Scott Sumner  

Don't solve problems, stop causing them

Prices on everything, please... Don't Confuse Government Suppo...

Given that I share the same utilitarian value system of many progressives, you might expect me to also be a progressive. If I had to provide a one sentence explanation of why I am not, I might use the title of this post.

When there is a crisis, progressives have a knee-jerk reaction to look for government solutions instead of:

1. Looking for ways the government caused the crisis
2. Considering whether the cure is worse than the disease

The latter might apply to the example of 9/11, which led to the TSA. I've read that air travel this summer will be a nightmare due to TSA incompetence. But we had to "do something" after 9/11, and hence chose to ignore overwhelming international evidence that private airport security is superior to government security.

Another example might be the Enron bankruptcy, which led to a Sarbanes-Oxley monstrosity that causes far more damage than a dozen Enron scandals.

Today, I'd like to focus on the first case, how government creates problems and then progressives enact legislation that makes the problem even worse.

Between the two World Wars, the US experienced three major bouts of falling NGDP (1920-21, 1929-33) and 1937-38). The most severe case (by far) led to a major banking crisis in 1931-33, mostly involving small rural banks. (A similar 50% drop in NGDP today would completely destroy our banking system.) Since World War II, we've had two much less severe cases of plunging NGDP growth. Both were associated with severe banking problems and both led to expensive taxpayer bailouts.

There are lots of aspects of this picture that need to be examined, and we should always be skeptical of monocausal explanations. One important aspect is the history of American banking regulation. Restrictions on bank branching led to the creation of thousand of small independent banks in the US, as compared to about a dozen nationwide banks in Canada. The lack of diversification in the US banking system helps to explain why we've had many banking crisis in the past 100 years, while Canada has not had any.

But that's only part of the story. After the 1933 banking crisis, FDR and Congress proposed two very different solutions. FDR wanted reflation, and Congress wanted deposit insurance. In respect, reflation was the right solution and FDIC merely made the US banking system even more unstable. In my view, FDIC largely caused the banking crises of the 1980s, and 2008.

To understand the problem with FDIC, consider the incentives facing the Atlanta branch of a giant nationwide bank, such as Bank of America. They could roll the dice with some high risk, high reward loans to real estate developers, but if things went bad they would end up hurting Bank of America, including all the various branches around the country that were not involved in lending to Atlanta developers. In contrast, a small Atlanta bank that ran the same risks would off-load much of the downside risk onto FDIC (and hence ultimately onto the taxpayers). The moral hazard problem is much worse for small banks than big banks.

Now we can see the Canadian system actually had two distinct advantages. The big banks were more diversified, and they also had less incentive to take socially unproductive risks in lending to developers.

Many people think that the 2008 banking crisis was all about subprime mortgages. This is not true; the 2008 crisis was very similar to the 1980s crisis, most bank failures were caused by reckless lending to real estate developers in Sunbelt states, as well as a few northern states such as Illinois.

Very few people realize how profoundly FDIC has distorted the political incentives in the US. Because the risk of lending to real estate developers has been partially offloaded to the federal taxpayers, states like Georgia have a powerful incentive to create a very pro-moral hazard financial system. Real estate development benefits almost everyone---construction companies and workers, realtors, appraisers, homebuyers, local banks, local governments, etc.

Think of the Sunbelt as like the PIIGS in the eurozone. And think of my state of Massachusetts as being like Germany. We have lots of high saving affluent households, but not much population growth. FDIC allows reckless Georgia banks to attract these savings, at very low cost (which does not reflect that actual risk to society). Neil Wallace once said something to the effect that, due to moral hazard, any bank CEO who is not taking socially excessive risks is not acting in the interest of his shareholders.

I've been telling this story since the 1980s S&L crisis, but I haven't had much success convincing anyone. Even I would admit that the 2008 crisis didn't really look like a FDIC story, at least at first glance. It looked like a real estate "bubble" and lots of stupid borrowers and lenders, including the big banks. But as more time went by, things came into clearer focus. Ultimately the big banks paid off the TARP loans. Their losses were not offloaded to the taxpayers. In contrast, taxpayers had to spend over $100 billion bailing out the depositors of those high-risk smaller banks that had lent money to real state developers, just as they did in the 1980s. BTW, FDIC fees are a tax on depositors of all banks, even banks in safe areas like Massachusetts. Some commenters wrongly think FDIC is some sort of private company, and the fees are not a tax. They are a tax on bank consumers.

