Free Market Financial Reform

by robekulick

As the economic slump continues, the housing market remains weak, and foreclosures continue to plague homeowners, people have become increasingly angry at Wall Street. Many perceive the behavior of Wall Street bankers as the direct cause of the recession and are particular bothered by the fact that the bankers were bailed out while the others have suffered. Now there are some distinct problems with the simple line of reasoning since the question of what caused the financial crisis is a complex one. I happen to think that  the economist John Taylor makes a compelling case that the Federal Reserve under Alan Greenspan is largely to blame as interest rates were kept extremely low throughout the 2000s:

Furthermore, although the big US banks were propped up by the government, many of the actual bankers who worked at those banks, including management, lost their jobs as a result of the crisis so its not as if all of the “guilty” Wall Street bankers walked away from the crisis unscathed.

However, economists of all stripes agree that it is a problem in a capitalist economy to have institutions that are considered “too big to fail.” Economists also generally agree that because the banking system plays an essential role in financing the businesses that drive the economy, collapses of the banking system impose a large negative externality on society.

Now left-spectrum economists like Paul Krugman have supported Dodd-Frank and advocated for a return to the highly regulated days of banking before the deregulation movement spearheaded by the Reagan and Clinton administrations. Many right-spectrum economists like Gary Becker, Scott Sumner, John Taylor, and Robert Lucas have vocally opposed the Dodd-Frank approach to regulation. But this does not necessarily mean that these free market oriented economists oppose financial reform entirely. See for instance the following speech given by Robert Lucas:

Thus, I thought it’d be interesting to explore the financial reform proposals of market-oriented economists. I’ll examine proposals by Nobel Laureate Gary Becker, and prominent bloggers Tyler Cowen and Scott Sumner.

In this post on this blog,, Gary Becker  proposes imposing higher capital requirements on banks (though only after the current economic slump is over):

“I believe capital requirements should be imposed on investment banks, hedge funds, and other financial institutions in the form of maximum allowable ratios of assets to capital. One major advantage of such a requirement is that it can operate rather automatically rather than requiring regulators to make discretionary choices. The extremely high leverage in many financial institutions during the past few years created a fundamental instability in the financial sector regarding its ability to respond to large negative aggregate shocks to the system rather than only individual firm idiosyncratic shocks. Limiting the ratio of assets to capital would help prevent the high leverages that contributed to the collapse of many financial institutions in the wake of the sharp falls in the values of the assets they were holding. Capital requirements also provide a way to respond to the “too big to fail” principle when, rightly or wrongly, large firms are often kept from going bankrupt. When large financial firms get into trouble, they impose costs on everyone else both due to the repercussions on financial and other markets, and to the taxpayer monies used to bail them out to prevent their complete collapse.”

In this piece for the CATO journal, Tyler Cowen advocates for an entirely new banking system based on the principle of “mutual fund banking”:

He explains:  “The alternative banking structure we explore entails changes on both the liability and asset side of bank balance sheets. Depository institutions would resemble mutual funds rather than current banks. On the liability side, the deposits of mutual fund banks would represent a claim on the asset portfolio held by the intermediary. Consequently, these bank liabilities may fluctuate in nominal value, depending on the worth ofthe underlying assets. “Non-par” banking would be possible, in which the number of deposit units or “shares” required to clear a check for a stated nominal sum would not be fixed at a one-to-one ratio. On the asset side, a wide variety of marketable claims, including equity, bonds, commercial paper, government obligations, options, futures, and commodities, would be available as investment vehicles for the fund.”

The advantage of this structure, as Cowen explains, is that the incentive for bank-runs disappears when the value of deposits adjusts continuously with the market.

Finally, Scott Sumner sees the adoption of a nominal GDP targeting rule by the Fed as obviating the need for all forms of restrictive regulation:

He writes: “Conservatives often ask me how I can in good conscience defend the Federal Reserve System.  Why don’t I advocate letting markets set interest rates, letting markets set the money supply.  Why not advocate free banking.  Etc., etc.

I would argue that I am doing this, and more.  You just aren’t paying close enough attention.  Milton Friedman wanted to show that tight money caused the Great Depression in order to get better monetary policy.  But an even bigger reason was to show that capitalism worked and that socialism wasn’t needed.

I’m trying to get the Fed to target NGDP so that we can have a more capitalistic economy, without feeling that if we don’t bail out GM, the unemployment rate might rise.  My hope is that if we do this, eventually we’ll see the obvious need for a NGDP futures market.  And that will lead us to see the obvious need to target NGDP futures prices, and let the market determine the money supply and the interest rate.  And then we’ll abolish TBTF, as we’ll no longer fear that big bank failures will lead to recessions.  And then we’ll abolish FDIC.  And then we’ll allow free banking; after all, even if a few wildcat banks fail it won’t affect the macroeconomy.  But it matters how you do this.  Go to wildcat banking without first getting rid of deposit insurance and you end up like Iceland.”

So what’s interesting is that all of these free-market economists advocate policies that could dramatically change the face of Wall Street without interfering with the basic market mechanism. What is consistent in these proposals is that they all depend on a rules-based approach to regulation, rather than the discretionary approach encapsulated by Dodd-Frank, where regulation will occur at the arbitrary whim of the consumer financial protection agency.  Such arbitrariness, with the potential for the regulated agencies to be captured by the entities they regulate, is a huge impediment to economic efficiency and growth. And all of these approaches address the issues of leverage, systemic risk, and too big to fail in a way that should make both readers of the National Review and Occupy Wall Streeters happy.