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Does the financial crisis discredit libertarianism?

Ilya says no; others say yes. The question is not a good one, however, because libertarianism, in any meaningful philosophical sense, hasn't influenced financial policy in decades. One might as well ask whether the financial crisis has discredited Jeffersonian republicanism or nineteenth century rural populism.

The real question is whether the financial crisis has discredited the pro-market, deregulatory movement in a general sense, or banking deregulation in particular. Neither Weisberg nor Huffington know enough to answer this question, which is extremely complicated, and will be the subject of debate for decades. A few preliminary thoughts here:

1. Americans reject unregulated banking, as have people in every country around the world. A truly "libertarian" or free market system would lack deposit insurance and a central bank—a system that existed in the United States in the nineteenth century. Such a system is certainly possible—it did exist—and it may even be optimal in some long-term-we'll-all-be-dead sense. But it creates extraordinary volatility that people greatly dislike. If you lend to (that is, deposit with) an unregulated bank, you might get a good interest rate, but you have no remedy if the bank becomes insolvent. This gives rise to bank runs, financial contagion, and panic. Most people simply don't want to take the chance that the place where they park their money will vanish and take their funds with it; hence the popularity of the government guarantee. In addition, because banks borrow from each other, the collapse of one can lead to the collapse of others, drying out credit, and harming the real economy. A government backstop is and has been political bedrock for decades. The government acts as lender of last resort through a central bank, depository insurance, and the rest. No serious person rejects this system in any modern economy.

2. If you have government-supplied insurance, then you have to have government regulation of people's financial activities. There is no way to avoid this conclusion. In a world without such regulation, banks would make excessively risk loans because they get the upside and the taxpayer bears the cost of the downside. Banks would also keep insufficient capital on hand to pay off depositors. And depositors, unlike ordinary creditors, would have no reason to investigate banks and ensure that they are operated safely. Although many people have criticized Depression era banking regulation—especially the constraints on the geographic reach of banks and the division between regular and investment banking—no serious person denies that if the government insures banks, then it must regulate them. The least controversial type of regulation is the minimum capital adequacy requirement, which obliges banks to keep a certain amount of cash or other liquid assets on hand to meet spikes in withdrawals. Unfortunately, there is nothing simple about these rules: in principle, the amount of capital kept on hand should be a function of the riskiness of the bank's portfolio. In practice, this is hard to do. But the basic principle is undisputed.

3. Over the years, there has emerged an academic and political debate about the optimal amount of banking regulation. Again, no serious—or, at least, influential—person taking part in this debate has disputed the need for some kind of insurance or lender-of-last-resort function. And no serious person has disputed the need for restrictions on what banks and other financial institutions that benefit from insurance can and cannot do. The debate was about a matter of degree. One camp believed that existing regulation was excessive; another camp believed that existing regulation was either adequate or insufficient. The two sides converged on many issues: for example, geographical restrictions did not reduce the riskiness of banking but in fact made it harder for banks to spread risks. So both sides could agree on this type of "deregulation."

4. The current financial crisis suggests, to the extent that one can draw inferences from one observation, that deregulation did go too far. Regulators and (probably) market actors appear to have overestimated the extent to which people could protect themselves from risk by purchasing various types of credit insurance on the market and in other ways diversifying their assets. Regulators may, alternatively or in addition, underestimated the extent to which government insurance caused people to engage in risky behavior by taking advantage of financial innovations that allowed them to evade minimum capital requirements and other regulations—on banks, insurance companies, and investment banks. If you are more heavily regulated if you own 30 years loans and less regulated if you own equivalent mortgage-backed securities, then you will sell the former and buy the latter, and take on more risk. There is certainly reason to think that some tweaking, perhaps serious tweaking, is in order. But it is tweaking nonetheless.

5. As Ilya notes, the Bush administration did contribute to the crisis, but not by promoting free market ideology or "libertarianism." Instead, it foolishly advocated what it called an "ownership society," one in which people would be encouraged to own homes (and health care accounts and retirement funds), through, as it turned out, artificially cheap credit, subsidies, and the like. There is no reason in the world to think it is better, in some abstract sense, to own your home than to rent it—any more than it is better to own DVDs than to rent them from Netflix. For some people, ownership is better; for others, renting is better. There was tremendous intellectual confusion here: there is a difference between helping the poor (for example, by giving them money) and rearranging the legal relationship between them and the goods and services they use (for example, paying them to own rather than rent). The main effect of this policy was to subject lower-income people to more risk—of the upside, to be sure, but also of the downside. When the housing bubble pops, and the economy tumbles into recession, any serious commitment to the idea of ownership requires that our new owners suffer their losses. But the Bush administration could not sustain the harsh implications of its philosophy, especially because it was complicit in encouraging people to take on risk who might otherwise have been more cautious.

The Bush administration pursued a two-track policy, then, one that both cut back on financial regulation and channeled financial activity toward the housing sector. The latter most definitely contributed to the financial crisis, though it is unclear how much. The former may well have but this question is even more difficult. Deregulation may have been hasty or ill-considered; that is not the same thing as saying that it could have been done better, and that therefore the lesson of the financial crisis is not that deregulation is bad but that the particular deregulatory approach of the Bush administration (and Congress, and the Clinton administration, etc.) was poorly thought out—a point that could be made about the deregulation of the S&L industry in the 1980s, which was also poorly thought out and disastrous as a result, and yet the more-or-less elimination of that sector was sensible. Deregulation may also have gone too far, which is not the same as saying that some degree of deregulation was sensible—a position that is held by most economists.

6. The moral of this story is that we live in a society with a highly regulated financial sector. It will remain highly regulated in the future, and the difficult problem now is to determine what the optimal type and level of regulation is. This is mostly a technocratic question that rests atop a rough social consensus that the government should trade off risk/volatility and growth. True libertarianism has made no headway against this consensus; it remains as irrelevant today as it has been since the 1930s.

