Another day, another jihad against the market. Today’s campaign against capitalism features a plan being trotted-out by Treasury Secretary Timothy Geithner to (i) mandate greater capital requirements for financial institutions, and (ii) impose aggressive new regulations to protect us against institutional risk-taking that threatens a reoccurrence of the kind of financial meltdown we’re going through today.
The idea that greater capital requirements would reduce financial risk, however, is dubious. In fact, Geithner’s plan might actually increase the number of risky market bets that we’re supposed to be worried about. If a bank, for instance, were determined to hit a certain risk/reward position, but federally-mandated capital requirements frustrated the achievement of that position by dialing down the risk (and thus, potential reward), the bank could easily get around the problem by increasing the riskiness of its investments beyond where they would have been absent the capital requirement, putting the bank back where it wanted to be on the risk/reward curve. Moreover, higher capital requirements increase the risk that a crisis will trigger a financial wildfire in the banking sector given that losses will lead to less lending, more asset liquidation (and thus, lower asset values), and more borrowing than might otherwise have been the case without the federally mandated capital requirements. And it’s the contagion and deflation that follow from such events — not individual bank failure per se — that is the real thing we need to worry about in the financial sector.
Likewise, the idea that risky investments by some big Wall Street firms put innocent third parties in financial danger is on far shakier ground than it widely believed. s economist Jean Helwege puts it in a recent paper featuring an empirical analysis of that proposition:
Regulators often fear that the collapse of a financial firm will lead to negative spillovers into the real side of the economy. The mechanism connecting these firms to the economy is not well understood, but two oft-cited channels are domino effects (counterparty risk) and the effects of fire sales on markets. This paper analyzes federal policy in light of these two factors. Evidence from past bankruptcies suggests that cascades caused by counterparty risk do not occur, as most firms diversify their exposures. Instead, crises tend to be symptomatic of common factors in financial firms’ portfolios, which lead to widespread instances of declining asset values. These low asset values are often misinterpreted as resulting from fire sales by distressed firms, but are more likely to represent massive losses from poor investment choices. Fire sales in the U.S. are less likely because bankruptcy laws allow substantial time for the disposal of impaired assets. In sum, the two main reasons for TBTF [too-big-too-fail] policy, counterparty risk and fire sales, are unlikely to pose major risks to the system should failed financial firms be permitted to file for bankruptcy protection.
What President Obama is selling is the idea that government must be the final arbiter regarding how much risk-taking is appropriate in this allegedly free market economy. It is unclear, however, whether anybody short of God is in the position to intelligently make that call for every single actor in the market. It is also unclear whether a market characterized by less volatility — and thus, less variation in profit and loss — creates more wealth over the long-run than an economy characterized by the boom and bust cycles allegedly driven by this unpoliced risk-taking. After all, economies that have been centrally regulated on this front historically have not performed very well — especially in comparison to those that haven’t. Finally, it is unlikely that vote-maximizing politicians — the parties that will have the final say on these regulations — have the right incentives to optimally dictate market risk even if such a thing could be theoretically done.