Market Failure or Government Failure?

Last year the New York Times ran several articles about the end of capitalism. Others picked up this meme and reinforced it with claims that greedy bankers and deregulated financial markets had brought the world to the brink of another Great Depression. Then--just in the nick of time--we were allegedly saved by timely, forceful and intelligent government actions. The groundwork was laid for the next phase: more government regulation of financial and economic life.

Left out of this narrative is the government's disastrous mortgage and housing policy. Without the policies followed by Fannie Mae and Freddie Mac--and the destructive changes in housing and mortgage policies, like authorizing subprime and Alt-A mortgages for impecunious borrowers--the crisis would not have happened.

Without warning, the federal government's 30-year policy of bailing out large banks changed when it allowed Lehman Brothers to fail. The Federal Reserve acted forcefully and determinedly to lessen the fallout from Lehman's collapse, but much damage was done.

Not all bankers overinvested in mortgages, but some got up to dance, believing that they would profit and the rest of us would pay to prevent failures.

Would bankers have made so many errors if there had never been a too-big-to-fail policy? Not all bankers overinvested in mortgages, but some got up to dance, believing that they would profit and the rest of us would pay to prevent failures.

Has the government learned from its mistakes by closing Fannie and Freddie and agreeing to put any housing subsidy on the budget? Do you hear the president, the Treasury, or the Federal Reserve insisting on an end to too big to fail?

Quite the opposite. The new financial regulations, spearheaded by Sen. Chris Dodd (D., Conn.), only bring back too big to fail by authorizing a Systemic Risk Council headed by the Treasury secretary.

Regulation often fails either because regulators are better at announcing rules than at enforcing them, or because the regulated circumvent the regulations. Consider the Basel Accord, passed following bank failures in Germany and the U.S. in the 1970s. This was supposed to reduce banking risk by requiring banks to increase capital if they increased holdings of risky assets. But financial markets circumvented it by putting the risky assets off their balance sheets. Unusual? Not at all. In 1991 Congress passed the FDIC Improvement Act, which authorized regulators to close banks before they lost all their capital. Regulators ignored it. Unusual? Not at all. Bernard Madoff, Allen Stanford, AIG--regulation failed in all of these instances.

This is because regulation is static, while markets are dynamic. If markets don't circumvent costly regulation at first they will find a way later.

The answer is to use regulation to change incentives by making the bankers and their shareholders bear the losses. Beyond some minimum size, Congress should require banks to increase their capital more than in proportion to the increase in their assets. Let the bankers choose their size and asset composition. Trust stockholders' incentives, not regulators' rules.

Secretaries Timothy Geithner and Hank Paulson told Congress at the AIG hearing earlier this month that they faced a choice: a bailout or another Great Depression. This is not true. Classic central banking offered a better alternative. Let AIG fail and lend to the market on good collateral. The Fed, acting as lender of last resort, should protect the market--not the failing firm. That policy worked well in the 19th and early 20th century by inducing banks and counterparties to hold collateral acceptable to the Fed following failures.

The market is not perfect. It is run by humans who make mistakes. But the same humans run government where they make different, often more costly, mistakes for which the public pays.

At the moment, we see the government spending excessively and making promises to spend that cannot be kept. This is already a major problem in states like California and countries like Greece, but the federal government will soon join them. At all levels of government, promises to pay state and local pensions and to provide health care far outstrip its capacity to pay. The Congressional Budget Office and many others have been warning for years about the $50 or $60 trillion of unfunded liability. Washington's answer on health care? Offer an expensive drug benefit followed by a more expensive "reform" that increases the unfunded Medicare-Medicaid liability. Dissemble about the real costs.

Regulators talk a lot about systemic risk. They do not--and probably cannot--give a tight operational definition of what this means. So setting up an agency to prevent systemic risk, as Mr. Dodd has just proposed, is just another way to pick the public's purse. Systemic risk will forever remain in the eye of the beholder. Instead of shifting losses onto those that caused them, systemic risk regulation will continue to transfer cost to the taxpayers. The regulators protect the bankers. They continue to lose sight of their responsibility to protect the public.

