Saturday, April 3, 2010

In Favor of Bailout Guarantees

. Saturday, April 3, 2010

Sorry for the light posting, but between grading a giant stack of midterms and frantically revising theses and working on seminar papers we're all pretty slammed around here. But I did want to highlight something that Krugman wrote that I completely agree with:

This is the Republican strategy for beating back effective regulation: just claim that what we’re really doing is telling big banks, sternly, that there will be no more bailouts — they’re not too big to fail.

And then, when the next financial crisis arrives — well, it will play just like 2008. President Palin or whoever will find themselves staring into the abyss — and conclude that they have to bail out the financial sector anyway.

In a crisis, the financial system will be bailed out. That’s just a fact of life. So what we have to do is regulate the system to reduce the chances of crisis and the taxpayer costs when the bailout occurs.


Emphasis in original. This is not only entirely correct, it is a good thing: in a financial crisis the biggest problem is a lack of confidence in the financial sector, which leads to runs on financial institutions. This becomes a self-fulfilling prophecy, where even solvent-but-illiquid firms can become insolvent overnight. Gary Gorton's new book argues that the recent financial crisis was an old-fashioned bank run.

How do escape the vicious cycle of bank runs? The government intervenes by guaranteeing the funds of depositors. This intervention may be costly, but is much less costly than continuing to let a panic eat the financial system from the inside out. Nevermind the fact that the government cannot make a credible commitment to not bailout systemically-important financial institutions: it would be a bad thing if they could! Such a commitment would lessen confidence in the financial system and thus make runs more likely, not less.

This is the case for regulation, and simply making banks smaller won't have an appreciable effect. The problem, from the perspective of regulators, is that it is impossible to accurately measure how safe banks are with much precision. The shorthand that regulators and investors have often used -- bank capital and leverage ratios -- are not only easily manipulated but they may be impossible to accurately calculate in the first place.

It isn't easy to create meaningful prudential regulatory standards, and I don't think Krugman's Roman v. Greek analogy works all that well. "Dumb" rules like those in the first Basel Accord are easily manipulated and may even incentivize riskier behavior. Which is why we got a second Basel Accord and are on our way to a third. These safeguards will inevitably fail, and we have to be prepared for that. Not by refusing to intervene, but by guaranteeing that we will do so, quickly and decisively, in ways that reduce panic but punish insolvent firms (and no, restricting CEO pay isn't the best way to do this). It's a fine line, but it's the one we walk.

Regulatory reform should be focused on how we're going to intervene in a panic, not trying to make sure we won't when everyone knows that we will.

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