Is the Financial Sector a Utility?

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I am a fervent believer in free markets.  More specifically I believe that they, much like Democracy, are flawed but vastly superior to any alternative.  As various elements in the world decry the current financial crisis as an indictment of the flaws of capitalism, I wait patiently for them to suggest the proven alternative.  Despite this, I am left wondering if the financial sector is an exception to the wisdom of free markets.

Does Regulation Even Work?

If I’m defending free financial markets, my first piece of evidence is the Office of Federal Housing Enterprise Oversight.   This organization was 225 people as of 2006, tasked solely with regulating and overseeing Freddie Mac and Fannie Mae.1 With both of those organizations now being operated by the government after becoming tremendously over-leveraged, the efficacy of regulation is certainly in doubt.  If an organization of 225 people cannot regulate a large financial entity, what good does adding more regulation to the system do?

Is Financial Destruction Creative? 

One of the great arguments for free markets is the idea of creative destruction.  An oversimplification of the idea is that when you have an asset bubble burst its capital is reallocated more effectively.  In the end the death of these asset bubbles is good for your economy.2  Hyman Minsky would argue that this is not equally true of a financial bubble.  He suggests that a financial boom and bust cycle differs from a normal market, in that the bursting of the bubble does not result in creative destruction, but instead simply a deflationary cycle.  Capital is actually destroyed instead of reallocated.3 This suggests that unbridled booms may not have the same benefits in the financial sector that they have in other markets.

Who’s Really At Risk?

We have empirical evidence to suggest that more politicians side with Minsky and believe that this deflationary cycle is something that must be avoided.  Namely they believe that they need to counter this deflationary cycle with government spending and bailouts.  If they support this idea then this inherently leads to an asymmetric risk profile.  During the booms, bankers and investors are rewarded handsomely because they’re allegedly taking a lot of risk, however during the bust, they are bailed out because society doesn’t want to deal with the “destructive destruction” that the bubble bursting brings.  They get rewarded for risk they aren’t actually taking.

What We Already Know

All of this sounds very theoretical and doesn’t necessarily suggest that if the government were to allow the banks to simply go bankrupt that it wouldn’t wind up being for the best.  However there is also empirical and practical evidence to suggest that some industries are inherently better served with some government interference. 

The most obvious example is FDIC insurance.  By putting the full faith and credit of the US government behind our banking institutions, we bring stability to the banking industry that was simply not there before.  Without this kind of insurance, people would literally have to analyze the balance sheets of banks to decide whether they wanted to keep their money there.  They’d also have to keep doing this due to fear of losing their life’s savings.  Ultimately this would deter many people from putting their money in banks at all.  This is not good for the flow of capital.

 A more glaring example is the insurance industry.  Imagine if insurance companies were not heavily regulated.  People could start insurance companies, charge unduly low premiums and when they didn’t pay off, they could simply declare bankruptcy and then insurance claims would go unpaid.  Once again it’s not necessarily good for the economy for insurance purchasers to have to do a tremendous amount of research before they can buy simple insurance.  Thus we regulate insurance companies to make sure that their claims will not go unpaid.  As AIG and the Credit Default Swap outcomes have shown us, insurance and banking are very closely related industries.

Utility Regulation

While all these arguments are compelling, it seems likely that the best outcome is somewhere in the middle.  Pro-regulation pundits are of course calling for blood and suggesting that the banking industry is out of control and needs tremendous reform.  One fears however that if the pendulum swings too far you will have the same kind of slow growth and poor allocation of capital that you see in other heavily regulated industries like utilities. 

While you don’t want to see the kind of insane risk, backed up by an asymmetric risk profile that we’ve all just witnessed, you also don’t want overly cautious banks.  In fact right now you’re seeing the pain of a “credit crunch” caused by banks that are afraid or unwilling to lend money.   Further diminishing banks’ willingness to lend doesn’t seem like a wise idea in the long term. 

Governments almost never run things efficiently, so you probably don’t want them taking too much control over our country’s capital allocation.  Central planning does not have a good track record for efficient capital flow.  While lawmakers are rarely reasoned, or contemplative, one can hope that this would be a case where they would invest the time in striking the right balance of regulation and market forces.

  1. OFHEO 2006 Performance and Accountability Report []
  2. Joseph A. Schumpeter – Capitalism, Socialism and Democracy []
  3. The Economist – Minsky’s Moment []

3 Responses to “Is the Financial Sector a Utility?”

  1. BMB says:

    It’s too bad that the FDIC isn’t one of those heavily regulated insurance companies. They might actually have enough money to handle all the bank failures — if they hadn’t stopped collecting premiums from the banks for an entire decade.

    The government can’t even do the ‘right’ things right.

    Of course, we might not have all these bank failures without fractional reserve lending (silly us — we thought that when we put our money in the bank that they kept it there for us). And the AIG debacle shows that insurance companies need to stick to insurance.

    Maybe we need an alternative, more conservative, not-for-profit banking system where our money can be kept without risk if we so chose. You know, like the First Mattress Bank.

  2. Brad says:

    Your point about the FDIC points out the whole trouble with regulation of course. The regulators get caught up in the same mania that’s sweeping the rest of the nation or world. Just like Fannie and Freddie got caught up in the mix and the FDIC drank their own Kool Aid.

    I always think about game theory and how there’s just no way to implement fractional reserve banking. When you’re trying to design a “game system” you never want to have an assigned (centrally planned) number in the mix. So, shy of just making up a number (30? 20? 5?) the only real way to have banking is to give in to the shocking notion that you should only be able to lend out what you have in deposits. That seems like a likely way to help get savings rates up and our debt load down. I’m just not sure we can swallow all that medicine at once.

  3. BMB says:

    I would agree. The problem is that would result in a considerably different environment for our culture, and our ‘gimme gimme’ society is a long way from ready to accept that way of life. Of course, future generations may have no choice.

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