Related Posts (on one page):

  1. Does the Financial Crisis Discredit Libertarianism:
  2. Does the financial crisis discredit libertarianism?
OrinKerr:
Excellent post, Eric.
12.23.2008 5:12pm
Sean O'Hara (mail) (www):

A truly "libertarian" or free market system would lack deposit insurance


ITYM: government-backed deposit insurance.

There's nothing to prevent private companies from insuring banks, though like a privatized justice system, police force, and highway system I think hard-core libertarians are severely optimistic about the practicality of their philosophy.
12.23.2008 5:13pm
a_j_1979:

There's nothing to prevent private companies from insuring banks

And who would insure the insurance companies that insured the banks in case of any sistemic crisis - like the current one?

Let's not forget taht the Credit Default Swaps are - or should be- a form of insurance of financial instruments. and when the undelying securities collapsed, the CDS sellers were unable to make good on their obligations
12.23.2008 5:28pm
Anderson (mail):
Does the financial crisis discredit libertarianism?

No. Nothing ever does.
12.23.2008 5:38pm
Timothy Sandefur (mail) (www):
You refer to "the popularity of the government guarantee." What do you mean by "popularity"? Do you have any evidence that, given the choice, consumers would prefer a government guarantee over a free market system that provided higher returns (or some form of private insurance)? Or do you mean "popularity with governments around the world of the government guarantee," in which case this "popularity" would seem a poor indicator of consumer preferences.
12.23.2008 5:42pm
Javert:

A truly "libertarian" or free market system would lack deposit insurance
Not true -- any more so than there is a lack of insurance for buildings, people, cars. The difference is that the healthy banks and taxpayers would not be pillaged to pay for the bankrupt ones.

Such a system is certainly possible—it did exist—and it may even be optimal in some long-term-we'll-all-be-dead sense. But it creates extraordinary volatility that people greatly dislike.
Given today's headlines, this must be intended as ironic. System-wide volatility, like we have today, is caused by Fed manipulation of the money supply and by whimsical financial regulations such as "mark to market" and "affordable housing."

If you lend to (that is, deposit with) an unregulated bank, you might get a good interest rate, but you have no remedy if the bank becomes insolvent. This gives rise to bank runs, financial contagion, and panic.
You really need to learn more about the history of banking and of financial systems. Try J.B. Say, Ricardo, Von Mises, Hazlett, Richard Salsman. Every horror you mentioned is caused not by free banking but by bureaucratic decrees.

Again, no serious—or, at least, influential—person taking part in this debate has disputed the need for some kind of insurance or lender-of-last-resort function.
Nice ad hominem.

And depositors, unlike ordinary creditors, would have no reason to investigate banks and ensure that they are operated safely.
Maybe irresponsible customers don't investigate, but responsible ones do -- just as they investigate their prospective doctors, mechanics, lawyers. But then the argument for regulations is always that we need a benevolent, all-powerful bureaucrat to protect irresponsible people from themselves.

You seem to think that financial regulations and government-mandated (and taxpayer financed) insurance lessens risk in the economy. The opposite is true -- as the history of socialist economies has proven. Under your system, market actors (e.g., Freddie Mac and Fannie Mae) take insane risks because they know that the risks have been socialized -- think bailouts.
12.23.2008 5:55pm
Charles Chapman (mail) (www):
You refer to "the popularity of the government guarantee." What do you mean by "popularity"? Do you have any evidence that, given the choice, consumers would prefer a government guarantee over a free market system that provided higher returns (or some form of private insurance)?
How about the evidence that in the U.S. congressmen and presidents who enacted, supported, perpetuated, and continued such guarantees have been consistently elected for the last 60 or 70 years?

How about the evidence no serious politician in the last 60 or 70 years, or at least no politician who has been elected, has run for congress or president on the platform of abolishing such guarantees?

Then again, perhaps we should do an experiment. What better time for a Republican or Libertarian candidate for congress to run on a platform on abolishing bank deposit insurance? I would love to see that debate. And the electoral results.
12.23.2008 6:00pm
einhverfr (mail) (www):
I think the key lessons that need to be looked at (close to Eric's point) are that we need to pay more attention to how things are regulated and deregulated rather than if. I have watched the responses to banking system collapses across the world. In one small Latin American country, the government's eventual response was to rely on the US for currency and banking management (ditching their currency for the US Dollar).

Loan-oriented systems require regulation. There is no counter-example I can think of which has been successful there. Therefore, we might argue that a truly libertarian economy would lack both banks and loans and would rely in reciprocal gifts and such instead.....

Heck Medieval Iceland seems pretty much like a Libertarian's paradise, and the economic system there did, in fact, work. But once again, their financial system was one without loans, credit, or debt in a formal sense.
12.23.2008 6:03pm
Steve P. (mail):
I second Prof Kerr, that was an excellent post.
12.23.2008 6:09pm
seadrive:
Regulation can be thought of as the codification of corporate knowledge. It can be a mechanism for handing the lessons of experience from one generation to another.

It has flaws. It can be badly constructed. It can hand down mis-learned lessons. It can obstruct progress. Law is often clumsy, especially where substitutes rigid rules for judgment.

But it can be useful, too.
12.23.2008 6:19pm
Cornellian (mail):
You refer to "the popularity of the government guarantee." What do you mean by "popularity"?

I think what he means is that every single congressman, senator and president from either party knows that "I want to abolish FDIC deposit insurance" is a very fast and efficient way to lose the next election.
12.23.2008 6:22pm
Bruce McCullough (mail):
"The current financial crisis suggests, to the extent that one can draw inferences from one observation, that deregulation did go too far."