The Senate Banking Committee has considered putting the Treasury secretary in charge of systemic risk management. But Treasury secretaries are the officials who authorized all or most of the bailouts since bailouts began, beginning with the mistaken policy of saving First Pennsylvania in the 1970s. This is not financial reform. Real financial reform requires that bankers--not regulators--monitor the risk on their balance sheet and accept the losses from mistakes. We will not get sound banking until the CEOs of the large banks and their shareholders are forced to pay for their mistakes.

For the first 150 years of this republic, the federal government ran a budget surplus in most peacetime years. Wartime deficits were followed by surpluses that reduced outstanding debt. President Truman paid for most of the Korean War, President Eisenhower ran a budget surplus except during the deep 1957-58 recession. Except for the Clinton years, deficits have been the rule since the 1960s. When Vice President Dick Cheney told Paul O'Neill that deficits didn't matter, he neglected to add "if the Chinese or Japanese buy the debt."

Gold standard rules and a strong belief in a balanced budget protected us from fiscal imprudence for the U.S.'s 150 years. Both rules are gone. Now both political parties favor a balanced budget when they are out of power.

Greece has a reluctant European Union to possibly offer some relief. But who will we turn to if we are so foolish as to wait for a crisis to reduce current spending and future promises? The president talks about freezing discretionary spending one day, but the next promises to build high-speed railroads and enact middle-class entitlements including an expensive health-care plan. When will the administration present a credible plan to prevent the looming financial crisis?

Capitalists make errors, but left alone, markets punish such errors.

Allan H. Meltzer is a visiting scholar at AEI.

Photo credit: stock.xchng/mokra

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Allan H.
Meltzer
  • Allan H. Meltzer is the Allan H. Meltzer University Professor of Political Economy at Carnegie Mellon University. He is the author of History of the Federal Reserve, Volume I: 1913-1951 (University of Chicago Press, 2002), a definitive research work on the Federal Reserve System. He has been a member of the President's Economic Policy Advisory Board, an acting member of the President's Council of Economic Advisers, and a consultant to the U.S. Treasury Department and the Board of Governors of the Federal Reserve System. In 1999 and 2000, he served as the chairman of the International Financial Institution Advisory Commission, which was appointed by Congress to review the role of the International Monetary Fund, the World Bank, and other institutions. The author of several books and numerous papers on economic theory and policy, Mr. Meltzer is also a founder of the Shadow Open Market Committee.
  • Phone: 4122682282
    Email: ameltzer@aei.org

What's new on AEI

image The money in banking: Comparing salaries of bank and bank regulatory employees
image What Obama should say about China in Japan
image A key to college success: Involved dads
image China takes the fight to space
AEI on Facebook
Events Calendar
  • 21
    MON
  • 22
    TUE
  • 23
    WED
  • 24
    THU
  • 25
    FRI
Wednesday, April 23, 2014 | 12:00 p.m. – 1:30 p.m.
Graduation day: How dads’ involvement impacts higher education success

Join a diverse group of panelists — including sociologists, education experts, and students — for a discussion of how public policy and culture can help families lay a firmer foundation for their children’s educational success, and of how the effects of paternal involvement vary by socioeconomic background.

Event Registration is Closed
Thursday, April 24, 2014 | 12:00 p.m. – 1:30 p.m.
Getting it right: A better strategy to defeat al Qaeda

This event will coincide with the release of a new report by AEI’s Mary Habeck, which analyzes why current national security policy is failing to stop the advancement of al Qaeda and its affiliates and what the US can do to develop a successful strategy to defeat this enemy.

Friday, April 25, 2014 | 9:15 a.m. – 1:15 p.m.
Obamacare’s rocky start and uncertain future

During this event, experts with many different views on the ACA will offer their predictions for the future.   

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.