Friday Interview: Addressing American Banking and Monetary Problems

The recent financial crisis helped shine a spotlight on longstanding problems linked to the American monetary and banking systems. Some people believe government needs to enact more regulations to fix those problems. Lawrence H. White, professor of economics at George Mason University, has a different perspective. White discussed the issue with Mitch Kokai for Carolina Journal Radio. (Click here to find a station near you or to learn about the weekly CJ Radio podcast.)

Kokai: The financial crisis — I think a lot of people who hadn’t thought about this issue before thought, “You know, there seems to be something wrong with our banking system and maybe even with the way that our money supply operates.”

White: Just a little bit.

Kokai: What are some of the big problems?

White: Well, we’ve dug ourselves into a deep hole. We have fundamentally fragile banking systems, and partly it’s because our monetary system is difficult to deal with. We’ve got a long history of restrictions on banks that have weakened banks in the United States. And rather than remove the restrictions — the regulations that have weakened banks — we keep adding patches on top of them.

So we got the Federal Reserve Act in 1913 in order to try to alleviate the problem of panics under the previous regulatory regime. That added a new layer of control; that created more unintended side effects. When that didn’t stop the Great Depression, we got deposit insurance. And deposit insurance temporarily alleviated the problem of bank runs, but it created its own problem with incentives for banks to take more risk. And what we’ve seen in the last few years is the chickens coming home to roost from that problem.

We’ve set up an incentive system where banks, in order to get the greatest value out of their deposit insurance — and even worse, their too-big-to-fail guarantees — have leveraged up, have taken on risks, have engaged in kind of herding behavior. And it’s gone badly.

What happened in the crisis was a combination of bad regulation of banks and bad monetary policy. We encouraged banks to load up on mortgages — in particular on mortgages to people who were not traditionally credit-worthy — in order to expand home ownership. So the Department of Housing and Urban Development placed mandates on Fannie Mae and Freddie Mac to make low-income mortgage loans. Fannie Mae and Freddie Mac bought those kinds of mortgage loans from the banking system. And at the same time, the Fed was injecting a lot of credit between 2001 and 2005, and so there’s lots of cheap credit going into the system that’s being funneled into housing.

It creates a rise in the price of housing, and that makes all these creative mortgage loans look like they’re paying off. It looks like the risk isn’t as great as we thought it was. We can lend to people with no money down, and in a couple of years they’ll have 10 percent down because the house price will have gone up 10 percent. That was the theory. And of course it all came crashing down when it turned out you can’t expand the supply of mortgages 10 percent, 15 percent a year for several years and expect that it’s going to be sustainable. It’s not sustainable. The population wasn’t growing that fast. Real income wasn’t growing that fast.

So we ended up with a massively overbuilt supply of housing, falling house prices, and they haven’t yet fallen as far as they probably need to, to clear the market. And it exposed the weakness of the banks, which had overloaded on these kinds of investments. And of course Fannie Mae and Freddie Mac failed. Bank of America and Citibank would have failed if not for federal interventions. AIG Insurance, which was insuring some of these mortgages through collateralized debt obligations. … Basically, the banking system took advantage of the guarantees that were given to them.

We had this odd combination of restrictions on one hand and privileges on the other hand, to the banks, that have led them down this garden path to where they’re engaging in — many banks have been engaging in — unsound banking. That’s what we need to clean up. So it’s a fundamental problem. It’s going to take restructuring the banking system so that it doesn’t depend on deposit insurance, doesn’t depend on too-big-to-fail guarantees, and I think restructuring our monetary institutions so that we’re not at the whim of Federal Reserve policy, but that we have some more reliable constraints on the creation of money.

Kokai: Now some people will hear about these problems … and say, “What we need is more regulation. We need to take what we have now and slap some more regulations on top of it.” From the opening remarks, it sounds as if you would say …

White: We’ve gone down that path.

Kokai: Yeah, we’ve done the regulation. We need to do something completely different.

White: Yes, it’s always that you hear in these kinds of crises, “Oh well, yeah, we didn’t have the right kind of regulation. We’ll get it right this time. Now that we’ve learned once again, through trial and error, that the kind of regulation we had didn’t really do the job, we need a new kind of regulation, or we need different regulators.” That actually makes more sense than what I sometimes hear, which is, “This was a crisis of a laissez-faire banking system.” Or, “This is the result of too much deregulation in the last 10 years.”

There hasn’t been any deregulation in the last 10 years. This is a crisis of a heavily regulated banking system, and the idea that we can get regulation right this time is really wishful thinking. It’s hard to think of all the unintended consequences that regulations have when banks who have a profit motive to do this figure out ways around the regulations or figure out ways to game the regulations. We tried — under the Basel II Accord, regulating bank capital — banks had to hold a certain amount of capital against risky assets on their balance sheets. So what did the banks do? They moved the risky assets off their balance sheets into special structured investment vehicles, which made the healthiness of the banks, the solvency of the banks, very much more opaque.

And in the crisis we saw that banks were reluctant to lend to each other because they didn’t know whether the other banks were fundamentally solvent. And we created that problem by trying to regulate their capital. We need to somehow think about untangling this thicket of regulation and getting to a more simple, transparent system where the market will regulate banks, where shareholders and creditors will choose which banks are credit-worthy, and there once again will be a penalty to a bank in the marketplace for behaving in a risky fashion.

Kokai: How much of the solution lies in getting the government out of this business as much as possible?

White: Well, I think the entire solution lies in that direction. I’ve done historical research on banking systems that are as unregulated as you can imagine, and they didn’t have these problems. When the U.S. was having panics and bank failures en masse in the late 19th century and the Great Depression, other countries weren’t having these problems because they didn’t have the kind of regulations that weaken their banking systems. Canada is a good example; [it] had no bank failures during the Great Depression. I mean, they had a depression because, right, they’re the United States’ neighbor, so they could hardly avoid it. But they didn’t have a banking crisis on top of it.

So, yeah, we need to think about ways to dismantle and pare back and eventually eliminate government intervention in the banking system, and then it’ll be on a sounder footing. It’ll be bank customers and bank creditors who keep an eye on what the banks are up to, and they can do that much more effectively than regulators ever have.