Arnold Kling  

Regulation and the Second Best

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Scott Sumner writes,


I resent my tax money insuring banks that make sub-prime mortgage loans, or risky construction loans. I'd like to ban FDIC-insured banks from making housing loans with less than at least 20% down. I am not opposed to allowing sub-prime loans, just not with FDIC-insured money. If some unregulated financial intermediary wants to make such loans, that's fine with me.

There is a classic proposition in economics called the theory of the second best. One way to think of this theory is that it suggests that when one economic distortion exists, removing a second distortion can make the economy worse off. If the second distortion helps mitigate the first distortion, getting rid of the second distortion can be a bad idea.

I think that is what is going on in Sumner's post. He suggests that easing restrictions on banks might be a first-best policy if there were no deposit insurance. However, taking the distorted incentives of deposit insurance, easing restrictions is not a good second-best policy.

For me, it is easier to understand his argument in these terms. Instead, he tries to play with the semantics of what is "regulation" and "deregulation," and I think this is confusing.

My belief that government should break up large banks is also a second-best argument. If there were another way for government to commit credibly not to give bailouts or other political favors to large banks, I would be for that. But given that the existence of large banks is an invitation for politicians to provide them with favors, I would rather see bank size restricted.


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COMMENTS (7 to date)
Hyena writes:

Wouldn't removal of deposit insurance have monetary implications, though? To me the system is essential to a fully credible electronic currency regime. The alternative is Treasury Express cards but I don't know that those would actually be better or not carry a risk of more deeply subverting property rights.

jsalvatier writes:

This is indeed a clearer way of describing this.

Matt C writes:

The conversation about how we should or shouldn't regulate banks given that we are not going to allow them to go bankrupt if they make a bunch of bad investments crosses over into nutty for me.

Does anyone else think it is fantastical to listen to conversations about how the government will figure out ways to stop big finance from making crappy loans they know won't be paid back?

I understand that you guys, as bloggers, have to talk about this from a current policy perspective. But it is very depressing to read discussions about how we should regulate given that our finance sector will get to play "heads we win, tails the taxpayer picks up the tab". Really, I'd rather the government just nationalized them all.

Tom West writes:

If there were another way for government to commit credibly not to give bailouts or other political favors to large banks, I would be for that.

That's sort of like saying if you're going to build an explosives factory, the government's not going to pay to put out your fire.

Nice idea, but when the factory goes "boom", not only have the owners lost their equity (which they should), but the whole town in now a smoking ruin (not so good).

The reality is industries that are central to society's well-being are going to be bailed-out, which means regulation is the best way to protect ourselves.

Vincent writes:

I am not sure it matters the size of the bank or if the deposits are insured. If all the banks take similar(same) low probability high loss risks then they will all fail big or small. I think the government steps in when some large percentage of the banking industry is failing. I am doubtful that we can ever expect the government to not step in in that case so it seem that the solution is to find a way to insure diversity between banks. Maybe this is more important that diversity within a bank.

Jacob Oost writes:

Hey, I thought of the theory of the second best while vacuuming and didn't even know it was called that! Maybe I should major in economics some day....

MernaMoose writes:

But given that the existence of large banks is an invitation for politicians to provide them with favors, I would rather see bank size restricted.

Perhaps. But I would rather first see politicians better restricted, and their power diluted.

Make seats in both houses of congress appointed positions, something along the lines of jury duty. No elections for the politicians to worry about. Also they can only be in for one term and that's it. No professional politicians.

Then, increase the number of members of the House, like (picking numbers out of the air) one for every 50k people. Anyway, enough that it's going to be pretty hard for anybody to bribe the entire House of Representatives.

And then -- I don't know. In theory this minimizes prospects of corrupting the politicians (though I'm sure something else will happen). But I suspect Tom West is right about this

The reality is industries that are central to society's well-being are going to be bailed-out


If we start restricting the size of banks, why not start restricting the size of other industries? The "big is bad" idea will spread everywhere.


Somehow the cost of getting "bailed out" needs to be set high enough that people are highly motivated to avoid it.

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