Free Markets, Banks, Personal Responsibility, & Self-control

In his column today, Paul Krugman makes the point that the housing bill passed last week and due for Presidential signature this week does not fix an important underlying problem. The bill provides a way for some homeowners to avoid foreclosure by refinancing their adjustable rate mortgages with smaller fixed rate loans, and it will provide additional support for the mortgage backers Fannie and Freddie Mac. But, in a piece called “Another Temporary Fix,” Krugman argues that future problems will not be avoided until and unless new banking regulations are introduced:

The back story to the current crisis is the way traditional banks — banks with federally insured deposits, which are limited in the risks they’re allowed to take and the amount of leverage they can take on — have been pushed aside by unregulated financial players. We were assured by the likes of Alan Greenspan that this was no problem: the market would enforce disciplined risk-taking, and anyway, taxpayer funds weren’t on the line.

And then reality struck.

From a psychological point of view, it is interesting to think about banking regulation and self-control. The pro-business free-market view places great stock in personal responsibility. We are all on our own, and those who fail fail because it is their own fault. In one sense, they are supposed to fail because they are responsible and no one else should have to take the blame. Certainly this is the conservative view of personal debt.

But sometimes personal failures have public effects. Call me a cynic, but I believe there would not be a housing bill but for the fact that the housing crisis affects us all. Everyone’s equity goes down when the real estate market collapses, and foreclosures at the rates we’ve seen are having a profound effect on the economy as a whole. In contrast, personal consumer debt and bankruptcy is a much more private phenomenon. We had over a million personal bankruptcies per year for many years, and yet all those individual tragedies were almost invisible. Now because, innocent people are being affected, politicians have the moral traction to get a bill passed. Of course, many the debtors who face bankruptcy are also innocent victims of a volatile economic environment, but that is another story.

Krugman’s column suggests that businesses, specifically banks, have failures of self-control, too. In a free market environment, failures of corporate responsibility are likely to occur, and regulations are justified to protect us all from the troubles these failures bring. Recently, new financial institutions have sprouted up outside the bounds of existing regulations, and it is, in fact, these institutions that have been source of many of our current woes. Rather than being quietly fixed by the wisdom of the marketplace, these failures have had powerful reverberations throughout the economy.

Problems of self-control abound, for individual consumers and for banks. The current crisis suggests that external controls can be very helpful for banks, just as they are for the rest of us. It is much easier to do the right thing if the environment pushes you in that direction. Where there are inadequate natural constraints in the marketplace, regulations can play a very valuable role, and recent events have reaffirmed the importance of banking regulation.