Protecting Banks from Themselves

I do not pretend to know enough about finance to understand the full implications of the alarming drop in value of Fannie Mae and Freddie Mac. But there is one thing I understand.

The free market does not stop people from making stupid mistakes. No system has yet been developed that can keep people from making stupid mistakes. The best the free market can promise to do is penalize stupid mistakes and drive them out of business. Milton Friedman once said (sorry, no link) that the vast majority new ideas will be bad ones. The role of the free market is weed out the majority of bad new ideas so that the minority of good ones can flourish. Any other system will try to prop up every innovation and ensure that the bad majority choke out the few good ones.

In particular, people are seduced again and again by high-risk gambles to make a fast buck, all convinced that they will be one of the fortunate few. Whenever a new industry appears or a mature industry is deregulated, a predicatable boom and bust follows. Vastly more people and business flock to the new industry than will ever be viable and a boom ensues. After a while, a shakeout follows, with most of the entrants failing and business consolidating in the hands of a relative few. The boom, with might better be characterized as a stampede, is followed by a bust as reality sets in. And in boom after boom, people refuse to see the bust that lies ahead.

In most cases, this is acceptable. The deregulation of airlines led to a great proliferation of airline companies, followed by a shakeout. No doubt passengers on some failed airlines lost their frequent flier miles, but the industry as a whole flourished. Our latest recession followed in the wake of the dot com bust. A great deal of foolishness and more than a little fraud was involved. People in the high tech industry suffered, but the economy as a whole experienced only a mild and brief decline -- even when the shock of 9/11 was added on.

Banks are no exception. Banks (or savings and loans), when freshly deregulated, will engage in all sorts of foolish behavior and fuel the sort of boom that leads to a bust. Sooner or later, reality will set in and a shakout will follow. The difference is that failing banks cause an unacceptable level of collateral damage. If the proportion of banks failing matched, say, failing airlines during the shakeout that followed deregulation (let along failing dot coms) untold numbers of innocent depositors would lose their life savings. Failures of unsound banks would lead to runs on sound ones. Vast numbers of people would fear to put their money in banks at all and funds for investment would diminish dramatically, with disasterous effects on the economy as a whole.

The same applies to insurance. A shakeout of insurance companies would mean huge numbers of people paying premiums would never be able to collect when the need arose. All types of harms would go uncompensated. Many individuals would be ruined by a single misfortune. Business, unable to rely on insurance, would become excessively risk-averse.

None of these observations are very new or original. But they are playing all too small a role in policy making decisions. Policy makers, in making regulation and deregulation should take the following basic principles into account:

(1) Deregulation will be followed by a boom, bust and shakeout.

(2) In most industries, this is perfectly acceptable. But don't act shocked when the bust and shakeout hits.

(3) In some industries, such as banking and insurance, a bust and shakeout would cause unacceptable levels of collateral damage.

(4) These industries should remain tightly regulated to protect the participants from themselves.

(5) When these industries push to be deregulated, it is because all of their members are sure that they will be the winners in the inevitable shakeout. They can't possibly all be right. So hold the line.