This assertion is patently ridiculous. The present financial crisis is a case of TOO MUCH REGULATION, not too much deregulation.


Where did the flood of "toxic mortgage debt" come from?

The Federal bank regulators forced banks to make bad-risk mortgages, also called "sub-prime mortgages". When banks had to keep them on their books, they didn't make many of them. Fannie and Freddie wouldn't accept them, because they were, well, bad-risk mortgages. Banks are naturally averse to making bad loans.

So Congress, in its infinite wisdom, forced Fannie and Freddie to take these sub-prime mortages. Banks no longer had to keep them on their books.

The Federal bank regulators continued to force banks to originate even more of these mortgages. Since the banks could pass the risk off to Fannie and Freddie, they no longer had a financial incentive not to make bad loans.
The Federal regulators created a system for flooding the market with bad mortgage debt, and it worked perfectly.

And voila!! The present financial crisis.

This is a case of TOO MUCH REGULATION, not too much deregulation.


Try reading Liebowitz's history of this, available at SSRN
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1211822
12.23.2008 6:25pm
Cody (mail):
Although an excellent post, I think point four could have used a lot more support. In particular, Eric is jumping from "regulator's underestimated risk" to "deregulation was to blame". It's quite possible that the former was caused in whole or in part by the latter, but if so the mechanism of causation isn't very obvious.

If we're going to blame deregulation, it'd be helpful to actually name the regulations which have been repealed or modified, with a brief explanation of how they led to the crisis.
12.23.2008 6:29pm
Frater Plotter:
It sounds as if the word "discredit" is being used in two distinct senses in this post. The ambiguity between the two may be accidental or deliberate; it's not clear, so I'd assume accidental.

The first sense of "discredit" being used is an objective one: to disprove; to test a claim and show it to be false; to present evidence contrary to the claim. To "discredit libertarianism" in this sense would be to put it to the test and find it objectively false.

The second sense of "discredit", though, is subjective: to besmirch or blacken a reputation; to inspire doubt or lack of confidence in a claim; to stir up opinion or ill feeling against it. To "discredit libertarianism" in this sense would be to cause people to dislike or distrust it.

The first sense of "discredit" implies that there is actual testing of the claim in question, and that the evidence is against it. The second sense, however, can apply whether or not the claim has actually been tested at all!

Many libertarians (and libertarian-wing Republicans such as Ron Paul) find reason for concern in the deep entanglement of the Federal government with the banking system. Their preference would be to reduce that entanglement, to limit the regulation of banking to that of ordinary economic transactions; viz., to investigate and punish fraud. The promulgation of complicated exceptions and weird new securities, under the false flag of "deregulation", did not actually put disentanglement to any sort of test.
12.23.2008 6:29pm
ARCraig (mail):
Part of the problem is a big, fatal misunderstanding of the term "deregulation".

If the government lowers Requirement A from 10% to 5%, hypothetically, that is not deregulation. When the government sets standards, they do not act as just a floor, the inevitably come to act as a ceiling, too. It's just as plausible for a government-set requirement to be too low for the market as it is too high. "Deregulation" would mean getting rid of a Requirement A, not fiddling with it one way or another. Things like reserve capital requirements or lending standards are not "deregulated" when the government says it's ok for banks to have less capital on hand or to give loans to otherwise un-creditworthy individuals. The only way these things would be deregulated is if the government took no position at all on what the "right" capital requirement, loan standard, interest rate, etc. is. When the government endorses a standard below the theoretical (and of course unknowable) ideal, it is just as wrong as when the government tightens down too hard with a requirement above the theoretical ideal. It's just another manifestation of government mismanagement of economic affairs, not "deregulation".

We've seen this kind of thing much more than any actual substantive disengagement of the government from these decisions. And now, because of the false conflation between the two supported by both parties, the idea of free markets are taking the bad rap for the failures of corporate statism- despite the fact that free-market thinkers like Milton Friedman did much more to understand and elucidate the failures of such corrupt public-private partnerships than the "mainstream" neo-Keynesians who continue to be in charge of government policy.
12.23.2008 6:31pm
MQuinn:

As Ilya notes, the Bush administration did contribute to the crisis, but not by promoting free market ideology or "libertarianism." Instead, it foolishly advocated what it called an "ownership society," one in which people would be encouraged to own homes (and health care accounts and retirement funds), through, as it turned out, artificially cheap credit, subsidies, and the like

I disagree that the home ownership policy is the culprit in a manner that avoids indicting the free market ideology. It seems that the real cause of this credit crisis is the lack of regulation over lenders -- a distinctly free market tenet. This problem exists both in and out of Bush's home ownership policy. Also, other aspects of the home ownership policy -- such as subsidies -- would not have resulted in the financial collapse, provided the borrowers could make their mortgage payments (which goes back to the lack of regulation over lenders). Thus, IMO, even if blame can successfully be laid upon Bush's home ownership policy, it still implicates the free market ideology.
12.23.2008 6:33pm
ARCraig (mail):
How could more government control have stopped loans the government was pushing for political reasons? The banks didn't go out and make bad loans because they thought it was a good idea. They did it because of a mixture of legal mandates and government interventions (such as the Fed's artificially low interest rates) things appear profitable that otherwise wouldn't have.
12.23.2008 6:38pm
PC:
Under your system, market actors (e.g., Freddie Mac and Fannie Mae) take insane risks because they know that the risks have been socialized -- think bailouts.

I won't defend Fannie and Freddie because they are moral hazards. But to think that Fannie and Freddie were taking "insane risks" shows a lack of perspective for the rest of the market. AIG got into trouble based on its involvement in CDSs, not it's regular, regulated, insurance business.

