Reply to McArdle

I don’t watch much TV, just sports and bloggingheads.tv.  One of the nice things about my blog is that people who I enjoyed watching on bloggingheads (and who seemed like larger-than-life figures) now pay attention to my views.  Matt Yglesias and Megan McArdle are examples.  In this post McArdle raises several objections to my argument that moral hazard was the root cause of our financial system problems.

Scott Sumner is a very smart guy, and I quail to disagree with him, especially on macroeconomic topics.  But I’ve been mulling over this argument a lot, and I’m just not convinced.  I go to a lot of pro-market think tank events where one speaker or another blames the financial crisis and the current recession on moral hazard, as well as basically everything else that has gone wrong in the last sixty years.  I’m afraid I don’t see it.

I appreciate the compliment but I am not that smart, and no one should “quail” to disagree with me.  Indeed until a few minutes ago I didn’t even know ‘quail’ could be used as a verb.  I only seem smart because for some reason I have always had an easy time understanding the paradoxes of monetary economics.  I got Cs in French, computer science, and freshman English.

Second, I don’t believe the current recession was caused by moral hazard, I believe it was caused by tight money.  But I do think a big part of the 1980s S&L crisis was caused by banks taking advantage of brokered $100,000 deposits to engage in real estate speculation.  I do regard that as an abuse of deposit insurance. 

I consider the subprime fiasco of late 2007 to be a separate issue from the recession.  If the Fed had targeted NGDP growth at 5% then the subprime crisis would not have caused a significant recession, nor would we have seen the subsequent huge losses in non-subprime mortgages, commercial loans, and industrial loans.  The latter were mostly caused by tight money.  I probably didn’t make this point in the post McArdle read, but I have made this argument in many other posts.  And I think this distinction is also very relevant to the next point she makes:

The sticking point for me is twofold.  The first is that we had crises before there was moral hazard–really, really dreadful crises, crises far worse than the one we’re having now.  I just don’t see how you can look at the 1930s and name the FDIC as the decade’s biggest financial problem.  Or this decade’s biggest financial problem.  The closest our era came to a really devastating financial crash along the lines of the 1929-1933 period was in the total unguaranteed institutional money market funds.

I agree with the assertion that the early 1930s were far worse than the last two years.  But there is an important distinction that McArdle misses.  In the early 1930s the banks were the victims.  In 2007 banks were the villains.  Here’s why.  As of October 1930 we were already deep in depression, indeed deeper than at the low point of this cycle.  And yet there had not yet been any banking crises at all!  The banking system back then was very strong, built to withstand hurricane force winds.  Our current system is very weak.  The economy was still booming in 2007 when the sub-prime crisis blew up.  The meteorological analogy would be that this time it took just a tiny puff of wind to push the entire banking system into extreme distress.

Why the big difference?  Why were banks so much stronger back then?  My answer is that they lacked deposit insurance, so they had to instill a sense of trust in the public.  They had to behave responsibly.  This is mirrored in bank architecture, which used to be very strong and impressive looking, like Greek temples.  By the 1960s a bank branch might look like a mobile home parked next to a strip mall.  Where would you rather put your money if there was no deposit insurance?  Don’t you get a warm and cozy feeling every time you see those massive bank vault doors made out of a stainless steel in a “real” bank?

Now it is true that the pre-FDIC banking system was far from perfect.  After October 1930 we did get bank runs.  This is because in the early 1930s nominal GDP fell in half, and there were also fears of dollar devaluation.  But we might have even survived that shock without deposit insurance, except for one other problem; branching restrictions.  Canada also lacked deposit insurance, and had no bank failures during the Depression.  What explains the difference?  Canada had no branch banking restrictions, and thus their banks were diversified nationwide.  They had 11 banks, we had 20,000.  Had we also had the Canadian rules on branching, we would probably have had a few failures, due to the extraordinary fall in NGDP that no bank could have expected, but things would have been much less bad than they actually were.  Here is my claim; if you separate out macroeconomic policies and simply look at bank practices, then banks behaved far more recklessly this time around than in the 1930s.

McArdle also argues:

Nor do I find the central story of how the FDIC induced this moral hazard very compelling.  Supposedly, ordinary depositors don’t bother to check the soundness of their banks because they don’t actually have skin in the game.

Anyone making this argument cannot have met many ordinary depositors.  If you stripped away my mother’s FDIC protection, she wouldn’t do any better of a job at evaluating Citigroup’s finances.  Moreover, this theory simply cannot explain the waves of bank failures that happened before 1934–failures in which the depositors neither expected, nor received, bailouts.  Bankers still got overconfident, lent too much, and then went out of business.

I understand this argument, but disagree for two reasons.  Suppose in 1925 your local bank announced it had begun issuing mortgages to anyone who could fog a mirror.  No money down, no income verification, 30 year mortgages.  All the other banks in your state continued to make their traditional mortgages, which I believe were of just 3 to 5 years duration, and did require income and downpayments.  What would have happened?  I believe there would have been long lines of people trying to get mortgages.  But what about the depositors?  How would they have reacted to this spectacle?  My hunch is that there would have been a run on the bank.  People often tell me that the average guy doesn’t pay any attention to how well a bank is run.  That doesn’t surprise me, why should they?  McArdle’s historical accounts are more relevant, but can also be misleading.  If the market worked as I predicted, there would have been no banks making these sorts of reckless loans.  But I still think people paid some attention to a bank’s soundness when deciding where to deposit money, otherwise why would banks (which were profit making businesses) waste all that money on those reassuring Greek columns on their facade?

Furthermore, although many banks failed even before the Great Depression, they were mostly very small and the expected loss to the average depositor during any given year was exceedingly low.  I don’t recall the exact number, but far less than 1%.  Thus an individual could free ride on the market savvy of others, much as I free ride when I rush through a grocery store never looking at prices, with the confidence that sharp-eyed housewives are keeping the store prices reasonable.  Furthermore, any account written during the 1930s gave a misleading impression, as the Great Depression was far worse than other recessions.  I’m sure that in the 1930s a few banks failed that most people thought were sound.  And that must have been very bewildering.  Here’s another analogy.  I have never attended Harvard and I have never driven a BMW.  But I think I have a pretty good idea of their quality.  Markets convey the quality information consumers need in all sorts of subtle ways, and consumers do not need to be experts in order to get the quality information they need.

McArdle continues:

The other reason that I don’t find it all that compelling is that I went to business school with these people, and talked to them when they were at the banks, and the operating assumption was not that they could always get the government to bail them out if something went wrong.  The operating assumption was that they had gotten a whole lot smarter, and would not require a bailout.  Maybe this had some effect on the margin.  Maybe it even subtly percolated into prices, and thereby, everyone’s consciousness.  But that is not a big enough effect to explain the whole thing.

