The recent crisis exposed a fundamental flaw with our banking system (actually it’s been there since 1934, but this was the worst manifestation of the problem.)  Because of various government backstops (FDIC, F&F, TBTF, etc) our financial system takes excessive risks.

Tim Congdon has an intriguing proposal to address this problem.  His plan would not eliminate moral hazard, but it just might reduce it:

Suppose that banks are short of capital because of bad asset selection and heavy losses, and that there is a risk of deposits not being covered by banks’ remaining assets-the situation allegedly facing Britain’s banks and economy in late 2008. Surely everyone ought to agree that, ideally, the job of replenishing banks’ capital should fall on the private sector, not the state, and that as far as possible accountability must lie in only one place. How might that be achieved?

I propose a structure which is almost the polar opposite of Buiter’s. In a 2009 monograph, Central Banking in a Free Society, I argued that the capital of the Bank of England should be provided by the leading banks, and that the functions of the central bank and deposit insurance agency should be amalgamated. Whereas Buiter wants, in effect, to nationalise the arrangements (and the costs) of cleaning up a banking system fiasco, I would privatise them.

My proposal is much less radical than it may seem. Recall that at present the banking industry as a whole can in fact be levied by the FSCS if its funds are exhausted as a result of losses at one or a handful of banks. So, making the commercial banks the shareholders in the central bank and giving the central bank an explicit responsibility to protect deposits, has two consequences. First, the central bank would extend loans only if confident they would be repaid. The well-behaved, risk-avoiding and profitable banks have a strong interest in preventing their risk-prone competitors from incurring losses and ruining the system. Secondly, if the system nevertheless ran into trouble, the first line of defence would lie in the private sector, via the capital-levying power of the Bank of England. If the government did have to come in, it would be only after the bankers had decided that they could not help themselves. It would indeed be a last resort.

I’d like to separate two questions:  Should there be a unified institution to handle deposit insurance and emergency capital provision, which is owned and financed by the banking sector?  And should this institution be the central bank?  I agree with Congdon on the first point, but don’t see the second as being essential, or even politically feasible (at least in the US.)  In America, banks already have partial ownership of the Fed (albeit less than people imagine) and that’s highly controversial.  So let’s look at the first question.

The beauty of Congdon’s idea is that decisions on bank rescue will be made by those with the right set of incentives.  Suppose a bank gets into trouble, but is not a systemic threat.  The socially optimal solution is bankruptcy, that’s how markets should work.  That sends a signal to the banks that they should take fewer risks.  It sends a signal to creditors that they should carefully monitor bank behavior.  It would be nice to send a signal to depositors, but that doesn’t seem politically feasible—at best we might be able to trim the maximum coverage a bit.

But what if the bank failure was a systemic threat?  In that case the institution would have an incentive to provide emergency capital injections–in order to prevent contagion that would threaten the rest of the banking system.  This institution basically internalizes externalities.  The money belongs to the banks, who would be shareholders (in some proportion to bank size.)  If funds were paid out, banks would have to chip in to re-capitalize the institution.

In once in 100 year disasters the Treasury might have to backstop the institution with Federal loans.  But as we saw with the TARP loans, the Treasury could simply require that these loans be repaid by the institution, once the banks got back on their feet.

In theory, taxpayers should monitor Washington regulators, so that they wouldn’t show favoritism to politically important special interests.  But we know from public choice theory that that doesn’t work very well.  The banks themselves are the best monitor, or perhaps a Board of Directors that is directly answerable to the banks.

Here’s another way of looking at the plan.  It’s politically difficult to get the big banks to hold enough capital to overcome the TBTF problem.  They’ll whine about picking up and leaving New York, London, or Zurich.  But it’s also unlikely that all big banks will get into trouble at exactly the same time.  This institution would pool capital in a way the could nip a potential financial panic in the bud, without requiring taxpayer money.

Of course the cost of this insurance fund will ultimately be borne by customers, so in that sense it is a tax.  But it has two advantages over a bailout using income taxes.  The tax reflects the external costs imposed by fractional reserve banking.  And second, the banks would have much more incentive than government bureaucrats to use the funds wisely.

OK, I’m not a banking expert—tell me what’s wrong with this plan?

Many economists (even some relatively free market economists) have begun to question the high returns flowing to the financial industry in recent years.  It’s not that people don’t understand that finance is important, or that it plays a critical role in our economy, but rather the claim is that finance is much more generously rewarded than in the past, and that those extra earnings are at least partly unmerited.

