Arnold Kling  

Peltzman on the Financial Crisis

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Last night, I heard Sam Peltzman talk on the financial crisis. He is known for the Peltzman effect, in which safety regulations (in cars for example) induce offsetting behaviors that increase risk. He described the history of financial regulation in terms of Peltzman effects. I think there is a lot of similarity with my chess game analogy.

Peltzman made a distinction between safety and soundness regulation and what he called operational regulation. I made a similar distinction in Not What They Had in Mind, but what he called operational regulation I called regulation of competitive boundaries. Peltzman emphasized, as I did not, that safety and soundness regulation actually got tougher over the past twenty years. Capital rules were tightened. The FIDICIA act gave the government the power to shut down banks before they became insolvent, when they fell below minimum capital standards. So we did not deregulate financial safety over the past twenty years.

Speaking of FIDICIA, Peltzman thinks that it should have been invoked to shut down Citibank and B of A in 2008. He also thinks that letting Lehman fail was not a mistake. He said, "But I'm just one little guy." That is how I feel--the ruling class has rallied around the bailouts and around the view that the Lehman failure was a mistake. Peltzman pointed out that because the Lehman failure is being described as a mistake in the standard narrative, the philosophy of bailouts is hard-wired into the thinking of future policy makers, regardless of what might be claimed about the new financial regulation law.

I am thinking of shaping my panel appearance at the same conference around my thesis that the insider-outsider distinction explains more of the political economy of financial bailouts and regulation than does the left-right distinction.

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COMMENTS (3 to date)
Ted writes:

The Peltzman Effect is nearly impossible to verify with any consistency or rigor so I'm not particularly interested in it.

We can debate whether FIDICIA could have safely shut down B of A (unlikely), but I can guarantee it couldn't touch Citigroup. Too many of its deposits and assets are held overseas (over 60% of it's deposits). If we tried to do anything to Citigroup, bankruptcy proceedings would happen in their subsidiary countries and the whole thing would be governed by various outdated international agreements that nobody really understands. It would have been an unthinkable mess.

mulp writes:

Should the money market funds been left to deal with their increasing insolvency as "depositors" began withdrawing their "deposits" for fear the funds were insolvent?

The Treasury, Fed, and the FDIC bailed out the money market funds in a way that assures "depositors" in money market funds that their "deposits" are protected by the full faith and credit of the Federal government, and all without the cost of paying deposit insurance the way one is forced to do in one form or another with a FDIC depository institution.

The high level of bailout of the money market funds has not been reported as far as I can tell. The degree to which probably a hundred million Americans depend on money market funds to be exactly the same as a FDIC bank savings account or in some cases, checking account, was anticipated by those opposed to allowing the existence of the very money market fund that failed to meet the requirements of a deposit institution.

I'm old enough to remember the public debate, and the arguments against allowing on demand withdrawals. As I recall, the initial concession was to allow a withdrawal by transfer to occur with a three day delay, but within a few years, one check a month was allowed. Now you can find money market funds that have better terms than major banks offer for checking accounts. As I understand history, money market funds have the same rules as savings and checking accounts in US banks in the 19th century.

Rebecca Burlingame writes:

In your chess game analogy, I particularly noted the need to change incentives so that the system is not constantly gamed. The same is true for countless laws which once served a purpose and now only create more injustice because they are used in ways that have nothing to do with their original intent.

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