Here she partly anticipates my response, but not fully.  Yes, it can’t explain the “whole thing.”  The subprime fiasco was no more than about 25% of the losses.  The rest was due to tight money.  The banking industry did not expect the Fed to suddenly allow NGDP growth to fall 8% below trend.  If they had known, they never would have made all those commercial loans that went bad, moral hazard or no moral hazard.  So I agree with that part.  But not with the rest.  Much of the sub-prime lending looks excessive risky, even ex ante.  Think about all the wacky stories you heard in 2005 about anyone and everyone getting mortgages on crazy terms.  Developers in Miami.  People flipping condos.  Are those the sorts of projects that you would make direct loans to if you were offered something like a three percent rate of return?  I don’t think so.  At least I wouldn’t.  Well then why did you and I lend banks money at something like 3% (via saving and checking accounts), which was then re-loaned out in all those wacky sub-prime ventures?  Is it possible that deposit insurance might have tipped the scale, and that without it you might have moved your money elsewhere?  Remember that there are very close substitutes to bank deposits, such as mutual funds that invest in Treasury debt, and these are very safe investments.   MMMFs even offer checking services, and these are close substitutes for DDs.

At Chicago I was always taught to ignore what people are thinking, look at how they act.  I think the Chicago people overdo that argument, but I am going to apply it here.  When people enter a new environment they absorb from their surroundings “the way we do things around here.”  Both FDIC and TBTF gradually moved the financial system to a higher risk profile.  It became the new normal.  The changes were small each year (although actually pretty fast in the early 2000s) and individual participants may not have been aware of the forces pushing the entire system toward greater risk-taking.  All they knew is that banks doing things a certain way were making more money than banks that weren’t doing things a certain way, and also that if you started doing things a certain way, the depositors didn’t seem to object.  Nobody wants to envision their actions driving their firm into bankruptcy, and I accept McArdle’s observations that bankers didn’t consciously think “lets get really reckless because we can always be bailed out if necessary.”  (Indeed I am really just restating a point she acknowledged in the quotation above (about “subtle effects”), but I wanted to emphasize this point in case others missed what she was saying.)  I am 54 years old, which is too old to clearly remember my youth.  But I have vague memories of being in large groups behaving a bit recklessly and thinking to myself; “‘there are so many people here that the cops can’t arrest us all.”  You feel emboldened.  By analogy, I think some bankers got lulled into thinking “everyone’s doing it; the government can’t let the whole thing collapse.”

In the end, we probably agree more than we disagree.  I share her view that the libertarian position is often too simplistic.  Moral hazard is probably here to stay; we may have to accept a few reasonable regulations making it harder for banks to take excessive risks.

PS.  BTW, my area of expertise is macro, not banking, so I quail at the thought that these arguments might be torn to shreds.  In my post I said that my views had moved in this direction because I found an interview of Charles Calomiris to be very persuasive.  So if there are any flaws in my argument, please go after Calomiris.

Update:  I thought this comment from “Don the libertarian Democrat” was very important:

“And the evidence? A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their stress-testing practices. The first meeting of that group sticks in my mind. We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests.  A quick survey suggested these were very modest stresses. We asked why. Perhaps disaster myopia – disappointing, but perhaps unsurprising? Or network externalities – we understood how difficult these were to capture?
No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight( NB DON ). All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did banks not understand that the official sector would not underwrite banks mismanaging their risks? Yet history now tells us that the unnamed banker was spot-on. His was a brilliant articulation of the internal and external incentive problem within banks. When the big one came, his bonus went and the government duly rode to the rescue. The timeconsistency problem, and its associated negative consequences for risk management, was real ahead of crisis. Events since will have done nothing to lessen this problem, as successively larger waves of institutions have been supported by the authorities.”

WHY BANKS FAILED THE STRESS TEST
Andrew G Haldane*
Executive Director for Financial Stability
Bank of England
13 February 2009

http://www.bankofengland.co.uk/publications/speeches/2009/speech374.pdf

I find most of Haldane’s work persuasive.


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31 Responses to “Reply to McArdle”

  1. Gravatar of Jon Jon
    19. December 2009 at 17:47

    Great post Scott.

    I definitely in the minority here, but I also feel that the conduct of the FDIC during the crisis was rather bad. I’ve never managed to get my head around why the Shelia Bair is mentioned so positively in the media.

    FDIC liquidation practices could be described ad hoc at best and frankly erratic. Among the most egregious bits of conduct involving WaMu. It essentially became impossible to evaluate the worth of bank bonds as a result of the regulatory uncertainty created by the FDIC.

    Shockingly there is barely a peep about this in the press. Yet the lawsuit has gained enough traction that the price of a “worthless” WaMu preferred share has risen to $30 with brief excursions higher.

  2. Gravatar of ssumner ssumner
    19. December 2009 at 18:23

    Jon, I appreciate the comment, as you probably know much more about this that I do. I rely on my knowledge of the Depression, my casual reading of current events, and my understanding of how people determine risk and make decisions. But I admit to being less well informed on this issue than many other people.

    BTW, don’t anyone ask me what I was doing when I was young, I’ll just claim I can’t remember.

  3. Gravatar of rob rob
    19. December 2009 at 18:42

    Speaking of bank architecture, did you happen to see the new Federal Reserve building in Houston when you were here? It looks like an immense structure built out of giant Legos.

  4. Gravatar of Bill Woolsey Bill Woolsey
    19. December 2009 at 19:57

    Investment banks didn’t have deposit insurance.

    People lent to them overnight when they had very little capital. They funded portfolios of mortgage backed securities.

    Citibank is a commericial bank that funded its activities with few deposits, much less insured deposits.

    I understand that in the twenties commercial banks posted capital ratios on their doors and they were 15%. They scraped those off and put on the FDIC stickers and reduced capital to legal maximums.

    Of course, the capital ratio required for mortgate backed securities were only about 2%.

  5. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    19. December 2009 at 20:20

    “And the evidence? A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their
    stress-testing practices. The first meeting of that group sticks in my mind. We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests.
    A quick survey suggested these were very modest stresses. We asked why. Perhaps disaster myopia – disappointing, but perhaps unsurprising? Or network externalities –
    we understood how difficult these were to capture?
    No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and
    show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight( NB DON ). All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did banks not understand that the official sector would not underwrite banks mismanaging their risks? Yet history now tells us that the unnamed banker was spot-on. His was a brilliant articulation of the internal and external incentive problem within banks. When the big one came, his bonus went and the government duly rode to the rescue. The timeconsistency problem, and its associated negative consequences for risk management,
    was real ahead of crisis. Events since will have done nothing to lessen this problem, as successively larger waves of institutions have been supported by the authorities.”

