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Sunday, June 08, 2008

Is Austan Goolsbee Betraying the Chicago Tradition? If So, is That Bad?

Greg Mankiw has a question for Austan Goolsbee:

George Stigler rolls over in his grave, by Greg Mankiw: Remember when the University of Chicago used to be the intellectual center of the deregulation movement? No more. A reader alerts me to this news:

Investment banks that obtain Federal Reserve Bank loans during a financial crisis should face much closer regulatory scrutiny, a key economic adviser to Democratic presidential candidate Sen. Barack Obama said.

Austan Goolsbee, an economics professor at the University of Chicago and one of Sen. Obama's closest advisers on economic issues, said the senator believed strongly in enhanced regulation of any financial institution that has access to the Fed's discount window.

"If you can borrow money from the U.S. taxpayer at a moment of crisis, that is a very sacred insurance policy underwritten by the U.S. taxpayer," said Mr. Goolsbee in an interview last week with Dow Jones Newswires. "We have the right to oversee anyone who is accessing that insurance policy."...

Mr. Goolsbee said that an Obama presidency would ensure that investment banks are regulated as closely as commercial banks.

Here's a question for Austan: Can an investment bank avoid such regulation if it promises never to use the discount window? Or is this insurance-regulation combo a mandate?

This story seems to confirm the fears of Vince Reinhart.

I agree that access to the Fed's lending facilities should come with regulatory restrictions. The question is whether banks should be allowed to move outside the regulatory umbrella if they voluntarily give up access to the discount window.

Isn't the problem credible commitment? A bank would also have to promise that it would not become "too big to fail" for the commitment from the Fed to prohibit access to the discount window to be credible. If a bank does become too big to fail, and if it runs into trouble and asks the Fed for help, then the Fed will be forced to bail them out if it wants to act in the best interest of the overall economy no matter what the prior agreement had been. Sending the economy into a tailspin and deep recession simply to honor a past promise to prohibit access to the window would not be the best policy at that point.

So, if banks can grow large enough to threaten the overall economy in the event of failure, I don't see how you avoid a regulatory solution. We either have to regulate the size of banks to make sure the threat to the overall economy does not exist, and then intervene if a bank grows too large. Or we need to allow banks to grow large enough to threaten the economy should they get into trouble, perhaps because large banks have desirable efficiency properties, but impose regulations to reduce the chances that they will need to be helped, and to limit their ability to damage the overall economy in the event that the help we can provide to a bank that is in trouble is not enough to prevent it from failing.

Update: Brad DeLong has a follow-up discussion.

    Posted by on Sunday, June 8, 2008 at 01:08 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (24)

          

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