Should the Bank's Loss Be the Law's Gain?


The great thing about laws is that they protect us when we are unwilling and unable to do so on our own. Laws are great because they make sure no harm is done. So when it came to our attention that JP Morgan Chase just lost $2 billion because of risky investments and hedging, it may have seemed that what was needed was more and better laws, not personal responsibility.

Of course this isn't true.

Laws are necessary but not sufficient. Laws will never be able to keep pace with new developments in the financial sector, or anywhere else, which is why laws will never prevent problems but only react to them. And being reactionary instruments, laws cannot prevent the next wave of risky financial instruments or clever schemes to make money off of money.

In addition to not being able to anticipate problems, laws have unintended consequences that are sometimes worse than the problems they were designed to correct. Look at the laws that led to the housing bubble. For a time, the government, through various policies but primarily through Fannie Mae and Freddie Mac, infused more money into the housing sector than the market would have on its own. By making loans easy and affordable for people who would have otherwise not been able to secure home loans the government encouraged a misallocation of resources that drove up home prices.

Making loans available to people who would not have qualified without government interference pumped more money into the housing market than the market demanded. This drove up demand, which in turn drove home prices beyond market levels. Housing prices fell because the market corrected itself. This correction is what we recognize as the bubble bursting. The bubble and the burst were unintended consequences of the government getting involved in the housing industry.

In the banking and finance industry the government also distorts risk assessment, thereby forcing a misallocation of resources. Keeping interest rates low discourages saving and encourages investing. Low interest rates make putting your money in the bank an unattractive option if you want a return on your investment. So if you want your money to make money, you put it in the stock market. The government is essentially affecting the supply and demand of money rather than letting the market set interest rates and therefore determine where capital flows. This forces money into circulation that would otherwise not be there.

The banking laws we have in place encourage risk taking in other ways as well. First, banks the size of JP Morgan Chase know they will get government bailouts when they bet wrong, which means they can take whatever chances they want, and there is no risk involved. Second, the FDIC insures traditional deposit accounts up to $250,000, which means that no matter what kind of investments a bank makes with your money, as long as your account is below the $250,000 threshold, no one loses. Banks can fail in any number of ways without anyone involved failing to make money. The unintended consequence of government interference is an increased willingness of banks and their investment arms to take greater risks, which become no risks at all.

Certainly FDIC insurance has many benefits, as did the Wall Street and automotive bailouts, but there are unintended consequences that may have counteracted the favorable effects, if not encouraged the sort of risky behavior that created the need for the laws in the first place. The only solution is for individuals to take responsibility for their own actions. In view of our attachment to laws, this is an unlikely solution, but it is the only one with any promise.

Laws allow us to relinquish personal responsibility. When we make a bad investment that we did not understand entirely, or get into too much credit card debt because we failed to control our spending habits, it is easier to blame the lack of sufficient laws than to blame ourselves. If we were not motivated to make money we would have no reason to enter the stock market or make risky investments. But if we are motivated to do these things, the least we can do is spend some time understanding what we are getting ourselves into. If we don't understand what others are doing with our money, or understand the risk involved, then we shouldn't get involved. And if we do get involved with something we don't understand, we have only ourselves to blame. Laws can't help this; only we can. More time and energy should be directed toward cultivating character than toward crafting laws.

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Jon Harrison

"Laws allow us to relinquish personal responsibility." Should we then dispense with laws? Or are there aspects of life that are too big or too complicated for even the 140+ IQs among us to handle? The fact is that without laws we are back in the jungle. When the strong and able surpass the weak and less able, that is not a bad thing (of course, don't try to tell this to a Democrat). But when the strong prey upon the weak, society suffers. And that's why we need laws, because the strong all too often will abuse their strength. Personal responsibility alone is not enough (unfortunately) to maintain a civil and humane society. (I make this as a general point. I realize that the author is not arguing for a society devoid of laws.)