    WHY BANKS FAILED THE STRESS TEST
    Andrew G Haldane*
    Executive Director for Financial Stability
    Bank of England
    13 February 2009

    http://www.bankofengland.co.uk/publications/speeches/2009/speech374.pdf

    I find most of Haldane’s work persuasive.

  6. Gravatar of Philo Philo
    19. December 2009 at 20:57

    Scott–

    Another great post (one of many). And, thank God, no philosophy!

  7. Gravatar of libfree libfree
    20. December 2009 at 06:43

    Scott-

    Good reply! I never like to be the guy in the room defending bankers, but historically we have treated banks rather badly. Sure we had massive banking panics before the FDIC but we wouldn’t let them branch and forced them to buy crappy state securities as reserves ect. ect. ect. The Bank of the United States followed by the era of “free banking” that wasn’t, and then we cleaned it up rather shoddily. I think most people’s banking history starts with the Fed. High school text books still grossly misstate the history of banking. If I have to explain “wild cat banking” one more time…..

    I think that people’s calculus changes when the rules change (incentives matter). How would we go about evaluating banks in a Non-FDIC environment? I’m not sure, but I’d probably use some measure that made sense to me. It’s something that I’ve never had to contemplate. The banks probably don’t spend a lot of time thinking about FDIC, but they don’t have to either. In a non FDIC world they would have to evaluate their decisions in regard to their reputations or they wouldn’t have a deposit base. I feel certain that a banking world without FDIC would look dramatically different then a banking world with FDIC. I’m not going to say better or worse though. I’m not proposing getting rid of the FDIC and think that there is a roll for a safety net, I just think that we should evaluate how we use that safety net and at least worry a little bit about moral hazard.

    Once again, great post and enjoyed Megan’s as well.

  8. Gravatar of StatsGuy StatsGuy
    20. December 2009 at 07:52

    Sorry, I gotta take McArdle’s side here (mostly):

    First, ditto on what Bill W. writes. Lehman, Citibank, Merryl, AIG, etc… They had giant towers of steel and glass (even more ‘burnt money’ than Greek columns). The backing of Saudi Princes (whose money was not insured). FDIC does not explain this. (TBTF, an implied backing due to size and threat to the stability of the system, _may_ explain this a little better, but even then falls short.) The shareholders were very nearly wiped out, and in WaMu, creditors too. (And neither are insured by the FDIC…).

    Add to Bill W.’s points:

    – Bank creditors are NOT insured by FDIC. CDOs are NOT insured by FDIC. Indeed, tally up the losses DUE TO FDIC to the Federal government, and the amount is low compared to the losses from other programs. Or, the loss due to ungathered taxes/social safety net overloads because of the Fed’s failures.

    Indeed, even if you project bank closures through 2013 (many of which would have been avoided by a better Fed response, just as in 1930), it’s just not that much money compared to the total cost of this mess…

    http://www.dsnews.com/articles/fdic-increases-budget-on-expectations-of-mounting-bank-failures-2009-12-17

    In short, IF IT WAS THE CASE that the FDIC moral hazard problem (as opposed to the broader TBTF problem) was so central, then we would expect FDIC losses to be rather large and immediate. But compared to the scale of the problem, they just aren’t – meanwhile, it’s quite possible that FDIC saved us from a huge disaster in 2008 (bank runs, conducted digitally…).

    – In any case, we DID get massive bank runs – but precisely by the people whose savings were NOT protected by FDIC. Notably, the shift to T-bills (with briefly negative interest rates) was largely driven by a flight to security. In the end Treasury had to offer blanket insurance to all depositors to stop it. So it didn’t seem like the lack of FDIC protection was really getting those folks to discipline the banking system as we’d expect.

    – Your discussion of banks/loans misses one of the key new dynamics in the modern finance architecture – the fact that many (most?) of the failed loans (especially in the initial portion of the crisis) were not loans made and held by the institution (“traditional” banking or “narrow” banking). They were securitized loans held _DIRECTLY by investors_. With absolutely _no FDIC guarantee_. These loans were rated by _private_ agencies. These securities were purchased because the buyers wanted “more direct exposure” to what they deemed to be high quality traunches of _collateralized_ debt instruments. They wanted more direct exposure because they believed the risk to be low, and the returns were much higher than direct bank investments. Thus, they levered themselves up to hold onto this debt _directly_, rather than investing through an FDIC insured intermediary.

    So how does FDIC insurance directly relate to CDOs? (Or CDS?) How does FDIC explain the massive shift in structure from narrow banking to securitized debt instruments (indeed, shouldn’t FDIC have pushed the system toward more narrow banking?).

    How does FDIC insurance directly relate to the single biggest catastrophe – AIG’s selling of “insurance” (read, a huge put option) on these instruments? AIG’s creditholders were not at all protected by FDIC (TBTF is another issue – but that’s about size and systemic stability, and is an argument that ‘private’ is not ‘better’ if private is too big). But they made the biggest and dumbest bets.

    And, indeed, the “markets” – AIG’s credit holders AND its share holders – all though AIG was fine right up until they got shorted into oblivion in the space of a couple weeks (including by the folks who owned AIG guarantees, such as Goldman Sachs, who had insisde information about the true extent of AIG’s CDS obligations, because they bought them).

    Having spent considerable time at Baseline Scenario, where the discussion is “Too Big To Fail” 24/7 (note that Simon Johnson was one of the questioners who received a direct Fed response, and is considered the champion of that viewpoint), I would agree with you that the entire FDIC/TBTF mess was perhaps 25% of the crisis to FDIC/TBTF. But most of it was probably TBTF, not FDIC directly. It is one of 4 or 5 factors which all aligned.

    But if you look back at the S&L crisis – the cost of that may be greater than the direct cost of this crisis to the Treasury at the end of the day (and the economy was smaller in the 80s). Yet we didn’t have a macro catastrophe.

    So, if we’re looking for differences between the 80s and now, or the 60s and now… FDIC is not the difference. TBTF (with the implicit reco that the Federal Govt. needs to break up banks) is a more complicated problem, and there are multiple versions of it – including the “political power” version as described in Simon Johnson’s famous Atlantic article…

    http://www.theatlantic.com/doc/200905/imf-advice

  9. Gravatar of Joe Joe
    20. December 2009 at 08:23

    As I said before, how does the removal of FDIC insurance provide a better platform for society as a whole? Because banks will behave better? That may have worked when people felt an obligation to the organization that they worked for, and the organization felt an obligation to the employee. Our current free agent society creates extensive asymmetry with regard to the organization as a going concern. These problems where most people in the bank do not care if the bank survives, just that they maximize their personal profit in the short run. So, i would propose that without FDIC insurance you have the same problems with risk taking. The organization as a unit that people cared about and worked for are gone. So FDIC is necessary, especially because 99% of savers/depositors do not realize they are LENDING a bank their money. It allows savings to be possible. Risk taking will occur no matter what, especially as people maximize their own short term gains at the expense of the “organizations” long term survival.

