We don’t understand the economy and the effects of intervention well enough to be able to improve things (financial edition)

See How I Became a Libertarian: The consequences of intervention are rarely what we expect or desire by Meir Kohn. He is a professor of economics at Dartmouth College. Excerpt:

"For many years, I have taught a course on the economics of the financial system; I have also written a textbook on the subject. Government regulation is an important topic in this course. The need for such regulation seems like a no‐​brainer. The financial system is obviously unstable: look at all those crises, including the stock market crash of the 1930s and the financial crisis of 2008. Surely we need government regulation to stabilize the financial system? But looking at the evidence, I came to believe otherwise. I saw that the history of the U.S. financial system could be understood as a series of cycles: the government intervenes in the financial system; the financial system adapts to the intervention; this adaptation makes the system more fragile and unstable, eventually resulting in a crisis; the government responds to the crisis with additional interventions intended to stabilize the system, and we have begun the next cycle.

The first of these cycles in the United States began almost two centuries ago, in 1832, when President Andrew Jackson vetoed renewal of the charter of the Bank of the United States, the sole national bank.

A consequence of this action was that, subsequently, banking in the United States was regulated solely by the states. The states prohibited interstate branching and often prohibited branching within a state. As a result, banking developed in the United States as a system of thousands of small banks. Since small banks are far more likely to fail than large ones, the history of American banking was one of frequent banking crises and panics, culminating in the great banking crisis of the 1930s.

At the time, many argued (rightly) that the solution to instability of the banking system was to remove the regulatory obstacles to consolidation. However, Congress, catering to special interests, came up with a different solution: deposit insurance. Even President Roosevelt, not exactly a libertarian, understood that this was a bad idea. He realized that it would allow banks to engage in risky behavior with no danger of losing depositors, an example of a problem of insurance known as “moral hazard.” So began the second cycle.

The moral hazard problem expressed itself in banks cutting their capital ratios. Before deposit insurance, a typical bank had funded about 25 percent of its assets with its own capital. This had the effect of protecting depositors against losses on the bank’s loans. Consequently, depositors had paid close attention to their bank’s capital ratio. If it fell too low, they withdrew their deposits. However, with the creation of deposit insurance, depositors no longer cared about their banks’ capital ratios. Banks responded by steadily reducing them, thereby increasing their leverage and thus their return on equity. The fall in capital ratios also had the effect of making the banking system far more fragile in the face of a shock.

For decades, however, there was no shock. For unrelated reasons, the environment remained unusually stable. By the 1970s, capital ratios had fallen as low as 5 percent. Then, in the late ‘70s, a steep rise in interest rates caused a rash of bank failures, culminating in the savings and loan crisis of the early 1980s.

Regulators, rather than admitting that deposit insurance had been a mistake, responded by doubling down. To address the moral hazard problem, they instituted capital requirements to force banks to increase their capital ratios. They also introduced a new form of government guarantee: the doctrine of “too big to fail.” So began the third cycle.

It was adaptation to the new capital requirements that set up the financial system for the financial crisis of 2008. Because nonbank financial institutions were not subject to capital requirements, profits could be increased significantly by shifting lending from banks to nonbank lenders. This happened on a massive scale — especially with mortgage lending — leaving the financial system as a whole with a very low effective capital ratio and consequently in a very fragile state.

Then, in the 1990s, the federal government began to promote subprime mortgages, lending to borrowers who would not have otherwise qualified for a mortgage loan. Since the government implicitly guaranteed most of these mortgages, lenders considered them safe. As a result, many financial institutions — banks, securities firms, and others — invested heavily in these instruments. In 2006, the housing market turned down and subprime defaults began to mount, leading to a major financial crisis in 2008.

What is the lesson from all of this? It certainly seems that government intervention, far from stabilizing the financial system, has been a major cause of its instability. For example, the crisis of 2008 was not caused by “greed on Wall Street” but rather by incentives distorted by two centuries of government intervention.

Does this mean that without government intervention the financial system would have been stable, or at least more stable? To answer this question, a study by Charles Calomiris and Stephen Haber compared government intervention and financial system stability across countries. They found that, indeed, more intervention is associated with greater instability. Their most interesting comparison is between the United States and Canada — two economies that are similar in most respects, except that the Canadian government has intervened very little in its financial system. The result? Since the presidency of Andrew Jackson, the United States has experienced 12 major banking crises. In the same period, Canada has experienced not even one — not in the Great Depression, not in 2008.

The lesson for progressivism is clear: we don’t understand the economy and the effects of intervention well enough to be able to improve things. The economy is a complex system that adapts to intervention in ways that are inherently unpredictable. The consequences are rarely what we expect or desire. So, for me, the first pillar of progressivism crumbled. We don’t know how to make things better through government intervention."