Today I’d like to defend finance.  Not the role it played in the housing debacle (in that specific case I agree with the critics.)  Instead I’ll try to show that even in the absence of policies such as Too Big To Fail, you would expect the share of income going to finance to be rising sharply, as compared to earlier decades.

Let’s start with a simple economy that produces lots of wheat and a little bit of iron.  The income distribution in society mostly reflects differences in productivity in farming.  Stronger farmers can produce somewhat more than weaker farmers, but not a lot more.  Hence income is distributed fairly equally.

Suppose productivity in the mining industry mostly depends on skill at noticing iron deposits.  Let’s also assume that this skill is distributed very unequally–some people are much better at spotting iron deposits than others.  The next assumption is crucial.  Once iron is found, it can be mined very easily.  The hard part is finding the iron in the first place.  In that sort of economy, income will become less and less equally distributed as iron becomes a larger and larger share of GDP.

In the 1950s and 1960s it wasn’t that hard to figure out where capital needed to be allocated.  Capital was allocated to produce steel, and the steel was used to produce cars and washing machines.  Capital was allocated to the production of aluminum, and the aluminum was used to make airplanes. The most productive members of society were those who made things, and Michigan was near the top in per capita income.

Today the most productive members of society are not those who produce things, they are those who discover the things that need to be produced.  Once you have the blueprint, it is easy to produce many types of software and pharmaceuticals.  The big money goes to those who figure out the blueprint, but also to those who allocate capital to the guy who has the idea for a Google, or Facebook, or Twitter.  In contrast, the technicians who actually implement the vision often earn modest salaries.  Thus companies are “discovered” in much the same way as an iron deposit is discovered by a skilled geologist.

And then there’s globalization, which means decisions about allocating capital can vastly improve productivity even in the old-line industries that were dominant in the 1960s, when the rest of the world hardly mattered.  Finance is not that important in an agricultural economy or even in an economy where the mass production of goods can be done with almost military precision.  It becomes extremely important in an economy where it is not at all clear what should be produced, or on what continent that production should take place.

I’m not sure if I’m saying anything new—this analysis is sort of related to the “economics of superstars.” But if it is well-understood, why do people seem so perplexed by the fact that finance earns much bigger incomes than in the 1960s?  Finance now plays a much more important role than in the 1960s.

Perhaps people are drawing the wrong conclusions from the housing fiasco.  Finance made a serious mistake in allocating so much capital to housing, but that’s not what caused the recession.  In a country with 100 million houses, the damage from adding two million a year for a couple years instead of one million a year for a couple years is modest.  The reason we have a severe recession is because of tight money, not too many houses.  Otherwise we would have had a severe recession in 2006-08, when housing construction collapsed, rather than 2008-09, when we actually had a big downturn.  And of course much of the sub-prime mortgage fiasco had nothing to do with housing construction, it was refinancing.

As long as we have an economy that is increasingly dominated by “idea companies,” where the idea is really, really hard to discover and really easy to implement once discovered, finance will earn huge gains.  In my model economy the iron spotters were highly productive and the iron miners had a relatively low marginal productivity.

Right now, those who develop new ideas are being highly rewarded.  More importantly, those who spot good ideas developed by others, and allocate capital to implement those ideas, are also highly rewarded.  Get used to finance earning obscene profits, it isn’t going away.  But if it makes you feel any better, they are producing something of great value (except when they screw up and allocate money to sub-prime mortgage borrowers.)

Some might point to the fact that finance also earned high incomes in the years right before the Great Depression.  And yet we obviously did not yet have high tech economy.   But those high incomes merely reflected the extraordinary bull market.  Today finance earns large incomes even during years where stock prices are not soaring.  In others posts I’ve argued that income is a pretty meaningless metric, as it is distorted by the mixing wage income and capital gains.  Whenever stock prices soar income will temporarily look much less equal.  But our recent move toward greater inequality is not just driven by stock gains during bull markets; it’s a secular trend that isn’t going away anytime soon.

I seem to be the only blogger talking about this, which makes me think either I am ahead of the curve, or more likely making a bonehead error.  But as of yet no commenter has yet found the bonehead error I am making.

Last time I wrote on this subject the eventual cost to the government from bailing out the big banks was estimated at a negative $7 billion–in other words a profit to Uncle Sam of $7 billion.  There was an expected loss on the AIG bailout of $36 billion, and I acknowledged that could be viewed as a backdoor bailout of the big banks.  Indeed the entire TARP is a giant favor to the banking industry even if every dollar is repaid.  And now it appears it all will be repaid, even the AIG bailout.  (I am excluding the loans to automakers, which I regard as a separate issue.)