Without question, we have too many laws. And some laws are written to fight the last war, as it were, and wind up doing more harm than good. But consider financial regulation. From the time the United States began to industrialize, the nation was subjected to periodic financial panics. During the first 150 years of the Republic, these occurred with a roughly 20-year periodicity -- 1819, 1837, 1857, 1873, 1893, 1907, 1929. These "market adjustments" involved serious hardship for millions of Americans -- hardship that the average working stiff could neither have anticipated nor avoided, no matter now much "personal responsibility" he exercised. After 1929 laws were passed to curb some of the excesses of finance capital. Granted, the regime thus created was far from perfect. (How could it have been otherwise? There are no philosopher-kings among us, after all.) Yet under that regime we find no major panics occurred for almost 60 years. In the 1980s the regulatory environment began to be loosened -- and suddenly we have Black Monday in 1987, various scandals and panics in the 1990s, and finally the epic meltdown of 2007-08.

The idea that federal deposit insurance contributes to an environment in which banks take big risks is absurd. Guaranteeing small private deposits is one of the smartest things government has ever done. How many national bank runs have we had since federal deposit insurance was created? No way the average guy or gal with a checking and/or savings account would hold his bank's feet to the fire over risk-taking because his account might be in danger. The average account holder has neither the knowledge nor the time to monitor the sophisticated and opaque business practices of his bank. He ought to be able to keep his small amount of cash in the bank (rather than under the mattress) without worrying about whether he might lose it.

The problem discussed here, which boils down to the state's guaranteeing of institutions that are too big to fail, can be remedied by simply breaking up the banks. Certainly this would be a better solution than crafting a 2,000-page piece of legislation that does little more, apparently, than muddy the regulatory waters. Breaking up the banks is a clean, easy solution that protects the taxpayer from the possibility of TARP II. It does no harm. Big international deals can be handled by a consortium, as was the practice in the past. Yet no doubt many libertarians would decry a breakup of the big banks as an attack on the "market."

This piece, like others that have appeared here, concerns mainly abstractions as opposed to reality. Libertarians are marginalized in our society (indeed, throughout the world), because so many of them favor (whether they recognize it or not) theory over life. All too many Libertarians want to change the world without taking ito account the world as it actually exists and functions.

Kyle Scott

It would be nice if you did have the answer and it was as simple as you suggest. But to say that there is one definitive answer that is so clear and so simple is to fall prey to the pretense of knowledge--certainty in our ability to foresee the consequences of our actions. I prefer humility which is why I caution against government action from a large centralized body that assumes it possesses remedies for all that ail us. (I develop ths argument in my book Federalism, in articles in Publius and Arator that followed the book and in talks at the John Locke Foundation).

Does making banks smaller make sense? Sure. Is it guaranteed to work? No. There are no guarantees which is why I try to caution against such certainty which is all this article does. It tries to return responsibility to the individual and it tries to highlight that when the government, or individuals, take action there are unintended consequences. That doesn't mean no action should be taken, it simply means to go in with eyes wide open, and when making a policy recommendation, add the caveat "Of course, we could be wrong, and there could be consequences we do not foresee." That embrace of humility is my goal.

Certainly laws are necessary, but so too is personal responsibility. And while you cite significant laws that have done good things you failed to address the issue that laws enable people to feel as though someone else is taking care of things and then allow individuals to be less vigorous. The central tension is not whether there should be laws or not but rather how and what laws are appropriate. FDIC insurance has created a lot of good as I wrote and you reiterated. But, it has allowed me, the depositor, the luxury of not having to pay attention to how the bank lends my money. It has allowed me to relinquish responsibility. People may not hold the bank's feet to the fire as you say but that doesn't mean they should be rewarded for it either.

I thank you for taking the time to respond and to have well-formulated thoughts and examples. It is always refreshing to see someone who disagrees with me do so thoughtfully. That sort of exchange is always welcomed and should be encouraged.

Jon Harrison

Thanks for that last paragraph. I did not mean to imply that I had the answer and that it was simple, too. I do see why you may have thought so, however. My views on most things, and especially with respect to such fuzzy "sciences" as economics and psychology, are eminently provisional (that is, I'm always ready for new information and arguments). Had I been writing an article rather than a brief comment, I would have made this plain. I do think that the arguments you advance in your piece are largely fallacious, but whether my own prescriptions are on the money is, I admit, by no means certain.

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