Tyler Cowen recently linked to a study by Charles Calomiris and Matthew Jaremski, which reaches similar conclusions:

Economic theories posit that bank liability insurance is designed as serving the public interest by mitigating systemic risk in the banking system through liquidity risk reduction. Political theories see liability insurance as serving the private interests of banks, bank borrowers, and depositors, potentially at the expense of the public interest. Empirical evidence - both historical and contemporary - supports the private-interest approach as liability insurance generally has been associated with increases, rather than decreases, in systemic risk. Exceptions to this rule are rare, and reflect design features that prevent moral hazard and adverse selection. Prudential regulation of insured banks has generally not been a very effective tool in limiting the systemic risk increases associated with liability insurance. This likely reflects purposeful failures in regulation; if liability insurance is motivated by private interests, then there would be little point to removing the subsidies it creates through strict regulation. That same logic explains why more effective policies for addressing systemic risk are not employed in place of liability insurance. The politics of liability insurance also should not be construed narrowly to encompass only the vested interests of bankers. Indeed, in many countries, it has been installed as a pass-through subsidy targeted to particular classes of bank borrowers.
Here's how government should react to disasters:

1. First, do no harm.
2. Look for regulations that contributed to the disaster and gradually dismantle them.
3. Only add regulation when there is a strong theoretical presumption of market failure, due to problems such as monopoly or externalities.

The government did not follow any of those three rules in setting up FDIC, the TSA, Sarbanes-Oxley, Dodd-Frank, or numerous other responses to crises.

And now the government is responding to the inequality "crisis" with minimum wage laws and taxes on capital, instead of the more theoretically justified low wage subsidies and progressive consumption taxes. But even before doing those things, we should first eliminate government policies that create inequality, such as use of hedge funds by government pensions, or excessively generous intellectual property rights, or restrictions on entry into law and medicine, or 1000 other regulations that increase inequality.

That's why I'm not a progressive.

PS. FDIC is only one of the ways that we encourage excessive debt. Our tax system also encourages debt financing and discourages equity financing.

PPS. Is our massively distorted economic system that favors reckless lending to real estate developers likely to be remedied by a real estate developer turned politician who drove four real estate development firms into bankruptcy, and has this to say about debt:

Don't forget, I'm the king of debt. I love debt.
Just asking.

PPPS. Why are so many southern politicians much more outraged by welfare going to poor minorities, than subsidies to real estate developers? Tribalism.

Comments and Sharing

COMMENTS (18 to date)
Kevin Erdmann writes:

Don't forget about restricted entry into entire cities. Look at the two income distribution graphs here. One is zip codes in the housing restricted cities. One is zip codes everywhere else. Outside 5 metro areas, we are living in a workers paradise.

Scott Sumner writes:

Kevin, Very interesting post. Good graphs.

Here's an ungated paper by Calomiris and Stephen Haber (the co-authors of 'Fragile By Design') on the history of the Glass-Steagall legislation;

Kevin Erdmann writes:

Thanks Patrick. Great short read.

EB writes:

Scott, I agree with you 150%. Yes, I'm ready to argue that the Fed should be closed to stop causing problems.

michael pettengill writes:
FDIC is only one of the ways that we encourage excessive debt. Our tax system also encourages debt financing and discourages equity financing.

How did FDIC cause money market funds to fuel the subprime mortgage aka not-conforming-to-GSE-mortgage-standards?

And is price a better indicator of price than labor cost value?

Ie, if hedge funds borrow money market funds to leverage capital to speculate in real estate based on prices significantly exceeding labor cost value, is that government manipulation of the mortgage market to get 80% of assessed value of 110% of labor cost GSE debt created that exceeds the true value that is five years later 90% of labor cost value due to money market funds refusing to back mortgage originations and debt creating an illiquid real estate market?

And given FDIC and FNMA were created in 1933 and 1935, why did it take until the 80s before they caused debt fueled real estate instead of equity financing?

And I talked with my FDIC banker in the 90s about borrowing money using my 70% home equity, and he said the bank didn't refinance mortgages - I can't remember how long before it became BofA but I asked a bank officer the same question in passing in the 00s when I had 95% equity, and the answer was the same. Yet I got calls almost daily to refi from mortgage brokers during those years.

