Too Big to Fail, Too Dumb to Learn

Putting the Cart before the Horse.

The awkward legislation designed in 2010 (Dodd-Frank), after the bank panic of 2008, to protect large banks and depositors by avoiding future taxpayer bailouts, will offer little help in the next financial rupture, and shows a misunderstanding of the engine that drives economics.

Although called a “science,” economics deals solely with human behavior, namely fear and greed and all its lesser forms like satisfaction and worry. Unfortunately, the economics profession is filled with mathematicians rather than with those who understand market behavior. Even psychologists, psychiatrists and other head doctors might offer better help. The banking failure was simply panic brought on by bankers loosing all faith in their competitor’s and their own financial value. This loss of heart was directly related to the frenzied bundling of good and worthless mortgage investments that Wall Street banks further layered and sold to their investor clients by the millions.

Restricting bank behavior, as Dodd-Frank does using penal legislation, the steroid Washington, D.C. serves daily–is foolish. It hamstrings the bankers, preventing them from acting like professional bankers and offers no real financial protection to borrowers or customers. Financial collapses just like recessions cannot be legislated out of existence.

Our best protection is to allow bankers to act like responsible bankers; to make credit decisions; to evaluate the likely risks in a loan request and charge the necessary interest to justify the loan, or decide that the risk is too great at any interest. But at the same time, bankers must have economic incentive to act like bankers. This is done by ensuring that the bankers have “skin” in each and every deal. This can easily be done by attaching economic incentives to performance. For managers, by keeping part of their accrued equity in all loans which they manage in some manner.

The old Solomon Bros. investment partnership did a huge business in investment banking for many decades. It was not protected by the FIDC, but their investors saw few losses. The reason? All partners of the firm shared personally in the profits and losses. They may have made some mistakes, but lack of investment oversight was not one of them.

The avalanche of banking regulations that have come out of Congress shows little is understood in our capitol about economics and the power of incentives. There is a myth that enough proper laws will protect us and the banks. Banks can protect themselves. It’s the public that needs the protection. And Dodd-Frank doesn’t do it, folks.

The restrictive Fed policies to build bank reserves advocated by some of our “smartest” policy makers may look first-rate on paper, but not on Main Street. Personal banker reserves? Now we’re talking.

As some financial revolutionaries (like Cody Willard/Market Watch-1/29/14) point out, the 0% Fed funds rate is more than questionable. It is one of the bandits that is holding our recovery hostage. Four years into a good recovery, we should be worrying about inflation. Instead, we are squabbling over disabling policies like a higher minimum wage to add the boost to wages that our lethargic economy has failed to provide. Minimum wages will rise when businesses feel that they can afford them and when they start losing good employees because their wages are too low. Legislating high wages is a fantasy that uneducated progressives engage in–until the minimums start closing businesses in their district.

If you think about it, the Fed incentives are all backwards. If banks could only borrow from the Fed at 0% when they lend to a start-up, or say, to a company hiring 10% more workers (where there is actual risk), the recovery might astound us. By now most know that it is these small companies and start-ups that have fueled every recovery in our history because there are so many of them. But banks won’t lend (money that they borrow at 0% from the Fed) to small businesses and start-ups when they can loan it to the U.S. Government, at no risk and earn 2-3%!—exactly what has transpired in this feeble recovery. Unfortunately, by shoring up the financial strength of our banks, Washington is trying to repair the cart. It should be feeding and strengthening the horse that pulls the cart. Time and again, Washington fails to understand where our real strength comes from. It comes from Fully-employed companies that hire employees. A strong economy makes strong banks. Strong banks do not make a strong economy.

The Federal Reserve Bank was a highly disputed agency during the early days of our Republic. Many believed that a central bank would work against the interests of the public while it provided financial support to large banking and business interests. Is it not our money (our tax dollars) they are playing with? We are seeing the discouraging effects of that central bank policy at work in our economy today. For those able to borrow at 0%, the economy is buzzing. For the rest of us, over-burdened with new agency and new legislative rules from Washington, the economy is still a struggle. We may have to await the new ideas that seem to sprout every four years in November.

Geoff Wood
6/20/2014