I think the meat of your comment is in the story about how Citibank's failure makes it harder for you to find a job.
First, note that if it weren't for regulators deciding on the amount of reserve capital Citibank was required to hold, the market would probably have demanded that it hold much more. For a long time iBanks have been benefiting from the Fed's power to bail them out. Unlike banks, whose asymmetric liquidity is due to customer deposits, iBanks are risk-taking businesses who are just trying to make people rich. If Yahoo can fail, why not Citibank?
So you were actually a temporary beneficiary of SEC and Fed policies that led to the over-leveraging of Citibank's capital and your previous ease at finding a job. Your major life decisions were perhaps influenced by this false sense of reality.
On to your thoughts on happiness: Would people be happier if they weren't allowed to eat junk food? What about if they weren't allowed to drop out of college? What about if they believed in a specific version of the Christian God? What if they wore an American flag arm band at all times in public?
It's highly subjective what makes people happiest. I personally don't want anyone telling me what will make me happiest.
I have serious trouble believing that "the market" would have led to Citi keeping larger amounts of reserve capital around. In fact, I'm pretty sure that it was the banks pressuring the government to let them hold less in reserve.
I am registered Libertarian, as I believe in marketizing problems whenever possible; however, the markets must be set up correctly to be truly free, and only the government can do that.
True, but have you ever been driving on an icy road and seen people going the speed limit, 55 miles per hour?
The psychology people seem to have is to believe that if the government regulates it, then anything that falls under the regulation requires no independent thought.
On the icy road, the safe speed maximum is probably about 30 mph, but many accidents are caused by people going the posted limit, as people seem to trust the wise planner above their own ability to judge.
Similarly, people assume that a firm that is regulated by the SEC and backed buy the FDIC is going to be a safe place to put money, which is not always true.
I agree with your last statement, but note that 1) the SEC required insufficient reserves, and 2) because the government set the reserve limits, there is the implication that it ought to bail out the firms that were "just following the rules".
Hence the view of firms being "too big to fail" comes from the idea that regulation is perfect and if only it's followed then everything will be fine.
In a better, more libertarian world, banking crises would result in some failures, and once-burned investors would look carefully at what reserves actually mean, look sceptically at rating-weighted reserve requirements, and expect that if things go wrong there will not be a bailout.
This would help put money into firms that actually know how to act in a trustworthy, sound way, not just the firms that are able to successfully lobby the SEC, the way Madoff's did.
The problem that I have with your examples is that it requires all actors, including consumers, to have nearly perfect information access, and to be able to act on that.
In the car example, I think we have a difference of philosophy. I think that regardless of the posted speed limit, some people will not exercise the proper judgement because they have evaluated the conditions differently.
In the example of reserve funds, imagine a world with similar information asymmetry to today. Banks are semi-transparent, and deposits are backed to some extent by the FDIC. However, the SEC takes less of an active regulatory role, the result of which is that some unscrupulous banks have started offering insanely high interest rates based on dangerous fractional reserves. People will likely flock to those banks, especially given that the FDIC is backing their investments... and then the whole thing collapses.
One solution is to get rid of the moral hazard inherent in the FDIC, and make it clear that the only way to hold your money safely is in cash, in your home. But one of the signs of civilization is increased specialization of labor; I should not have to do the job of banker and regulator all rolled into one, just to have a place to keep my money. Worse, it's not even clear that this is possible, because of inherent information asymmetry.
We can argue about whether an adequate ad-hoc bank insurance solution would arise, however, I'm not sure that such an invention would increase efficiency in the market.
As for regulation, there doesn't really seem to be any real alternative, unless the direct consequences for the operators of failed financial institutions became much more dire. And criminalizing poor business decisions doesn't seem very Libertarian at all.
If I walk into a bank and consider depositing my hard earned cash, perhaps I'd demand enough transparency to determine whether to trust that entity with my cash, in exactly the same way that I must trust Amazon when I place an order online, etc.
Information will always be imperfect, but it's in both parties' interest to increase transparency. It's barely even a coordination problem in today's world.