Some people like to blame this crisis on the subprime loan market, but the Alt-A market is much bigger and that shoe has yet to drop. Commercial real estate is bigger still and congress is now being approached to bail that market out.

Of course the OTC derivatives market is a free for all encompassing CDSs (a small portion) and that's a massive unwind waiting to happen. Anyone want to guess how long it will take to unwind $500 trillion to $1 quadrillion in derivatives if the global market tanks?

I fully agree that the Fed was a major problem in this. Greenspan was a fan of the perpetual bubble. I still joke with friends about a paper Greenspan wrote in the late 60s about how fiat currency couldn't be sustained, and when he became Fed chair he set out to prove it.
12.23.2008 6:40pm
ARCraig (mail):

I still joke with friends about a paper Greenspan wrote in the late 60s about how fiat currency couldn't be sustained, and when he became Fed chair he set out to prove it.


Ron Paul made him sign a copy of it once.

That would be an example, by the way, of a Congressman who supports abolishing FDIC and the Federal Reserve, to answer whoever it was claiming no such creature exists.
12.23.2008 6:47pm
PC:
How could more government control have stopped loans the government was pushing for political reasons? The banks didn't go out and make bad loans because they thought it was a good idea. They did it because of a mixture of legal mandates and government interventions (such as the Fed's artificially low interest rates) things appear profitable that otherwise wouldn't have.

Sort of. The artificially low interest rates were a huge problem. There was cheap money for too long (thanks Greenspan!). If you are referring to the CRA, the last study I saw put CRA based loans at 20-23% and those loans were 50% more likely to be held by the originating banks, rather than being packed, sold, cut up and resold with a higher rating.

There were various state governors that saw the mortgage debacle coming in the form of "predatory" loans and tried to stop it. The Bush administration disagreed and said individual states can't regulate interstate banks (interstate commerce).

The biggest problem with the mortgage crisis was the complete lack of accountability. A mortgage originator had no financial incentive to verify that a borrower could actually repay the loan.

There were perverse incentives created by "cheap" money and a lack of regulation. There is no way someone should be able to walk into a loan company with no documentation for a job or assets and get a loan for hundreds of thousands of dollars with negative amortization terms.
12.23.2008 6:54pm
PC:
That would be an example, by the way, of a Congressman who supports abolishing FDIC and the Federal Reserve, to answer whoever it was claiming no such creature exists.

iirc, that includes Ludwig von Mises and Austrian Economics. I'm not sure if those economists are "serious," but I think they are worth listening to.
12.23.2008 7:04pm
methodact:
Ah, the crux of matters, the bottom line, the man behind the curtain! The New World Order is hundreds of years in the making, via the International Bankers, i.e., the Illuminatti:

There are literally hundreds of films on this topic. The average person has not seen even one. Virtually everything else is mass distraction from the People, dog-and-pony shows and bread-and-circuses to keep the people's attention diverted and with at least a modicum of content.

They have deliberately orchestrated this global economic depression and their aim is World Government, with them in control, with carbon taxes to be paid by every human being directly to them. Alex Jones recites this mantra 4 hours a day on his radio show. These people work towards the elemination of 80% of the world's population. They are eugenicists.

The shortest line to understanding how things work, is to read G. Edward Griffin's The Creature from Jekyll Island.

If books are too old school, immersion into the videos The Capitalist Conspiracy, and, Money as Debt, provide a crash course for any would-be-knowledgeable serious person.
12.23.2008 7:16pm
Peter Twieg (mail):
"No serious person rejects this system in any modern economy."

Does this mean that Lawrence White, the author of The Theory of Monetary Institutions, does not count as a "serious person"? He may not actively reject the current system, but he persuasively argues that there are no strong arguments against free banking. Or how about George Selgin?

It's interesting to wonder how many countries only have nominal lenders of last resort as well. This seemed to have been the case for Iceland, unfortunately, but I wonder how many other cases like Iceland's exist.
12.23.2008 8:00pm
Dilan Esper (mail) (www):
You really need to learn more about the history of banking and of financial systems. Try J.B. Say, Ricardo, Von Mises, Hazlett, Richard Salsman.

Only on the Internet do you get anonymous commenters who think that Eric Posner-- ERIC FREAKING POSNER!-- doesn't know the arguments of Say, Mises, and Ricardo (as well as the refutations).
12.23.2008 8:43pm
Javert:

Only on the Internet do you get anonymous commenters who think that Eric Posner-- ERIC FREAKING POSNER!-- doesn't know the arguments of Say, Mises, and Ricardo (as well as the refutations).

No, you only have to observe the plethora of Ph.D.'s in economics -- which Posner doesn't even have -- who have barely heard those names, let alone who have actually read and understand their works. He might know the important works in his specialty, international law, but his post displays a woeful ignorance of the history of economic thought.
12.23.2008 9:28pm
LM (mail):

You really need to learn more about the history of banking and of financial systems.

Again, no serious—or, at least, influential—person taking part in this debate has disputed the need for some kind of insurance or lender-of-last-resort function.


Nice ad hominem.

Nice irony.
12.23.2008 9:45pm
Dilan Esper (mail) (www):
No, you only have to observe the plethora of Ph.D.'s in economics -- which Posner doesn't even have -- who have barely heard those names, let alone who have actually read and understand their works.

Can you name any of those Ph.D.'s in economics who don't know about Say and Mises, let alone Ricardo (heck, I read some Ricardo in HIGH SCHOOL!)? Or is this just an assertion?

He might know the important works in his specialty, international law, but his post displays a woeful ignorance of the history of economic thought.

Do you know who Eric Posner is? What his background is?
12.23.2008 9:47pm
PC:
Do you know who Eric Posner is? What his background is?

