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December 28, 2008

When are the private costs high enough to prevent externalities?

Eric Posner and Megan Mcardle are having an interesting conversation about when the private costs of bank failure are high enough to not require regulation even if you are going to provide deposit insurance. 7

Almost everything in the world has negative and/or positive externalities. But despite this, we do not intervene to subsidize everything with good negative externalities, or punish everything with bad. That's because things with substantial negative externalities often contain sufficient punishment to deter the individual; likewise, things with positive externalities often carry enough reward to produce a socially optimal amount. For example, if I am a bus driver, the negative externality of my suddenly jerking the steering wheel to the left and driving the bus off a cliff is much higher than the cost to me--many lives against my one. But my own life is very valuable to me. The threat of its loss is enough to deter such behavior 99.9999% of the time.

In a world with bank insurance but without regulation [corrected, thx to traveler456], I would start up a Posner bank, ask you for a deposit, and then use your money to buy lottery tickets. If I win the lottery, I pay you back; if I don’t, I dissolve the bank and you go to the government for your funds. I wouldn’t bother to hide my investment strategy from you; you wouldn’t care because you would be paid in any event. I would set up hundreds of banks and give the managers a salary that they would receive if and only if they collect deposits and use them to buy lottery tickets; otherwise, they are fired. (Corporate law junkies will point out that the government will pierce the corporate veil and go after my lottery winnings, but in the real world, with thousands of shareholders and not-lottery but still risky investment schemes that unfold over decades during which dividends are paid and the money spent, that’s not so easy.)

I think Posner's point only stands if the deposit insurer is charged the same rate for insurance regardless of what they invest in. If Banks holding riskier portfolios (like this lottery ticket scheme) with poor expected returns are charged higher fees, you don't need regulation. Companies will have the incentive to behave without regulation. Only in the one-price-fits all deposit insurance market do we need to force all banks to have the same risk taking behavior.

But Posner has an interesting point about the capacity of regular folks to evaluate bank reliability. Megan comments "The moral hazard for depositors may be large. But I doubt it. Most depositors are not capable of determining whether a bank is faulty or sound, and they weren't in 1830, either." Eric responds "This can’t be true. In the nineteenth century, elaborate efforts were made to keep track of bank risk. Merchants discounted bank notes after consulting books that compiled risk estimates. The notes of larger and more stable banks were discounted less. Since people often made payments with bank notes, they must have had a sense of how risky different banks were, and taken the risk into account when making deposits, to say nothing of common memory about which banks have stayed in business and for how long. Today, people don’t pay attention to bank risk because of deposit insurance; but people certainly think about risk when they make uninsured investments, for example, when they buy stocks or corporate bonds or, for that matter, stereos and personal computers."

In our current regulatory environment we try to protect people from risks that they don't have a good handle on. But we forget that if we stopped nannying them on many of those risks, sources of information and improvements in decision making to assist in this process could be profitably created. Libertarians are often mocked for saying that Consumer Reports like services would pop-up everywhere in their utopia, but there is real truth there.

Oh, and the conversation started with Does the financial crisis discredit libertarianism?.

Posted by OneEyedMan at December 28, 2008 6:48 AM

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