One of our commenters (Kosta) led me to this blog piece by Krugman. I'm feeling bad that I keep giving him a hard time, so this is my opportunity to show you that I don't harbor some irrational hatred for the guy. Krugman does a nice job of laying out the issues and summarizing the key influential viewpoints, so this is a useful platform on which to build a discussion.
I especially like Krugman's analogy to health reform, though I disagree that health reform is somehow easy while financial regulation is hard. What we have just been through was a long, painful, and costly process of passing health care legislation. I think we have an improvement, but we'll see what happens when the government tries to enforce participation. The analogy to health reform draws in my running Canadian example, which I discussed here among other places. Just as there are lessons for the US in Canadian health insurance, there are lessons in Canadian banking. As one of my former colleagues at the University of Western Ontario, Ig Horstmann, was fond of saying, "Canadians love insurance." They have government-provided health insurance, relatively generous unemployment insurance, and their banks (because they are forced to do it, or in part for other reasons) are essentially self-insured. As economists know of course, there can be problems with being too well-insured, and it seems clear that the US does not want to be Canada. But that doesn't mean you can't learn something from what Canadians do.
Now, the first point of discussion has to do with a typical characterization of US banking and monetary history. The story goes like this. In pre-Civil War times there were only state-chartered banks, and these banks could issue private currency. There was a plethora of banks, and a plethora of circulating bank notes, and it seems generally agreed (with some exceptions) that this system did not work well. Bank notes circulated with discounts, counterfeiting problems were severe, and the quality of bank notes could be hard to evaluate. After the Civil War, the state bank notes were taxed out of existence, and the National Banking System was created. Given the regulatory structure, the currency issued by National banks was essentially safe, so one problem was solved. However, during the National banking era (post Civil War to 1914) there were banking panics, the last of which was in 1907. By the early twentieth century, the view was that the financial system was unstable, and that having a central bank could cure the problem. Thus, we have the Federal Reserve Act of 1913, and the Fed goes into business in 1914. Things seem to work reasonably well until the Great Depression. Then, the conventional view seems to be that the Fed was somewhat inept, and did not appropriately perform its roles as lender of last resort and supplier of liquidity to the financial system. Further, there was too much risk-taking by banks (they were somehow too closely connected to the rest of the financial industry) which, combined with the helping hand of the Fed, led to the failure of 1/3 of the banking system in 1933. Then, according to the conventional view, this was all fixed in the Banking Act of 1933 (otherwise known as the Glass-Steagall Act) which introduced deposit insurance, Fed regulation of savings deposit rates (regulation Q) and the separation of banking from other financial intermediation activity, among other things. Then we have the Quiet Period of US banking (Krugman says "quiet period" comes from Gary Gorton - I was looking for the reference but couldn't find it - anyone know?) until the savings and loan crisis (late 1980s, early 1990s). In 1980, there was a key piece of legislation, the Depository Institutions Deregulation and Monetary Control Act, an important part of which deregulated savings and loan institutions and made them look more like banks. This was followed by the Gramm–Leach–Bliley Act of 1999, which further relaxed the Glass Steagall Restrictions that prevented bank holding companies from getting into non-bank financial business. Now, one could see how deregulation could accentuate moral hazard problems in banking and lead to a need for regulators to limit bank risk-taking in new ways. However, some people (including Gary Gorton apparently, but I've heard other people say this) argue that Glass Steagall limited competition among banks (and between banks and other financial institutions) in ways that made them take less risk, and that lifting these restrictions produced the obvious result.
