
There is often a conflict between policies that make things feel good in the short run and those that are optimal in the long run. This is one reason why I am fairly pessimistic about global warming—the world’s political systems are not well suited to addressing this issue.
Perhaps the most famous example in the field of economics is the public debt. Decisions to reduce the public debt (higher taxes and/or lower spending) are exceedingly unpopular in the short run, and only pay off in the distant future. Thus I expect our fiscal situation to get worse over time. Indeed it’s amazing that it did not become unsustainable until the mid-2010s.
Bank regulation is another area where this problem occurs. The best regulatory structure is probably no regulation at all. Unfortunately, the creation of deposit insurance and too-big-to-fail has made that option infeasible. Without regulation, banks would have the incentive to take wildly excessive risks with the taxpayer’s money. One option would be to eliminate both deposit insurance and bank regulation.
The second best policy is higher capital requirements. But these are often so complex that clever banks can occasionally find ways to evade the intent of the rules.
And then there’s “greater supervision”. This is roughly the equivalent of a politician telling voters they plan to reduce the budget deficit by addressing “waste, fraud and abuse.”
A recent article in Bloomberg caught my eye:
President-elect Donald Trump’s advisers are considering how they will reshape the leadership of the Federal Reserve including elevating Fed Governor Michelle Bowman to be the central bank’s next vice chair for supervision, according to people familiar with the matter. . . .
She has spoken widely about bank regulation, often to community banking audiences. She strongly opposed Barr’s bank-capital proposal, part of an international agreement known as Basel III that is intended to prevent future bank failures and another financial crisis, arguing that increased capital requirements would likely curb lending activity at a time when the banking sector was healthy. Instead, she has said banks need better supervision.
Why not someone like Christopher Waller?
Fed Governor Christopher Waller, who has previously been considered a possibility for chair, may no longer be under serious consideration after he backed a half-point interest-rate cut in September, the people familiar said. Trump called the larger-than-usual Fed cut, just weeks before the presidential election, “a political move to try and keep somebody in office.”
Even in the best of circumstances, it is unlikely that better supervision would adequately address problems in the banking system. But after the recent reversal of the Chevron decision, it’s even less likely that bank regulation will be effective. Here’s Amy Howe:
In a major ruling, the Supreme Court on Friday cut back sharply on the power of federal agencies to interpret the laws they administer and ruled that courts should rely on their own interpretation of ambiguous laws. The decision will likely have far-reaching effects across the country, from environmental regulation to healthcare costs.
Bank regulation is based on some of the most ambiguous laws on the books.
READER COMMENTS
Ahmed Fares
Jan 13 2025 at 2:38am
As regards banking, this worked:
Some Current Issues in Financial Reform
steve
Jan 13 2025 at 11:45am
When banks were not regulated they regularly caused banking financial crises. AS Lord Acton, one of the founders of libertarian thought noted…
“The issue which has swept down the centuries and which will have to be fought sooner or later is the people versus the banks.”
Steve
Scott Sumner
Jan 13 2025 at 1:16pm
“When banks were not regulated they regularly caused banking financial crises.”
This is not accurate. I’d encourage you to read people like Larry White and George Selgin. American banking was far more regulated that Canadian banking, and had far more financial crises.
Pierre Lemieux
Jan 13 2025 at 3:16pm
Steve: Scott is right even if this may not be an intuitive idea. After all, we seem to have been born with the idea that banks could not survive without state regulation and that a central bank is essential. I have an old EconLog post where I summarized some of the issues.
Among other things that may interest you is the quote of Renée Haltom, an economist with the Federal Reserve Bank of Richmond:
Kevin Corcoran
Jan 15 2025 at 3:27pm
I’d add some additional reading on top of the authors suggesting by Scott Sumner – Tyler Beck Goodspeed’s very insightful book Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772. The Scottish banking system was both the least regulated and most stable banking system in history – and it was only after the introduction of banking regulations (in response to special interest lobbying from banks trying to shield themselves from competition, naturally) that the Scottish banking system began to have real financial crises.
