Saturday, June 13, 2009

Did the Free Market Cause the Current Crisis? - Part III

In earlier posts (Part I here, Part II here) I began answering the question: “Did the free market cause the current crisis?” I explained that three main factors caused the housing bubble, which I have branded the but-for cause of the recession. Two of the three factors – homeownership incentives and bad Fed policy – have little to do with the free market and everything to do with government intervention. The third factor, however, is a direct result of free markets.

President Carter began the deregulation movement back in the 1970s. Deregulation has been a good thing for most industries: the markets for telephone service, air travel, and package delivery are more robust than they were 30 years ago. Reagan, of course, continued and strengthened the deregulatory agenda. Unsurprisingly, the clamor for deregulation soon spread to the banking industry. This was not a good idea. The banking industry is different from other industries in two critically important ways.

First, banks (including investment banks) allow cash lenders, or savers, to find potential borrowers with as little friction as possible, thereby enabling beneficial gains from trade. Because (a) so many people are willing to lend through banks (Americans know they need to save – though they don’t always do a good job) and (b) borrowed money pays for most business expansions, banks can have an enormous influence over the entire economy. When banks no longer act as economic lubricants – perhaps they are worried many borrowers will not repay their loans – one of businesses’ major funding sources is cut off.

If businesses can’t borrow money to open new factories, buy new machines, or pay wages, the entire economy feels the ripple effects. When a single person loses his job, he spends less money. The spending decline doesn’t stop there, however. The future beneficiary of the first person’s spending now sells fewer goods, so he also experiences an income drop. This process continues throughout the economy. Keynes used this multiplier effect to explain how a fall in consumer confidence and investment spending in the late 1920s and early 1930s spiraled into the Great Depression. Although other industries can influence the macroeconomy, none is as influential as banks. It’s no wonder that a majority of recessions in America have been correlated with problems in the banking industry.

The second critical way the banking industry differs from other industries relates to the first point. Banking risks impose a negative externality on society. Negative externalities are typically reserved for microeconomic analysis. But negative banking externalities are relevant to the macroeconomy for the reasons noted in the above paragraph. I’ve attempted to model the problem using a simple-form game below.

Bank 2
Bank 1Safe5, 5, 01, 7, -1
Risky7, 1, -12, 2, -2

Each bank seeks to maximize its profits and can engage in safe or risky behavior. The four rectangles filled with numbers contain Bank 1’s profits, Bank 2’s profits, and external social costs, respectively. The sum of the three numbers are the net social benefits. Thus, if both banks engage in safe lending, each earns a profit of 5, there are no external costs, and net social benefits are 10. If one bank engages in safe lending while the second engages in risky lending, the second will earn higher returns and people will begin to invest more money in the second bank and less in the first. The risky bank’s profits will be 7 while the safe bank’s profits will only be 1. The bank’s risky behavior begins to impose a cost on society (because there is a higher risk of failure), which I’ve quantified as -1. Why does the second bank earn a higher expected profit when it engages in risky behavior?

Although it seems that people should be hesitant to put their money in risky banks, it is possible that people are unable to assess the riskiness of banks. But even if people recognize that the second bank has a much higher probability failure, it might be rational to invest in the risky bank for at least two reasons. First, investors recognize that banks receive special treatment from the government; when banks fail the Fed acts as the lender of last resort and governments put together a bailout package. Second, even in markets entirely free of government intervention, investors can hedge against losses through various financial instruments, so investors can profit off the higher returns but cash out before experiencing huge losses. The government makes things worse by offering FDIC insurance.

The safe bank will soon realize that if the other bank is engaging in risky lending, then it will increase its profits by also offering risky loans. Once the second bank starts taking on risky loans, expected profits rise from 1 to 2, and the other bank’s expected profits fall from 7 to 2 (because more people invest in the second bank). Now that all banks are taking on excessive loans, however, they impose a huge cost on society. If they fail, they can bring the entire economy to its knees. Net benefits fall from 10, when both banks are safe, to 2 with excessive risk taking.

This is the classic prisoner’s dilemma with a twist, because now there are external social costs. In the simple two-bank game presented, of course, both banks could simply agree to engage in safe behavior. This would maximize joint profits and social benefits. Furthermore, anti-trust laws do not prevent this form of “collusion.” In real life, though, collusion would be difficult because there are hundreds of banks and enforcement would be impossible. Banks would surreptitiously try to take on riskier loans, thereby hoping to gain an edge over their competitors.

The results of this analysis is that banks take on suboptimal levels of risk without government regulation, and a fortiori when government introduces moral hazards problem. This analysis certainly explains the banking industry’s increasing acceptance of mortgage-backed securities and collateralized debt obligations over the past decade. Subprime loans weren’t safe, but banks were willing to take on a lot of them because of the higher expected return. Banks knew there was a probability that the housing market would fall apart, but the prisoner’s dilemma pushed them to either offer risky loans or become unprofitable.

Therefore, because (a) banking problems can have a massive effect on the entire economy and (b) banks have a tendency to engage in suboptimal levels of risk, they, unlike most other industries, should not have been deregulated. Governments should limit capital-to-equity ratios and should perhaps prevent banks from becoming excessively large.

Nonetheless, in answer to my main question, “Did the Free Market Cause the Current Crisis?” I still feel that it is disingenuous to blame the deregulatory movement. Imagine that the government “deregulates” driving by allowing people to drive as fast as they want – without seatbelts. To make the analogy complete, the government also encourages everyone to drive more quickly, telling them that formerly risky driving is now safe. New smooth roads are constructed that make drivers feel as if they aren’t traveling very fast. In this situation we would see a lot of speeding. We probably wouldn’t be surprised when accident and fatality rates increased. Furthermore, I don’t think we’d blame the accidents on freedom, but on bad government regulations. And, in the end, bad government regulation is responsible for the current crisis.
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