  10. Gravatar of OGT OGT
    20. December 2009 at 08:49

    Woolsey is correct neither the shadow banking industry, the guys making mortgage backed securities out of bundles of sub-prime mortgages nor investment bankers are subject to FDIC. There were certainly moral hazard problems and, more importantly, principal-agent problems, but little of it had to do with FDIC.

    I think the Fed’s lender of last resort activities have had far more to do with the increasing fragility of the financial sector than deposit insurance. The financial sector has continually innovated into new vehicles to expand liquidity, things like CD’s and REIT’s and Hedge Funds and so forth that have eventually blown up in their faces. In each case the Fed has rode to the rescue but the regulatory follow up and correction has been lacking.

    Notice that share holders and management have fared much worse at Blair engineered take overs than at Bernanke/Geithner/Paulson engineered rescues. In short, one shouldn’t have lender of last resort functions without insurance funds and regulation.

  11. Gravatar of Thorfinn Thorfinn
    20. December 2009 at 09:39

    Where moral hazard seems largest is in the investment banks–which all switched over from being LPs to publicly owned at around the same time they started taking risks. Much harder to take those risks when a partner’s net worth is one the line.

  12. Gravatar of ssumner ssumner
    20. December 2009 at 10:44

    I’m going to do another post and come back to these comments. But let me clarify a few things. I am not blaming the failure of AIG and investment banks on FDIC. I argued that the financial crisis was 25% moral hazard (including TBTF) and 75% tight money. So I’m not sure you guys realized that that was my position (not your fault as I didn’t emphasize the role of tight money in the post McArdle linked to.)

  13. Gravatar of OGT OGT
    20. December 2009 at 12:55

    Ssumner- Re: 75%/25%, even in your EMH model you have to give some weight to the principal agent problem. A great number of upper management types made out fine at Lehman and AIG even without the bailout. The term Simon Johnson uses for it is looting.

  14. Gravatar of ssumner ssumner
    20. December 2009 at 15:17

    Bill, Those are good points. Of course TBTF was also factor, and the other problem was that the leverage could not withstand a sudden 8% downshift in NGDP growth. I do not mean to suggest the whole problem was FDIC. But I do think it played a role, although perhaps a greater role in the 1980s S&L crisis.

    Don, Great comment. Much more important and informative than my post. I wonder what others think.

    Philo, Thanks. I’m glad I didn’t say blaming FDIC was a “useful socially constructed fiction.”

    libfree, Thanks. And I am not trying to absolve banks. From a public policy angle we need to address perverse regulatory incentives. But banks share some blame. Even with FDIC they made some poor decisions for their shareholders. And some of the TBTF stuff comes from the political influence of big bankers.

    Statsguy; You said;

    “Bank creditors are NOT insured by FDIC.”

    I have two responses. Doesn’t TBTF help bank creditors? And we are talking about how these things influence behavior at the margin. FDIC does increase the incentive to take risks to some extent, even if banks do still suffer considerable loses when things go bad. Ironically I am now arguing the other side from what I was debating a few weeks ago. At that time people were telling me that the big bankers didn’t suffer. Now it seems people are saying because the big banks did suffer, and because shareholders and creditors lost money, moral hazard couldn’t have been a problem. I say that all these things increased leverage (and read Don the Libertarian’s comment) and then the tight money was the coup de grace.

    Regarding AIG, how is TBTF “another issue?” I was clearly talking about moral hazard. Moral hazard isn’t just FDIC, I have always thought TBTF was also a key, especially for the big banks and their insurers.

    You said;

    “Your discussion of banks/loans misses one of the key new dynamics in the modern finance architecture – the fact that many (most?) of the failed loans (especially in the initial portion of the crisis) were not loans made and held by the institution (“traditional” banking or “narrow” banking). They were securitized loans held _DIRECTLY by investors_. With absolutely _no FDIC guarantee_.”

    Yes, but I was talking about the banking crisis. To the extent that these bonds were sold off to non-banks, then FDIC played to role. But it is equally true that to the extent these bonds were sold off to non-banks, they did not hurt bank profits, and thus did not contribute to the banking crisis. You can’t have it both ways.

    You said;

    “I would agree with you that the entire FDIC/TBTF mess was perhaps 25% of the crisis to FDIC/TBTF.”

    Well then we agree. And the other 75% was monetary policy which produced a sharp break in NGDP growth, and which explains why the macro crisis was far worse this time than in the 1980s. (Which I think addresses your last point.)

    Joe, Without FDIC the jerks you describe would have less money to play with. I’m not going to deposit money in one of those banks. I will go with a conservative bank or a mutual fund in safe bonds.

    OGT, Again, TBTF was a problem for investment banks. Read Don’s comment. And to the extent MBSs were sold to non-banks, they had zero role in the banking crisis.

    Thorfinn, Good point, but in the future investors will take that into account, and move money out of investment banks that behave recklessly. I believe GS was more responsible. Again, we must end TBTF to discipline investment banks.

    OGT, Yes, that may be a problem. But it is certainly not a problem that can be addressed effectively though regulation. Investors need to take that issue into account when deciding where to invest. The problem is that by bailing out creditors, we are bailing out the people who supplied these jerks the money in the first place. BTW, if you read my post I criticize Allison for not being more critical of the values of his fellow bankers. But the solution must either come through better corporate governance laws, or better oversight from investors. There is no way that low-paid Washington regulators are going to be able to protect shareholders from their own companies. Ain’t going to happen.

  15. Gravatar of Joe Joe
    20. December 2009 at 15:32

    Scott,

    You are not my Mom or my Grandmother. FDIC insurance allows them to save in a productive manner instead of mattress hoarding. Better overall for society. And even with FDIC IndyMac/WaMu saw bank runs. And when the Prime fund broke the buck, I, and lots of other people, moved all of our MMMF assets, which in normal times are a very safe productive investment, which caused the institution of temporary deposit insurance for MMMF so the commercial paper market did not die overnight. I could move them to an FDIC insured account so the could still be productive as opposed to buying massive amounts of gold to bury in my backyard because everything is going down. Recall the Panic in Sep08. Crazy stuff was going on. And there is no “Safe” bond/asset in that environment, so the FDIC is very helpful in those situations; If it was not there, it would be instituted after.