When the crisis first broke we were told the main problem was the big banks, and the underlying regulatory problem was “Too Big to Fail,” which encouraged the big banks to take excessive risks.  I now think my original view was wrong.  It appears that at the end of the day the biggest banking fiasco in the history of the universe will not result in any long run net taxpayer transfer to big banks.  And yet the owners and managers of those banks incurred mind-boggling losses.  So how plausible is it that TBTF was the primary cause of excessive risk taking in 2004-07?  If even a crisis this big didn’t result in  the long-run transfer of one cent of taxpayer money to big banks, does it seem likely that expectations of those transfers were a powerful motivating factor in the the MBSs they bought? Were they expecting an even bigger banking fiasco?  I suppose it’s possible, but I just don’t see it.

In contrast, massive quantities of taxpayer funds will be transferred to depositors at smaller banks, who (in collusion with the banks themselves) gambled recklessly by lending taxpayer-insured funds out to risky construction projects.  There I really do see a moral hazard problem, indeed what happened was essentially a repeat of the 1980s S&L crisis.  Once might be a fluke; twice is a systemic problem.  I’m increasingly likely to view the big bank crash as a fluke and the smaller bank crash as a chronic policy problem.  Indeed didn’t the same dichotomy occur during the Great Depression, with most failures being smaller banks?

So here are the eventual taxpayer losses we are looking at:

Fannie and Freddie  — $165 billion and rising

FDIC — Over $100 billion

FHA — Who knows, even today they’re still encouraging new sub-prime loans.

AIG — $0

The big banks — negative $7 billion

Would it be fair to say that the initial reporting of the crash of 2008 was a bit misleading?  The reporting that led most people to form indelible opinions that they will probably never re-visit or re-evaluate?

Some will argue that the Fed policy of buying MBSs indirectly helped the big banks.  Maybe so, but if we are talking about indirect effects from government programs, then what about the indirect effects of the Fed letting NGDP fall 8% below trend in 2008-09?  That hurt banks far more than any Fed MBS purchases helped them.

So tell me, why is my hypothesis wrong?

Continental Illinois was just the largest and most dramatic example of a bank failure in which creditors were spared any pain. Irvine Sprague, in his 1986 book:

“Of the fifty largest bank failures in history, forty-six””including the top twenty””were handled either through a pure bailout or an FDIC assisted transaction where no depositor or creditor, insured or uninsured, lost a penny.”

The 50 largest failures up to that time all took place in the 1970s and 1980s. As the savings and loan (S&L) crisis unfolded during the 1980s, government repeatedly sent the same message: lenders and creditors would get all of their money back. Between 1979 and 1989, 1,100 commercial banks failed. Out of all of their deposits, 99.7 percent, insured or uninsured, were reimbursed by policy decisions.

Then Russ discusses LTCM and the 1995 Mexican bailout before eventually arriving at the current crisis:　

That brings us to the current mess that began in March 2008. There is seemingly little rhyme or reason to the pattern of government intervention. The government played matchmaker and helped Bear Stearns get married to J. P. Morgan Chase. The government essentially nationalized Fannie and Freddie, placing them into conservatorship, honoring their debts, and funding their ongoing operations through the Federal Reserve. The government bought a large stake in AIG and honored all of its obligations at 100 cents on the dollar. The government funneled money to many commercial banks.

Each case seems different. But there is a pattern. Each time, the stockholders in these firms are either wiped out or see their investments reduced to a trivial fraction of what they were before. The bondholders and lenders are left untouched. In every case other than that of Lehman Brothers, bondholders and lenders received everything they were promised: 100 cents on the dollar.

A few comments:

1.  Reading Russ’s paper makes me realize just how much our system is biased toward debt.  And by the way, it isn’t just moral hazard; our tax system is also biased toward debt and against equity.  People talk about Americans borrowing too much, but given all these distortions it’s surprising that we don’t have even more debt.  Why didn’t I take out some mortgages and buy Florida condos?  I’d like to think it was civic virtue, but I suppose it was just laziness.

2.  This also made me realize the importance of Lehman’s failure.  It wasn’t just an isolated bankruptcy; it was a regime change that made enormous quantities of debt appear to be far riskier than just a few days earlier.  And the change was made just as the US was entering a severe recession.  I’m all for cracking down on moral hazard—but September 2008 was not the best time to do so.