Regional skateboard champion in 1992?
12.23.2008 10:06pm
Laura S.:
Eric writes:

The Bush administration pursued a two-track policy, then, one that both cut back on financial regulation and channeled financial activity toward the housing sector.


I disagree with both of the facts stated. 1) The Bush administration did not pursue a policy of financial deregulation—arguably the financial sector is somewhat more regulated now than it was when Clinton left office. Remember that little thing called Enron happened in-between. 2) The long-standing policy of the Democratic Party as expressed in congressional legislation has been to expand home ownership. I am not aware of a special emphasis by Bush that would justify your remark.

An ownership society is a Bush-advocated concept but you're wrong to conflate it with other elements of government policy. Do we really need to rehash the past? Republicans called for more regulation of the home-mortgage market in the past six-years. Democrats resisted those legislative attempts tooth and nail because they perceived an adverse effect on low-income home ownership.
12.23.2008 10:18pm
Javert:

Can you name any of those Ph.D.'s in economics who don't know about Say and Mises, let alone Ricardo (heck, I read some Ricardo in HIGH SCHOOL!)? Or is this just an assertion?
Just look at the curricula of the top 20 Ph.D. programs in this country. It is well known that the history of economic thought is a dying field, and that economics, with very rare exceptions, has been co-opted by mathematics.

Do you know who Eric Posner is? What his background is?
Yes, but so what. Education: Yale and Harvard, in philosophy and law; Chicago as a law prof. His body of work has nothing to do with the history of economic thought. But knowing his background, or not, is irrelevant to my point, viz., that "his post displays a woeful ignorance of the history of economic thought." In fact, it's common knowledge -- at least to those who know anything about insurance and financial markets, that innumerable financial and investment institutions, e.g., hedge funds, buy private insurance.
12.23.2008 10:49pm
Javert:

You really need to learn more about the history of banking and of financial systems.

Again, no serious—or, at least, influential—person taking part in this debate has disputed the need for some kind of insurance or lender-of-last-resort function.

Nice ad hominem.


Nice irony.
Nice try. My claim was backed by arguments in response to his post.
12.23.2008 10:54pm
LM (mail):

Nice try. My claim was backed by arguments in response to his post.

He didn't bring up his qualifications. You did. And you did it in response to the substantive arguments of the OP. Any substantive counter-arguments you also made are irrelevant to this question. Your attack on his expertise was gratuitous and ad hominem. (Not to mention, as Dilan pointed out, misinformed.)
12.23.2008 11:08pm
Ricardo (mail):
Not true -- any more so than there is a lack of insurance for buildings, people, cars. The difference is that the healthy banks and taxpayers would not be pillaged to pay for the bankrupt ones.

Private insurance is, of course, regulated by the government in much the same way as commercial banks are. Just as a commercial bank must be adequately capitalized and liquid enough to pay off its short-term liabilities, insurance companies are very strictly regulated to ensure they invest in a portfolio of safe and liquid assets so they can make good in a worst-case scenario.

You really need to learn more about the history of banking and of financial systems. Try J.B. Say, Ricardo, Von Mises, Hazlett, Richard Salsman. Every horror you mentioned is caused not by free banking but by bureaucratic decrees.

Von Mises was in favor of abolishing deposit insurance and also abolishing fractional reserve banking at the same time. This is because he realized, along with many others, that as long as you have fractional reserve banking without deposit insurance, you have bank runs.

Eric Posner might have started his argument with point 0: "Americans do not want to get rid of fractional reserve banking." Then, given fractional reserve banking, you need deposit insurance. And given deposit insurance, you need regulations, etc.
12.23.2008 11:47pm
Bad (mail) (www):
"ARCraig (mail): How could more government control have stopped loans the government was pushing for political reasons? The banks didn't go out and make bad loans because they thought it was a good idea."

How many times do we have to hear this repeated as if it were simple dogma? The government influence instruments were LATE to the game in the subprime lending boom, and they rarely constituted anywhere near a majority of the business.

Nor was it the government at all which came up with and pounced on the idea of bundling tons of tiny slices of these bad assets and confounding them in a nearly impenetrable maze of bets and insurance instruments so that no one had any incentive to care about this or that mortgage and even now we aren't even sure who owns what amount of what bad assets. It's that which makes the crisis extremely damaging, because no one can tell what's bad and what's good: there's a huge failure of information, which is one of the worst things to have in a free market system.
12.24.2008 12:12am
Laura S.:

The government influence instruments were LATE to the game in the subprime lending boom, and they rarely constituted anywhere near a majority of the business.


Yes they were late players, but sadly this hurts rather helps your conclusion. Loans made in 2006,2007 are the epicenter of the problem. Subprime loans from 2005 and earlier have held-up comparably well. And Freddie DID dominate that late wave.
12.24.2008 12:57am
Jon Roland (mail) (www):
Milton Friedman once said in a television interview, "I support free markets but not large organizations". The present meltdown is the result of the pathological behaviors to which large organizations are susceptible, regardless of whether they are in the public sector or private sector. In other words, it is problem not of market operations but of the nonmarket operations that are characteristic of the internal dynamics of large organizations. This is discussed under the topic of "agency theory", which examines the problem of getting agents to reliably serve the interests of their principals. Large organizations with a hierarchical structure almost inevitably develop conflicts of interests and agendas among the echelons and departments, such that middle management will often capture senior management and pursue short-term strategies that placate shareholders but lead to long-term disaster.

My recommended solution is not regulation in the model of previous regulation like Sarbanes-Oxley (which in my view is unconstitutional), but the creation of a court jurisdiction under which private parties can complain to grand juries who then investigate the inner workings of organizations that are too large or well-connected to fail, not using some fixed rules but exploring for dangerous behaviors that may never have been previously identified, and disclosing those behaviors so that corrections can be made before disaster occurs. That is the only way to reconcile the conflicting demands of transparency and trade secrecy, and puncture bubbles in their inception.
12.24.2008 2:02am
Bruce McCullough (mail):
"BAD" writes:
"Nor was it the government at all which came up with and pounced on the idea of bundling tons of tiny slices of these bad assets..."

