Don't solve problems, stop causing them By Scott Sumner

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

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

1. Looking for ways the government caused the crisis

2. Considering whether the cure is worse than the disease

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Here’s how government should react to disasters:

1. First, do no harm.

2. Look for regulations that contributed to the disaster and gradually dismantle them.

3. Only add regulation when there is a strong theoretical presumption of market failure, due to problems such as monopoly or externalities.

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

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

That’s why I’m not a progressive.

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

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

Don’t forget, I’m the king of debt. I love debt.

Just asking.

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