Shrink The Government's Role To End Too-Big-To-Fail

We have now entered the Bizarro World of financial regulations, where the people who in 2008 orchestrated billions in bailouts for “too big to fail” institutions are now insisting that they can craft a plan to end “too big to fail.”

That’s right. The same people who once insisted that the only way to head off an economic crisis was for the federal government to bail out large financial institutions now say they’ll devise cunning ways to head off an economic crisis without government bailouts.

We’re talking Big Name players, here.

Ben Bernanke, a principal author of the 2008 bailouts, is following up his Courage to Act book by participating in the Minneapolis Fed’s ongoing Ending Too Big To Fail Policy Symposium.

That effort is headed up by Minnesota Fed President Neel Kashkari. Mr. Kashkari, of course, is the man put in charge of the $700 billion Troubled Asset Relief Program (TARP) by former U.S. Treasury Secretary Henry M. Paulson.

That’s the same program that Paulson and Bernanke pressured Congress to sign off on. Former Sen. Jim DeMint (now my boss at The Heritage Foundation) distinctly remembers Paulson telling Senate Republicans, without any substantiation, that world financial markets could collapse over the weekend if Congress didn’t pass TARP immediately.

And now Bernanke and Kashkari – two main architects of TARP – are working on a plan to end government bailouts?

The word irony isn’t really strong enough to describe this situation. We’re clearly in the realm of Orwellian double-think: “We’ve always been at war with too-big-to-fail, we just had to do it last time because things were so bad.”

Theatrics aside, there’s an enormous gap among policymakers in both the economic and political reality of too-big-to-fail.

On the political side, many feel like we’re in a “new” political environment, where Congress will automatically bail out failing firms. More than one Congressional staffer has given me some version of this story, and they use it to argue for “second best” policies to mitigate too-big-to-fail.

Many favor higher equity capital requirements, for instance, because they feel that lowering firms’ probability of default in this manner is the best we can do.

But this solution ignores the fact that politicians paid a huge political price for TARP and the various Federal Reserve “emergency” programs.

There’s no doubt the government’s response to the crisis gave rise to the Tea Party movement. Outraged by the prodigal spending and cronyism, these voters propelled Republicans to take control of the House and gain five seats in the Senate. In the 2014 midterms, Republicans took the Senate. (It looks like a great deal of this outrage still exists among Democrats too.)

Since 2010, many politicians made it to Congress after promising to end bailouts. Now they simply need the courage to act as they promised.

That’s where economic reality comes into play. The truth is that no objective economic evidence shows that recessions result when the federal government doesn’t save large financial firms

Given the political reality, conservative policymakers have a clear opportunity. They want to end too-big-to-fail by limiting government, and that’s a winning message because expansive government power is what causes too-big-to-fail in the first place. Here are just a few points that help to make the case.

  • The U.S. made it through the industrial revolution without a central bank and without anything remotely similar to TARP. Business cycles are really not any tamer now than they were back then.
  • Just prior to the Roaring Twenties, before the Fed could really do too much damage, the U.S. suffered a depression and recovered very quickly despite no active government stimulus policies.
  • In the wake of that depression, voters overwhelmingly supported the current president, Calvin Coolidge, the man who took over during the crisis when President Harding died. Coolidge was effectively re-elected in 1924, with roughly three times the votes of the Progressive candidate, Robert LaFollette, and approximately twice those of the Democratic candidate, John Davis.
  • The Federal Reserve failed miserably in its first major test: it let the money supply collapse, thus prolonging – and perhaps worsening – the Great Depression. Even Bernanke has acknowledged the Fed screwed up monetary policy during this era.
  • Whatever power the Fed does have, it failed to prevent the 2008 crisis and the deepest downturn since the Great Depression. (Reflecting on the events of September 16, 2008, in the prologue of his book, Bernanke states: “We had been fighting an out-of-control financial crisis for more than a year.”)
  • A long list of government policies – particularly with regard to housing finance and risk-weighted capital requirements – contributed to the financial crisis.
  • Starting (at least) in the 1860s, the federal government’s meddling in the financial sector has increased. This expansion has been matched with a near steady decline in the level and role of private equity in financial firms.
    Many policymakers can’t let go of the idea that we can design a safer system from the top down, even though history demonstrates this approach does not work.

Very serious policymakers are now discussing such drastic choices as federally backing all short-term debt markets, eliminating short-term debt markets, outlawing the use of cash, and obliging financial firms to fund public investment projects in return for an explicit public backstop.

Anyone who values a free society should oppose each of these extreme measures, and never forget the problem they are supposedly designed to fix is one that elected officials cause in the first place. We will never end the too-big-to-fail problem unless we hold politicians accountable for their actions and elect officials willing to allow firms to fail.

The good news is that’s exactly what many U.S. voters did in the wake of the 2008 crisis. As long as the trend continues, Congress can implement policies that actually mitigate too-big-to-fail by reducing government’s role in financial markets.

They can, for instance, repeal the Dodd-Frank Act, a law that largely enshrined too-big-to-fail. Congress can also bring more market discipline to the financial industry by ending the Fed’s emergency lending authority and the FDIC’s ability to guarantee banks’ obligations.

They can allow market participants to decide if they truly value deposit insurance, ultimately eliminating the need for federally backed deposit insurance. They can also reform the bank resolution process so that financial institutions can go through bankruptcy rather than get swallowed up by larger banks.

All of these reforms are grounded in the idea that the government should not try to ensure the safety of financial markets. It’s an impossible task, and trying to do so allows government officials to pick winners and losers in the industry while consumers suffer with higher prices and fewer options.

Congress needs to refocus financial-market regulation based on the principle of limited government.

The proper role of government in financial markets is to deter and punish fraud, and foster reasonable disclosure of information that is material to investors. We can never really end the threat of too-big-to-fail, but we can take away the conditions that make it easy for Congress to implement.

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

This piece originally appeared in Forbes. This and more can be read at http://www.forbes.com/sites/norbertmichel/2016/06/01/shrink-the-governments-role-to-end-too-big-to-fail/#7df811aa90b9