As explained here, when a community or nation enforces some rough approximation of the rule of law, capitalism inevitably follows. When left alone, entrepreneurs will invest and/or produce in order to improve their own lives, and in so doing will benefit those who purchase the goods and services they offer. Whatever its moral virtues, a system of free markets would understandably have very few supporters if it were economically inferior to competing political economies. Fortunately, capitalism is better at both preserving rights and producing the “greatest good for the greatest number.”
It does this (ideally) by means of the efficient allocation of capital and by promoting fierce competition for consumer dollars, forcing producers to continuously drive down prices and to improve quality over time, or lose market share to firms that do. Another way to express this is the term “market discipline.” It is easy to list once dominant corporations that were humbled or driven out of business by firms that created better business models or innovated new technologies: Sears Roebuck, Compaq Computers, Kodak, Polaroid, Circuit City, Pan American Airlines, Blockbuster, etc. Of course, the state obstructs and corrupts this salubrious discipline when it arbitrarily confers advantages on some market participants and handicaps others, or when it creates a “moral hazard” by subsidizing irresponsible behaviors.
As you must know, we are now facing severe loss of confidence if not an outright crisis in our banking system, with dangerous economic spillover effects, following the failure of Silicon Valley Bank and Signature Bridge Bank, and the potential failure of Republic Bank. Notably, since the advent of federal deposit insurance on January 1, 1934, market discipline has largely been eliminated from our banking system. Until the most recent full-blown banking crisis in 2007, this insurance was limited to $100,000 per customer/per bank, when it was then raised to $250,000.
Because financial incentives drive economic outcomes, the impact of such insurance cannot be overstated. So long as they remain within the insured limits, depositors have no reason to investigate the soundness of their bank’s capitalization and risk appetite, as they will suffer no loss if their institution implodes. Moreover, since it is easy to spread deposits among several banks, even millionaires need not worry about the risks created by unsound banking practices, a classic case of government-created moral hazard.
This moral hazard lies at the center of our banking crisis. Virtually all commercial banks rely on deposits for their survival, as they earn their profits by achieving a spread between the interest (if any) they pay on deposits, and what the earn on the investments they make and the loans they extend. Thus, they have a strong motive to compete for deposits by offering a slightly better interest rate or other services (such as free checking) than competitors. However, it is an inescapable law of economics that to achieve financial returns in excess of the risk-free rate (generally thought of as the interest rate paid on short-term government debt instruments), an investor must accept more risk of loss, with the most potentially profitable investments requiring the greatest risk.
Thus, subject to governmental regulation (discussed below) banks are free to engage in highly risky behavior in order to obtain deposits and boost their profits. However, for the obvious reasons known to anyone with even a casual familiarity with public choice theory, the rules promulgated by government agencies are no substitute for market forces. First, there is the well-known danger of “regulatory capture,” whereby due the “revolving door” between government agencies and industry, and the power of industry lobbyists, the bureaucrats come to identify with the interests of those they regulate.
Second, there is the tendency of high-ranking agency officials to promote the power and prestige of their organization over the interests of the public at large, expressed by the pithy phrase “where you sit is where you stand.” They are thus loath to concede authority to rival agencies that might have greater relevant expertise, or to propose rules that may have negative political consequences.
Third, in contrast to the private sector, bureaucrats are protected by civil service laws and thus almost never held accountable for even the most egregiously negligent decisions. While a “star” performer in the private sector will be promoted (or will leave for a better job) and an inept employee will eventually be let go, it is almost impossible to fire a civil servant. Accordingly, in bureaucracies, mediocrity is the norm.
Finally, and perhaps most importantly, rulemaking is an inherently clumsy, blunt, and unwieldy tool for achieving public policy goals. It is impossible to draft rules that anticipate every contingency, and thus they will inevitably either be either too permissive, leading to yet another banking crisis or so restrictive as to preclude banks from playing their key role in providing credit and liquidity in a free market system. In contrast, in a properly functioning capitalist regime, poorly managed banks will fail, and well-run banks will prosper.
In a free-market system banks would compete for customers by a variety of means. These may include offering private insurance to depositors, as brokerages do with SIPC; restricting their charters in various ways, such as simply charging modest fees for warehousing customer funds and providing checking services; holding a higher percentage of depositors’ cash on hand to meet any bank runs; and by adopting fully transparent investment policies and procedures, audited by independent firms, that would reassure potential depositors. It would almost certainly be the case that new firms would emerge hoping to profit by offering their own independent evaluations of banks’ financial strength, as S&P and Moody’s do for bonds and AM Best does for insurance companies.
Until the moral hazard just described is remedied, I am afraid we will lurch from one banking crisis to another, with regulators, like generals, always fighting the last war and innocent consumers being used as cannon fodder.