    Those “jerks” in banking I know from MBA days are the self professed Libertarians who will do anything to maximize their own gains…no one got hurt as far as they knew. Yes Despicable, but real.

    And The big bets were made by uninsured entities..Lehman/Bear

  16. Gravatar of StatsGuy StatsGuy
    21. December 2009 at 07:36

    TBTF and FDIC are separate issues – and the point of my comment was to argue for strictly separating them. Moreoover, Allison’s post gives precedence to FDIC, which is (if a problem at all) just a tiny fraction of the problem.

    TBTF is the bigger problem, but even then you focus solely on the moral hazard aspect of it. The political aspect is also a significant part of the problem. That is not moral hazard; it is neocorporatism and capture. Old fashion style.

    Having said that, as per McArdle – I have a hard time accepting that even TBTF is more responsible for AIG’s failure than simple agency problems and stupidity. Academics often underweight the role of sheer stupidity in the private sector. The AIG losses were caused by one unit of AIG, which was one of the smaller units (in manpower) – the incentives were whacked even without TBTF. And even without the moral hazard angle of TBTF, the systemic stability argument notes that a company like AIG does not take into account US welfare if it goes under (a massive negative externality), only it’s own. That’s not TBTF, that’s Tragedy of the Commons. Even without moral hazard we still have asymmetric rewards all over the place. This is problematic if there are benefits to size (and there are – scope of deals, lower cost of capital, market power), but if the company isn’t paying the cost of size (due to systemic instability). For example, AIG wasn’t forced to post collateral for many CDS because of its size, its reputation, and it’s (credit bureau granted) credit rating. When companies bought CDS from AIG, they (with the exception of Goldman) weren’t thinking that AIG would go under and the US would cover them – they were thinking “it’s AIG”.

    So when you say 25% is moral hazard from FDIC/TBTF, I would say 25% is TBTF (and only half of that is moral hazard). It seems that right-leaning pundits (aka Allison) like to play up the moral hazard aspect because its consistent with a particular worldview, while left-leaning pundits like to play up the political-capture angle because it’s consistent with their anti-corporatist views.

    Finally, as to the other 75% of the problem… Yes we agree there, although I think that “monetary policy” and the decisions made by the Fed were inseparable from other aspects of the broader money system – notably, the overvaluation of the dollar due to reserve currency demand (and the structural dependence on imports), failure to enforce capital asset ratios (due to a federal executive that was overly eager to please), principal-agent problems in ratings agencies, technological/financial “innovation” at banks due to advancing IT, a belief in an overly strong version of the EMH as a proxy for regulation… So yeah, all of that together is 75%.

  17. Gravatar of ssumner ssumner
    21. December 2009 at 12:31

    Joe, You said;

    “You are not my Mom or my Grandmother. FDIC insurance allows them to save in a productive manner instead of mattress hoarding.”

    The facts don’t support this. In the 1920s there was very little hoarding of currency despite the fact that several hundred banks failed each year, and also despite the fact that there was no deposit insurance. So your mom and grandma aren’t typical. Again, for those who don’t trust banks, there are plenty of alternatives such as mutual funds holding governemtn bonds. The MMMF scare was overblown. So what if once every 20 years a MMMF falls from $1 to 99 cents for a few days. If we try to create a riskfree society, we’ll end up creating far more risk, as we have just seen.

    The example you gave of Bear Stearns actually supports my point, not yours. They were bailed out by the government, and this helped lead to the Lehman fiasco. Lehman behaved recklessly toward the end, turnign down posible mergers, becasue they assumed they’d be bailed out just as Bear Stears had been. So that supports my argument.

    Statsguy, You said;

    “TBTF is the bigger problem, but even then you focus solely on the moral hazard aspect of it. The political aspect is also a significant part of the problem. That is not moral hazard; it is neocorporatism and capture. Old fashion style.”

    When I was in grad school I was taught that subsidies to not enrich industries. Instead, they are bad because they cause inefficiency. This farm subsidies don’t make farmers richer, but they do cause waste. I haven’t seen any evidence that would make me discard that view.

    You said;

    “When companies bought CDS from AIG, they (with the exception of Goldman) weren’t thinking that AIG would go under and the US would cover them – they were thinking “it’s AIG”.”

    I think this is exactly the wrong way to think about things. If people think “we can’t lose, it’s AIG” and later events show they were right, that becomes reinforcing. After a while they stop thinking about why they don’t need to worry, they just instinctively know they don’t. But if AIG’s creditors had taken big losses, you can be sure that next time around their attitude would be very different. Again, look at the anecdote from Don, it is very revealing.

    You said:

    “So when you say 25% is moral hazard from FDIC/TBTF, I would say 25% is TBTF (and only half of that is moral hazard). It seems that right-leaning pundits (aka Allison) like to play up the moral hazard aspect because its consistent with a particular worldview, while left-leaning pundits like to play up the political-capture angle because it’s consistent with their anti-corporatist views.”

    They is a reason for that asymmentry (at least from my point of view.) Moral hazard causes fiancial crises. While political capture is also bad, it doesn’t cause financial crises, it causes other forms of inefficiency.

    BTW, Much of the problem with the ratings agencies comes from the perverse incentives created by regulation. Also don’t forget that it was the buyers of the mortgage bonds that were pressuring the ratings agencies to give them higher ratings. It is not the jobs of ratings agencies to be regulators, that the government’s job. They were serving their customers.

  18. Gravatar of Ash Ash
    21. December 2009 at 14:14

    No one blames the Great Depression on the moral hazard problem. The moral hazard problem is a product of the post 1980 regulatory environment where we’ve effectively insured all deposits upto $ 50 million via the increase in deposit insurance limits and CDARS ( http://en.wikipedia.org/wiki/Certificate_of_Deposit_Account_Registry_Service ).

    The argument that ordinary depositors cannot analyse the risk of their banks is also redundant – if we need to give depositors a risk-free alternative, as Scott suggested, give them a vehicle where their deposits are invested in risk-free T-bills. In fact, something very similar to this existed in the United States and it was called the United States Postal Savings System ( http://en.wikipedia.org/wiki/United_States_Postal_Savings_System ).
    The current system attempts to offer depositors risk-free deposits which can then be invested by banks in extremely risky ventures. Clearly someone needs to pay the price for this risk-transformation and right now, that’s the taxpayer.

    The argument that bankers didn’t really bet the house and expect the government to bail them out is also too simplistic a view of the moral hazard problem. One rebuttal is Andrew Haldane’s point that bankers just didn’t protect themselves against any extreme scenarios, correctly expecting the regulatory authorities to ride to the rescue.

