Mike in The Nation

“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?

8 thoughts on “Mike in The Nation”

  1. Clearly, those that supported the bailouts had a model of bank failures in their heads. The point is you can’t test such a model because we never observe the systemic effects of non-bailed out bank failures. This may be because they don’t exist or because bailing out banks removes the systemic effects.

    Or do you imagine we can derive from first principles the perfect bank failure model with no need to subject it to data?

  2. There have been a couple of bank failures in the game economies of Second Life and Eve Online. The data from those collapses is probably more interesting than useful…

  3. “A long time transpired between banking crises in the US.” Yes, but you can also look historically to the financial panic and bank crises pre-New Deal, like 1837, 1873, 1893, 1907, etc. Between history and international evidence, there should be enough data. Many bank were allowed to fail during these episodes and there weren’t bailouts like the current one.

    Basically, how do we apply the successful New Deal financial regulation to the shadow banking system? For me, that’s the main question. How many banking or financial crises between 1933 and 1980? That’s no coincidence. This is why there has been a long time between banking crises.

  4. gabe, did those episodes result from policies that in net increased welfare?

    “New Deal financial regulation” is Glass-Stiegel? If so, same question. Are we optimizing by minimizing the risk of systemic disruption (whatever that is) or are we maximizing welfare?

  5. “did those episodes result from policies that in net increased welfare?”

    Well, it seems that analyses like Calvo-Loo-Kung are looking at a tradeoff between benefits from financial deregulation with the costs, but where can we see the benefits empirically? Growth was no better in the USA after financial deregulation than before. The costs are clear in the current crisis. First benefits need to be established, and they haven’t been yet, otherwise there are only minuses.

    Basically, some benefit from financial deregulation has to established. Currently, supporters of financial deregulation, when faced with the current crisis, handwave about some “benefits” from deregulation, and then equivocate.

    From Calvo-Loo-Kung “Although it is much harder to establish that financial development causes growth, few would doubt that, at least temporarily, financial deregulation could promote higher growth.” Well, actually I would.

    “We base our analysis on estimates of the costs of financial crises in emerging market economies (since the 1980s), a cauldron of financial crises in the last thirty years.”

    Their selection of dates is very convenient, where they use the low period as the 1980s, which was Latin America’s lost decade. A more useful comparison would be the 1950-1960s where financial deregulation hadn’t begun anywhere, even Chile, but this was not a low growth period, which is probably why this wasn’t done. Plus, there are many different policies enacted over this period, some good and some bad. Argentina’s boom in the 1990s was not just about financial deregulation. Also, n=2 right?

    So to have a real discussion about welfare, we need to find some more numbers on welfare benefits from financial deregulation, so far I’m not convinced. Welfare concerns are important, but I’d be willing to sacrifice a non-zero amount of output to never see 10% unemployment again. How has welfare in the USA increased on net from financial deregulation?

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