“Let’s look at several of the problems that happened over the past few years in the financial sector, and see how legislative efforts have attempted to address them. (Spoiler alert: not very well.)”
Mike tells this story:
Our regulator’s goal isn’t to make a system in which there are never failures but a system in which failures are cleaned up in an orderly and nondisruptive fashion. Like an elaborate game of Jenga, even removing the smallest piece can collapse the entire structure, and regulators need to be able to remove any piece without having the entire real economy collapse.
This is a great story. Can it be rationalized? What objective function of regulators would lead them to aim to prevent “disruption”? A disruption now and again might be good by standard measures of welfare. Does Mike have a public choice model in mind? Do bailouts improve the chances of re-election?
Is the system as precarious as Mike suggests? Bailouts are sold to the public using a counterfactual that is rarely, if ever, observed. Namely, if the bailed out institutions were allowed to fail, it would have produced an undesirable level of systematic risk. When have failed banks caused systematic risk? The Great Depression had bank runs which caused a bad situation to get worse. But bank runs weren’t, by far, leading the causal chain. You need deflationary expectations, no deposit insurance and no branch banking to get those sorts of bank runs.
Besides, is the recent banking crisis evidence of the system’s precariousness or evidence against it? A long time transpired between banking crises in the US.
UPDATE: What is systemic risk?