    A broader rebuttal is a Hayekian “spontaneous order” argument i.e. it is not at all necessary that each economic agent was consciously aware of the big picture and trying to maximise the value of the moral hazard subsidy. A system that exploits the subsidy efficiently can arise just by each agent adapting to and reacting to the local incentives put in front of him. For example, the CEO is under pressure to improve return on equity and increases leverage at the firm level. Individual departments of the bank may be extended cheap internal funding and told to hit aggressive profitability targets without using capital. And so on and so forth. It is not at all necessary that each individual trader in the bank is aware of or working towards the big picture.

    An even broader rebuttal is an Alchian-esque evolutionary argument. Given enough diversity, a stable environment and some selection mechanism, agents don’t even need to adapt to or react to the incentives for the same result to be achieved. The obvious selection mechanism in banking is the principal-agent relationship at all levels i.e. shareholders can fire CEOs, CEOs can fire managers, managers can fire traders etc. If we start out with a diverse pool of economic agents pursuing different strategies, only one of which is a high-leverage,bet-the-house strategy, sooner or later this strategy will outcompete and dominate all other strategies (provided that the environment is stable).

    On deposit insurance vs TBTF, deposit insurance was the main driver of the S&L crisis and TBTF the main driver of this one.

    In the absence of moral hazard, AIG would have still gone bust. But a bailout would not have been needed because an AIG bankruptcy would not have brought down every other bank in the system. Pre-deposit insurance/TBTF banks operated with much higher levels of equity than they do now and would have been able to absorb the hit without going under. High leverage is a product of the cheap funding driven by the moral hazard guarantee. Going back to the “natural selection” argument, any CEO who would have elected to operate with low leverage would have been fired a long time before the crisis hit for gross underperformance relative to his peer group.

    Also, I would second Don’s approval of Andrew Haldane’s work on this topic. He is far and away the most insightful and honest regulatory voice in the debate and he does not mince his words. This more recent paper by him is also essential reading – http://www.bankofengland.co.uk/publications/speeches/2009/speech409.pdf .

  19. Gravatar of StatsGuy StatsGuy
    21. December 2009 at 15:03

    ssumner:

    “But if AIG’s creditors had taken big losses, you can be sure that next time around their attitude would be very different.”

    First, this assumes that the primary mechanism for disciplining management is bondholders. Not, for instance, stockholders – who were nearly wiped out.

    Second, this argument relies on a story about “long term consequences”. If this story were true, we should observe that the response to AIG’s rescue was that very large companies would remain free to underwrite CDS contracts without posting collateral.

    However, for the last two years, virtually all CDS contracts have required posting of collateral… Even contracts underwritten by TBTF firms. Thus, the evidence supporting this story does not exist.

    Regarding Don’s vignette (and Don always posts great stuff), the major part is agency problems – that’s why underlings report data that benefit them.

    It’s the job of _management_ to manage these agency problems (that’s why they are called principals). So the presumption behind TBTF is that the _management_ explicitly relied on TBTF in the decisions NOT to manage their agents. But then Manager were paid by Shareholders… So presumably shareholders of AIG, Lehman, Bear Stearns… they were all counting on being bailed out. Except, by and large, shareholders lost their shirts.

    The Moral Hazard narrative is intellectually appealing – it makes the underpinnings of the catastrophe seem clear. Both the left and the right like it (for different reasons). But the puzzle has a lot of pieces, and a lot of them just don’t fit together.

    BTW – an interesting tidbit – the only major company that DID require that AIG post collateral on its CDS contracts was precisely the one that feared AIG might go under. Yep, Goldman. Goldman only intervened because the value of the collateral itself was in jeopardy as the financial crisis spread.

    In other words, the mechanism for TBTF was not moral hazard, but naked political power. Story from Naked Capitalism:

    http://www.nakedcapitalism.com/2009/11/goldmanaig-conspiracy-theories-theres-a-reason-they-wont-go-away.html

    My issue with giving moral hazard dominance over other causes is that it underplays other factors – including, for instance, McArdle’s observations about the sheer arrogance of wall street and its disdain for public regulators (along with the willing obeisance of the press).

    The story you tell is basically this:

    “The underlying trigger was moral hazard, and the reason it got so bad was an incompetent/ideological Fed”

    Moral hazard was only one of _many_ underlying triggers… (But I do agree that the reason it got so bad was the Fed.)

  20. Gravatar of Ash Ash
    21. December 2009 at 16:56

    I agree that the principal-agent problem is severe in banking, essentially because of asymmetric information. Just consider how much a Goldman Sachs shareholder really knows about the source of their profits.

    My only addition to this would be that the rents flowing from the moral hazard subsidy exacerbate and help maintain the principal-agent problem. How so? In the ordinary course of things, principal-agent conflicts cannot be sustained over the course of repeated interactions – something has to give. Either both parties will figure out mechanisms to mitigate the conflict or the party that loses out will walk away. Market mechanisms do not guarantee that no mistakes are made. However, they do ensure that repeated mistakes are unlikely. As the saying goes, “Fool me once, shame on you; fool me twice, shame on me.”
    The problem in banking is the presence of this significant rent flowing from the taxpayer. Each iteration of the repeated game has a significant pot of money up for grabs courtesy of the taxpayer. Therefore, even if the shareholder has lost out the last time around, it doesn’t preclude him from trying his luck again this time. Essentially, the ability of the system to work around and solve the principal-agent conflict is broken.

    Again, the principal-agent problem, the problem of ignorance/irrationality etc are all significant but the result of such a levered financial system thanks to the moral hazard issue makes all the above problems worse than they would be otherwise.

  21. Gravatar of Joe Joe
    21. December 2009 at 19:11

    Scott,

    My grandparents had their savings confiscated by Partizaners in post WWII Europe, hence they came to the US. The problem is we are in a situation where people KNOW FDIC insurance, not 1920 where it did not exist; And anytime a bank run starts deposits are suddenly insured to quell the panic. It helps them feel better about their 10,000 in the bank. And yes, most people do not have the time/knowledge to understand what their banks are using their deposits to invest in. And it helps prevent those unnecessary overblown panics called bank runs. Any panic is overblown, but in a situation where order matters where the first ones out are the only ones made whole.

    Bear Stern Bailout is different from FDIC; They were not using deposits to gamble. They were using wholesale funding.

  22. Gravatar of Artturi Björk Artturi Björk
    22. December 2009 at 02:59

    StatsGuy:

    First, this assumes that the primary mechanism for disciplining management is bondholders. Not, for instance, stockholders – who were nearly wiped out.