Mortgage-backed securities and the collateralization thereof preceded, by many years, the 'bad assets' that Fannie and Freddie flooded the system with. Once Fannie and Freddie opened the floodgates, that was all she wrote.

But fora GSE spewing bad debt into the system, there'd be no problem with these types of securities. Before FAnnie and Freddie were FORCED to take the subprime debt, they only spun off high quality mortgages with miniscule default rates. So again, it was the federal government, and not the Wall Street quants, who created this mess.

Absent Congress forcing Fannie and Freddie to recycle bad debt, we'd have no financial crisis, even with Wall Street quants bundling debt.

Absent Wall Street quants, Congress still would have forced trillions of dollars of bad mortgage debt into the financical system.
12.24.2008 2:10am
PC:
Loans made in 2006,2007 are the epicenter of the problem.

Ugh. No. Not even close. The worst of this problem has yet to surface. Subprime loans are a small fraction of the problem. There is a $500 trillion to $1 quadrillion market of OTC derivatives out there. That's a huge range to guess in because there's no clearinghouse to figure out who owes what.

The subprime loan market is a drop in the bucket compared to the other bad debt on (or off, thanks deregulation!) the books.

On the upside, if you work for a hedge fund or major bank you can bilk the tax payer for you yearly bonus.
12.24.2008 3:23am
ShelbyC:
Dilan, I'll confess to being ignorant. Why shouldn't Eric freakin' Posner have his econ cred questioned? Nothing jumps out from his CV and some of us don't know the guy.
12.24.2008 5:37am
Peter Twieg (mail):
ShelbyC-

Presumably because he's the son of Richard Posner and economic expertise is transmitted via blood.
12.24.2008 9:44am
sdfsdf (mail):
Nice post, Eric. I might use this post in my Spring regulation class.

--Eric Rasmusen (sdfsdfdsf because of frustration with logging in)
12.24.2008 10:46am
Andy Freeman (mail):
> Do you have any evidence that, given the choice, consumers would prefer a government guarantee over a free market system that provided higher returns (or some form of private insurance)?

The counter evidence consists of the popularity of a govt guarantee for bank deposits.

I note that banks are not the only place where people invest money. As of early 2008 (who knows about now), most investments did not have a govt guarantee, so it's pretty clear that consumers are not adverse to getting higher returns without a govt guarantee.
12.24.2008 11:39am
Timothy Sandefur (mail) (www):
In response to my perfectly legitimate inquiry as to what evidence we have that consumers actually prefer government-sponsored banking insurance to the possible alternatives, Charles Chapman huffily answers as followS: "How about the evidence that in the U.S. congressmen and presidents who enacted, supported, perpetuated, and continued such guarantees have been consistently elected for the last 60 or 70 years?" This seems like an extremely weak basis on which to interpret consumer preferences. It assumes that voters and consumers are the same people (which they usually are, but not always); it assumes that voter preferences are the same as consumer preferences; it assumes, amazingly, that the candidate's position on government banking insurance rates highly in a voter's choices of what candidate to support, and that that position matters other than other variables in choosing whom to vote for.... Mr. Chapman's answer is simply absurd. The reason why a debate between candidates on the platform of abolishing banking insuance is such a silly idea is precisely that there are far more pressing issues (and issues on which voters are vastly better educated) than this relatively obscure topic. Mr. Chapman's "evidence" doesn't support his claim, let alone his apparent smugness.

Cornellian makes a similar statement: that the assertion that consumers prefer government-backed deposit insurance to market alternatives is proven by the fact that politicians know that they would lose their elections if they proposed abolishing FDIC deposit insurance. So far as I know, that experiment has never been tried. And, again, what tactics a politician considers worthwhile are not exactly a good indicator of consumer preferences. It's not as good an indicator of preferences as, say, a poll. And it's definitely not as good an indicator as, say, allowing consumers to choose, and then watching what they do! Finally, when we're talking about an issue most people don't understand and don't have a formulated opinion on--and, in fact, on which they basically just take the government's word for it--it's a little silly to assess consumer preferences in this manner. Consumer preferences can't be interpreted based on political actions, even in a democracy, and an uneducated populace who has never really had the opportunity of much debate on this subject should not be taken as the Voice of the People.

We simply do not know whether consumers would prefer government-operated deposit insurance (with all the questionable elements that this includes) to the potential market alternatives. Nobody knows whether government banking insurance is "popular" or not.
12.24.2008 12:55pm
Dilan Esper (mail) (www):
Presumably because he's the son of Richard Posner and economic expertise is transmitted via blood.

Not blood. But certainly being around economics and economists his entire life and having read up on the subject (which, by the way, shows in his writings even when I disagree with him) would seem to indicate that he knows a lot about the subject. Let's put it this way, I'd be beyond shocked if he didn't know about Austrian Economics, and I don't think there's even a miniscule chance that he doesn't know about Ricardo.
12.24.2008 1:17pm
David Friedman (mail) (www):
Eric writes:

"A truly "libertarian" or free market system would lack deposit insurance and a central bank—a system that existed in the United States in the nineteenth century."

Except that that was not a "truly free market system"--banking was regulated a the state level and at least some of the regulations contributed to instability. An example of a more nearly free market system would be Scottish banking in the 18th century, as described by Larry White (and, of course, Adam Smith, writing about then contemporary institutions).