As a note to your remark about my speed limit explanation, why is it then that on an extremely icy road people go exactly the posted speed limit rather than, say, 90 miles per hour? Clearly they are taking the sign literally and at face value.
So one regulatory approach that would be an improvement over the current one might be to require a reserves "rating" to be published, much like the smoking causes cancer warning. Perhaps right under the bank's logo it would have to say "This bank has a reserve score of 71 (moderately risky)".
And yes, there would be room for 3rd party ratings to be applied to bank solvency as well. I'm not sure what the best approach would be, but consider that most securities regulations were made in the 20s before the information revolution (ironically, the "Financial Services Modernization Act" removed a few of the depression-era regs that were actually smart and prevented moral hazard and conflict of interest). Surely there would be a lot of clever approaches. One idea that intrigues me is that the government could offer its rating, but banks would be required to obtain several. I'd love to see someone like Michael Moore create his own such agency and use his genius to publicize it.
Analogously, consider the FDA drug approval process. Everyone knows that the FDA process is flawed, as people are routinely killed by side-effects of drugs. So why not have several ratings: One from a consortium of insurers, one from the AMA, and one from the FDA -- each group has a slightly different downside risk (and upside) to approving a dangerous drug or failing to approve a safe one in a timely fashion. Why not have a grid of 3 checkboxes on every drug. The absence of an AMA approval might be a warning sign to some, but not others.
If you think this idea is silly, consider what happens when the FDA gets it wrong and lots of people die because of a drug... exactly nothing but a too-late knee-jerk reaction. Usually the drug is immediately pulled even if it has other valid uses, etc. One perverse example: many doctors knew the dangers of Vioxx well before the scandal (the same risk exists in lesser form with all such drugs, even Ibuprofen) and good ones didn't use it on patients at risk for bleeding without great caution. Yet it took a few years and then bang, it's gone from shelves even though there are a few essentially identical drugs that stayed on the market and do still occasionally kill people when used without caution by docs.
I'm not claiming to have the whole idea of optimal regulation for the 21st century figured out, but I'm just brainstorming. Surely there would be a lot of great and clever ideas. The current, one-size-fits-all approach leads to massive and often ineffectual regulatory apparatus.
Why shouldn't coming up with ad-hoc regulatory / information-dissemination / transparency-reducing systems be something that startups do? Why not in the case of medical trials have data published to the web so that people can make mash-ups with all the data that is being considered by regulators? A few weeks ago the SEC approved a plan to put financials in XML format, but it's all very primitive and is unlikely to be all that useful, but the core idea of transparency through an API is a good one, I think.
The role of the "regulator" of the future, I think, is to design a good API spec (metaphorically and literally) and possibly make a list of all of the watchdog groups offering analysis. State and federal governments could fund their own watchdog groups too -- maybe I notice that Wyoming's prescription-drug watchdog group has been right a bunch of times in a row, so I begin trusting it more than the one in my own state. Maybe I decide to trust Michael Moore's group or Paul Graham's. Over time the best would rise to the top and every mistake would give new groups a chance to enter the limelight -- maybe a YC startup was the only one not to approve Vioxx, for example.
Toward the libertarian goal of efficient, small government, we should be focusing on regulation that increases transparency and also increases the number of entities that can act as private watchdogs. It's exceptionally telling that the SEC received repeated complaints about Madoff's fund from various sources and still did nothing. One might argue that the SEC is understaffed, but it found the staff to shut down prosper.com, a startup that was making humanity better off, on a technicality, not even on any remote accusation of fraud. More likely, prosper.com competed with the established finance powerhouses, so the SEC was probably just acting to keep competition out of the industry.
Most of what all of the regulatory agencies do is coordinate information, and if the modern world (and the internets) have done one thing, it's make such problems extremely easy and inexpensive to solve. My basic argument is that the antiquated structures create a false sense of security and get in the way, as well as soak up tons of industry lobbying dollars to the point where industries tend to become highly regulated and highly protected, the two biggest characteristics of libertarian dystopia. The military industrial complex and now the financial and auto industries are that sort of thing. Big agriculture is too, as well as many others.
