Kling vs. Cochrane

He is merely grumpy. I am cynical.

John Cochrane has two hands. In the same post, he writes that SBV’s demise was enabled by

a truly spectacular failure of elementary regulation

and also offers this aphorism:

To an economist, no action is really a mistake, it's just an optimal answer to a different question. 

So, did the regulators make mistakes, or did they come up with an optimal answer to a different question?

While I’m picking on John, his solution to bank regulation is “narrow banking.” A bank that connects people to the payments system, through checking accounts, is only allowed to invest in short-term riskless assets.

But that still leaves out actual banking. Actual banking is when the bank issues liabilities that are riskless and short term (like deposits) while holding assets that are risky and long term (like home mortgages or commercial loans).

John would not want to eliminate actual banking. He just wants to wall it off from the payments system. So we can suppose that it would make the payments system safer.

But I think it still leaves the question about what we want actual banking to look like. John hopes that actual banking would be left entirely to the private sector, unsupported by any government insurance or guarantees and unmolested by heavy regulations.

With no government involvement in actual banking, I suspect that actual banking would be subject to booms and busts. We would have too much risk-taking in good times and too little risk-taking in bad times. On this topic, a reader refers me to a paper by Robin Greenwood and others.

we show that the combination of rapid credit and asset price growth over the prior three years, whether in the nonfinancial business or the household sector, is associated with a 40% probability of entering a financial crisis within the next three years. This compares with a roughly 7% probability in normal times, when neither credit nor asset price growth is elevated. Our evidence challenges the view that financial crises are unpredictable “bolts from the sky” and supports the Kindleberger-Minsky view that crises are the byproduct of predictable, boom-bust credit cycles. This predictability favors policies that lean against incipient credit-market booms.

I don’t think that the public would tolerate the government sitting back while booms and busts take place. The government will have to act. Something must be done. It may not be a worthwhile something. But it must be done.

In theory, “something” could serve to dampen the cycle. Guarantees are a subsidy to banking and regulations are a tax. You want the subsidy to be most stimulative when everyone in the private sector is bearish. You want the tax to be most restrictive when everyone is bullish.

But actual government policy is “an optimal answer to a different question.” As individuals, banking bureaucrats want to be able to leave government for lucrative jobs in the financial sector. Those jobs tend to include lobbying the government to make the subsidy always more generous and the tax always less onerous. Barney Frank is now the poster child for someone who crusades for regulation in government and does, er, something else in the private sector.

And at a higher level, I believe that government is always trying to get more control over credit allocation. It wants to channel funds to its preferred uses, especially its own spending.

It’s not that bureaucrats are insincere when they say that they are trying to stabilize the economy or protect the consumer or what have you. It’s just that in a Darwinian process, it turns out that the financial policies that survive are the ones that increase the bureaucrats’ control over the financial sector.

“Quantitative easing” is a classic example. It was marketed as a temporary policy to fight a recession in 2008-2009 when interest rates were close to zero. It is now permanent, whether we are in a recession or in a boom. The way I look at it, the larger Fed balance sheet has survival value because it channels more of the public’s savings into government debt.