The predecessor to BofA did offer me mortgages without too much hassle, the first in 1980 when two of us had 25% equity plus 18% interest debt service and taxes was only 30% of our income, and then in 1986 when he eagerly offered a non-conforming loan so I didn't need to put in $65,000, 35% for a 8% mortgage.

Bottom line, I can't understand how FDIC beginning in 1933 caused the change from equity finance to debt finance when FDIC banks effectively reduced or stopped a half century of equity backed debt for real estate in a transition beginning with the election of Reagan. The low equity debt finance was done by non-FDIC shadow banks.

And the tax benefits of interest deductions are far less than before 1980 thanks to Reagan et al tax reform, so shouldn't that have reduced debt real estate finance since 1980?

Scott Sumner writes:

Thanks Patrick.

Michael, You asked:

"How did FDIC cause money market funds to fuel the subprime mortgage aka not-conforming-to-GSE-mortgage-standards?"

I'm not sure they did. As I indicated, subprime mortgages were not the biggest problem, it was loans to developers that went bad. Loans made with FDIC-insured funds.

If people or institutions lose money on investments made with non-taxpayer insured funds, that's not a public policy issue. It's only a problem for taxpayers when there are taxpayer bailouts.

You asked:

"And given FDIC and FNMA were created in 1933 and 1935, why did it take until the 80s before they caused debt fueled real estate instead of equity financing?"

There was lots of debt before the 1980s, the problem was that NGDP growth plunged in 1982, and this put banks under tremendous stress. Ditto for 2008. Financial crises tend to occur when NGDP growth plunges, although the underlying problem had been there for decades. It was easy to repay debt during the Great Inflation, for obvious reasons.

As far as your other questions, one additional factor is that the power of special interest groups continually pushed regulators to make it easier and easier to borrow money. To the political establishment, moral hazard is a feature, not a bug.

Kevin Erdmann writes:

Real home prices declined in the early 80s and early 90s by about the same percentage as they did in the 2000s. The difference was that inflation was a bit higher, so aggregate nominal home prices didn't have to decline, and thus there weren't self-perpetuating default crises associated with those periods.

There used to be a time when populists like William Jennings Bryan wanted to get after the banks by repaying loans with inflated dollars. This isn't good enough today. We want to see blood in the streets. Nothing but defaults will do. So we made that happen and then we all patted ourselves on the back for doing what needed to be done. That showed us. Homebuyers and lenders needed to learn that we were willing to force them to learn that we were willing to force them to learn that.....

The worst part is that there aren't more bankers in jail for not having the foresight to know that we were willing to destroy their collateral for the sake of teaching them a lesson.

It has occurred to me that this whole episode is really like those moral panics about Satanists in the woods or child molesters in the daycare centers.

pgbh writes:

"Restrictions on bank branching led to the creation of thousand of small independent banks in the US, as compared to about a dozen nationwide banks in Canada. The lack of diversification in the US banking system helps to explain why we've had many banking crisis in the past 100 years, while Canada has not had any."

I don't get this. The US has more banks than Canada, so we are less diversified?

Peter Gerdes writes:

The claim that progressives look for government solutions while ignoring the problems of government action is only true in certain arenas.

Progressives look for government solutions in matters like:

  • economic welfare/fairness
  • social/education/etc.. equality
  • health provision and education

However the situation suddenly reverses in matters like:

  • Moral turpitude/social norms (naked people, porn, sexual relations etc..)
  • Religious observance and respect (blue laws)
  • Potentially self-harmful behavior (drug taking, non-vaccine taking)
  • Rude/offensive/adult speech (at least until very recently)
  • Respect for authorities (following police orders, mandated government access etc..)

Here it is the progressive who says "sure porn may be filthy, respectful language desirable, and drug use unfortunate, and it's usually good when people help the police but the harms of government enforcement far outweigh the benefits.


The impression that progressives are pro-intervention and blind to it's costs is merely a consequence of the huge success of the progressive agenda in the modern western state

If you go back a 100+ years or travel to less developed areas of the world the pattern looks exactly the opposite. There are no massive agencies to manage economic and social fairness, little government provided aid, education or healthcare. However, the rules enforcing religious observation, sexual purity, drug use and foul language are a huge factor in people's lives (especially outside of the cities) and violating these rules can get you severely punished or killed.

