So this post isn't really about Eugene White, though his paper on bank regulations sounds extremely interesting. This post is more about our friend Russ Roberts at Econ Talk. As usual, I'd like to say that I have a great deal of respect for Russ, and unlike many economists and jerks (I'm looking at you Freakonomics) he is always willing to listen to opposing view points, and he very rarely goes on pejorative or mocking jaunts about those with whom his beliefs clash.
However, he proposed a very interesting rationale, which you've probably heard, about the reason for the Financial Crisis. Namely that it was the moral hazard that created the risk. That regulation, and regulations creating the FDIC in particular and requiring capital limits, etc., that spurred the banks to take risks with money that they might not have done had the market been allowed full freedom.
These matters are , of course, very complicated, and we both are guilty of oversimplifying to make a point. However, I think Robert's worldview in this is very much compromised by his stance on overall social policy.
1) First of all, it is always convienent to argue about what might have been, I know, I've done it myself. But without evidence, such arguments are at best, merely speculative. It is simply impossible to know what moral hazard may have done before the fact.
Quickly, let's redefine moral hazard: Moral hazard is the theory that by insuring banks against their risks, and "bailing them out" when they become insolvent, you inure them to future risk and exacerbate the problem. And further, that this cycle is self perpetuating, relying on the government as a backstop to all financial risk.
2) Academics and business types tend to forget something critical. A government has a moral obligation to protect its people. FDIC insurance, as allowed for the individual, is to insure them against destitition. There is no risk posed by Moral Hazard that isn't worth it for that reason alone. Academics and business types, love to talk about how failure is necessary for the system to work. I disagree. Quite simply, total loss is not required for a system to learn. Fear alone is a learning tool, enough to galvanize and secure. Total loss on the otherhand, does little else but disenfranchise. And a people that is disenfranchised are a people that can quickly resort to violence, and the sorts of moral exigencies that are a clear result of fear and violence.
3) As to the moral hazard of the banks. Love him or hate'im, when Paulsen let Lehman fail, he destroyed moral hazard for the banks. People forget about that. Most of Lehman forget about that. Most of the former Lehman Brothers employees are now at Barclay's, other banks, or in private equity and hedge funds. I'd guess that there isn't a single one that isn't employed now, saving some of the support staff. So its easy to forget just how scary that time was. There is no moral hazard, there is no blanket policy of forgiveness. If the system can withstand it, the regulators will always discharge what they cannot sustain.
4) Regarding banking institutions taking on high risk because they believe the government will bail them out. I see two flaws. First of all, prior to 2008 there was a fairly limited pool of evidence that such a thing would occur. Though the government did help out in the SnL crisis, the monies used to bail out the system came in large part from other banks. Lehman, was not a contributing member to that bail out, so there was some justice (and refutation of moral hazard) in its not being saved. Second of all, academics and business people (and I should stress that I mean economists and financiers largely) tend to forget that economic crisis are based largely on the collective actions of human beings. And that human beings have a poor perception of long-term risk and long-term gain, and at worst, are completely irrational.
And it is for that reason that I hold to the hypothesis that the financial crisis was caused by a mixture of:
--Lack of Proper Regulation
--Short Term Gain over possible risks by bankers
--Greed (unwillingness to wind down when it became transparently clear that a meltdown would occur)
--Poor record keeping
--Intentional racial targeting (again for short-term gain)
--Inappropriate compensation for bankers
--Lies and obfuscation intended to keep the investing public in the dark as long as possible