"Nationalization and free markets
Could nationalization of the banks pave the way for a free market banking system? A suggestion in this post by Arnold Kling makes me wonder.
What I mean is that a post-nationalized system could consist of two types of bank.
One would be the nationalized banks. These would be plain utilities, a bit like old building societies. They’d take in guaranteed deposits and make vanilla loans to firms and households. They’d use money markets to smooth liquidity conditions, but not to fund their businesses.
The second type would be unregulated banks which could operate as they please, but with no government protection for depositors or investors.
Mightn’t this system give us the best of both worlds - there are guaranteed deposits for those who want them, but there’s also a source of innovation and dynamism?
What would be the drawbacks?
One is the sheer practical difficulty of getting from here to there. How do we slough off RBS’s risky operations to leave us with its utility-style business? In current conditions, with investors acutely risk averse, how would non-regulated banks raise funds to start?
Another problem is whether the free market system would be a danger to the wider economy. What if a large bank fails? Free market optimists might say that the contingency is a remote one, as the market would regulate them, by starving risky banks of funds in the first place. Or they could argue that the only losers would be depositors and counterparties who knew the risks they were taking and staked only money they could afford to lose. The wider economy might suffer from a dip in demand as there’s a modest adverse wealth effect, but nothing catastrophic.
Pessimists, however, could argue that there’s systemic risk here, as those who lost from this bank failure are unable to meet their obligations to third counterparties.
A third problem is the classic adverse selection problem. Good borrowers would prefer to borrow from the nationalized utility banks as their guaranteed deposits mean they can offer cheaper loans. Private sector banks are then left with only the riskier prospects.
You might think that this point raises a fourth difficulty - that the nationalized banks have such advantages that free market ones would be unable to compete. I’m not sure. If the free market is as dynamic and innovative as its supporters claim, then it’ll find a way. And if it isn’t, then nationalized banks aren’t as bad as they claim.
Feel free to add other difficulties.
But the question isn’t: would this system be ideal? Perfection is unobtainable. It is: would this system be better than a heavily but imperfectly regulated industry? Could it be that state ownership, far from being the enemy of private enterprise, might in this case be a precondition for it?
What I mean is that a post-nationalized system could consist of two types of bank.
One would be the nationalized banks. These would be plain utilities, a bit like old building societies. They’d take in guaranteed deposits and make vanilla loans to firms and households. They’d use money markets to smooth liquidity conditions, but not to fund their businesses.
The second type would be unregulated banks which could operate as they please, but with no government protection for depositors or investors.
Mightn’t this system give us the best of both worlds - there are guaranteed deposits for those who want them, but there’s also a source of innovation and dynamism?
What would be the drawbacks?
One is the sheer practical difficulty of getting from here to there. How do we slough off RBS’s risky operations to leave us with its utility-style business? In current conditions, with investors acutely risk averse, how would non-regulated banks raise funds to start?
Another problem is whether the free market system would be a danger to the wider economy. What if a large bank fails? Free market optimists might say that the contingency is a remote one, as the market would regulate them, by starving risky banks of funds in the first place. Or they could argue that the only losers would be depositors and counterparties who knew the risks they were taking and staked only money they could afford to lose. The wider economy might suffer from a dip in demand as there’s a modest adverse wealth effect, but nothing catastrophic.
Pessimists, however, could argue that there’s systemic risk here, as those who lost from this bank failure are unable to meet their obligations to third counterparties.
A third problem is the classic adverse selection problem. Good borrowers would prefer to borrow from the nationalized utility banks as their guaranteed deposits mean they can offer cheaper loans. Private sector banks are then left with only the riskier prospects.
You might think that this point raises a fourth difficulty - that the nationalized banks have such advantages that free market ones would be unable to compete. I’m not sure. If the free market is as dynamic and innovative as its supporters claim, then it’ll find a way. And if it isn’t, then nationalized banks aren’t as bad as they claim.
Feel free to add other difficulties.
But the question isn’t: would this system be ideal? Perfection is unobtainable. It is: would this system be better than a heavily but imperfectly regulated industry? Could it be that state ownership, far from being the enemy of private enterprise, might in this case be a precondition for it?
Me:
I like the idea, but I think that narrow/limited purpose private banks could also be a possibility:
Posts
See here from the FT:
http://blogs.ft.com/economistsforum/2009/01/putting-an-end-to-financial-crises/#more-315
"What will change this behaviour is to not let it happen. Banks should be allowed to initiate only conforming, i.e., government-approved, AAA-rated mortgages and business loans. These would be long-term, fixed-rate loans with 20 per cent-down and payments below 25 per cent of income.
The government, via the Federal Financial Authority, would use tax records to verify loan payment-to-income ratios. It would also spot check collateral. Once approved, the banks would bundle and sell “their” loans within mutual funds.
Again, traditional bank runs wouldn’t arise. And today’s bank runs, which entail lenders and equity investors avoiding risky banks, wouldn’t either. Why? Because banks would bear zero risk. Mutual fund owners would bear risk, but not the banks. And these lenders would know they were buying government-approved AAA-rated loans, not Bear Stearns‘ CDOs.
This limited purpose banking is a modern version of narrow banking proposed by Frank Knight, Henry Simons, and Irving Fisher. Banks would hold deposits, cash checks, wire money, originate loans, and market mutual funds, including money market funds with no guarantee of par value redemption.
With limited purpose banking, financial crises would largely disappear. Banks would never fail, never stop originating loans, never expose the public to massive liabilities, and never see their stock values evaporate. Banks would be stable, boring economic cogs - like gas stations.
The Fed would also gain full control of the money supply. To expand the money supply, the Fed would continue buying treasuries from the public and supplying cash. But banks wouldn’t be multiplying and contracting M1 (cash plus demand deposits) based on their ever changing decisions about lending deposited funds.
Milton Friedman, who also advocated narrow banking, blamed the Depression on the Fed’s failure to offset the M1 money multiplier’s collapse. In the past year the M1 multiplier has contracted by over 40 per cent, forcing the Fed to double base money. If the multiplier shoots back up, we could see the money supply and prices explode."
Check it out.
Posted by: Don the libertarian Democrat | February 11, 2009 at 10:56 PM