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Politics trumps economics

I (Russ) was at the Hoover Institution yesterday listening to a joint Hoover—Brookings conference on the US financial system in the aftermath of the crisis. There were some big picture sessions and some focused sessions (on Too Big to Fail and bankruptcy, for example.) A book is planned based on the papers that were presented.

The session on Too Big to Fail featured a number of ideas for how we might prevent the next crisis or reduce the costs of the next crisis, what I call the meltdown/rescue/reform cycle. (And almost all the speakers seemed to believe that Dodd-Frank has not solved the problem.)

At the end of that session, I raised the following issue. Everyone in this debate on Too Big to Fail treats it as an economics problem. But it’s a political problem. Economists can spend hour after hour debating ways to regulate large banks—capital requirements, risk-weights, new kinds of restrictions—but what is the evidence that these details matter at all in the face of the political power of banks? We solved Too Big To Fail before–it was called FDICIA and it was largely ignored in the crisis.

So won’t large banks throw their weight around again if enforcing regulations means a reduction in their ability to be highly leveraged and put other people’s money at risk other than their own? Along the way to the next crisis they will game the system, get around regulations or if necessary, have the regulations get ignored.

A Martian coming down to earth would see all of the minutiae of regulation as totally irrelevant. Forget what we say our policy is. What the politicians and bureaucrats do is to keep the borrowed money flowing. That’s what the incentives are for regulators and the politicians they report to. These incentives drown out the best intentions of economists. I closed my point by saying that until the political power of large financial institutions is reduced, we’re just fooling ourselves. The political power of large institutions is the problem that needs solving, rather than trying to figure out the best way to tweak the current system to work more effectively.

And of course, my preference is to live in a world where investors and financial institutions live and die on their own. Get some skin in the game. But that’s not a politically viable solution either. Until there is enough political support against the big banks, economists are just fooling ourselves. We’re playing intellectual golf.

If economists want to make the world a better place, we need to think about how to change the incentives facing politicians and not just the incentives facing investors and managers and consumers as if they exist in a political vacuum.

I have to confess that these thoughts make me uneasy. They remind me of the Stigler-Friedman divide. Friedman tried to change the world. Stigler laughed at him and made my point–the political incentives are what matter. You’re wasting your time. But I don’t think Milton was wasting his time. I think he made a real difference.  And I do think there’s a real virtue to putting forward accessible policy ideas that people can rally around. The best way for me to reconcile Stigler and Friedman’s view for me is to remember the importance of simplicity. Clear simple ideas have a chance of changing the world even when it may seem that the politics are against you.

I still need to think about this some more.

After my comments, a stranger approached and thanked me. Turned out he wasn’t an economist. He was part of the video crew transmitting the conference back and forth between the east coast and the west coast. Made my week.

I think economists fail to realize what a Kafka-esque world we live in trying to engineer the perfect regulatory system while the banks involvement in the process will always dwarf ours. We should be thinking about the political process and not just the economic process. The person in the street might have a better idea of what’s important.