just why is it so vital to save a financial system soaked in run-prone overnight debt? Even if borrowers might have to pay 50 basis points more (which I doubt), is that worth a continual series of crises, 10% or more downsteps in GDP, 10 million losing their jobs in the US alone, a 40% rise in debt to GDP, and the strangling cost of our financial regulations?
My take:
1. As I have said before (scroll down to lecture 9), the nonfinancial sector likes to hold riskless, short-term assets and issue risky, long-term liabilities. Financial intermediaries emerge to take the other side.
2. When governments run deficits, they need help from banks, which hold government debt. It used to be that governments ran deficits to finance wars. Now they run deficits routinely.
3. Banks have an easier time convincing customers that bank liabilities (i.e., the funds customers hold on deposit) are riskless if government will provide implicit or explicit guarantees.
From (2) and (3), we see that banks and government are co-dependent. This co-dependency makes it unlikely that we will find a free-market banking system.
We can expect government policy to be ambivalent with respect to the financial sector. On the one hand, it wants the financial sector to thrive, so that deficits can be financed and the economy has plenty of credit available. That argues for lots of guarantees with limited regulation. On the other hand, it wants to restrain the moral hazard that leads banks to take on too much risk and make the system prone to crises. That argues for limited guarantees and lots of regulation.
Policy makers do not deal rationally with this ambivalence. Instead, over time both guarantees and regulation tend to increase. For instance, in the wake of the financial crisis the government has extended both its guarantees (money market funds) and its regulation (non-banks that are “systemically important”). It is true that some types of financial regulation, such as restrictions on interstate banking, interest-rate ceilings, or other anti-competitive rules, have declined over time. But in the area of safety and soundness regulation, over the years the effort has been to make regulation more sophisticated and effective. That this has not been successful is due in part to the greater prevalence of guarantees and also to what I call the regulator’s calculation problem.
I suspect you are being too charitable. For instance, “
Gd smart phones, yeah they allow,me to be awake commenting at 3 am, but there are also downsides.
“it wants to restrain the moral hazard that leads banks to take on too much risk and make the system prone to crises. ”
I suspect they,want it prone to crisis so they can justify more regulaion. It isn’t the risk that creates the crisis, it is the interconnectedness.
When governments run deficits, they need help from banks…. On the one hand, it wants the financial sector to thrive, so that deficits can be financed and the economy has plenty of credit available.
I’m not sure how much the gov’t depends on banks. Much of this is done by the bureaucracy: bonds are floated and bought with printed money; the bureaucrats hand out money directly from all the programs we apparently need to keep the economy going.
To #2, I would suggest that banks don’t necessarily need to hold government debt to assist fiscal stimulus – they can also extend more credit to private borrowers who may be “crowded out” by government borrowing.
In other words, banks can facilitate fiscal stimulus by increasing the supply of credit to meet the additional demand for credit, regardless of the assets that they choose to hold.