A Policy Trilema? Maybe Not
A “trilemma” is like a dilemma, only there are three things to choose from and you can have just two. The current debate over post-crisis financial regulation suggests we face such a trilemma: We can choose any two of the following, but not all three: 1) efficient capital markets 2) no bailouts to big banks and 3) a depression-free economy.
From the 1980s until 2007, we essentially opted for one and two. Financial markets operated with more freedom than at any time since the 1930s and the Federal Reserve stood ready to cut interest rates if asset prices tanked. But the idea that big banks might be able to get new capital from the Treasury was scarcely even contemplated. Choosing one and two resulted in a global financial and economic crisis worthy of the name depression.
In the aftermath, congressional Democrats are claiming that we can have three out of three. In effect, the bill introduced to the Senate by Christopher Dodd purports to prevent future depressions without sacrificing the efficiency of our financial markets or committing taxpayers to future bailouts of the banking system. This trifecta is not credible.
This is from Niall Ferguson and Ted Forstmann.
I agree that the regulation taking shape in Congress will not solve the trilemma, but I think it can be solved. The right approach is less government, not more: no Fed, no stabilization policy, no deposit insurance, no financial market regulation, and so on.
Absent the moral hazards created by policy, private actors will be more cautious about risk. Absent the false assurances of regulation, financial market participants will exercise due diligience and diversification. The economy will experience ups and downs but not depressions, and financial crises will occur but not seriously damage the rest of the economy.
This view is fantasy, you say? No, it’s a description of the U.S. economy – roughly – from its inception to the founding of the Fed in 1914. The policies that generate moral hazard were all but absent, and U.S. economic performance was impressive. Recessions and financial panics occurred, but none on the scale of the Great Depression or the Great Recession.
Just a coincidence? I think not.
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Matt
I keep hearing people say, get rid of the Fed, let’s go back to the good ol’ days that were before the Fed existed.
I openly admit I am not a history scholar in regards to what went on, but I do know that bank failures were common place. People would lose their life savings just like that. I also know that since 1914 our country hasn’t exactly fallen apart. We have grown significantly.
That being said, here is my question: Please explain why things would be so great without a Fed, or point me in the direction of someone that does explain it well. I don’t want a lot of comments about why the Fed is horrible, I want to know why being without one would be so great, with some historical facts to back that up.