If you didn't live in a modern western state it would be the progressives who always seemed to be warning about the unintended consequences and overreach

Brandon Berg writes:

pgbh: I think what he means is that there is less diversification in the portfolios of individual banks. Large banks are likely to have highly diversified positions, whereas small local banks are not, and are likely to be overexposed to local market conditions.

AS writes:

As long as there is a government with the power to pass harmful legislation, it will pass harmful legislation. Only by dismantling the government itself will you get rid of harmful legislation. Simply wishing away the symptoms without addressing the root cause will not make an impact.

Benjamin Cole writes:

This post is confused on a couple issues.

1. There is moral hazard if shareholders are wiped out in a bank failure. There should be a board of directors representing shareholders, who do not want the S&L or bank to fail. The fact that depositors are protected seems besides the point, and perhaps even preferable. We might see big-time disintermediation without the FDIC. Of course, we are seeing disintermediation anyway since cash in circulation is exploding.

2. Unfortunately, to date, the Fed has not embraced helicopter drops or money financed fiscal programs. Ergo, the way money enters our economy is through real estate lending, since the vast bulk of commercial bank lending is on real estate. If one believes that real estate lending is reckless, then one should be very open-minded towards helicopter drops.


Alex Godofsky writes:

Scott, I find that this is one of the rare cases where I disagree with you, regarding the FDIC.

The way I see it is,
1. We think money that is immune to runs is valuable.
2. The government is really the only thing that can manufacture such money.
3. The government *could* just print the money and have it backed by the implicit taxing power, OR
4. The government could license a bunch of institutions to make the money, back it with real investments, and then regulate those investments to try to minimize the subsidy.

The second option obviously has the problem that regulation is imperfect, etc. but it has the advantage of a larger capital stock*.

*if instead the government printed the money by purchasing Treasurys then sure, that would cause portfolios to rebalance into private investments too... but Treasurys are also valuable financial instruments the financial system has difficulty replicating, so there's also a cost to reducing their stock.

I think this is probably good!

Similarly, in healthcare I believe you don't actually want a pure laissez-faire system, (if I recall correctly) you've endorsed things like "Obamacare, but only for catastrophic insurance" and similar. These also involve regulation, but they try to minimize the distortion of the regulation while achieving the public policy goal, and maximize the use of markets.

Kevin Erdmann writes:

Alex said: "*if instead the government printed the money by purchasing Treasurys then sure, that would cause portfolios to rebalance into private investments too... but Treasurys are also valuable financial instruments the financial system has difficulty replicating, so there's also a cost to reducing their stock."

Isn't the stock of treasuries whatever the government wants it to be, regardless of how many are owned by the Fed?

Lorenzo from Oz writes:

So, how many problems does the EU have to cause before we look at it as, well, problematic? :)

BTW, have you seen this?

Michael Savage writes:

I see FDIC incentives differently. They insure depositors, not banks. If the bank fails, the decision makers' losses are unchanged, in terms of career and reputation, plus equity losses.

I think the 'moral hazard' of bailouts is generally misunderstood. Beneficiaries are bank creditors, not banks directly. Maybe it encourages more reckless lending *to* banks, permitting banks to take more risk. But there are reasons to doubt this. Equity investors were keen for banks to take more risk. Retail depositors typically don't think much about credit risk. And wholesale depositors who aren't covered by insurance were also happy to deposit with risky banks in run-up to crash.

Bill Woolsey writes:

The moral hazard created by Depositor Insurance is that depositors recklessly put their money in banks with minimal capital. Since depositors do this, any bank that doesn't leverage massively is not maximizing shareholder value.

Once a bank is highly leveraged, then taking high risks is profit maximizing. Most of the gain goes to shareholders while most of any losses go to depositors (or, rather, FDIC.)

But then when these rents are competed away, the result is that depositors get the benefit and the cost goes to FDIC. Depositors get a high guaranteed return because the banks are taking high risks. And yes, stockholders do lose everything in bankruptcy.

This makes it difficult for a bank to operate safely. It must keep low capital and take high risk to get a normal return for stockholders while paying high returns to depositors who bear no risk.

I think the problem with some of these comments is that reckless behavior by depositors is taken for granted and perhaps even valued.

Also, FDIC is only the most explicit generator of moral hazard. Ad-hoc bailouts of bank creditors can have the same effect. Oh, and when expected bailouts don't materialize, we can see runs out of what were thought to be protected instruments.

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