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Financial Regulation in the Twenty-First Century

Thoma vs. Mankiw on Opt-Out Financial Regulation

I score this one for Mark Thoma. Mark Thoma is... puzzled, I think is the word... by Greg Mankiw's claim that there is something intellectually wrong with Austan Goolsbee's endorsement of the idea that there should be "enhanced regulation of any financial institution that has access to the Fed's discount window.... Mr. Goolsbee said that an Obama presidency would ensure that investment banks are regulated as closely as commercial banks." Mankiw writes:

George Stigler rolls over in his grave: Remember when the University of Chicago used to be the intellectual center of the deregulation movement? No more.... This story seems to confirm the fears of Vince Reinhart [that the Fed's actions in Bear Stearns will be used to argue for more spending and more regulation...]

Mankiw is wrong here on a bunch of levels.

First, George Stigler is not rolling over in his grave. On matters of financial regulation, George Stigler showed great deference to Milton Friedman, and Milton was in favor of extremely tight regulation of any financial institution whose liabilities served as part of the economy's stock of liquid assets--as those of us who did the reading that Tom Sargent assigned and read Friedman's Program for Monetary Stability know: the restrictions that Friedman thinks should be imposed on what reserves banks must keep, what assets banks can hold, and what promises banks can make about the liquidity of their liabilities are absolutely draconian.

Second, Mankiw is mistaken in portraying the belief that additional regulation of not just commercial but investment banking as Obama's initiative. Here Obama is simply backing Ben Bernanke, who said last month:

Ben Bernanke, Liquidity Provision by the Federal Reserve, May 13, 2008: Although central banks should give careful consideration to their criteria for invoking extraordinary liquidity measures, the problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis. Recall Bagehot's advice: "The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times" (p. 24).... In light of the recent experience, and following the recommendations of the President's Working Group on Financial Markets (2008), the Federal Reserve and other supervisors are reviewing their policies and guidance regarding liquidity risk management.... [F]uture liquidity planning will have to take into account the possibility of a sudden loss of substantial amounts of secured financing.... [I]f moral hazard is effectively mitigated, and if financial institutions and investors draw appropriate lessons from the recent experience about the need for strong liquidity risk management practices, the frequency and severity of future crises should be significantly reduced...

Mankiw appears to be trying to portray this as Obama, and it's not: it's Bernanke and Geithner and Kohn and company.

Third, Mankiw does not grasp the reason that Ben Bernanke believes that the Fed needs additional regulatory tools. Mankiw asks:

George Stigler rolls over in his grave: Here's a question for Austan: Can an investment bank avoid such regulation if it promises never to use the discount window? Or is this insurance-regulation combo a mandate?

And here I want to turn the mike over to Mark Thoma, who starts out:

Economist's View: Is Austan Goolsbee Betraying the Chicago Tradition? If So, is That Bad?: [A]ccess to the Fed's lending facilities should come with regulatory restrictions. The question is whether banks should be allowed to move outside the regulatory umbrella if they voluntarily give up access to the discount window...

And then Mark puts his finger on it:

A bank would also have to promise that it would not become "too big to fail" for the commitment from the Fed to prohibit access to the discount window to be credible. If a bank does become too big to fail and if it runs into trouble and asks the Fed for help, then the Fed will be forced to bail them out... no matter what the prior agreement had been. Sending the economy into a tailspin and deep recession simply to honor a past promise to prohibit access to the window would not be the best policy at that point.... [B]anks [that] can grow large enough to threaten the overall economy... [require] a regulatory solution... either... regulate the size of banks... [and] intervene if a bank grows too large. Or... allow banks to grow large... because large banks have desirable efficiency properties, but [then] impose regulations to reduce the chances that they will need [help]... limit their ability to damage the overall economy...

The key which Mankiw does not recognize is that access to the discount window is not a favor that the central bank provides that is good for the bank in return for the bank's acquiescing in a regulatory power grab. Granting access to the discount window is a step the central bank takes in the interest of avoiding the mass unemployment that would be produced by bank failures that disrupted the payments and investment-finance system. The central bank is then required to take the next regulatory step to try to curb the moral hazard that its guarantee generates.

The last people to offer the financiers freedom from regulation in exchange for freedom from financial support in a crisis were Herbert Hoover and his Treasury Secretary Andrew Mellon, with Mellon's cry to let the Great Depression roll forward to its natural free-market conclusion. To quote Hoover:

[T]he “leave it alone liquidationists” headed by [my] Secretary of the Treasury Mellon, who felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” He insisted that, when the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. He held that even a panic was not altogether a bad thing. He said: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”...

That did not turn out so well. Ever since monetary policy has been made--and monetary theory made as well--in the shadow of the Great Contraction. That was why Stigler deferred to Friedman so completely on issues of financial regulation. And that was why Friedman was so anxious to make sure that no financial institution that provided a share of the economy's liquid, spendable assets had enough freedom from regulation to make large leveraged bets that would take it down in a crisis.