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The 'Two Drunks' Model of Financial Crises

Wednesday, March 13, 2013

It’s unlikely that banks and government can be disentangled, but a healthier relationship could begin with a new approach to credit guarantees.

In this article, I make four observations about the relationship between banks and government.

1. Banks help government grow, and vice-versa.

2. Banks bail out governments that get in trouble, and vice-versa.

3. Politicians want to make credit allocation decisions. Whatever its nominal purpose, bank regulation is used to enable politicians to undertake credit allocation.

4. The dangers of government financial guarantees are almost impossible to avoid. The best principle is to try to restrict such guarantees to “limited amounts, for limited purposes.”

Credit and Credibility

In his book The Cash Nexus, Niall Ferguson emphasizes the connection between financial power and military power. For governments, the ability to mobilize the military depends on the ability to mobilize financial resources. In turn, a government with a strong military will earn the trust of financiers.

Separately, banks and governments benefit from positive feedback between perception and reality. That is, perceived strength translates into actual strength, which in turn enhances perceived strength.

Credit allocation invites cronyism.

When a government has a formidable reputation, its cost of obtaining obedience is low. It can easily raise money through taxes and borrowing. This ability to raise money easily translates into actual strength.

When a bank has a formidable reputation, it will enjoy low borrowing costs. These low borrowing costs will in turn improve the bank’s profit margin. Again, this translates into actual strength.

Working together, banks and government can enhance this positive feedback loop. A government with a reliable group of lenders will be stronger than a government without such support. Banks with government guarantees will enjoy more confidence than banks without such guarantees.

These positive feedback loops suggest that the growth of government and the growth of banks will tend to be linked. Government growth is enhanced by access to financial resources mobilized by large banks. Growth of banks is enhanced by access to guarantees provided by government.

The Two Drunks Model

Carmen Reinhart and Kenneth Rogoff, in their monumental study This Time is Different, point out that bank crises and government debt crises often follow one another. I call this the “two drunks model” of financial crises.

Think of two friends who walk to a neighborhood bar every Saturday night. On a given Saturday, the first friend may be too drunk to walk without assistance, and he may have to lean on the second friend in order to make it home. The following Saturday, it could be the second friend who needs to be supported in order to get home. However, if both of them get too drunk and try to lean on one another to get home, they may collapse together.

This is how I picture the current situation in Europe. Many European banks are unsteady. They need government guarantees and capital injections in order to stay in business. At the same time, many European governments are heavily indebted and running large deficits. They need banks to continue to lend to them in order to fund their spending.

The growth of government and the growth of banks will tend to be linked.

Troubled banks and troubled governments are leaning on one another, like two drunks. It is still uncertain whether they will make it home. Regardless, we can expect banks and governments to support one another as best they can. Banks do not want to see governments fail, and governments do not want to see banks fail.

Crony Credit

Politicians have a seemingly irresistible urge to allocate credit. Regardless of the theoretical merits of allowing capital to flow freely to its most productive uses, government officials believe they know better. Japan and China are particularly notorious for centralized credit allocation.

In the United States, the government undertakes credit allocation primarily through loan guarantees. Favored sectors have included housing, agriculture, higher education, and more recently “green” energy.

When I was working as an intern for Senator Hubert Humphrey in 1973, I remember seeing his proposal for a national development bank, which was going to use the low borrowing rates of the government to fund investment in infrastructure without having to put the cost on the federal budget. Even though I was a liberal and had so far taken only a smattering of economics courses, I remember being appalled at the way that this could turn credit markets upside down, taking funds from profitable projects and putting them into unprofitable ones.

The attraction on the left of increasing the government's role in credit allocation seemingly will never go away. Very recently, I read of renewed calls for an “infrastructure bank.”

Credit allocation invites cronyism. Once governments are in the business of granting generous credit terms to particular industries and firms, it is inevitable that interest groups and influence peddling will emerge.

It is important to recognize that credit allocation is implicit in all forms of financial regulation, including regulations that are put in place in the name of other purposes, such as safety and soundness. For example, the international bank capital regulations, known as the Basel accords, privilege certain types of loans by assigning them low capital requirements. Most notoriously, these low capital requirements were assigned to highly rated mortgage securities during the period leading up to the financial meltdown of 2008. Without such favorable treatment, banks would not have had the incentive to focus on agency ratings and to load up on mortgage credit.

Troubled banks and troubled governments are leaning on one another, like two drunks. It is still uncertain whether they will make it home.

Although the general public is unaware of the implications of seemingly benign regulation for the allocation of credit, industry insiders are keenly aware of those implications, because hundreds of millions of dollars of potential profits are at stake. Intense behind-the-scenes lobbying takes place, and indeed it took years of industry pressure to convince regulators to adopt the capital rules that fueled the boom in mortgage securitization.

Limited Amounts, Limited Purposes

In my view, any realistic understanding of the relationship between banks and government should lead one to be pessimistic that the two can be disentangled. Governments need banks, and banks need government. Bailouts cannot be decisively banned. Crony credit is a fact of life. 

How can we promote a healthy relationship between finance and government? Here are two ideas that will not work:

1. Stronger regulation. This is the premise behind the Dodd-Frank bill. The idea is that regulators will be empowered to prevent risk from building up in the financial system. However, I believe this is doomed to fail, just as all previous attempts to create a crisis-proof financial system have failed. New developments and new economic conditions inevitably erode financial regulatory schemes. Politicians and interest groups will discover ways to twist these regulatory schemes into mechanisms for allocating credit, and this also dilutes the effectiveness of the regulations.

2. Promises to end bailouts. Such promises simply are not credible. Whatever officials may say today, in the next real crisis, they will compare the immediate consequences of allowing major financial institutions to fail with the costs of a bailout, and they will choose a bailout. Bank executives know this.

Instead, what I suggest is that we try to “ring fence” government involvement in credit markets. The idea would be to have government provide credit guarantees in limited amounts, for limited purposes.

Regardless of the theoretical merits of allowing capital to flow freely to its most productive uses, government officials believe they know better.

For example, in housing, Congress should limit the amount of mortgage loans that can be guaranteed each year by all federal agencies, including Freddie Mac and Fannie Mae. This amount should be less than 10 percent of the volume of current government lending. In addition, government guarantees should be for limited purposes. That means no guarantees for second mortgages, cash-out refinances, or mortgages for non-owner-occupied housing.

These principles should be applied to higher education. The total amount of student loan guarantees should be tightly capped, at much lower levels than have been issued in recent years. The loans ought to be guaranteed only for students pursuing degrees with strong employment prospects.

Finally, these principles ought to be applied to deposit insurance. No bank should be allowed to issue more than $1 billion in insured deposits. This would slow or reverse the trend toward greater concentration in banking.

Again, I am not optimistic about the prospects for disentangling government and banking. However, I think that applying the principles of “limited amounts” and “limited purposes” to government guarantees is the least problematic approach.

Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He blogs here.

FURTHER READING: Kling also writes “What Do Banks Do?” “Reform Government Pay with Step Decreases,” and “16 Tons of Keynesian Economics.” The Shadow Financial Regulatory Committee asks “How Can We Do Better Than the Basel Liquidity Coverage Ratio?” Timothy P. Carney contributes “Tim Geithner a Champion of the Big Banks, but Not a Shill.” Edward J. Pinto says “Truth in Government Lending Is Long Overdue.”


Image by Dianna Ingram / Bergman Group


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