> The psychology people seem to have is to believe that if
the government regulates it, then anything that falls under
the regulation requires no independent thought.
But according to your own line of thought, shouldn't people be fully responsible for their own conduct, regardless of the surrounding circumstances? If so, how is lack of governement regulation going to help people determine the correct speed to go at on icy roads?
My point is just that a rational person generally uses his/her cognitive faculties to assess risk, but that regulation often leads to short-circuiting of critical thought.
The heuristic becomes one of people believing that the government must have already looked out for all dangerous possibilities, so anything that is legal is safe.
I don't feel the need to look down my nose and say "people should be individually responsible" because I don't consider that productive. I think people are naturally responsible enough to look out for their own interests, unless they are misled.
One example: investors in Madoff's hedge fund were misled by the SEC stamp of approval on that fund. Don't you think that normal scepticism about the returns ought to have led to some scrutiny?
Speed limit signs set a minimum and a maximum speed, yet I always see drivers careening along on icy roads at the posted maximum. They must have more faith in planners than I do, as I try to determine how icy the road is and go at a safe speed.
I don't think financial regulations are any different, but unfortunately most people take the fact that a firm is regulated to mean that it's totally safe. Similarly, many foods that will result in an early death are perfectly legal and consistent with the USDA food pyramid.
To be clear: you are suggesting that banks have kept low reserves because they took their government requirements as a sign of what was prudent to lend. Rather than asking their many teams of risk analysts, they made lending decisions based on an arbitrary number set by the government, despite the fact that this level has not been raised or lowered in decades, is uniform across all banks, takes no heed of the current financial situation and has never prevented a crash in the past.
If this were true (and it certainly is not!) then the market really would be just as incompetent as its critics say it is.
In an environment where the government decides what is prudent, there is no incentive for a bank to say "We are sounder than our competitors because we keep more reserves". Why not? Because they would be competing against the government for their definition of soundness.
Sure it could happen theoretically, but it would be a tremendous competitive disadvantage.
The way it is today, any bank that is legally allowed to operate is considered equally sound by borrowers and investors, and banks have no incentive to try to prove to customers that they are actually more sound than their competitors.
In a highly regulated environment, that works for all banks because they know that if there is a major economic downturn everyone will get bailed out.
Notice that all banks were required to accept TARP loans whether they needed them or not. Why? To avoid SIGNALING which banks were hurting and which were not. Why? To avoid capital flowing to the banks that were actually sound!
Why? Well, partly because government wants to avoid a crash, and partly to keep the status quo going strong. Also, consider what all of the major industry players in banking want... what does any firm want? No competition. They were all happy to share a big market and to have as few as possible attributes on which to have to compete for business.
Simple, smart, behaviorally sensible regulations make sense, but the SEC has been notoriously behind the curve for years. The missing piece has been to regulate appropriately while allowing there to be an incentive for banks to actually compete on the basis of soundness. The decision not to let the concept of bank soundness enter the brains of mere citizens must be a knee-jerk reaction to the great depression.
Instead, in exchange for various political concessions, banks were given every incentive to be extremely leveraged. Consider the impact of the GSEs on housing prices, MBS prices, etc? The implicit guarantee of Fannie and Freddie alone probably led to banks thinking (rightly, it turns out) that any housing related crash's impact on banks would be bailed out.
Side note: Are the banks going to be better off after the bailout? Of course they will be. The desired "sweet spot" for most firms is to be in a heavily regulated, heavily protected industry, as it means that there are huge barriers to entry and the profits (though sometimes essentially set by regulators) roll in year after year. See the military industrial complex for an example of the idealized sort of model.
Market forces have been very far from banking for a long time. Why else would financial services be the biggest donors to both parties. Libertarians are not opposed to regulations, just not ones that create perverse incentives and lead to massive bailouts! Any time a firm would rather spend its money on lobbyists and campaign contributions rather than innovation, there is a big problem.
> First, note that if it weren't for regulators deciding on the amount of reserve capital Citibank was required to hold, the market would probably have demanded that it hold much more.