MarkW
Jan 13 2025 at 1:43pm
“it’s amazing that it did not become unsustainable until the mid-2010s”
There used to be a sizable block of voters who favored fiscal responsibility, and some politicians got elected by appealing to them (at least at times). But the balanced budget amendment, the ‘Contract with America’ and even the ‘Tea Party movement’, are all rapidly disappearing in the rear view mirror. I know none of these things were anywhere nearly as effective as advertised, but once upon a time a substantial number of voters really were looking for politicians to make these kinds of campaign promises.
Rajat
Jan 13 2025 at 5:12pm
I have two comments:
1. I agree with your pessimism on global warming, but compared to other issues where similar short-run/long-run and free-rider issues at at work, governments and private agents have done a lot more than one would expect. Climate change mitigation really captured the rich world’s public’s imagination as a worthwhile thing to do in the 2010s in a way that I didn’t anticipate. Compare the difficulties now faced by attempts at trade liberalisation, an activity that is privately beneficial (in at least the long run) irrespective of what other countries do.
2. Re your amazement that US/rich country public finances only became unsustainable in the mid-2010s, I think this was in large part a hangover from the Bretton Woods era. Governments were somewhat disciplined to not incur high deficits to avoid excessive dollar (and gold) outflows. At least, that’s my Wikipedia-level understanding. You probably have a better informed view on this.
Scott Sumner
Jan 14 2025 at 12:58pm
On your second point, I agree that this might be a factor. But surely the general decline in the quality of policymaking at least partly reflects the decline in our political culture. In America, we are essentially becoming a banana republic (in a political sense, not economic or technological.) It would be odd if this sort of political climate produced good policy.
Thomas L Hutcheson
Jan 13 2025 at 8:23pm
I think too big t0 fail is immensely more damaging than deposit insurance.
As Keynes said, “Madmen in authority, who hear voices in the air [taxation of net CO2 emissions, progressive c0nsumption taxes, deficits = Σ(expenditures with NPV>0)], are distilling their frenzy from some academic scribbler of a few years back.”
We should aspire to be that scribbler.
Scott Sumner
Jan 14 2025 at 12:59pm
I believe exactly the opposite, I’m far more worried about FDIC insurance. Smaller banks tend to be more reckless.
Jose Pablo
Jan 14 2025 at 6:30pm
Indeed it’s amazing that it did not become unsustainable until the mid-2010s.
15 years of unsustainability looks pretty sustainable to me. How many years need the US government debt to be “sustained” to convince you of its sustainability? If no number of years of sustainability will convice you, then your mental model fails explaining reality, and since reality can not be abandoned, then your mental model of government debt should.
Taxes (and government expenditures) are the curse. Debt is a (parcial) relieve to those illneses, making them more bearable.
It seems that it is you this time the one forgetting that reducing taxes in the short term also have positive consequences in the long run. Positive consequences that should be “higher” than the negative consequences of higher debt. As illustrated by the fact that the oportunity cost of “money (not) collected by taxes” is higher or equal to public debt interest rates.
Jose Pablo
Jan 14 2025 at 6:39pm
The “cost” of FDIC (whatever it may be) should be balanced against the reduction in the “information costs” to the 100 millions households with bank accounts.
I am grateful of not having to examine in detail the balance sheet of a bank (an extremely boring and unforgiving activity) before opening a new account. An activity, by the way, that is out of reach to most of those 100 million households.
It can still make no sense. But it is not that clear to me.
robc
Jan 15 2025 at 12:35pm
Not necessary. If FDIC didnt exist, Berkshire Hathaway or whoever provided the insurance for the bank would handle that.
My broker has insurance for up to $10MM (last I checked), so why wouldnt my bank?
Jose Pablo
Jan 15 2025 at 2:24pm
That was my point.
