How bailouts (and political power) destroy markets

by Russ Roberts on October 12, 2010

in Financial Markets, Gambling with Other's $

A reader the other day asked me something about the power of banks and what the government lets them do and I suggested that the most important thing government could allow banks to do is to fail and go out of business when they do a lousy job. This post from Synthetic Assets (HT Macroresilience) suggests that the perverse effects of government bailouts in the name of “systemic risk” are worse than I thought:

An important fact has been omitted from the ongoing discussion of the widespread failure to follow legal procedure not only in foreclosures, but also informing and managing mortgage backed securities:  This is just another example of the consequences of moral hazard that is deeply engrained in the way our financial markets work.  The financial industry functions on the assumption that contracts and activities that are either illegal or unenforceable under current law will – as long as they involve significant bank losses or liabilities – always be made legal retroactively.

Over the past half century the financial industry has not treated the law as a bedrock institution that constrains the nature of its activities, but rather as a set of rules that can be forced to adapt to the industry’s needs and desires.  Thus, the industry knowingly and deliberately creates standardized contracts that are either designed to circumvent the law or in some cases flatly illegal under current interpretations of the law, and then when a case involving the contract arises (which in many instances happens only long after the standardized contract has become an institution), the financial industry tells the court that the dubious or illegal contract is so widespread that the court would create systemic risk by enforcing the law.  (This idea was established by Kenneth Kettering in “Securitization and its Discontents” and the next two paragraphs draw very heavily from Kettering’s article and perhaps form little more than an opinionated summary of several of his sections.)

The post goes on to discuss how various financial “innovations” were illegal when put in place but were eventually condoned by the courts or the politicians in the name of avoiding systemic risk.

These are further examples of a process I discussed in my paper on the financial crisis. The bankers don’t sit around  (necessarily) figuring out how to rip us off but all the incentives are against prudence and favor their risk-taking. We, the taxpayers, end up paying for their mistakes.

These arguments, if true, have to explain how bankers continue to make so much money. If banking is a protected sector that the government coddles and rewards, why doesn’t competition for banking jobs reduce the returns to more normal levels?

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