Boy, Does This Ever Sound Like Canada! (Guess Which Side)

April 22, 2010

Political Fatal Conceit

By Monty Pelerin

Economists and lawyers think differently. Economists believe that incentives are more effective to alter behavior; lawyers believe that coercion via laws is the way to affect behavior.

The parable of the Sun and the Wind is illustrative. They are both intent on getting a man to remove his overcoat. The Wind tries to blow the coat off, an action which only produces behavior that makes retention of the coat more valuable. The Sun heats up, making removal of the coat more comfortable than retention. In the latter case, the man willingly removes his coat.

In the parable, the Sun behaved like an economist providing incentives to alter behavior, while the Wind behaved like a lawyer trying to coerce behavior.

In Washington, most elected politicians are lawyers. Too many believe that they can achieve desired behavior via coercion. They distrust incentives and markets. All problems are seen as having legislative solutions -- i.e., coercions or controls. Our current financial mess is being approached in such a fashion.

There is no real reform underway for the banking system. If real reform were intended, the following bank expansion, as reported on from the NY Times, would not have been permitted and encouraged:

In the last year and a half, the largest financial institutions have only grown bigger, mainly as a result of government-brokered mergers. They now enjoy borrowing at significantly lower rates than their smaller competitors, a result of the bond markets' implicit assumption that the giant banks are "too big to fail."

Instead of worrying about the real problem, the administration and Congress took the populist route of demagogy, attacking the executives and their pay levels. While many believe that those attacks were not unwarranted, they were political diversions and not constructive to producing any solution.

Size matters! The moral hazard associated with too-big-to-fail enables large banks to engage in more risky behavior than prudent. Because of the implied government "put" to save them, investors and depositors provide funds in excess of what they otherwise would. The normal corrective forces of the free market are negated by such a "put," enabling big banks to engage in bad behavior. 

When George Schultz was Treasury Secretary and was approached with the "too-big-to-fail" issue, he is reputed to have responded, "Well, then, make them smaller." That was the right advice then and now. However, according to the Times,

... there is no attempt to break up big banks as a means of creating a less risky financial system. Treasury Department and Federal Reserve officials have rejected calls for doing so, saying bank size alone is not the most important threat.

Gary H. Stern, former president of the Minneapolis Federal Reserve Bank and co-author of Too Big to Fail: The Hazards of Bank Bailouts, described the current bill as follows: "It tries to address the problem but it's half a loaf at best. It doesn't address the incentives that gave rise to the problems in the first place."

The belief that Washington is able to design any legislation for any purpose would be laughable if it were not so harmful. Can anyone point to a single government program that has been successful in terms of its original intent and costs? Is there anything that has ever been "regulated" properly?

Any bill that passes without breaking up the large banks is doomed to failure. It will ensure a repeat of this crisis, except on a larger scale. Past interventions created the conditions for this banking crisis. The impossibility of effective regulation enabled it to fester and grow.

Congress now proposes more of the same. Apparently, they don't understand the definition of insanity as attributed to Einstein: "doing the same thing over and over again and expecting different results." Or perhaps they do and are arrogant enough to believe that they can legislate anything, including legislating away the law of unintended consequences.

The issue is not bad regulations, bad regulators, or bad bankers. The issue is complexity. No one person or group is capable of writing effective legislation for complex markets. No legislation can replace market monitoring and discipline. That would be true even if regulators were not influenced by politicians (the "public choice" argument).

To believe otherwise is to engage in what Friedrich Hayek termed the "fatal conceit." According to Greg Ransom, who made this observation almost a year ago:

The interpretation of Barack Obama and his government as an instantiation of what Friedrich Hayek examined in his classic book The Fatal Conceit has become one of the dominant narratives of today. In May John Stossel wrote a widely circulated pieceon the topic. This week, Thomas Sowell weighs in. So does Sheldon Richman. And also Ralph Reiland. I'm guessing we'll be hearing more about this over the next month and year.

The only way to solve the financial crisis is to allow markets to discipline bad banks. Effective reform of the banking system can be achieved in only two ways:

• 1. Break up the too-big-to-fail banks and preclude their attaining the size where that adjective would ever apply again.
• 2. Revisit the entire concept of banking to move it closer to free-market banking.

Both solutions would be amenable to bank failures without bailouts. The threat of real failure reintroduces market discipline to banking. It provides an incentive for bankers not to take the additional risks that increase the probability of failure. Nothing being talked about in Washington today achieves that goal.

A financial bill will pass. It will be accompanied by all the celebratory hoopla that infects Washington. It will not break up the big banks. It will be another Washington charade designed for the rubes that are expected to vote in the next election. This kick-the-can behavior is what got us into the mess, and it guarantees an even bigger crisis in the future.

Eventually, the crisis will repeat itself. It is probable that the next crisis will produce a worldwide collapse of the banking system. At that point, item number 2 above, the real solution, will be addressed. 

When that point is reached, we will have come full circle back to the old Jefferson-Hamilton debates about banking. Hopefully, Jefferson will then be seen as correct, and the world can get a banking system that serves the people rather than the bankers. Properly designed, banking will no longer be the cause of periodic business and financial crises.

Monty Pelerin maintains a website at economicnoise.com. Contact him at montypelerin@gmail.com.

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