Last night AEI presented the 2014 Irving Kristol Award, the institute’s highest honor, to Nobel Prize-winning economist Eugene Fama. During a Q&A session with Paul Gigot, editor of The Wall Street Journal’s opinion page, Fama offered a way to avoid future financial crises:
Gigot: If the government had, say, not intervened to bail out Bear Stearns, had not taken over Fannie and Freddie, had not done the various things it did, is it possible we would not have had a recession?
Fama: Oh no, no, no. The recession, I think, was already in the works. The fact that people were defaulting on their mortgages—people don’t wake up in the morning and walk away from their houses. Usually it’s because they can’t make the payments. So I think we were already headed into a recession at that point.
Now, we’ll never know. I said at the time, “Boy, it would be a nice experiment just to let these guys fail,” because failure doesn’t mean that the assets go away. Temporarily they might have depressed prices, but eventually they’ll get purchased by other people and be put back into play.
Now no government Republican, Democrat, or otherwise will ever let that happen. The inclination is always to bail. In bad circumstances the inclination is always to bail. But what really came out of that period that really bugs me is the worst possible perversion of capitalism—the whole idea of “too big to fail.” That somehow has to get taken off the table. I don’t think Dodd Frank really lays a glove on it, because the real problem is that these too-big-to-fail institutions basically have a put option on the asset side of their balance sheet, which inflates the value of their debt, basically makes it riskless because the government is going to pay it off.
One way to take that off the table is to increase the equity requirements. Not like they’ve been talking about them, though. They have to go up to maybe 20, 25% equity financing of these too-big-to-fail banks.
Gigot: Instead of 10%?
Fama: Yeah, instead of 10%. That doesn’t hurt, there’s nothing in—well, Miller got the Nobel Prize for the Modigliani-Miller theorem, which basically says the way you finance yourself is irrelevant. And the banks will scream and say, “We need all this debt-financing because otherwise it will be idle money.” Well, look at mutual funds, they’re 100% equity-financed. No problem there.
I think just letting the megabanks fail, dead stop, would have caused such a severe, deflationary depression that America would never repeat the experiment. Too Big To Fail might well become a permanent feature of the financial landscape. Where I think Fama is completely correct is on capital levels. As I wrote not long ago:
The US has suffered 14 major banking crises over the past two centuries, as documented by Charles Calomiris and Stephen Haber in their new book, “Fragile by Design: The Political Origins of Banking Crises and Scarce Credit.” (None in Canada, by the way.) One could reasonably assume US economic growth would have been a least a smidge better without all those other crises.
In a recent Wall Street Journal op-ed, Calomiris and coauthor Allan Meltzer note that at the start of the Great Depression, the big New York City banks ”all maintained more than 15% of their assets in equity” and none went bust. Likewise, “losses suffered by major banks in the recent crisis would not have wiped out their equity if it had been equal to 15% of their assets.”
Wouldn’t a 15% leverage ratio hurt bank lending and economic growth? Consider: First you have to calculate whether it would hurt economic growth more than a continuation of America’s serial financial crises. Second, it’s a pernicious myth that debt is somehow “more expensive” than equity capital. The more stock a bank issues, the less risky the bank becomes, and the lower the return shareholders demand.
Don’t banks know this? Look, banks are responding to incentives. Bank debt operates on unequal footing thanks to Washington’s “too big to fail” backstop. University of Chicago economist John Cochrane explains that without government guarantees, “a bank with 3% capital would have to offer very high interest rates—rates that would make equity look cheap.” Like researchers Anat Admati and Martin Hellwig in their book “The Bankers’ New Clothes,” Cochrane endorses dramatically higher capital levels. So should policymakers if they want to avoid another century of financial shocks.