"But it creates extraordinary volatility that people greatly dislike. If you lend to (that is, deposit with) an unregulated bank, you might get a good interest rate, but you have no remedy if the bank becomes insolvent. "

Not true of the Scottish system. Banks were partnerships, without limited liability, and normally had at least one very wealthy partner, thus providing a remedy. Some banks also had an optional clause, under which they could temporarily suspend payment but were then obligated to redeem the notes later at a premium.

Dilan Esper writes:

"Only on the Internet do you get anonymous commenters who think that Eric Posner-- ERIC FREAKING POSNER!-- doesn't know the arguments of Say, Mises, and Ricardo (as well as the refutations)."

1. Eric is not an economist.

2. The most prominent of the three economists mentioned is Ricardo. Most professional economists couldn't adequately explain his arguments--he was a very smart man and they aren't trivial arguments. I would guess that most PhD economists, if asked, would say that Ricardo believed in the labor theory of value, a widely believed claim persuasively refuted by George Stigler quite a long time ago.

3. I know Eric, although not well. I've even reviewed a book of his. I would be mildly surprised if he knew, in any detail, the arguments of Say, Mises, and Ricardo as well as the "refutations." That's not a criticism of him--he's a law professor not an economist, let alone an economist specializing the history of economic thought.

4. I suspect, from the tone of Dilan's comment, that part of its basis is Eric's last name. His father is a very smart and original man and has made a very large contribution to the economic analysis of law. But he isn't an economist either, let alone a specialist in the history of economic thought, and I would be mildly surprised if he could do an adequate job of explaining Ricardo either.
12.24.2008 1:25pm
FlimFlamSam:
Sad to say, but government forcing banks to make loans to poor minorities is what caused the entire mess. That's not a failure of libertarianism.
12.24.2008 5:09pm
L. H. White (mail) (www):
Thanks to David Friedman for the pointer to my work. I second David's point that the 19th century US was not an example of free-market banking. Vera Smith rightly called the US system "decentralization without freedom". Before the Civil War, entry was blocked by stated chartering restrictions. Important restrictions on note-issue were built into so-called "free banking" laws. Branching was not allowed across state lines, and often even within states. After the Civil War, similar restrictions on note-issue were built into the National Banking Acts. Branching continued to be disallowed as before.

Scotland and Canada were better examples of nearly free banking. They were not characterized by what Eric calls "extraordinary volatility". People living with them did not "greatly dislike" their banking systems. An insolvent bank could be run upon, but a run did give not give rise "financial contagion, and panic". People who took their money out of a suspect bank put it into a more trusted bank. Canada (without the US's restrictions on branching and note-issue) had none of the panics that plagued the US in the 1857-1933 period.

Eric writes that "No serious person rejects this system in any modern economy." On a standard definition of "serious person" that's simply untrue. But perhaps Eric is using "serious" in such a way as to make it true by definition.
12.24.2008 6:54pm
Dilan Esper (mail) (www):
Mr. Friedman:

I never said that Eric Posner was an economist, though your denigration of his father, I would say, reflects a very narrow view of what constitutes an "economist". Richard Posner has been making economics arguments in academic works for 35 years, he has quite a strong following and if his economic knowledge was limited and unsophisticated, you would surely see his work get criticized on that ground. In fact, that doesn't happen very much. And I am sure that Richard Posner is quite aware of Ricardo as well as Say and the Austrian economists and their basic contentions.

As I noted above, if you read Eric Posner's writings (even his writings on such things as war powers), they are redolent with the point of view of an economist, which suggests to me that he knows quite a lot about economics as well. He certainly would have been around University of Chicago economists for much of his life and would have surely heard a lot of their arguments.

The thing, though, is that I think you are cheating here as to what constitutes "understanding" the arguments of Say, Mises, and Ricardo as well as the refutations. I have several reasons to think this:

1. You put "refutations" in scare quotes. Certainly you understand that Say's Law has been thoroughly discredited and is not accepted by mainstream economists. And you surely understand that there is a reason that most academic economists (including those who might have sympathized with his politics) think that Mises' theories on monetary policy are total bunk and have published numerous works laying these arguments out.

Ricardo is a somewhat different case, in that his work does provide the intellectual grounding for the case for free trade and that has, as far as I know, stood the test of time. Still, the original poster was holding him out as documenting the "history of banking and financial systems", which I take to be something other than his work on free trade. And since the modern, empircally supported understanding of banking and financial systems rejects the sort of thing the poster was peddling, I don't think he was talking about Ricardo's theories on trade.

You are dealing with very fringe theories here. Theories that almost the entire economics profession rejects. Because they are provably, obviously wrong.

2. If you go back and read Eric Posner's post, above, you will see that he clearly knows about economics and specifically about the refutations of Austrian fairytales. You think a professor of Eric Posner's stature would make a claim about how serious academics view banking regulation if he had no idea about the views of academic economists who opine on the subject? Really, for your view to be correct, Eric Posner would have to be a completely dishonest puffer. And he is clearly not that (and I say that as someone who has grave disagreements with the man on a number of war-on-terror issues).

3. I was exposed to Ricardo in high school and we covered Say's Law-- and the reasons why it is incorrect-- and the Austrian economists in money and banking class. And I did not even go to a top or even middle-ranked undergraduate college. I attended a basically open enrollment state teacher's college before going off to study law.

It is a patently ridiculous claim that Eric Posner never heard of these things, when he writes a post that shows a clear understanding of money and banking regulation and references the conclusion of the debates that they started, was exposed to economic arguments all his life, and includes economic arguments in his own work.

Let me suggest something to you as well as to the above commenter. If you guys drink the Kool-Aid of Austrian economics, a lot of very smart people, including most of the leaders in the field of academic economics and the big players in finance and governmental agencies that deal with the issue such as the Fed and Treasury, not only disagree with you guys but think you are nuts. That's the reality.

