Two economists, Peter Boone and Simon Johnson,  argue that the recent bailout is merely another installment in a cycle that, if we continue on our current trajectory, will lead to a crash on par with that which precipitated the Great Depression.

The doomsday cycle has several simple stages. At the start, creditors and depositors provide banks with cheap funding in the expectation that if things go very wrong, our central banks and fiscal authorities will bail them out. Banks such as Lehman Brothers – and many others in this past cycle – use the funds to take large risks, with the aim of providing dividends and bonuses to shareholders and management.

Through direct subsidies (such as deposit insurance) and indirect support (such as central bank bailouts), we encourage our banking system to ignore large, socially harmful ‘tail risks’ – those risks where there is a small chance of calamitous collapse. As far as banks are concerned, they can walk away and let the state clean it up. Some bankers and policymakers even do well during the collapse that they helped to create.

They argue that the current regulatory system is broken and needs a fundamental overhaul. Perhaps this is true. But if banks and other lenders knew for a fact that if they invested irresponsibly and things went sour they would NOT be bailed out by the government, would they act more responsibly? If so, at least part of the trouble is not inadequate regulations but a safety net that distorts the true cost of risk. Let ’em fail. But, many reply, if they fail, they will bring down the entire economy. If so, the solution is clear: break them up. The only other alternative is to increase government control over those entities whose failure threatens everyone.

h/t  Steven Rybicki

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12 COMMENTS

  1. The simple solution would be to take the Fed out of the business of setting interest. As it stands, the criminals have access to a privileged source of better-than-free money, which they can then use to generate all sorts of frauds and crimes…. (Derivatives, Carbon Credits, etc) … while the honest people have to borrow through other channels, where money is either exceedingly scarce or exceedingly expensive.

    The whole point of having interest rates was to apply normal supply-and-demand discipline to both borrowing and saving. Until this is restored, all the money will remain in the criminal sphere.

    Won’t happen, of course, because the criminals have total control. As demonstrated nicely when 70 occupants of the Senate confessed their role as accomplices in bribery by re-confirming Bugsy Bernanke.

  2. There’s another element to add onto this: *why* did the institutions pursue such risky schemes? Even with the implicit government guarantees that they had, it was still dangerous for them. As folks like Lehman Brothers found out, it’s not always good to be at the mercy of the government.

    David Layman (“Spengler” at First Things) has argued (here) that the reason the financial industry created all the additional high-risk derivatives, like MBSs and CDOs, and pretended that they were not risky is because they needed unrealistically high return rates to meet the obligations of retirement funds.

    When retirement funds require a return of 8-9%, there needs to be a product out there that can achieve that. There weren’t enough high-return low-risk securities out there to meet demand, so the market turned to the only place with supposedly “guaranteed” high returns: real estate. The idea was to turn real estate into mortgage-backed securities, so that mutual funds and retirement funds could cash in on the housing boom. But because those entities were required to only invest in safe, highly-rated securities, the ratings agencies were deputized to rate all of those MBSs as highly as they could.

    This was great at first. As the housing boom and the retirement funding boom both continued, there was more and more demand for MBSs. That’s why mortgage brokers had such a high incentive to sign up anybody they could find, no matter how broke, for a mortgage. The retirement funds were buying up everything in sight, and the ratings agencies were greasing it all up with AAA ratings.

    So yes, we need loads of reform to discourage big banks from thinking the government is going to guarantee them against risk. But we also need to figure out how to cope with a retirement flood without having to manufacture trillions of imaginary dollars in derivatives and then pretend that they are safe bonds.

  3. The gov’t doesn’t set interest rates, except for money that it lends. The rest of the market is private. What the Fed does is try to influence the amount of money the banks can create. The fault is not with the Fed, it is with a system where a private group of citizens can create money. IN fact, they create about 95% of the money in circulation. The current doesn’t need to be reformed; it needs to be abolished.

  4. John, am I correct to infer that what you mean by “a system where a private group of citizens can create money” refers to credit?

  5. The responsibility for creating credit needs to be transferred to a democratically accountable body that can then auction out credit parcels to private banks to ration out for socially optimal objectives.

  6. “…the solution is clear: break them up.”

    Mark it is fine idea, I am 100% there with you, but I do not see anything short of a revolution that could accomplish this. Corporate interests own our politicians, our courts, and it appears that any populist political movement will be subverted. If you can see a path, I love to hear it.

  7. In the United States the economic and political systems are dysfunctional because of their corruption by corporations. The Democratic and Republican Parties are heavily corrupted and can no longer be trusted. The only option is to build a new party which I would call the Center Party since its aim would be to build a platform that avoided the Principal – Agent problems of Big Government and Big Capitalism.

  8. ” The only other alternative is to increase government control over those entities whose failure threatens everyone.”

    You have just made a powerful case against the further nationalization of health care, where “those entities” are human individuals.

  9. Am I mistaken or did I hear that the current plan for improved regulation will place the Regulatory Agency within the FED….. with the idea that it must be “independent”. Independent from whom one might wonder.

  10. Could the precipitation of another great depression possibly lead people to see that Small is Beautiful?

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