The guest commentary below was written by Dr. Daniel Thornton of D.L. Thornton Economics. Click here to read his original TBTF essay.
Source: David Shankbone
As I expected, several friends wrote suggesting that I was being too bold in saying that my proposal was the only way to end too big to fail (TBTF). In addition, Neel Kashkari commented on my proposal on Hedgeye.com (I was a guest commentator) saying:
“We should also have a constitutional amendment that bands traffic. No need for new roads. Problem solved!”
I don’t know how to respond to Kashkari’s non sequitur. However, in responding to my friends’ thoughtful comments, will elaborate on why I believe Kashkari’s proposal won’t end TBTF. My friends suggested that there are two other ways to end TBTF that can be broadly summarized as:
- Prohibiting the size of financial institutions so that none is too big.
- Requiring banks to use methods that incentivize them to hold sufficient capital.
As is the case with Kashkari’s proposal, the premise is that these restrictions will prevent financial crises and, hence, end TBTF.
That would be wonderful if true, but I doubt it.
Preventing banks from failing won’t necessarily prevent financial or other economic crises. Indeed, the financial crisis arose because large financial firms (including some commercial banks) were holding large volumes of derivative securities—securities whose value depends on the value of the real assets that underlie the security; many of which were mortgage-backed securities (MBS).
Large investment firms, government sponsored agencies (GSEs), e.g., Freddie Mac and Fannie Mae, and American International Group, Inc., (AIG) were all bailed out along with the United States auto industry (Ford didn’t participate and has done well).
If we are going to prevent TBTF by limiting the size of firms, do the limits apply to all firms or just banks and other financial institutions? Exactly how large is large? What measure of size do we use—gross sales, number of employees, assets relative to the size of industry assets? If we impose capital requirements, do we impose them on banks, as Kashkari’s proposal suggests, or on all firms? Should the capital requirements vary by industry and firm size? Doing this is a bureaucrat’s dream, but society’s nightmare!
The problem is that crises involving big firms can occur in many ways and for a variety of reasons that won’t be foreseen. Financial markets and economies are very complex, so it is unlikely that any program that economists might come up with to prevent crises will succeed. The probability of another crisis involving a big firm or firms is high. We just don’t know when or how it will occur.
A Constitutional Amendment to End TBTF
The government could pass a law ending TBTF, but the probability of that is zero. Consequently, my suggestion that there be a constitutional amendment forbidding the government or any government-created entity, e.g., the Federal Reserve, from bailing out any firm of any size for any reason is the ONLY way to end TBTF.
My conclusion would be the same even if I didn’t believe that TBTF was harmful. But I believe it is very harmful. I am completely serious about this recommendation. I hope that someone with high stature and financial resources agrees with me and takes on this challenge.
However, as a British friend pointed out even this might not be bulletproof. The constitution is subject to interpretation. There is also the possibility that the government will attempt to disguise a bailout as monetary or fiscal policy. In any event, as for President Kashkari’s suggestion that we pass a constitutional amendment banning traffic, I am against it. It’s a bad idea!
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