So when an academic obviously aware of the consensus in academic economics and the issues involved makes a sensible reference to that academic consensus, and you guys come back and claim that one can only make that claim if you haven't read any Say or Mises or Ricardo, you come off like the proseltyzer who continues trying to convert the skeptic by saying "you only reject the Bible because you haven't read it". No, plenty of people HAVE read the Bible and rejected it, and similarly, plenty of people (I would suspect every person who got far enough along in an economics major at an American university) have been exposed to the arguments make and are aware of the reasons that they have been debunked. Eric Posner doesn't reject because he doesn't know-- he rejects because he knows.
12.25.2008 12:06am
Peter Twieg (mail):
Esper -

Understanding Ricardo goes far beyond understanding Ricardian equivalence, and understanding Say goes far beyond understanding Say's law. No one said that either Richard or Eric Posner use generally bad economic arguments, just that it's unlikely that they've sufficiently immersed themselves in old economic arcana to make comprehensive critiques of these authors.

And dismissing "Austrians" generally, even those who have successful and well-respected records in academia, does you know intellectual favors in making you appear qualified to assess who is and who isn't a "serious economist." I find it highly, highly doubtful that Eric Posner seriously meant to imply that Larry White isn't a serious economist, it's far more likely that Mr. Posner just isn't aware of his work. This isn't an allegation of dishonesty, just an understandable ignorance.

Of course, at least Mr. Posner has been civil enough to not use this ignorance to trash his opponents. On the other hand, your implication that people must think Larry White is nuts merely for being associated with the Austrian School when you obviously know nothing else about him is rather troubling. Why not just back down in the face of authorities on these matters that outclass you?

For the record, I had Mr. White's The Theory of Monetary Institutions recommended to me by a professor who knew nothing about Austrian economics after my junior year as an undergrad. It was an excellent, comprehensive book on exactly what the title implies. Perhaps it might do you some good peruse it.
12.25.2008 8:56am
cathyf:
The least controversial type of regulation is the minimum capital adequacy requirement, which obliges banks to keep a certain amount of cash or other liquid assets on hand to meet spikes in withdrawals. Unfortunately, there is nothing simple about these rules: in principle, the amount of capital kept on hand should be a function of the riskiness of the bank's portfolio. In practice, this is hard to do. But the basic principle is undisputed.
Another important aspect -- as banks change the amount of cash that they hold in response to their changing assessments of the risk of a bank run, it results in changes in the supply of money. The current crisis is fundamentally a series of "bank runs" (but not just on banks, but on all sorts of investment institutions) where institutions which have written insurance products have revised upward their estimates of the probabilities of the insurance paying out and are collecting cash and cash-like assets to pay out on the insurance that they have written. This is sharply deflationary, of course.

The steepest decline ever in the US economy was in 1937-38. In 1935 the Federal Reserve noted that banks were holding reserves that were more than twice the required minima. So they had the brilliant idea that they would double the mandated minimum. The notion was that this would be a regulation with no downside, in that it would have no effect on bankers' behavior (it was what they were doing anyway, after all) and would increase depositors' confidence in the safety of their deposits. Instead what happened is that bankers took this as a signal that the government had some information that was causing them to expect and prepare for a banking crisis, so the bankers responded by increasing their reserves by even more. Which was, of course, very deflationary, and threw the country into the 37-38 depression. ["Theories of the 1937-38 Crisis and Depression," Melvin D. Brockie, The Economic Journal, Vol. 60, No. 238 (June 1950), pp. 292-310]

A fundamental job of the Fed is to keep the money supply stable and thus avoid both inflation and deflation. To do this, they have to constantly adjust to market actors whose activities are increasing or decreasing the money supply.
12.25.2008 4:18pm
Dilan Esper (mail) (www):
Peter:

The mainstream economics profession holds the ARGUMENTS of Austrian economists, as well as Say's claims about money, in utter contempt. (I think Krugman once said that when someone asks him why he doesn't give consideration to the arguments of the Austrian school, he replies that it is for the same reason he doesn't give consideration to the arguments of the Flat Earth school.)

This doesn't mean that some believers in Austrian economics haven't done some serious work. And it isn't an ad hominem attack. It's just that Austrian economics is agreed among serious economists to be complete BS. And Eric Posner knows this, which is why it ridiculous for people to claim in this thread that he wasn't familiar with their arguments. Of course he is aware of them!

Note that neither Eric Posner nor I was making a comprehensive critique. Rather, we are both simply observing that Austrian economics and the views of the Austrian school on money and banking have been totally discredited and have no acceptance in the mainstream of the profession.

The fact that people continue to publish arguments making the same false, debunked Austrian claims about money and banking no more evidences serious economic thought than the fact that some doctors endorse homeopathy establishes that homeopathy has any serious scientific support.

These are fringe theories that have no place in the discussion about how we got into the current mess and how we might get out of it.
12.25.2008 6:53pm
LM (mail):
Dilan Esper,

The fact that people continue to publish arguments making the same false, debunked Austrian claims about money and banking no more evidences serious economic thought than the fact that some doctors endorse homeopathy establishes that homeopathy has any serious scientific support.

You really need to learn more about Austrian homeopathy.
12.25.2008 9:16pm
Brandon Berg (mail) (www):
There is no reason in the world to think it is better, in some abstract sense, to own your home than to rent it—any more than it is better to own DVDs than to rent them from Netflix.

This is a bad analogy. Because a person typically spends only a few hours watching a DVD, there's really no point in owning it, and renting is clearly superior in almost all circumstances. But you use your home all the time--even if you're not in it you're storing your stuff there--so there's not nearly as strong a case for renting as there is with DVDs.
12.26.2008 2:16pm
Dilan Esper (mail) (www):
Well played, LM.
12.26.2008 4:38pm

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