In particular, if I’m a bank and I’m making risky loans, I have an incentive, if I can, to make those loans using other people’s money, in other words to make highly leveraged loans. But when I do that I don’t take into account the fact that if the loan goes bad it’s not just me who fails but all of my creditors. In other words I’m creating systemic risk by making these loans on borrowed money. That’s an externality which I have no incentive as a bank to take into account. And the only way that that externality will be taken into account is if someone else, a regulator for example, puts a limit on leverage. That’s a simple lesson from economic theory that was ignored six years ago. I hope it won’t continue to be ignored.

This statement is by Eric Maskin, a past winner of the Nobel Prize in economics. He made it at a recent conference at Mercatus. I’m assuming that the author of the article in which this statement is quoted, Tim Cavanaugh, quoted him correctly.

Maskin is wrong. He has not identified an externality. It’s true that lenders who are borrowing other people’s money are subjecting those other people to risk. It’s not true that that constitutes an externality. Those other people–creditors–know that and can price the risk accordingly in the terms of the loan. I’m not saying they will. They might make mistakes. But mistakes are not an externality per se.

It’s also possible that federal deposit insurance will warp incentives by bailing out the creditors. Creditors, knowing this, will not be as careful in lending to banks. But then that’s an externality created by government. (It’s one, by the way, that even FDR was uneasy about in 1932, before he was president. He wrote that deposit insurance would “lead to laxity in bank management and carelessness on the part of both banker and depositor.” Not surprisingly, given how spacey FDR was, that didn’t stop him from signing a law creating deposit insurance the very next year.)

So Maskin’s comment, “the only way that that externality will be taken into account is if someone else, a regulator for example, puts a limit on leverage” is false. The way you would get the externality taken into account is by removing the warped incentive that deposit insurance creates.

His mistake reminds me of one that Tyler Cowen made last month. Tyler wrote a post titled, “What is the market failure in data storage and protection at the retail level?” and tried to identify the market failure. He did not succeed. As I wrote on his site:

I see how your proposal could make sense, but I don’t see how this is a market failure. The company and the customers bear the costs and there are market transactions between them. So it’s hard to see where the externality is.

One of the participants at the event contacted me and told me that, indeed, Tim Cavanaugh did quote Eric Maskin accurately. Here is the link and you can go to the 36:00 point (approximately) for the relevant quote.