This was your original point. Let's stay on track.
Your claim that regulators decide how big Citibank's reserves should be is false. They set a minimum, not a maximum.
You then tried to draw an analogy between speeding and regulation, one that, as I have explained, is totally inappropriate.
You then claimed that "most people take the fact that a firm is regulated to mean that it's totally safe", which is a massive exaggeration. If that were true, bank bonds would be considered as safe as government bonds and bank runs would never happen. All other regulated industries would be exactly the same. Also, you are confusing reserve requirements with broader regulation as a whole.
You then claim that banks raising their reserves would be "competing against the government for their definition of soundness", despite the fact that no government has ever claimed any 'definition of soundness'. This appears to be something that you have invented.
You then give an argument as to why other forms of regulation encourage banks to hold lower reserves. This contradicts your original point, which was that if reserve requirements were abolished then the market would force banks to raise reserves. What you have demonstrated is that the market, bail-outs and broader regulation would actually force reserves to even lower levels in the absence of reserve requirements. You have changed your argument from one about reserve requirements to one about broader regulation, and bail-outs such as TARP.
I don't think you have refuted my speeding analogy. Do you ever drive in an area with ice on the roads? I recommend that you observe the phenomenon before you dismiss it.
I do not think you have refuted my claim that regulation leads to people suspending critical judgement about risks.
Reserve requirements are a good example of this effect. Industry lobbyists try very hard to have the limit decreased while benefiting from the public perception that the regulator has assured that the bank's assets are sound.
If you don't buy my argument then you probably believe that people are so stupid that without regulation banks would hold $0 in reserves.
The alternative view of humanity is that people are sensible enough to demand sound practices from institutions they deal with on important matters.
My argument is that banks don't use reserves as a way to win customers the way they would if regulators weren't giving an A+ to every bank that holds the minimum :)
One exception is Goldman Sachs. It did not need TARP funds to remain solvent. Yet Treasury forced all banks to accept the funds. What did Goldman do? It immediately paid a huge dividend to its investors.
What happened? Goldman actually had more sound practices than the rest of the industry and was not in danger of failing. It would probably have waited for bankruptcy proceedings and picked through the assets of the other banks, strengthening its already strong balance sheet.
Regulators did not want more money to flow to the firm that had good practices, so it insisted on bailing everyone out. This was to hide information from investors and customers. Goldman angered regulators by paying out the dividend right away, but managed to signal its health.
To understand the point of libertarians on this issue, consider the world in 10 years from today. We might have had a world where chastened investors and customers looked a lot more carefully at the risk management practices of banks before trusting them. Instead, we have a world in which our government owns 30% of all banks and regulators are being hailed as the saviors of the banking industry.
Do you want to live in a world where people act based on reality, or one where taxpayer money is appropriated without congressional approval and given to selected industries, and the appropriators are hailed as heroes that helped the little guy keep his job, prevented another great depression, etc.
It all comes back to the burden that people take upon themselves to assess the riskiness of the decisions they make. Industry loves to have its status quo practices rubber stamped by regulators, to add additional credibility. It all works out well as long as there can be another bailout, etc., but it's not based on reality and represents the slow transfer of wealth from the most productive companies to the ones with the most effective lobbying.
>I don't think you have refuted my speeding analogy.
My point was that you analogy doesn't apply. Pointing to ice on the roads is completely missing the point: that the analogy doesn't hold in the first place.
>I do not think you have refuted my claim that regulation leads to people suspending critical judgement about risks.
I did not say this! I said that specifying a reserve requirement does not reduce bank reserves. Please keep this argument to reserve requirements, not general regulation.
>If you don't buy my argument then you probably believe that people are so stupid that without regulation banks would hold $0 in reserves.
The UK does not have reserve requirements and they don't have zero reserves. But they did not raise their reserves to safe levels either, refuting your original point.
Incidentally, it's you that's arguing that regulation encourages banks to hold lower reserves than they would without reserve requirements. You are constantly conflating reserve requirements and general regulation, moving an argument about one to a conclusion about the other.
