The ideal free-enterprise system rewards entrepreneurs with the full value of what their products contribute to society if they succeed and punishes them to the full extent of the resources they have wasted if they fail. Civilized democracies temper these incentives, especially when it comes to penalizing failure. Consider banking, in which, more than in any other field, managers work with other people’s money. At worst, failing bankers’ liability would be limited to their losing their jobs—unlike in medieval times, when they could be sent to debtors’ prison or even beheaded. That gives bankers asymmetric incentives. They keep more of the wealth they create while suffering fewer of the losses they inflict on their investors and society. As a result, they have an incentive to take on more risk, not all of which is socially beneficial. Following the banking crises of the 1930s, such potential for banker misbehavior was controlled through strict regulation.
For decades after World War II, much of the industrial world was engaged in rebuilding and catch-up growth, so banking could be boring and staid. After all, how much genius was required to finance the next road or bridge? The strict regulation was not onerous. In the past few decades, though, as industrial countries have reached the limits of what is possible with existing technologies, banks have had to finance more innovative new ventures. Some deregulation was needed to free bankers to take on the greater risk these ventures involved and finance them in creative, value-enhancing ways. Banks, faced with greater challenges, have had to attract high-quality personnel, which has meant higher banker compensation. These necessary changes have unfortunately also opened the door to excess.
Even while deregulation has increased the upside for bankers, the downside has diminished, exacerbating the asymmetry in incentives. A number of banks have become large and complex, straddling many markets and countries. If such a bank collapses, it will disrupt markets and possibly create contagion as investors worry not just about who is directly exposed to the bank but also about who is exposed to anyone who is exposed. In a panic, the authorities do not want to punish the greedy or careless banker, for many innocent people would suffer as well.
Not on Their Watch
Given a choice between the intangible future benefits of teaching risk-loving bankers a lesson and avoiding the possibility of being known to posterity as the government that let the system collapse, it does not take a genius to predict the government’s decision. Recognizing that foolish but too-big-to-fail bankers will be bailed out, investors put more money into them, making bankers bigger still and even more risk-loving.
Bankers are not the only problem. Governments and quasi-governmental institutions like U.S. mortgage lenders Fannie Mae and Freddie Mac have spread their securities into every nook and cranny of the global financial system, in the process making themselves too big to fail. This facilitates undisciplined government spending, paid for by future generations. And of course, with reckless banks buying government debt and the spendthrift government rescuing banks as needed, the economy is sucked dry by the irresponsible and the imperishable.
When everyone expects losses for the very big to be socialized, not only does capitalism lose its key virtue of allocating resources well and incentivizing their proper use; it also loses public legitimacy. Ordinary citizens find it difficult to understand why they should pay their debts, especially when they are so much closer to subsistence than rich bankers are. Is it any wonder that so many support the Occupy movements?
So what is to be done? Large financial institutions could be broken up, but so long as they herd on the same risk as they are wont to do, we may get “too many to fail” instead. While a few habitually mismanaged banks with a culture of aggression should be shrunk, the more general approach to regulating large institutions will require closer scrutiny of internal pay and risk-management systems, higher capital and liquidity requirements and more organizational simplicity and transparency to facilitate the closing of at-risk institutions. Furthermore, regulators should encourage a greater variety of financial institutions, because greater diversity and redundancy in the system will ensure that no single firm is indispensable. And they should require that large banks diversify their holdings of “safe” assets across many governments so as to reduce their mutual dependence.
Finally, democracies tend to protect failing institutions because individuals are unprotected. For example, official U.S. policy is more interventionist in downturns, regardless of its effectiveness, partly because unemployment is so costly to workers, who have little savings, whose unemployment benefits run out quickly and whose health care is tied to a job. A more comprehensive safety net for individuals, while reducing incentives to work a little, might allow politicians to accept more corporate or financial-sector failures. If no entity is imperishable, the free-enterprise system will work better and with more democratic legitimacy.