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Friday, September 24, 2010

Regulating the Banks: There's an Externality, Right? ...Right?

The way I see it, there are two reasons usually used to justify government regulation: morality and economics. Oftentimes, the economic argument is used just because it's harder for most people to dispute an "economic fact" than someone else's ideology. But when it comes to Wall Street, well, it's obvious that the reasons are going to be economic.


Earlier this month, U.S. News & World Report published an article titled "Why Elizabeth Warren Will Benefit Wall Street," by Rick Newman. One of his points is essentially that Warren will be a boon because banks need someone watching over their shoulders to make sure they're not screwing us all over. It's high time for more government reform, and we may finally be getting it. But maybe I should stop a second. If government is getting involved here, I need to take a closer look. Is there a market failure here? Is government regulation the only way to achieve efficiency in the market for credit and loans? Is there an externality involved with unregulated--or, at least, less regulated--banking activity?

Newman's article points out that Warren has long been a critic of "sky-high credit-card rates, hidden fees and other objectionable lending practices." Credit card rates, fees, and lending practices of any variety look to me like they have two sticky little components that keep them from sounding like they have anything to do with externalities: they're market-based and they're intentional. There is a market for credit and loans--no one's going to deny that. And if Jonesey's credit card interest rate soars to exorbitant highs, Jonesey is the only one who's going to be feeling the hurt from it--well, maybe Jonesey and his wife and kids, but certainly Mrs. Peabody three states over isn't going to be any better or worse off. No one forced Jonesey to get the credit card, either. No one forced him to take that car loan. He chose to enter into a contract with his bank, and the exchange of funds was a market interaction each considered beneficial: Jonesey got to buy his 62" high-definition TV on his new credit card, and that new minivan his wife had been bugging him about, without having to save up all the money at once; the bank got to collect interest. If either party had thought it wasn't beneficial to him to enter into the contract, the contract wouldn't have been made. No mafia involvement here, no guns to the head or threats about sleeping with fishes.

But the system is broken, Newman says. In fact, he says that "the system is so flawed that Wall Street as we know it would have collapsed if the feds hadn't rushed in to rescue it in 2008." Well, if something's that broken, then I guess even if I can't find a way to call this an externality, there must still be some kind of market failure the government should fix. Only, it's not certain that it was a market failure that caused the collapse. The subprime mortgage market was the front and center crisis in 2008, but it's been suggested that the problem there wasn't too little government regulation, but too much. Congress had passed legislation that required lenders to accept borrowers they considered too risky and give them mortgages anyway. If the market had been allowed to do as it would, without regulation like that, there might not have been a housing bubble to pop--or at least, not such a fatally large one.

So if there's no externality, and the market failure we have seen may have been caused by overregulation, why is the government getting involved?

Well, if it can't be justified economically by efficiency standards, I guess the driving reason in proponents' minds must be their sense of morality. I'll take their values as given, they can think and support whatever they like. Fine by me.

But is it really so hard to admit it?


"Why Elizabeth Warren Will Benefit Wall Street" by Rick Newman

"Regulation, not deregulation caused the current mortgage crisis" by Mary Mostert

You wrote: "So if there's no externality, and the market failure we have seen may have been caused by overregulation, why is the government getting involved?"

How about if we say that inefficiency that results from government policy/action is "government failure"?
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