Finance Minister Jim Flaherty is arguing that he should have more power over what banks do because if the banks screw up it is Ottawa that is “on the hook.” Of course it doesn’t occur to him that Ottawa isn’t actually “on the hook” in the sense that the government HAS to bail out banks. In fact the government is not responsible for dumb decisions made by bank executives unless the government DECIDES to be responsible.
What we need here is a metaphor: Say I have a 30 year old son that is pretty reckless with his finances. He is undoubtedly a full adult and he actually has a really good job that gives him a strong income. Despite this he keeps getting in trouble with harebrained schemes and silly ideas. He is completely broke and he can’t possibly pay even the minimum requirements on his credit card.
I as his parent have two options: I can let him go bankrupt, or I can bail him out. As a loving father, and despite the fact that it puts my own finances under strain, I decide to bail him out.
Now there is somewhat of an assumption that I will be “on the hook” the next time he screws up. I haven’t even so much as tried to say this is a one time deal in any credible way, so this assumption seems to hold. So in order to protect my own savings I start telling him what to do and I start interfering with his life. He lets me because he knows that he relies on me to save him (and if this metaphor were to be more complete he would also allow me because I own a gun and he doesn’t).
If I had treated my son as an adult and allowed him to work out his own mistakes I wouldn’t have a reason or an excuse to interfere so much with his life. The reason for my interference isn’t to prevent him from screwing up, it is to protect myself, but the best way to protect myself would just be to declare that he will never receive a bailout ever again.
There are several problems with my metaphor (what metaphor isn’t problematic?). The biggest problem is that the government doesn’t have a paternal relationship with the banks. There are no familial issues of love and loyalty. A more accurate metaphor would be that I am not bailing out my son but a complete stranger.
Actually come to think of it, that isn’t a metaphor at all. I am in fact bailing out a complete stranger. I am not even doing it by choice I am being forced to bail out this stranger. In exchange another stranger (who is supposedly acting as my agent) is going to start vetoing decisions of the first stranger. I fail to see how this is remotely a good deal for me. It is far worst than bailing out my son because at least that was someone I presumably love.
So no Mr. Flaherty you shouldn’t get more power to veto bank decisions. You should instead stop forcing me to bail them out of the bad decisions. I am not even sure why you think you are such a mastermind that you can do a better job at producing a secure banking system than the market anyway. Or for that matter why you assume your successor will be as brilliant as yourself. It isn’t like government decisions have never lead to horrific disasters at any point in history.
I don’t like the idea of governments bailing out banks either but the father/son relation example is different than that of the government/bank. When the father doesn’t save the son then the son declares bankruptcy and rebuilds his financial life. The same is true in the case of government and bank but the problem in the real world is that the consequences can be very different. The son’s creditors are injured in the first case as they are in the second but the second case can also see the bank’s counter parties and customers injured and then those counter parties’ and customers’ counter parties and customers, etc. etc. The financial is so vast and so complex that the failure of a significant player can seriously impact the entire system and those of us that have dealings with and within that system.
I don’t believe that the solution to bank failures needs to be an either/or situation but that’s another discussion I’m sure. I just wanted to highlight the fact that the cases are different and the solutions will produce different consequences and so the metaphor isn’t very useful IMO.
I freely admit that the metaphor is flawed (I even said so in the post). I do however maintain that it is useful. By humanizing the relevant institutions you can more easily grasp how they will react to certain circumstances. Of course you can’t take the metaphor too literally and over extend it, but this is true of all metaphors.
But let’s argue the main point.
What you describe is admittedly bad, but it is at worst a short term correction. Capital will likely sooner rather than later reallocate and every creditor will remember the cautionary tale (or be doomed to suffer the same fate again). This may mean a nasty year, this may mean a very nasty year, but it would be over soon.
Bail outs at best solve the problem by creating a new and even worst problem. Moral hazard is not a minor issue. In a market system people and groups have to be allowed to fail for the proper allocation of resources and to instill prudence. Without failure then corporate leaders will more often take the long shot and as a result they will need more and more bail outs.
Russ Roberts of Econ Talk had a good metaphor that explains the problem (far better than mine). He compared it to a poker player who always had his bets covered by a loan that he wouldn’t have to pay back even if he lost I encourage you to take the time to listen (I think this is the right one) http://www.econtalk.org/archives/2010/03/ritholtz_on_bai.html
You did indeed acknowledge the existence of problems with the metaphor although the one you actually mention doesn’t rate very high on my list. At any rate, if we were really only talking a year of financial disruption then it might well be worth seeing a routine bankruptcy play out. I suspect that the likelihood of such circumstances occurring in the real world is pretty slim but it’s hypothetical so anything is possible. I do agree that moral hazard is an important consideration and should definitely occupy a key spot in future regulation but it will take a back seat if the failure is significant enough to begin a contagion in the financial system or leak into the real economy and cause havoc.
No easy answers for sure and it’s evidence that regulation must be proactive and carefully considered in terms of its consequences, both intended and unintended.
Banks must be allowed to fail. If the possibility of failure is removed from a bank’s decision making process there is no incentive for prudence. The most reasonable solution is for the banks to expect no bail out and make decisions accordingly. The government can then stop worrying about the banks.