Part of the conventional view of this historical experience is that there is something inherently wrong with banking - in converting illiquid assets into liquid liabilities banks leave themselves open to runs and panics. A Canadian perspective on this might be entirely different. A Canadian might look at US banking history and wonder why these Americans can never get it right. They get off on the wrong foot, and it just goes from bad to worse. Canadian banking history is essentially one long Quiet Period. Before the Bank of Canada came into being in 1935, chartered banks could issue currency. This private money system worked quite well (see this paper) - notes issued by different banks traded at par, banks redeemed each others' notes, and there was an apparently efficient system for clearing the notes. Further, without a central bank, the Bank of Montreal played a quasi-central banking role, and the banks appeared to be self-policing and capable of preventing incipient panics. Private note issue was ultimately phased out in 1944. There was no deposit insurance in Canada until 1967, and yet failures of banks in the 20th and 21st centuries has been insignificant - one failure in the 1920s, the failures of two small banks in the 1980s, and no failures during the Great Depression or the recent financial crisis.
One interpretation of what is going on in Canadian banking is consistent with Gary Gorton's ideas, and one commenter (Kosta) suggested something similar. We could say that Canadian banks have a lot to lose from bad behavior. They enjoy significant monopoly rents, and they risk losing them. If they take on too much risk and there is a large chartered bank failure, the Canadian government will step in and break them up like ATT. In equilibrium the government never has to impose the punishment, but the banks understand that the government is committed to this off-equilibrium behavior. The more I think about this story, the less I like it. One lesson from the US financial crisis is that some of the players who contribute to the riskiness of large financial institutions really have nothing to lose. The professionals who designed financial instruments and marketed them for Bear Sterns and Lehman Brothers, for example, have valuable skills, and some of them are now employed at the Fed, Fannie Mae, Freddie Mac, and in other financial firms. They were handsomely compensated and are doing just fine now, thank you. It seems to me that we can explain the behavior of Canadian banks adequately by looking at how they are regulated - it doesn't have much to do with the implicit threat of punishment.
Now, particularly since Krugman brings up the Diamond-Dybvig (DD) model, I should talk about that. This paper by Gary Gorton is also essentially a DD story. I have found DD useful in modeling (e.g. here and here). The model captures in a nice way the insurance role played by banks - essentially a story about how liquidity is shared through the banking system in an efficient way. But that is about as far as it goes - people just give DD too much credit (sorry Doug and Phil). In the original paper, it can be easy to write a bank contract that prevents a run, and when it's not DD don't solve the problem properly. Ultimately, the model has nothing to say about deposit insurance, moral hazard, or central banking - all the things we really care about. For the bottom line on the DD model, see work by Huberto Ennis (Richmond Fed) and Todd Keister (NY Fed).
I have no doubt that the possibility of runs and panics is a real problem in some banking systems, but DD is not instructive. One thing that seems clear is that deposit insurance is one fix put into the US banking system that appears to be working. Runs (other than the phenomenon Gorton discusses in the paper I linked to in the previous paragraph) were essentially absent in the US banking system during the financial crisis, and the the FDIC seemed capable of resolving small bank failures (and even larger ones like Washington Mutual) quickly.
If we get away from a Diamond-Dybvig view of banking, and think in general equilibrium terms, in monetary economies with central banking (like this one, we can come away with a very different view, both of history, and of the reasons for the financial crisis. Panics, of the type discussed by Gorton here could just be viewed as liquidity shortages, as could the National Banking era panics (see this paper). It was a problem for some financial institutions during the financial crisis which were funding long-maturity assets with short-term repurchase agreements that they could not borrow from the Fed (though of course the Fed was lending to pretty much anybody who had decent collateral and maybe even some who did not), just as it was a problem in the National banking era that the currency was not "elastic." Canadian banks in 1907 facing a line of depositors wanting to withdraw their deposits could print notes and simply swap the deposit liabilities for notes in circulation - they created the liquidity privately. In banking systems without private note issue we rely on the central bank to supply liquidity appropriately.
Here's a question. Once there is a central bank lending facility in place, why isn't deposit insurance redundant? Surely the central bank can stand ready to lend on good collateral, and if the collateral is no good and the bank is deemed to be insolvent, the central bank can resolve it in the same way the FDIC does. Why not?
That's all for today. Comments are welcome. I'm all ears.