    I don’t think it assumes that at all.

    We can make an assumption that the management acts perfectly according to the interest of the stockholders and the moral hazard problem of TBTF does not go away in the slightest.

    Bond holders are a primary mechanism of disciplining stock holders and the bond holders don’t have an incentive to do this if they are not disciplined by the threat of bankruptcy.

    As long as TBTF is in place big institutions will be able to borrow money cheap regardless of the risk of defaulting on their dept. This obviously means that the stockholders and management don’t have to make the trade off of risk versus reward and can make -EV bets with huge variance.

    If they are leveraged enough their EV for the bet will be positive as a huge part of the cost will be born by taxpayers.

    This story obviously brakes down if it can be shown, that TBTF institutions did not receive money cheaper than the rest of the market compared to their risk of going under.

  23. Gravatar of OGT OGT
    22. December 2009 at 06:04

    Ash- I certainly agree with the idea that moral hazard, very specifically through lender of last resort activities without appropriate regulatory follow up or even ceremonial haircuts to investors have made the financial system more fragile. In fact, I think the deregulatory stance combined with continued implicit and explicit government backstops in the last thirty years has been bat sh*t crazy. All of this is rather separate from FDIC.

    The Hayekian and Alchian analysis you present is compelling, Minsky seems to have picked up a great deal from them. But, I’d argue moral hazard is not technically necessary for those dynamics to apply. It is only necessary that asymetric risks and rewards are present for many actors for the system to continue. The credit cycle is quite capable of doing this itself. Moral harzard is just a subset of asymetric risk and reward, though a galling one to be sure.

  24. Gravatar of Ash Ash
    22. December 2009 at 15:03

    OGT – I’m most certainly not claiming that moral hazard explains everything. As you mention, asymmetric risk-reward of any sort can drive such an outcome.

    My contention is that the popular conception of moral hazard is too narrow. In the language of complex adaptive systems, the Hayekian or Alchian explanation is equivalent to saying that the moral hazard problem can be an “emergent” outcome rather than one driven by explicit agent intentions.

    The other point is that most other asymmetric risk-reward situations such as the principal-agent problem, shareholder-creditor conflict etc cannot persist forever. Sooner or later, either the terms of the contract will be changed or the disadvantaged party will walk away from the contractual relationship. The option for one party to walk away is ignored by so much of the analysis concerning these issues. For example, this paper ( http://www.law.uiuc.edu/_shared/pdfs/Squire_Risky%20Debt_0910.pdf ) explaining the asymmetric risk incentive facing shareholders in AIG concludes that it is not cost-effective for creditors to monitor shareholders and therefore, the problem persists. But if this is the case, the optimal course of action for creditors is to simply walk away.

    As I said earlier, with the presence of the moral hazard subsidy and a pot of gold up for grabs at the start of each iteration of the game courtesy of the taxpayer, the option to walk away is no longer the optimal course and the problem does persist.

    Minsky’s fundamental thesis that stability breeds instability is valid. He also recognised the dangers of bank bailouts. But his claim that this instability is endogenous to a free market system is harder to buy. Anyway, that’s another topic entirely!

  25. Gravatar of StatsGuy StatsGuy
    22. December 2009 at 15:26

    “stockholders and management don’t have to make the trade off of risk versus reward and can make -EV bets with huge variance”

    Yes, this is true, and creditholders are one of the mechanisms of enforcement. Yet there are reasons this effect could be quite small – inherent negative risk aversion on the part of stockholders (who don’t like their stocks going to zero)… & other enforcement mechanisms. So the question becomes empirical.

    Showing that the cost of capital for large institutions is lower than for small institutions is necessary but insufficient, as we would expect this for any industry. However, the following facts might be supportive:

    – If TBTF banks had stocks with higher beta than smaller banks over a long period of time; We should see the stocks of the largest companies (AIG) have a higher beta than stocks of smaller financial companies. Likewise, we should see them taking riskier bets, since creditors of smaller companies do not benefit from TBTF implied insurance. (My sense is that the answer to this may depend on whether you include 2008 in the dataset.)

    – If over a long period of time, average total returns (stock gains and dividends) in finance (risk adjusted) compensate for the risk of severe loss – in net, rewards should exceed rewards in other sectors. My sense is this tells the opposite story as above (again contingent on whether 2008 is included), although this is difficult to separate from secular trends like the shift toward services in general.

    – We should see TBTF institutions buying lower quality (riskier) assets than non-TBTF institutions …unless, of course, principal agent/political problems in ratings agencies distorted this.

    Then in order for TBTF moral hazard to be the key driver behind phase 1 of the crisis (before the Fed blew it), we have to rule out many other explanations:

    Behavioral dynamics, raw political power, reserve currency run (long term trade deficits), other perverse incentives (e.g. short time horizons in mgmt/stockholder relations)…

    That’s a pretty high empirical bar to jump – yet advocates of TBTF moral hazard as THE primary factor rely rather heavily on a few well-recycled anecdotes. I have no doubt that folks like Professor Johnson recognize the real complexity of the issue; but they have elected to make TBTF the focal point of their efforts for public relations reasons. Which is a great thing, so long as we don’t lose track of the other problems.

  26. Gravatar of ssumner ssumner
    22. December 2009 at 18:02

    Ash, Well put, you defend my position better than I do.

    Statsguy, You said;

    “First, this assumes that the primary mechanism for disciplining management is bondholders. Not, for instance, stockholders – who were nearly wiped out.

    Second, this argument relies on a story about “long term consequences”. If this story were true, we should observe that the response to AIG’s rescue was that very large companies would remain free to underwrite CDS contracts without posting collateral.”

    These arguments don’t seem very convincing to me. Bondholders are more risk averse than stockholders, because they have little upside. So of course shareholders will allow banks to take more than the socially optimal amount of risk. If bond buyers refuse to buy a firm’s debt, that is a form of discipline.

    The second point also seems consistent with my argument. I am not arguing that firms want to fail. Certainly if new information becomes available firms may take appropriate action. Some of this may be forced by regulators. But even without regulation I would expect banks to become more conservative after a fiasco. It is obvious, ex post, that they underestimated the risks they were taking.

    You said;

    “The Moral Hazard narrative is intellectually appealing – it makes the underpinnings of the catastrophe seem clear. Both the left and the right like it (for different reasons). But the puzzle has a lot of pieces, and a lot of them just don’t fit together.”

    I certainly don’t think moral hazard caused any catastrophies. As I keep saying, most of the problem was produced by tight money, which drove down asset values and people incomes (and comapnies revenues.) So I am the last person anyone should claim is claiming a monocausal explanation.

    I am confused by your principal agent discussion. management is the agent, not the principal.

