The important point is that, to the extent the market-centered credit system is here to stay, the institutions that support the liquidity of that market system are also here to stay. Even more, to that extent we should view those institutions as essential to the operation of our credit system. The problem is not, as KC would have it, how to keep those institutions out of the safety net but rather how to bring them in explicitly, along with a reformed system of regulation and supervision that ensures their safety and soundness.
Pointer from Mark Thoma. KC refers to two officials from the Kansas City Fed, who argue against providing a government backstop for repo-based finance. Mehrling is in favor of such a backstop.
One problem with government providing guarantees to financial firms is that it gets really ugly when you have to make good. For example, on Greece, Michael Hudson writes,
The crisis for Greece - as for Iceland, Ireland and debt-plagued economies capped by the United States - is occurring as bank lobbyists demand that "taxpayers" pay for the bailouts of bad speculations and government debts stemming largely from tax cuts for the rich and for real estate, shifting the fiscal burden as well as the debt burden onto labor and industry. The financial sector's growing power to achieve this tax favoritism is crippling economies, driving them further into reliance on yet more debt financing to remain solvent. Aid is conditional upon recipient countries reducing their wage levels ("internal devaluation") and selling off public enterprises.
Since 2008, one key source of divergent views has been on the size of the financial sector. If you think that as of early 2008 the financial sector was the right size, then you want to try to restore it. That puts you in Merhling's camp. If you think that as of early 2008 the financial sector was too big, then you want to trim back government support and let it shrink. That is where I stand. Note that this is one issue that does not break clearly on ideological lines.
My basic thinking is that all of us would love to hold short-term, riskless assets and to issue long-term, risky liabilities. Obviously, we cannot all do that. We can get somewhere by undertaking diversification and by developing specialized knowledge about asset behavior. The financial sector tends to specialize in doing these things, so that what we tend to see is individuals enjoying balance sheets with riskless assets and risky liabilities, while financial institutions have the reverse. Up to a point, this is ok. But it can easily get carried too far, as people develop overconfidence in the financial sector. The financial sector profits from our overconfidence, so banks naturally think that it is the job of government to maintain confidence in banks. Politicians do not want confidence in banks to suffer on their watch. All of this creates a very troublesome dynamic.
While it works, having a large financial sector feels great. We in the nonfinancial sector get to issue lots of risky liabilities and hold what appear to be low-risk assets. However, when things crash, things do not feel so great.
My problem with the large financial sector is the inevitable cozy relationship between banks and government. Michael Hudson, quoted above, takes a left-populist stance against banks. He takes a simplistic view of the problem, thinking that banks are bad and government is good. In my view, the cozy relationship between government and big banks has a natural logic. You have to worry about it at all times, not just wait until the crisis comes.