Economics, Monetary Policy, Pethokoukis, Regulation

How do we reform the US financial system without returning to the 19th century?

A bronze sculpture of the New York Stock Exchange Bull is seen at the Museum of American Finance in New York October 2, 2008. REUTERS/Shannon Stapleton

A bronze sculpture of the New York Stock Exchange Bull is seen at the Museum of American Finance in New York October 2, 2008. REUTERS/Shannon Stapleton

Some right-of-center folks will point to a pre-income tax, pre-Federal Reserve America as the the policy model for 21st century America.That view is well outlined by James Grant in the FT:

I divide [U.S. financial] history into two eras, ancient and modern. Between the civil war and the Depression, banks looked after themselves. There was no federal deposit insurance, the dollar was defined as a weight of gold and no bank was too big to fail. A good banker lent against the collateral of short-dated commercial bills, not – heaven forfend – property. In those long-ago days, capitalists bore the costs of the downside as well as the fruits of the upside. …  When, more than 100 years ago, George Gilbert Williams, president of the famously conservative Chemical Bank, was asked for the secret of his success, he replied: “The fear of God.” You can have the fear of God or the socialisation of risk, but you cannot have both at once.

Of course, we have socialized risk through both deposit insurance and the bank bailout culture of the past generation. The moral hazard issues presented by the latter seem obvious. As to the former, while deposit insurance — much like Social Security and Medicare — is a well established feature of the modern American policy landscape, many financial experts see it as problematic. A study by the Kansas City Fed illustrates the basis for their concern:

This analysis of insured and uninsured banks in [1930s] Kansas suggests that FDIC insurance was most appealing to weaker banks because it enabled them to compete for deposits on the same basis with stronger institutions. …

An important question is what implications the Kansas experience with uninsured banks might have for public policy and deposit insurance today. Deposit insurance is now a critical and seemingly permanent piece of the public safety net in the United States. Not only is deposit insurance important in protecting small depositors, but it is also key to maintaining financial stability and public confidence during periods of financial stress. However, as shown by Kansas banks, deposit insurance removes a strong incentive that banks once had to maintain higher capital and exert tight control over risk exposures in order to attract and keep depositors.

The Kansas experience, as well as these more recent crises, further indicates that deposit insurance might be leading to a costly misallocation of resources in the financial sector and throughout the economy, since this insurance allows weaker banks with poorer lending records to attract funds just as readily as stronger institutions.

The recent financial crisis also shows that policymakers still struggle to find a good solution despite steps taken to tighten regulation and supervision. Consequently, it may be time to re-examine deposit insurance and rethink how far it should be extended and what risks and activities insured banks should have the authority to pursue.

Well, how do we get there from here? How do we create a broadly stable financial system where market forces drive decision making? Limiting the government backstop by breaking up big, complex banks may be one part of the solution. Simpler, transparent, and higher capital levels are another. But monetary policy has a role to play by preventing the sorts of deep downturns that can trigger financial crises — and then a huge government response both regulatory and fiscally. This is a big reason I am attracted to the idea of changing the Fed’s mandate to one where it would target nominal GDP levels. Scott Sumner:

Conservatives often ask me how I can in good conscience defend the Federal Reserve System. Why don’t I advocate letting markets set interest rates, letting markets set the money supply. Why not advocate free banking.  Etc., etc.

I would argue that I am doing this, and more.  You just aren’t paying close enough attention.  Milton Friedman wanted to show that tight money caused the Great Depression in order to get better monetary policy.  But an even bigger reason was to show that capitalism worked and that socialism wasn’t needed.

I’m trying to get the Fed to target NGDP so that we can have a more capitalistic economy, without feeling that if we don’t bail out GM, the unemployment rate might rise.  My hope is that if we do this, eventually we’ll see the obvious need for a NGDP futures market.  And that will lead us to see the obvious need to target NGDP futures prices, and let the market determine the money supply and the interest rate.  And then we’ll abolish TBTF, as we’ll no longer fear that big bank failures will lead to recessions.  And then we’ll abolish FDIC.  And then we’ll allow free banking; after all, even if a few wildcat banks fail it won’t affect the macroeconomy.  But it matters how you do this.  Go to wildcat banking without first getting rid of deposit insurance and you end up like Iceland.

First things first.

4 thoughts on “How do we reform the US financial system without returning to the 19th century?

  1. Here’s the question. What is wrong with the FDIC approach to all banking?

    Bonus question: how about a transaction tax on derivatives and similar and that tax goes into an insurance fund for bailouts?

  2. Helloooo. I believe the late, great shadow banking system had all the market driven features for which Mr. P yaarns. Remember the run on money funds that obliged the Treasury to offer an explicit guarantee? And the repo crisis that forced the govt to inject liquidity to bail out dealers? And don’t forget the asset-backed security business that turned cash into crap mortgages.
    The thing about simpler times is that they never come back. Or that they were simple at all. Read Ron Chernow’s “House of Morgan” for the many times JP called together his buds and twisted arms until they had an answer for the Panic of (insert year here.)

  3. ” How do we reform the US financial system without returning to the 19th century? ”

    The issue isn’t today vs. 19th century, it’s a money economy or not, robbery or not. People decide what money is worth, all they need to know is what it is, a standard of value. The 1913 Federal Reserve Act called for regulating, not what the US Constitution calls for regulating, money’s value, but the money supply. The money supply can only matter if money’s value doesn’t, if what money is doesn’t, if robbery, not money, is intended, if fiat money replaced the gold dollar. Ignoring money’s value leaves the primitive condition, price-haggling, financial complexity, as the only behavior option. So far from controlling money, the Federal Reserve robbed the nation of the money economy a century ago, tries in vain to conjure a replacement out of price-haggling and counterfeiting, a useless price-control scheme, financial chaos plagues the world. With communication vastly improved otherwise, the promise of a much better world, the continuing inability to communicate value by so well-known an expedient as a standard of value grows ever more glaring. Abolish the Federal Reserve, restore the gold dollar.

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