On financial regulation

I heard several good arguments today from different episodes of EconTalk. While I certainly don't claim to be an economics expert or even a well-versed amateur, I have to say that I'm a sucker for a good argument and will continue to post about well reasoned counterintuitive analyses when I see them, regardless of the topic. And as always, I'd love to hear disagreements.

Charles Calomiris spent a lot of time defending free markets, as economists tend to do. By most accounts, we seem to have avoided financial calamity and are now in the stage of thinking how to avoid this painful process from repeating itself in the future. The token democratic answer, as always, has been that we need more and more regulation over financial transactions in order to decrease systemic risk. I've heard some convincing arguments from the regulatory side, but to use this most recent financial collapse as an example of free market failure is absolutely absurd. The financial industry is without a doubt one of the most heavily regulated industries in the country and when a problem arises it is blasphemous to blame the free market system without any critical regard to the current governmental regulations.

Take a regulatory body that is relatively tangible to most people: the FDIC (Federal Deposit Insurance Corporation). This is the governmental agency, funded by tax payers, that insures deposits up to a certain point (which I believe was at around $100,000 pre-crisis and has since sky rocketed). In the days before the FDIC, if Wells-Fargo failed, you could have kissed your savings account goodbye. The concept is foreign to me, and it seems relatively cut and dry that the average consumer with low to moderately sized checking and savings accounts benefits from knowing that no matter what happens to their bank, their money is safe.

So what's the problem? Well, risk was once, and should still be, a competitive selling point for banks. Why put your money in bank A rather than bank B? Easy, a back of the envelope cost benefit analysis of the interest that the different banks are offering versus the risk of default will lead you to the bank which best suits your individual tolerance for risk and greed for return. The minute that government decided that all balances under a certain nominal value were 100% insured, the consumer stopped using risk as a shopping point, and in turn banks were forced to compete solely on monetary return. In turn, banks logically made riskier investments because the potential returns are much greater and their risk is almost entirely subsidized by you the taxpayer. Blaming the bank for making risky investments, and claiming that its eventual failure is a result of greedy bankers and unrestrained capitalism misses the point by a mile. If the market were truly free, banks would compete to minimize risk and advertise their minimal risk exposure as a selling point to consumers who would in turn determine the optimal amount of risk that they are willing to handle for a given investment.

To be fair, the FDIC is but a small part of the financial system and I'm not trying to boil down this complex financial debacle to something as simple as one regulatory policy. But if we sum enough of these backwards policies up, the financial collapse makes more and more sense. Most of you have heard that much of this crisis rested on a housing bubble, but this housing bubble was again by no means a case of free markets gone awry. Seemingly innocuous government policies, including enormous tax-credits for home owners, played a crucial role in creating an artificial demand for home ownership which lead to an unfounded inflation of housing prices that could only be sustained for so long.

I'm by no means a complete free market liberetarian (yet), but I do tend to think that letting markets decide on at least some of these matters is a far better option then government. Financial reform is in need, and some new policies might be extremely helpful, but it could all be counter productive if we don't delete/revise the harmful policies that were created with good intention, but make little economic sense in hindsight. It's a lot easier to blame the CEO of Bank of America for his greed and affluence than it is to revamp the government support system that drives companies toward such policies. That's unfortunate.

*posted on fingerprints.and.snowflakes*