A minor miracle happened today. I made it to the end of a Paul Krugman column without disagreeing with anything.
In fact, I found that his assessment of the need for risk regulation of the banking sector was a tad too moderate. Even if deposits were not federally insured, the external costs of insufficient regulation are too great to leave unchecked.
In talking about risk management with students, I often mention that a good guideline for buying insurance is whether a loss would seriously disrupt one’s life. Unless your TV blowing up puts a serious dent in your financial picture, buying insurance on that TV is a very bad idea. Salespeople in consumer electronics know this, which is why they push extended warranties harder than the product itself. Even if the warranties were not actuarially outrageous, they are still a bad idea. The answer for sound insurance policies is to purchase insurance only against catastrophic losses.
The lesson is this: for losses that can be absorbed without too much pain, a consumer who self-insures is better off over the long run. This applies broadly. Over-insurance—and the resulting over-treatement—is one of the main problems in the health care market, for instance. The reason Obamacare is bad policy is not because of mandates. It is a failure because we should be structuring health care reform around incentivizing consumers to internalize more risk through high-deductible plans and health savings (as well as borrowing).
This lesson can be writ large to the financial sector as well. We do not need to insure against all risks because risks are what drives innovation, creativity and work. Firms, including financial institutions, need to be allowed to face the consequences of bad decisions. The economy can absorb failures and bankruptcies and market devaluations.
But we do need protection against catastrophic risk, just as almost everyone needs some kind of catastrophic health insurance. I would put my trust in markets against anyone who has a clue how the real world works—that is to say, people who realize that we don’t live in a financial fantasyland where all that is necessary to avoid systemic, potentially catastrophic risk in the financial sector is market discipline and letting financial institutions fail. The external effects on the rest of the economy, which we’ve seen through hundreds of years of financial crises, are too large to suffer a laissez affair approach to our large financial institutions.
I’m ambivalent about the mix of policy tools that would be optimal, and I’m cognizant that regulation dampens profits in the financial sector. But just as I’m willing to pay a little bit for the term life insurance that I have little prospect of needing in the next couple of decades, I’m willing to pay for financial regulation that protects against catastrophic failures, such as what happened in 2008.
I’m also not naïve enough to think that regulators know best. The brightest financial minds do not, by and large, become government regulators. And as the debacle of Fannie & Freddie show, government regulation sometimes creates merely the illusion of security. But neither am I content to let the Jamie Dimon’s of the world make unrestricted gambles with other people’s money.
Faith in markets promotes growth and prosperity. Fantasies about markets just promote potential disaster.