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September 22, 2008



Perhaps "new" in the current context, but in fact a very old idea. The old (pre 1970s) model of bank regulation focused on restaining banks from competing against each other.

Tord Steiro

A couple of months ago I would have scratched my head and twisted my face at the idea of too much competition. However, as I have just digested some of the works of Ha-Joon Chang, I am about to see some logic in too much competition.

In order to defend the idea of too much competition, Chang mentions two points, in particular:
1. Asset specificity.
2. Increasing Returns to Scale

I can see his points, but where does asset specificity and IRS come into play here?

The excessive risk-taking is not mentioned by Chang, on the other hand, could that be some result of IRS? If increased scale could lower your cost, it could be worth taking excess risk in order to grow enough to incorporate the lower costs.

And, of course... If you are big enough, the government has no choice but to bail you out if you fail, so I guess it is some prospect for IRS after all.

But there is a lot more to this story, I think. And I am still confused.

So Dani, one more, please?

Justin Rietz

.I think this is a sideline issue.

The Federal Reserve has pumped money into the economy at an unbelievable rate for the past 15 years. The consequences:

1. Rapid asset appreciation / malinvestment - first the tech bubble, then the housing bubble.

2. Low interest rates that cut into banks' margins. In order to make up the difference, banks focused on volume rather than on the credit quality of borrowers, i.e. subprime loans for anyone who could sign their name on the dotted line. And since limitations on leverage are weak, banks stretched their capital too far in order to meet this volume.

3. When interest rates are too low, there isn't enough savings to match investment demand. In an economy with no central bank controlling interest rates, an increase in investment demand would raise interest rates and therefore cause savings to go up until savings supply met investment demand. However, in the U.S., the Fed prevented such an adjustment, so in order to meet demand financial institutions over-leveraged.

4. Low interest rates meant poor returns on less risky assets and inflation. The result is that investors became willing to take on excessive risk in order to earn a slightly higher return.

The solution? Remove the power of the Federal Reserve to set interest rates and limit the leverage financial insitutions are allowed to take on. Eliminate fractional reserve banking for demand deposits and other "on-demand" deposits that consumers expect to always be available. In my opinion, fractional reserve banking is more or less fraud - when you opened a checking account, did the bank tell you that they keep less than 10% of your money in reserves and loan out the rest, and that if you and many of the bank's other customers demanded their money at the same time, they couldn't return it to you?

John V

Why do you read Angry Bear?

Michael Margolis

Eichengreen repeats here either a common fallacy or a piece of folk wisdom that will mean greatness for the economist who shows it not to be fallacious.

Profit maximizing firms don't wait until they are pressured by razor-thin margins to innovate. They do it as soon as they deem the innovation profitable. In tales from basic economics, the investment banks pressured by encroaching commercial banks would simply have gone out of business until their sector was down to its new equilibrium size.

I suspect there is something to the idea that institutional self-defense corrupts profit-maximization in these cases. This might lead to some desperate experiments and speed up innovation. Thus, I think, the intuitive appeal of such stories. But we're talking about banks here, not soldiers out of ammunition. If the chance to make a killing on derivatives was there in 1970, the existence of respectable profit streams would not have stopped them. Not all of them.

Tord Steiro

@Michael Margolis

"Profit maximizing firms don't wait until they are pressured by razor-thin margins to innovate. They do it as soon as they deem the innovation profitable."

What if innovation is risky? Why would you expose yourself to an elevated risk if your profit margins are already good? The thing is, you wouldn't. If your profit margins are squeezed, you have to start looking around for innovations, hence, you act riskier.

It's like driving. If you have plenty of time, you are more inclined to drive carefully, if you are in a hurry, you take shortcuts, speed whenever you can, and drive riskier.

And excessive risk-taking is at the bottom of this crisis which ever way you turn it around, so the story seems plausible to me. So far, at least.


While it's plausible that deregulating commissions helped create this problem, that's no reason not to have deregulated them.

A stock transaction can be handled with less computing power than a Google search. Sorry if that's changed a once cozy little industry, but the finance crowd didn't cry much when phone operators and (many) bank tellers were replaced by computerized operations.

Interestingly, while the cost of financial transactions has been reduced by technology, the financial services industry has grown, not only in real dollars, but as a percentage of GDP. Can anyone actually quantify what we've supposedly gained from these increased costs, or are hand-waving homilies the best rationalization available?

Perhaps a better comparison is to food. Despite recent price increases it's still cheaper than it was in decades past. The cost of production as a percentage of GDP has shrunk, yet no one seems to think that's a justification for selling tainted food.

Sorry, Wall St., in every other area you (usually correctly) tout reduced production costs and increased competition as progress. I see no reason that shouldn't be true of financial services.


Speaking of unintended consequences, how about this 1999 story from the New York Times, foreshadowing another classic case of government failure:


"In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

"The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

"Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

"In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.

"''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.''

"Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market.

"In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

"''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''"

Ken Houghton

All right, I'll be fair: Economists may used "unintended consequences" whenever you can't demonstrate by an intuitive approach that would be understood by any Intermediate Micro/Macro student what the result would be.

For instance, you can argue (ex post facto) that the deregulation of the 1970s led to increased automation in the industry, a larger set of investors, day-trading, etc. But you can only do that because Michael Margolis is correct that some firms saw that deregulating commissions meant that you could target another market segment (price-sensitive investors, a.k.a., those who probably shouldn't be in the market directly in the first place because they cannot afford to lose) with tiered pricing and automated order routing.

As Steve Randy Waldman notes, "Financiers will destroy the world however much money you give them (it is never enough), if they have a profitable scheme for doing so and if they are not held back by regulation."


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