Here Russ discusses how the system encouraged abuse:

George Akerlof and Paul Romer describe similar incentives in the context of the S&L collapse.   In Looting: The Economic Underworld of Bankruptcy for Profit, they describe how the owners of S&Ls would book accounting profits, justifying a large salary even though those profits had little or no chance of becoming real. They would generate cash flow by offering an attractive rate on the savings accounts they offered. Depositors would not worry about the viability of the banks because of FDIC insurance. But the owners’ salaries were ultimately coming out of the pockets of taxpayers. What the owners were doing was borrowing money to finance their salaries, money that the taxpayers guaranteed. When the S&Ls failed, the depositors got their money back, and the owners had their salaries: The taxpayers were the only losers.

This kind of looting and corruption of incentives is only possible when you can borrow to finance highly leveraged positions. This in turn is only possible if lenders and bondholders are fools””or if they are very smart and are willing to finance highly leveraged bets because they anticipate government rescue.

When you read Russ’s paper you begin to wonder if much of the US economy is just a giant Ponzi scheme:

1.  Bank creditors ignore risk, knowing they will be bailed out.

2.  Bank equity-holders have an incentive to borrow at low rates (due to the protection of creditors), and so they take highly leveraged gambles.

3.  Bank presidents have an incentive to take big risks, as they can earn large bonuses if the gambles pay off.

4.  Bank depositors have an incentive to look for the highest rate of return, regardless of how reckless the bank is.

5.  Home-buyers have an incentive to take out mortgages with the smallest possible down-payments, particularly in non-recourse states.

Taxpayers are left holding the bag.

And that is just the banking system.  Insurers like AIG (and their customers) had an incentive to take enormous ricks, knowing they would be bailed out.  Hospitals in McAllen Texas spent vast amounts treating poor patients, knowing Medicare will bail them out.  Then there is our pension system; corporations have an incentive to have underfunded pension plans.  And does anyone think Uncle Sam would allow states like California or Illinois to default on pension obligations?  And why stop at states?  Perhaps whole countries are playing this game.  What about lenders to Greece?  How about Iceland; didn’t their citizens recently vote down a proposal that they pick up the cost of meeting deposit insurance obligations in British and Dutch branches of Icelandic banks?  I am certainly not suggesting that the Icelandic banking fiasco was some sort of nefarious plot hatched by Icelandic taxpayers, but rather that there may be a good reason why they never contemplated the tax liability associated with the European branches of Icelandic banks.  With the possible exception of taxes, government-created moral hazard is the primary factor distorting market economies around the world

Some of my commenters suggest that if we had my monetary nirvana of 5% expected NGDP growth, then people would take greater risks.  Perhaps, but also think about this.  The biggest single factor driving bailouts is the fear that failures would worsen a recession.  If government policymakers knew there was going to be 5% expected NGDP growth regardless of whether Lehman was bailed out or not, then I think it would be easier for them to ‘do the right thing” and refrain from bailouts. I don’t recall all that many bailouts during the prosperous Clinton years.  Gambles were made (in tech stocks) but for the most part those who lost money paid the price.  My point is not that Clinton himself had anything to do with the difference, rather that we are more risk averse when a financial failure seems likely to trigger a recession.

I have been a long-time foe of Fannie and Freddie (going back 20 years) and I am pleased that Russ was able to dig up a lot of dirt.  Here is just one of many examples:

The most important change at Fannie and Freddie, however, was their approach to the down payment. In 1997, fewer than 3 percent of Fannie and Freddie’s loans had a down payment of less than 5 percent.

But starting in 1998, Fannie created explicit programs where the required down payment was only 3 percent. In 2001, it even began purchasing loans with zero down. With loans that had a down payment, it stopped requiring the borrower to come up with the down payment out of his own funds. Down payments could be gifts from friends or, better still, grants from a nonprofit or government agency.

A few weeks ago I was kind of shocked to see respected bloggers speak well of the financial reform package.  I can’t see how it addressed ANY of the major causes of the 2008 fiasco.  But easily the most inexcusable aspect of the bill was that it didn’t even address Fannie and Freddie.  People excuse that on the basis that there is a lot of political support for F&F.  But if you can’t reform them right after a $165 billion taxpayer bailout, when will they be unpopular enough that we can address their flaws? (And the best way to address the flaws would be to phase them out of existence.)

And no ban on sub-prime mortgages?  I thought that was the cause of the crisis.  You’d think a minimum 20% down-payment would have been the centerpiece of the bill.   Two years ago all my left wing friends said; “See how bad capitalism is?  All those unregulated banks made lots of sub-prime loans.”  OK left-wing friends, where is the regulation that prevents banks from reverting back to sub-prime lending?

