Regulating Investment Banks

Austan Goolsbee, speaking in part on behalf of Barack Obama, says that since recent events have shown that the Fed may need to step in and rescue failing investment banks those banks should be regulated closely in much the way that commercial banks are. Greg Mankiw seems upset about this but he doesn't mount much of an argument beyond the query "Here's a question for Austan: Can an investment bank avoid such regulation if it promises never to use the discount window?"

My first read on this was that a "promise" would be no good. A bank can't "promise" not to fail. Nor can a bank promise not to be bailed out if it does fail. A bailout, when justified, isn't a favor you do for the bank. It's something you do because it's necessary to avoid larger negative consequences throughout the economy. So a promise to avoid the discount window would be valueless. But if the public is going to need to guarantee that financial institutions that grow "too big to fail" don't fail, then the public is going to need to regulate those institutions. Mark Thoma and Brad DeLong say much the same thing, with some added professional economisting and the added insight that Ben Bernanke appears to be on the side of more regulation here.

Photo by Flickr user Epicharmus used under a Creative Commons license

Comments

As DeLong notes, George Stigler and Milton Friedman were also in favor of such regulatory practices. In fact, most economists understand a moral hazard when they see one, and know that the only solution is for the entity providing the insurance (in this case the U.S. taxpayers) to impose conditions on the entities being insured (in this case investment banks) to make sure the insurance being provided does not encourage overly risky behavior.

Posted by DTM | June 9, 2008 10:40 AM

it is entirely possible that, once upon a time, greg mankiw was an honest soul and a worthy representative of the economics profession: i have no idea.

but since i've been aware of him - basically, since he went to work for the bush administration - he has demonstrated exactly the fundamental dishonesty, inclination towards propaganda, and pugnacious arrogance that mark said administration.

as richard clarke said about those who favored iraq, no, bush administration veterans shouldn't be allowed back into polite society. when i see the name "greg mankiw," i assume that we're going to be treated to dishonest hackery, and i haven't been disappointed yet. he's intellectually repellant, and his arguments are not to be taken seriously.

Posted by howard | June 9, 2008 10:45 AM

For that matter, the CEO of JPMorgan-Chase, who took over Bear-Stearns, said in a post-takeover interview that that very deal justified the need for better and stronger regulation.

Posted by El Cid | June 9, 2008 10:46 AM

These investment banks should be allowed the freedom of choice. Either a) remain small enough so that they don't become "too big to fail" or b) submit to regulation.

Posted by Peter K. | June 9, 2008 11:04 AM

I saw that item in my RSS reader the other day, and my only thought was, "why do I subscribe to Mankiw again?"

I moved on without figuring it out.

Posted by jack lecou | June 9, 2008 11:26 AM

Mankiw has taken comments off (comment is not free) because he's turned into such a commonplace shill. This is the guy who tried to pass burger flipping as a manufacturing job to make Bush's economic numbers look better. What he's proposing is completely unreasonable -- the continuation of the system that created the problems with the addition of an expensive public bailout option in place for the transgressors. Moral hazard for thee but not for me (or my mega-corporate sympathees). Funny, his textbooks are still pretty good.

Posted by Eric | June 9, 2008 11:43 AM

Mankiw has taken comments off (comment is not free) because he's turned into such a commonplace shill. This is the guy who tried to pass burger flipping as a manufacturing job to make Bush's economic numbers look better. What he's proposing is completely unreasonable -- the continuation of the system that created the problems with the addition of an expensive public bailout option in place for the transgressors. Moral hazard for thee but not for me (or my mega-corporate sympathees). Funny, his textbooks are still pretty good.

Posted by Eric | June 9, 2008 11:50 AM

Goolsbee in the article says that because banks can borrow at the discount rate, they should face tougher oversight.

Mankiw asks Goolsbee, if banks could promise to never use the discount rate, would Goolsbee still advocate tougher regulation.

Thoma, DeLong, and Yglesias all say that a bank could never credibly promise not to use the discount rate, or at least promise not to become too big to fail. This answer, regardless of how valid a point it may be, does not respond to the question.

Imagine that Mankiw asked Goolsbee if he would, hypothetically speaking, eat his own grandchildren. And imagine that instead of venturing an answer, everyone who heard the question starting blathering about the fact that Goolsbee doesn't have grandchildren.

This may be true, but wouldn't we surmise that they're missing the point? Might we, and Mankiw, be interested in a yes or no answer, regardless of how realistic the question is?

Posted by Jeff H. | June 9, 2008 12:21 PM

jeff h, if i ask you, as you plan your driving route, whether you have taken into account the ability of matter to occupy two places at once, you'd be entirely justified in simply ignoring my question as too fatuous to consider.

more seriously, why is anyone obligated to answer a pointless question? when did you stop beating your wife?

if mankiw wants to push legislation that prevents the fed from bailing out investment banks (or their counterparties) under any and all circumstances and propose a regulatory method to be sure that the future bernanke doesn't break the law, then there's something to talk about. there is nothing to talk about regarding opting out of "too big to fail."

Posted by howard | June 9, 2008 12:31 PM

Jeff H,

Um, they did answer the question Mankiw actually asked. That question was (quoting Mankiw):

"Can an investment bank avoid such regulation if it promises never to use the discount window?"

Their answer is no. Their explanation is that such a promise isn't going to be credible.

You actually asked a different question, specifically this hypothetical question:

"[I]f banks could promise to never use the discount rate, would Goolsbee still advocate tougher regulation?"

They didn't answer that hypothetical question because Mankiw didn't ask it. I also might note your hypothetical question is quite unclear. Specifically, what exactly has changed in this counterfactual world to make the promise credible? Is the failure of investment banks no longer posing a threat to the greater economy? Or are somehow investment banks no longer capable of taking risks that could cause them to fail? Or something else? You'll probably have to make your counterfactuals more clear if you want anyone to attempt a serious answer.

Posted by DTM | June 9, 2008 1:52 PM

Actually, it doesnt matter what the bank promises. Let the government promise to never bail out the investment banks, and they should have trouble raising enough capital to bother anyone.

Posted by jimmy | June 9, 2008 2:37 PM

Matt, here at Chicago, my professors look at Mankiw the way people on this thread do: he's a Bush shill.

Stop reading him.

Now, what always surprises me is that these people who want to be Friedmanites or Stiglerists never bother to look at what they actually wrote, even in such simple books as Theory of Price.

Oh, wait, it doesn't surprise me at all, since they usually have a right-wing political agenda, like Mankiw.

Posted by Greg | June 9, 2008 3:44 PM