Arnold Kling  

Government and the Financial Sector

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Perry Mehrling writes,

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.

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COMMENTS (9 to date)
effem writes:

Shouldn't the price of long-term risky assets just fall to the point where society is indifferent? It seems to me that banks - as a result of having a govt guarantee - are able to extract a "free lunch" by underpaying for long-term risky assets relative to the true market clearing price.

effem writes:

overpaying, not underpaying

R Richard Schweitzer writes:

As my Evidence Prof would say (back in '51):

"Lez med'tate bout dat."

What are the functions of government - at the various levels, of course.

Which "function of government" encompasses the above proposed activities?

Lez med-tate bout dat!

Costard writes:

The curious thing is that we cannot even agree upon the problem, much less the solution. Merhling believes the system has not gone far enough; Hudson that the system is unfair; and you (and myself) that it is inefficient and distorts risk.

Ideology becomes manifest in terms of what we see as important, and what unimportant. Hudson calls the situation in Greece a regressive tax and condemns it, notwithstanding the fact that entitlements and progressive social policy were bought largely on the back of the easy credit now being paid for. If the loss of credit is hurting wages, then the (unwise) issuance of that credit must have sustained them. Gravity also is unjust if one believes that men should fly, but nevertheless Greece is falling, and from such a height that the extent to which the EU weighs them down, is irrelevant to the final outcome.

Merhling argues precisely the opposite. Federal absorption of risk will maintain for us all of the great benefits of our profligacy. Debt is risen to historic levels, finance is unhealthy large, already we have become economically dependent upon an irresponsible and unaccountable organ. We are all aware of the imbalance; we recognize that someone who bets the house after losing the car, has lost reason and clings to hope; so what does this argument appeal to other than fear, or a misplaced faith in regulators who, like generals, always fight the previous battle?

On the other hand if we agree that risk is risk, and not merely a trojan horse in the struggle between ideologies and classes, it becomes immediately obvious what sort of system will function best and most justly. Namely one in which risk and reward fall together, and we do not by laws or regulation divorce effect from cause.

Jameson Burt writes:

Over 75 years, won't most banks enter bankruptcy?
They might
1. Pay 3% interest, charge 7% interest,
then see 1980 where they must pay 15% interest.
2. The assets underlying their loans bubble
as in 2008.
3. ...
Fanny Mae and Freddie Mac absorb some fluctuations,
otherwise banks wouldn't make 30 year loans.
Unlike casinos, banks can't guarantee that
each loan over its lifetime has an expected gain.
Volatility enters a very small chance each year
that the bank will fail, but 75 years of very small chances guarantees failure.

So, over many years banks will necessarily present failures.
We shouldn't usually punish frugal banks
with complete failure and ensuing
bankruptcy that spreads throughout the economy.
Our nation's final score, our GDP,
at least occasionally gets improved not with
government foresight (which itself must be approached although its economics can't be omniscient), but with government somehow handling the failure.

Banks and government must work together,
with banks having no historical basis to request
freedom from government regulation.
Oh wait, they do have one basis
-- free from government regulation,
banking executives but not their stockholders
can expect more income.

Kyle writes:

Let me ask the same thing I ask everyone who tells me the financial sector is too big: how big should it be? 1% of the economy? 3%? 5%? How will you know you're right, and how will you make it so? Ask the government for help?

How about this instead: the financial sector should be as big as the market demands of it, and the government should be held to a standard that avoids a cozy relationship between them. If such an arrangement is impossible then let's just kiss libertarianism goodbye, because what's the point?

Matt C writes:

The paragraph that starts "My basic thinking . . . " is excellent.

Kyle, maybe a benefit of saying "the financial sector is too big" is communicating an idea to people who would otherwise be incapable of considering "letting banks fail".

I'm sure Arnold doesn't want to prescribe or even guess at a precise size, but I bet you and me and he can all agree that the financial sector would be smaller today had the cozy relationships you talk about not been in place 3 years ago.

Kyle writes:

Thanks for the discussion Matt C,

Regulatory capture does serve to bolster big banks, but it also squeezes out competition. It could be that without the “cozy relationship” between the banks and the government, the financial sector would have been smaller over the past two decades. It could also be that with a more honest government with smarter regulations, we could have seen an even bigger growth in the sector, with less damaging effects, as more companies and governments worldwide chose to do business here. There are other possibilities, too. I don’t know what would have happened, and I argue Arnold doesn’t either.

So Arnold has made an estimate of how big the financial sector should have been in early 2008. But how did he draw the line – the one that says no sector should EVER be bigger than THIS? My argument is that someone of the free market persuasion doesn’t typically draw one. I could be wrong though, and would like to hear more.

Matt C writes:

I see our financial system as deeply intertwined with the state, to the point where we can only guess wildly what a modern free market version would look like. (I actually suspect that a non-dirigiste financial sector is impossible for now.)

Of course we can't disprove that a somewhat freer financial sector, dating back some distance in time, might not have ended up bigger. But what we have seen in reality is massive flows of money from the state to the financial sector, and the repeated rescuing of that sector from financial disasters.

Again, I don't think Arnold is prescribing that no sector should ever be bigger than "this" under *any* imaginable circumstances--just that what *did* happen has led to a sector that is bloated and living at the expense of more productive possibilities. To some extent it is an assertion that you feel is plausible or not. I would say the same thing about the health care sector and the education sector, too, for similar reasons.

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