Fool me once, shame on…shame on you. Fool me – you can’t get fooled again.

Paul Gift —  17 December 2008

I’d like to share a quote on banking industry regulation:

“To restrain private people, it may be said, from receiving in payment the promissory notes of a banker for any sum, whether great or small, when they themselves are willing to receive them; or, to restrain a banker from issuing such notes, when all his neighbours are willing to accept of them, is a manifest violation of that natural liberty, which it is the proper business of law not to infringe, but to support. Such regulations may, no doubt, be considered as in some respect a violation of natural liberty.  But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as or the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.” (emphasis added)

We all know that the banking industry is unique relative to other industries and needs unique regulation…this is not news.  But, did I mention that the aforementioned paragraph was written by one Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations all the way back in 1776?!? (see book 2, ch. 2)

Adam Smith believed that the role of government was to protect and maintain a system of private property (i.e. protect against invasion and provide an administration of justice) and to provide public goods.  There are very few circumstances in which he supported government intrusion in the market mechanism.  One of those circumstances is in the banking industry where the free market of capitalism may “endanger the security of the whole society.”  This is amazing stuff considering the lack of industrialization and the general lack of economic knowledge at that time (e.g. the labor theory of value and the lack of knowledge of what determined a price, the general view of precious metals as wealth, exports as “good,” imports as “bad,” etc.).

Fool me once: The lack of banking regulations and the Great Depression.  We learned our lesson and instituted regulations in the form of the Glass-Steagall Act of 1933.

Fool me twice: The relaxing of S&L regulations during 1979-1982 and the subsequent S&L crisis in the late 1980’s and early 1990’s.

Fool me – you can’t get fooled again: The relaxing of banking regulations in the late 1990’s repealing many Glass-Steagall elements (e.g. Gramm-Leach-Bliley Financial Services Modernization Act of 1999) and the situation we’re going through now.

Not to say that these are the only causes, but my oh my, there’s a lot of fooling going on here!  I think, in general, we have learned from Adam Smith, but we’re also working with a Congress that very much loves embracing free market principles involving lobbying dollars AND THEN sitting down to vote.  We recognize that it would be idiotic to let our judges do that but barely make a peep when our policymakers do it everyday.  Let me guess why: When elected to Congress you are forced to get a shot that miraculously makes it so that you no longer like money?

6 responses to Fool me once, shame on…shame on you. Fool me – you can’t get fooled again.

  1. 

    I fully agree with Paul Gift. My view can be viewed on my blog.
    http://www.financialenigma.blogspot.com

  2. 

    If Thom, Josh, and Geoff can’t convince you, there’s not much I can do. 🙂

  3. 

    Peter, I agree with Kroszner and Rajan that there was no “fooling” going on 80 years ago. With regard to the S&L’s, the relaxing of restrictions enabled them to act more severely on their moral-hazard. Finally, I agree with Calorimis about monetary policy and risk evaluation (in the post, “Not to say these are the only causes.”). Being the free market guy that I tend to be, I want to agree with everything you write…really bad. But, I can’t. Not when it comes to the banks, an industry that can “endanger the security of the whole society.”

  4. 

    Paul, I’m afraid I can’t agree with your characterization of any of the three cases. Recent historical work on Glass-Steagall (e.g., by Kroszner and Rajan) suggests that universal banking played little role in the banking crisis of the 1980s and that Glass-Steagall served mainly to protect private interests through forced cartelization of the commercial- and investment-banking industries. Virtually everyone agrees that the 1980s S&L crisis had little to do with “deregulation,” but with the moral-hazard problem created by deposit insurance. On the current situation, see Charles Calorimis and Larry White (linked here) on GLB and other recent relaxation of Glass-Steagall-era regulations, none of which appear to have anything to do with the subprime crisis.

  5. 

    Lie? With all due respect, if you read it again you’ll see that’s not the message of the post.

  6. 

    Does it bother you to lie like this? Adam Smith was talking about paper currency versus specie, not about preventing commercial banks from owning investment houses.

    Credit default swaps are still not tanking. The housing market did not collapse until Fannie and Freddie, the GSEs, did.

    So much for a blog with “truth” in the title.