Utopia, you are standing in it!

Plenty of people warned of dark days ahead. An essay anyone can read with profit is Ross Levine’s "An Autopsy of the U.S. Financial System: Accident, Suicide, or Negligent Homicide?"

The paper studies five important policies:

• Securities and Exchange Commission (SEC) policies toward credit rating agencies,
• Federal Reserve policies concerning bank capital and credit default swaps,
• SEC and Federal Reserve policies about over-the-counter derivatives,
• SEC policies toward the consolidated supervision of major investment banks, and government policies toward Fannie Mae and Freddie Mac.

Levine concludes that

• The evidence is inconsistent with the view that the collapse of the financial system was caused only by the popping of the housing bubble ("accident") and the herding behaviour of financiers rushing to create and market increasingly complex and questionable financial products ("suicide").
• Rather, the evidence indicates that senior policymakers repeatedly designed, implemented, and maintained policies that destabilized the global financial system in the decade before the crisis.
• Moreover, although the major regulatory agencies were aware of the growing fragility of the financial system due to their policies, they chose not to modify those policies, suggesting that "negligent homicide" contributed to the financial system’s collapse
• Although influential policymakers presumed that international capital flows, euphoric traders, and insufficient regulatory power caused the crisis, the paper shows that these factors played only a partial role.
• Current reforms represent only a partial and incomplete step in establishing a stable and well-functioning financial system.
• Since systemic institutional failures helped cause the crisis, systemic institutional reforms must be a part of a comprehensively effective response.

The most interesting morsels are:

• The New York Times warned in 1999 that Fannie Mae was taking on so much risk that an economic downturn could trigger a “rescue similar to that of the savings and loan industry in the 1980s,” and again emphasized this point in 2003; and
• Alan Greenspan testified before the Senate Banking Committee in 2004 that the increasingly large and risky GSE portfolios could have enormously adverse ramifications! A rare occasion on which Greenspan did not talk in riddles.

Stern and Feldman’s Too Big to Fail in 2004 used insights gleaned from the formal economic literature to frame warnings in 2004 about the time bomb for a financial crisis set by current regulations and government promises.

The prediction of the Kareken and Wallace moral hazard model of deposit insurance is if a government sets up deposit insurance and doesn’t regulate bank portfolios to prevent them from taking too much risk, the government is setting the stage for a financial crisis. If financial intermediaries do not bear the full consequences of their actions (because they are insured) then profit maximising portfolios will be too risky. The Kareken-Wallace model makes you very cautious about lender-of-last-resort facilities and very sensitive to the risk-taking activities of banks.

Tom Sargent said that Jose Scheinkman made a list of the ten academic papers that the Reagan administration should have looked at. Number one on his list was Kareken and Wallace.

The idea that deposit insurance leads to more financial crises even troubled FDR before he signed the 1934 U.S. bill to introduce deposit insurance.