Who’s to Blame? Follow the Money

Throughout this crisis the left has been determined to blame the “unregulated” parts of the financial system, and this has required their defense of some pretty unsavory quasi-public parts of our economy (Fannie & Freddie, FDIC, the Fed, etc)  Just to be clear, I don’t mean to suggest that the left doesn’t also have problems with those institutions.  They do.  It’s just that when conservatives try to blame government meddling for the crisis, the left reflexively reacts and points out that at the peak years of the sub-prime boom (2005-06), private banks were making more sub-prime loans that Fannie Mae (FNM) and Freddie Mac (FRE).  And regarding deposit insurance, they usually suggest that it was essential to prevent 1930s-style panics, and/or the moral hazard problem was overrated.   (Actually, the bank panics of the 1930s were caused by NGDP falling in half and fear of dollar devaluation.)

Initially the left had some strong arguments.  When the crisis first got severe in 2008, it looked like F&F might remain solvent.  But what a difference two years makes.  The net cost of the bailout of banks is expected to be minus $7 billion, which means the federal government will make a $7 billion profit.  I think it is only fair to include the losses in American International Group (AIG) in that total, however, as AIG was bailed out to save banks that had derivative agreements with the moronic insurance giant.  The total losses the AIG plus the banks are now estimated by the CBO to be $29 billion.  Let’s review all the actors in this unfortunate drama:

F is for failure:

  1. The Fed.  Losses unknown, but its tight money policy created the severe recession, which dramatically worsened the financial crisis.
  2. Fannie and Freddie:  Estimated losses $145 billion, and rising fast
  3. FDIC, estimated losses $100 billion
  4. The UAW:  estimated losses from bailing out this adjunct of the Democratic party is $34 billion
  5. Banks plus AIG:  Estimated bailout costs is $29 billion and falling.

Yep, that sure looks like a failure of laissez-faire capitalism.  And I didn’t even mention the FHA, which is furiously at work trying to create another sub-prime fiasco.  Why do so many of the villains acronyms start with an F?  What does that stand for?

To get serious for a moment, here’s my take on financial reform.  We are looking at the wrong problem.  Everyone seems to visualize those traumatic days in late 2008 when the entire banking system seemed in danger of freezing up.  And of course the subsequent severe recession, which everyone blames on the financial panic.   But as readers of my blog know I think the Fed, not the financial system, was responsible for that crisis.  It’s not that I am trying to exonerate the banking system, bankers did screw up.  But there are really two separate problems that need to be disentangled, and then treated separately:

  1. How to prevent another panic/recession
  2. How to avoid future taxpayer-financed bailouts

The first problem can probably be eliminated with a 5% NGDP targeting scheme, level targeting.  If I am wrong, and the banking system freezes up despite this policy, then I am willing to let the Fed do some “lender of last resorting” (or is it lending of last resort?)

OK, but what if there are still losses to the taxpayer, maybe banks don’t repay those Fed loans.  My first response is that if once every 25 years the banking system screws up, destroys many hundreds of billions of dollars worth of bank equity, and oh by the way costs US taxpayers $29 billion, then the public policy parts of this crisis are pretty insignificant.  Let’s have the reforms focus on the bigger taxpayer hits.  Here is my solution:

  1. Gradually phase out F&F.  We can’t do it immediately, as it would hurt an already fragile housing sector.  But phase them out over a period of 10 years.  Other countries do fine without these monstrosities.  I recall that even Barney Frank is coming around to this view.
  2. Cut the FDIC insurance coverage from $250,000 to $50,000 per depositor.  This would still cover the vast majority of Americans.  Have Obama give a speech telling Americans with more than $50,000 in the bank that if they are concerned about the safety of their deposits, the extra money should be put in T-securities of MMMFs.  (In reality this reform would have to be phased in very slowly.)  Require that all FDIC-insured banks keep enough Treasury securities on their balance sheet to pay off all the insured deposits.  I don’t think banks would be able to raise enough money from small depositors to finance their activities, so they’d have to rely on higher cost sources of funds.  That’s what we want, isn’t it.  Bank selling $100,000 CDs would have to offer significantly higher rates than they currently do.
  3. Abolish “To Big To Fail,” and replace it with 5% NGDP target, plus lender of last resort in a severe freeze-up of the banking system.  If all this still isn’t enough to prevent panics, consider the idea Mankiw discussed where bank debt would automatically convert to equity when a bank got in trouble.

There, that didn’t take 1500 pages.  (I warned you yesterday that I was in the mood to develop grand schemes to save the world off the top of my head.)

PS: Don’t tell me that the losses to FDIC are not losses to the taxpayers.  They are.  In a competitive banking industry (with a flat long run cost curve), any mandatory insurance fees are passed on to bank customers, just like an excise tax on cigarettes is passed on to smokers.  There are thousands of banks in the US, and the long run cost curve is probably pretty flat.  Sometimes I hear news stories about how “progressives” are trying to have the banks pay a fee to cover the cost of future bailouts, so that taxpayers don’t have to pay.  (Rolls eyes)  I have an even better idea; the state of Massachusetts should re-write the sales tax law, requiring stores to pay the 6.25% sales tax, not customers.  Wouldn’t that be wonderful!

About Scott Sumner 490 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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