When I open my online bank account the first thing I see is a banner informing me that they are FDIC Insured, which means that they are using this for commercial reasons and that, very likely, a “FDIC like” private business make economic sense.
It will work with a very similar fee structure and account protection as provided by FDIC. The FDIC receives no appropiation from Congress and the “backed by the full faith and credit of the U.S. government” part is, so far, free but have a great commercial vaule. My bank quickly makes me know that “backing” (odly enough since, according to Scott it is the “full faith and credit” of a broke entity. Which should have no value)
Which is hard to believe is that a privately sponsored FDIC would make total sense and would benefit the banking industry but a government sponsored FDIC is a horrible idea that provides the wrong incentives to the whole industry.
[If the problem is the “so far free to taxpayers” reinsurance that the government is providing, let the government charge the FDIC a market fee for that (which to be honest I don’t know if the FDIC does already but it is a good idea that would benefit taxpayers]
Thomas L Hutcheson
Jan 15 2025 at 11:52am
“Decisions to reduce the public debt (higher taxes and/or lower spending) are exceedingly unpopular in the short run, and only pay off in the distant future.”Deficits (most probably) represent a transfer of resourced from investment to consumption. The reduction in growth starts immediately although it can persist into the “distant future.”
Actually, I think postponing levying a tax on net emissions of CO2 is a better example of costs that only appear in the distant future.
Jose Pablo
Jan 15 2025 at 2:48pm
Deficits (most probably) represent a transfer of resourced from investment to consumption.
How come?
Quite the contrary, “taxes” represent a transfer of resources from investment (you can’t invest your taxed away dollars) to consumption (directly to “government expenditures” but these are, for the most part, a pure redistribution of resources to, by desing, people more willing to “consume” than the original taxpayer).
Taxes are also a transfer of resources from consumption to consumption (pure redistribution of consumption). But this effect is “neutral” (if you leave apart the “incentives” problem) and, also, the progressive nature of the tax code is specifically design to place a higher tax burden on people with high propenstiy to invest with good returns. And even more so if a new tax code is enacted to offset the deficit (you can bet it will be full of “tax the rich” provisions at the margin).
All this should result in the transfer from investment to consumption being the most relevant effect of taxes (particularly of additional taxes required to reduce the deficit).
“Government debt”, on the contrary, represents a transfer of resources from low opportunity cost savings to consumption (same mechanism that before).
In this regard, “government debt” is much better than “taxes” for future growth. Particularly so since the additional investment that would result from lower taxes (aka more deficit) will partially come from foreign debtholders willing to finance the US investment growth at very low interest rates.
Jose Pablo
Jan 15 2025 at 2:51pm
I think Thomas, that you are making the mistake of equating “deficits” to “government expenditures” (which indeed are a transfer from investment to consumption).
But they are not the same. For a “given level of government expenditures”, the higher the deficit (aka the part of government expenditures not financed with taxes) the lower the transfer from investment to consumption that government expenditures represent.
Jose Pablo
Jan 15 2025 at 4:12pm
This is one reason why I am fairly pessimistic about global warming—the world’s political systems are not well suited to addressing this issue.
This is an interesting one. I think that “political systems” are “better” suited to addressing this issue than individuals (if “better” means having a lower discount rate of future potencial effects, which is just one, of many, possible oppinions).
In fact when governments in Europe are addressing this issue quite agressively and have tried to address it even more so, individuals have forcefully opposed the measure (I am thinking of the yellow vest episode in France).
https://en.wikipedia.org/wiki/Yellow_vests_protests
Even more, it is very difficult to know what is the “right” discount rate in this case. How much consumption are you willing to give up now to avoid an pretty much unkonwn increase in the probability of extinction of the polar bear in 50 years time is, for the most part, an individual preference. Different people will have different opinions on this.
I don’t think there is a “collective”right answer. So, very little can be concluded from the fact that Scott discount rate is higher than democratic governments discount rate which are (very likely) higher than individuals discount rate.
This three entities have different preferences, so what?
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