You then go on to talk about TARP again, illustrating my point.
The ice on the roads creates a risk of the car going out of control. Unanticipated volatility in the market creates the risk of a bank being insolvent.
To manage the risk of your car going out of control, you choose a safe speed.
To manage the risk of a bank becoming insolvent, it chooses an amount of capital to keep in reserve.
I seriously doubt you take exception with any aspect of the analogy so far...
A speed limit sign suggests a speed that is safe to drive. However like any regulation it is only an imperfect estimate. Yet people seem to drive at that speed under adverse weather conditions completely irrationally.
A reserve requirement suggests an amount of reserve capital that is safe for operation of a bank. However like any regulation it is an imperfect estimate. Few banks carry reserves in excess of those set by the requirement.
These are completely identical scenarios. In each case, humans cluster around the regulation without exercising independent judgment. Drivers slide off of the road all the time, and a bit of recent price volatility sent many banks into insolvency.
Your example about the UK is noteworthy but I would argue that due to the dominance of US banks (and US regulations) in financial markets, UK banks are inclined to mirror US policies in order to remain competitive with US banks. Analogously, a Russian firm may adopt some US accounting practices if it wishes to attract investment from the US.
There are two factors: The first is the way that the bar is set by the regulation in the first place. T
he second is the grouping/incentive effect. If your competitor has too few reserves then you are at a disadvantage for not copying that behavior unless the economy crashes (such that your competitor goes out of business and you don't).
>A reserve requirement suggests an amount of reserve capital that is safe for operation of a bank.
In one case we have members of the public who have passed a driving test. In the other, we have the foremost experts in the field, using the latest theories of risk, working with millions of dollars of modelling and statistical equipment, with their jobs on the line. For what good reason would a single one of them look at the reserve rate and say "Although the government doesn't claim that this is a safe rate for banks to operate at, but instead sets it completely arbitrarily, and admits to the fact that it's totally arbitrary, and has not changed this rate in several decades because it is an obsolete tool of monetary policy, I am nevertheless going to take it to 'suggest' a safe level of reserves, totally ignore all of my models and education, and just pick that number on a completely irrational basis."
That just makes my point even better. Experts set safe speed limits for non-experts to follow. Minimum reserves are set arbitrarily and experts that decide actual reserve levels will not pay them any attention.
risk compensation is an effect whereby individual people may tend to adjust their behaviour in response to perceived changes in risk. It is seen as self-evident that individuals will tend to behave in a more cautious manner if their perception of risk or danger increases. Another way of stating this is that individuals will behave less cautiously in situations where they feel "safer" or more protected.
Mirrlees also did highly theoretical work on another incentive problem: “moral hazard.” As is well known to those who study insurance, insurance coverage gives the beneficiary an incentive to take more risks than would be optimal. This is called “moral hazard.” Mirrlees’s insight, based on a complex mathematical model, is that the problem can be solved with an optimal combination of carrots and sticks. Insurance payments are essentially a carrot. But “sticks” could be designed also, so that an insured person who takes risks pays a penalty for doing so. With this combination of carrots and sticks, the insured person acts almost as if he is uninsured, and the insurer acts almost as if he were the insured.
First, note that if it weren't for regulators deciding on the amount of reserve capital Citibank was required to hold, the market would probably have demanded that it hold much more. For a long time iBanks have been benefiting from the Fed's power to bail them out. Unlike banks, whose asymmetric liquidity is due to customer deposits, iBanks are risk-taking businesses who are just trying to make people rich. If Yahoo can fail, why not Citibank?
So you were actually a temporary beneficiary of SEC and Fed policies that led to the over-leveraging of Citibank's capital and your previous ease at finding a job. Your major life decisions were perhaps influenced by this false sense of reality.
On to your thoughts on happiness: Would people be happier if they weren't allowed to eat junk food? What about if they weren't allowed to drop out of college? What about if they believed in a specific version of the Christian God? What if they wore an American flag arm band at all times in public?
It's highly subjective what makes people happiest. I personally don't want anyone telling me what will make me happiest.