When the crisis broke in 2007 I was completely ignorant about some of the details of what had been going one.  Of course I had heard that there were lots of sub-prime loans, and that in recent years almost anyone could get a mortgage.  But when I bought my house in 1991 I was told I needed to put 20% down or else buy mortgage insurance.  I had no idea that the practice had been phased out.  Here is Russ describing what happened:

When the down payment was less than 20 percent, Fannie and Freddie required private mortgage insurance (PMI). On a zero down payment loan, for example, the borrower would take out insurance to cover 20 percent of the value of the loan, protecting Fannie and Freddie from the risk of the borrower defaulting. But starting in the 1990s, an alternative to PMI emerged””the piggyback loan, a second loan that finances part or all of the down payment. The use of piggyback loans grew quickly beginning in the 1990s through 2003 and even more dramatically in the 2004-2006 period.  For example, in a study of the Massachusetts mortgage market, the Warren Group found that in 1995, piggyback loans were 5 percent of prime mortgages. The number grew to 15 percent by 2003. By 2006, over 30 percent of prime mortgages in Massachusetts were financed with piggyback loans. For subprime loans in Massachusetts, almost 30 percent were financed with piggybacks in 2003 and more than 60 percent by 2006.

Here is something I haven’t heard many people talk about.  Couldn’t one argue that moving away from mortgage insurance for less than 20% downpayment mortgages was a factor in the crisis?  Maybe I am missing something simple here, but it seems to me that with mortgage insurance you actually have institutions with “skin in the game.”  Perhaps the mortgage insurance companies would have been just as reckless as AIG, and allowed O% no -income verification mortgages with phony appraisals.  But even in that worst case scenario the existence of mortgage insurance have reduced the losses to the banking industry.  Even if the mortgage insurance companies had to be bailed out, at least they would have absorbed some of the losses now absorbed by banks and taxpayers.   And I think in practice they would not have been quite that reckless.

My second observation is that the big mistakes were made in the 1990s, when we allowed F&F to dramatically lower their standards and stopped requiring mortgage insurance on less than 20% down mortgages.  And this loosening of standards occurred right after one of the biggest banking fiasco’s in American history–the S&L crisis, which required an enormous taxpayer bailout of our deposit insurance system.  When this happened everyone was running around saying “See deregulation doesn’t work, we need to re-regulate the banking system.”  And I think that they did tighten up in a few areas like capital requirements.  But the most important trend in the 1990s was actually deregulation, the dramatic lowering of the standards on who could get a mortgage.  I don’t know how much of this was explicit deregulation, and how much was a failure of regulators to do something affirmative in the face of financial “innovation.”  So I am not trying to make an ideological point here, or point fingers at one party of the other.  My point is that we responded to the S&L crisis by talking about the need for tighter regulation, and then acted in a completely contrary way.  As far as I can see our current actions also have little to do with the 2008 crisis.

I think the debate over regulation gets clouded by ideology.  What does “increased regulation” mean?  Does it mean more government involvement in banking, or less?  Consider our current banking system in America, where we essentially nationalized all bank liabilities in 1934.  When you deposit $100 in the bank, you are loaning it to the Treasury, which re-loans it at the same rate to the bank.  Those are insured deposits.  Now consider a “regulation” that said banks could only lend out money from insured deposits on mortgages with more than 20% down-payments.  While this proposal would increase “regulation,” it would also reduce the role of government in our banking system.  Instead of the government being liable for deposits in any bank failure, they would only be liable for those where banks were engaged in relatively safe behavior.  It would dramatically reduce the scope of deposit insurance.

I agree with Russ’s Hayekian perspective, we can’t solve these problems by trying to micromanage the economy.  But I also think that libertarians must be careful in offering policy advice in complex environments.  When Iceland’s government deregulated banking, and allowed Icelandic banks to open extensive branches in Europe, the Icelandic government was in many was becoming more involved in the Icelandic economy, exactly the opposite of how it may have initially appeared.  Their government took on vast new liabilities associated with the British and Dutch deposits of Icelandic banks.  That’s a responsibility that the Icelandic government did not have before deregulation.   Deregulation is usually good, but not when it increases the role of government in our financial system.  I’m afraid that much of the banking “deregulation” of the 1990s did exactly that, it enormously increased our government’s explicit and implicit liabilities.

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. 
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