    You said;

    “My issue with giving moral hazard dominance over other causes is that it underplays other factors – including, for instance, McArdle’s observations about the sheer arrogance of wall street and its disdain for public regulators (along with the willing obeisance of the press).”

    This paragraph seems to describe moral hazard to me, so maybe we understand the term differently. Isn’t that arrogance exactly what you would expect of someone who was too big to fail? That’s what moral hazard is.

    Joe, You seem to be saying that because FDIC makes people behave very stupidly, and shovel lots of money to reckless banks, we must continue FDIC so that people will continue to behave like children and we continue to have these sorts of fiascos. Because after all, people are stupid. Except they weren’t stupid prior to 1934.

    BTW, FDIC would not have helped your grandparents in Europe.

    Artturi, I agree.

    OGT, I agree about the other problems, but I would point out that before FDIC, American banks behaved much more conservatively.

  27. Gravatar of Artturi Björk Artturi Björk
    23. December 2009 at 00:29

    StatsGuy: I agree, that my suggested “test” was quite inadequate and that your proposals are probably much better.

    I don’t know however if there is a correlation between beta and the high variance bets that TBTF institutions make. For example if they make bets that are -EV that usually pay out a modest ammount, but sometimes cause huge downswings you could argue that the beta of the stock should actually be smaller than the markets…

    we have to rule out many other explanations:

    Behavioral dynamics, raw political power, reserve currency run (long term trade deficits), other perverse incentives (e.g. short time horizons in mgmt/stockholder relations)…

    Doesn’t it work the other way around?

    If there is a mechanism in which if we make an plausible assumption of rational behaviour of management, stockholders and bondholders that results in the observed behaviour, then the theory is useful.

    If those other factors can be shown to have resulted in this kind of behaviour with plausible and demonstrated assumptions, then they obviously are as valuable, but until then they aren’t very useful.

    It’s pretty hard to compare the magnitudes of causes, whose mechanisms are not well understood so maybe it’s not really smart to say that moral hazard is the primary cause.

    One could say instead that moral hazard is sufficient to cause to observed behaviour.

  28. Gravatar of Bonnie Bonnie
    23. December 2009 at 02:53

    There are a couple of things about “moral hazard” regarding the financial crisis I’d like to point out:

    1)Federal officials take an oath to preserve, protect and defend the Constitution of the United States as a primary function, bankers do not. Bankers are more or less private citizens, whereas Federal officials are bound by oath to behave a certain way which many ignore within minutes of affirmation.
    2)As far as authority over the monetary system, the Constitution grants Congress the authority to coin money, regulate the value thereof, and punish counterfeiting, nothing more. One can refer to Thomas Jefferson’s opinion on the [un]contitutionality of the establishment of a national bank for a better understanding of what Article II Section 8 means from his point of view. In it, he points out the hazard of allowing congress to wander past the bounds of its authority regarding money or any other kind of purpose.

    http://avalon.law.yale.edu/18th_century/bank-tj.asp

    I’d also like to point out that what some may view as the ‘good fight’ isn’t always what is most practical. The American economy was a basket case during and for several years after the rebellion against the British Crown. If economic and political stability had been at the top of the revolutionaries’ value list, one could argue that being under the British Crown was probably the best thing they had going for them without having to go through all the messiness of war and political chaos. Fighting for what is just may not be and most likely isn’t the practical thing for the here and now, and at times may even seem fanciful or dogmatic as I’m sure the revolutionaries seemed that way to those who were left crying in their beer over personal misfortune resulting from their actions.

    Of course judging a course of action regarding our monetary construct or the cause of the financial crisis is purely subjective, depending on one’s values. You have all the answers to what appears as a perplexing libertarian fixation on dogma in your post, but you seem to miss entirely that many may not be as concerned about what is practical for here and now as they are about what is just.

    The moral hazard that the bankers ‘took advantage of’ comes from the monetary construct that says the Treasury will absorb losses, and that construct came from the government that did “tell them what the … to do with the money” after making it rather impossible to conduct business outside that construct by law. The government’s monopoly on money and its abuse of it is not only despotic, but the failure of that construct is a blazing red flag that it is quite impractical when it results in a mass raping of the citizenry, regardless of who benefited from it, and is well beyond any explicit power of taxation granted by the Constitution.

    Perhaps the gold standard is not the best alternative, and I appreciate that being pointed out, but there has to be a better answer than the one we currently have. You have invested a great deal of time and intellectual energy in this recession and understand it far better than do I, and not even you can understand the actions of the Federal Reserve. At this point I wonder what its primary motivators are because those who make up the FOMC can’t all have the intelligence of a gnat. Perhaps it’s just dogma, but I suspect there’s something else going on there and it most likely has little to do with the best interest of the average guy on the street. I think I’d rather have the reality that is spelled out in the Constitution where political power is distributed among the states which compete with each other economically than be left hoping that some day the central monetary despot will finally decide to smile upon all the little people and we’ll all be happy again.

  29. Gravatar of ssumner ssumner
    23. December 2009 at 06:03

    Bonnie, I agree with many of your comments, such as the need to greatly reduce the size and scope of the federal government, and to return power to the states. Indeed in another post I recommended breaking the US up into 50 independent countries.

    You said;

    “You have all the answers to what appears as a perplexing libertarian fixation on dogma in your post, but you seem to miss entirely that many may not be as concerned about what is practical for here and now as they are about what is just.”

    I am a utilitarian, so I believe that what is just is also what is practical. And not merely practical for right now, but for all time.

    I have used this blog to suggest reforms that would get the Fed out of the business of making discretionary policy decisions, and turn monetary policy over to the market. The only role of the government would be to set the value of money, which as you point out is a duty proscribed in the Constitution.

  30. Gravatar of JTapp JTapp
    2. January 2010 at 12:30

    The FDIC guarantees contribute to consumer carelessness just like health insurance copays cause us to use more health care than we otherwise would. Personal example:

    For all of 2008 and up until last week my local bank has been paying over 4% APR on free checking accounts, at a time when you still can’t get an annual CD greater than 2.5% from just about anywhere. I moved all of our money market funds into it (since the money market was yielding basically 0%). I casually asked around a few bank VPs how they could afford it and they couldn’t give me an answer. The best was “we can’t stop now without offending everyone who is rushing to put their money in.” The housing and job market here are just like they are everywhere else.

    Without the FDIC, there’s no way I would have bet on that bank or encouraged everyone I know to do the same. (The bank lowered rates to 3.5% last week, but that’s still above average).

  31. Gravatar of ssumner ssumner
    4. January 2010 at 06:58

    JTapp, That is a good example.

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