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An End to Bailouts
Conservatives should seek one; here’s how

(Roman Genn)



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Many commentators, including the FDIC’s vice chairman, Tom Hoenig, have proposed breaking up the banks, either according to the products they offer (a new Glass-Steagall) or by size, in order to reduce the risk of financial crises. But this proposal would not by itself significantly improve our banking system. Breaking up banks would likely result in a system that was more fragmented and less diversified. Note that companies doing a single line of business, such as Fannie Mae, generally performed worse during the crisis, not better, than did companies that were more diversified. A banking system of small entities is not necessarily a safer one. Over 400 small banks failed this business cycle.

The percentage of small banks that are unprofitable is currently five times that of the largest banks. This reflects the regulatory advantages that large banks enjoy, of course, but also differences in the types of risk different banks take on. Government insurance against risks should be limited to the deposit-insurance fund, but what constitutes risk is an empirical matter, not a mere preference. For legislators or regulators to determine which categories of bank activities are risky and which are not is misguided, and the decision will be driven more by politics than by economics. History does not suggest that a banking system characterized by small undiversified banks is a safe one. Returning to the banking system of the 1920s and ’30s would not be an improvement.

Against the kinds of reform I have endorsed, it could be objected that eliminating government guarantees and rescues would lead to depression and financial panic. But in truth, guarantees and rescues already threaten to produce just those outcomes. For example, the run on mutual funds in 2008, to the extent there was one, was caused by an unlimited extension of deposit insurance under the Transaction Account Guarantee Program. As TAG offered businesses and high-wealth households a federal guarantee, they shifted their money out of mutual funds and into banks. The economy then worsened as the amount of funding available to corporate America decreased: Banks did not lend out the new deposits, and a contracted mutual-fund industry had less demand for commercial debt. As we painfully learned, wrapping a government guarantee around one portion of the financial sector will draw money away from other segments. The aggregate supply of funds is not increased, but simply redistributed.

Another justification for government intervention in the financial sector was the “breaking of the buck” by money-market mutual fund Reserve Primary — that is, the dropping of its net asset value below the par value of $1.00. The potential for widespread losses in other money-market funds raised the specter of bank-style runs among mutual funds. But Reserve Primary was heavily invested in Lehman debt; its losses were the result of a bad bet, not a run on mutual funds of a kind the government should offer protection against. Investors in Reserve Primary have recovered 99 cents for every dollar of investment — hardly a loss justifying a host of government interventions.

Republicans suffer from their image as the party of Wall Street, even though Wall Street’s campaign contributions are close to evenly divided between the GOP and Democrats and even though Wall Street resides deep within the Democratic stronghold of metropolitan New York. By philosophy and temperament, Republicans are actually the party more inclined to oppose Wall Street bailouts. One of the most striking differences between Republicans and Democrats is in their levels of trust in government. Republicans are typically skeptical, Democrats typically supportive, of an expansive government with broad discretionary power. In this, Republicans have a natural advantage with independent voters, who generally oppose bailouts. Independents in the General Social Survey are consistently found, however, to have less confidence in banks than do Republicans or Democrats. To be pro-bailout and pro-bank is a recipe for electoral defeat.

Republicans have historically regarded finance as a countervailing force to the power of the state. Although in principle they hold that government should not rescue failed firms, they have too often made an exception for the banking sector. The Republican-party platform of 1912 read, “Our banking and currency system must be safeguarded from any possibility of domination by sectional, financial, or political interests.” Today our banking system is dominated by sectional, financial, and political interests. For Republicans, sensible financial reform will require a return to principles, not an abandonment of them.

– Mr. Calabria is the director of financial-regulation studies at the Cato Institute. He was previously a senior staffer of the United States Senate Committee on Banking, Housing, and Urban Affairs.


Contents
January 28, 2013    |     Volume LXV, No. 1

Articles
  • Too many Republicans wanted us to take the plunge.
  • A lesson learned, unlearned, relearned, painfully.
  • Republicans should reclaim the 37th president.
  • Our mental-health system is failing those most at risk.
  • How Robert H. Bork galvanized a movement.
  • Personal attacks and cultural collapse did not reduce his joie de vivre.
Features
Books, Arts & Manners
  • Daniel Johnson reviews The Barbarous Years: The Peopling of British North America: The Conflict of Civilizations, 1600–1675, by Bernard Bailyn.
  • Elizabeth Powers reviews John Keats: A New Life, by Nicholas Roe.
  • Andrew Roberts reviews The Blood of Free Men: The Liberation of Paris, 1944, by Michael Neiberg.
  • Thomas S. Hibbs reviews The Invisible Hand in Popular Culture: Liberty vs. Authority in American Film and TV, by Paul A. Cantor.
  • Ross Douthat reviews Django Unchained.
  • Richard Brookhiser on the urban pigeon.
Sections
The Long View  .  .  .  .  .  .  .  .  
Athwart  .  .  .  .  .  .  .  .  
Poetry  .  .  .  .  .  .  .  .  
Happy Warrior  .  .  .  .  .  .  .  .