootleggers were politically powerful financial firms (Freddie, Fannie, Wall Street firms, big banks) who wanted a bigger piece of the mortgage pie.

The terms under which funds enter the banking system are affected by regulation. If uninsured creditors are really wink-wink insured, then the FDIC should charge higher deposit insurance premiums on banks with lots of uninsured debt. On the other hand, if uninsured debt is really going to convert to equity if the bank falls below its capital requirements, then the only issue is to make sure that Aunt Molly does not invest her life savings in funds that hold uninsured debt.

This is where I wind up in agreement with the Baseline Scenario lefties. The core problem is to reduce the political pull of the big banks. Thus, my preferred solution is to break up the big financial institutions. Do not allow them to have any more assets than Canadian banks--in terms of absolute dollars, not in terms of ratio of assets to GDP. Then you can come up with regulations that will get the incentives right.

(*translation: Smackdown!)

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COMMENTS (4 to date)
Tyler Cowen writes:

I am "filling in" for Gorton here, but perhaps he would argue that the unregulated, run-prone sector will in general be more profitable than the regulated sector. At the margin the unregulated, run-prone sector will increase in size and scope, etc. That's not inconsistent with your Basel citation (though the timing is a bit off, given that Gorton cites the 1980s).

Gorton is very likely well aware that a smaller banking sector might be more profitable. The point still remains that the unregulated, run-prone mode of financing that sector might be more profitable yet and so we return to the basic dilemma.

So while I don't mean to endorse everything he is arguing, I'm not sure that your arguments provide a smackdown of it either. I'm not objecting to your points, but rather your view and his view (if fleshed out in more detail) don't need to be so far apart.

Doc Merlin writes:

The lesson from the late 1800's is that small banks also have extremely high political pull. Breaking up the large banks won't really fix the problem imo. The problem is a result of the power of regulators to regulate. Once that exists, politicking and corruption are inevitable.

Greg Ransom writes:

I'm with you on breaking up the banks.

Too big to fail plus hostility to anti-trust is the libertarian road to serfdom, as I said about 5 years ago.

Don't break up banks. Just end government insurance on deposits.

Banks should be in the business of matching deposits to investments that meet the risk and time preferences of the depositors.

Vault cash for the risk-averse who want the right to withdraw their cash without notice, then money-market deposits. Then, mortgage investments (not government insured) for those who want more risk and return, without the right to withdraw funds, except as the mortgages mature or pay off.

Banks make money from intermediation, but no one would deposit money into a bank that does this, without the implicit subsidy of a government guarantee to repay the deposits. Why should the government be subsidizing banks?

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