Returns Without Risk - The Republicans Vision of Banking Reform And How It Makes Recessions Worse

Matt Yglesias at Vox reports on the extent to which Republicans are changing laws to profit them and their donors. In the midst of this list he reports on something hugely important.

Banks - or more broadly, the financial system that creates credit - are essential to an economy. If credit markets suddenly collapse, they bring down the economy with them.

Once upon a time, a bank would fail and the folks with deposits in that bank would lose all their money. Folks with money in other banks would panic and make a run on their bank to withdraw deposits. That could quickly put that bank under. And then more people would make a run on their bank to withdraw their money. And on it would go until the economy in that region was destroying jobs and wealth. Bank runs led to recessions.

In the first 33 years of the 20th century - from 1900 to 1933 - the US suffered from a recession 48% of the time. There were 10 recessions between 1900 and 1933 and the final one was such a doozy that it got the label of depression; during it GDP dropped by half and unemployment hit 25%.

After the Great Depression, legislators decided that they would protect depositors in banks so that a bank failing wouldn't automatically bankrupt its depositors. This helped to stop the runs on banks after one bank failed so that one bank's failure did not spread like a virus to take down other banks and communities.

Given the size of banks, it became increasingly difficult to bail out depositors and ignore failing banks. So legislators decided to offer what was essentially insurance to banks - bailout money - in return for those banks following certain rules. For instance, a bank would have to keep on hand a certain number of deposits, follow certain lending guidelines, etc. The government would protect the banking system and in return the banks would follow certain rules that lowered returns but also lowered risk.

Before the regulation that came in the wake of the Great Depression, the US was in recession half the time. 48%. After the regulations, it was in recession only 14% of the time. Then the Bush Cheney administration deregulated - lifting the rules that banks complained were too restrictive - and within just a few years the country plunged into the worst recession since the Great Depression. Banks got their higher returns. They also created more risk to the entire economy.

Dodd-Frank put back in place some regulations and quite simply reached the same conclusion the country reached after the Great Depression: a community cannot afford to let the financial system collapse so it will offer a combination of rules that keep banks out of trouble and insurance to keep the larger economy out of trouble. We will bail out banks but they have to follow certain rules that make that bail out less likely.

At the time, some Republicans said that this was ridiculous. Banks should be treated like any other business and simply allowed to fail, arguing that all those rules only inhibit smart bankers from making money. Let banks do what they want and let them fail if that turned out badly, these Republicans said. They were, essentially, asking for a return to how things were regulated before the Great Depression, the world that plunged the country into recessions about half the time.

Now the Republicans have full control of government. What have they chosen? Deregulation that allows banks to act more freely, even if that adds risk. Oh, and they've left in place the bailout money. What does that mean? Banks are more likely to take risks that raise returns and we the taxpayers get to bail them out.

One of the few certainties in finance is the link between risk and returns. The investments that offer the most return offer the most risk (think junk bonds or stock in a startup) and the investments that offer the least risk offer the least return (think bank savings account). The Republicans are now moving us closer to a world in which banks get the returns and we get the risk.

Banks are essential to a modern economy. They can be regulated by market success or failures, although that can plunge an economy into recession half the time. Or they can be regulated by government rules, something that cuts the odds of recession to about one quarter of what they would otherwise be but puts the taxpayer on the hook for bailouts. Or, as the Trump administration has chosen to do, they can be freed of market consequence with the promise of bailout money AND free of the  regulation of government rules. Thanks to the 2017 GOP, banks will be able to operate without the discipline of regulators or markets.

Let's be clear. With these rules, the rational strategy for bankers will be to take excess risk (and the excess returns that - at least temporarily - come with it). This type of legislation is guaranteed to trigger recessions more frequently and more severely. It makes the banking system more vulnerable and taxpayers liable twice: they'll suffer from the layoffs and drop in value of their pensions and 401(k) accounts when recessions hit with more severity and they will pay for the bailout of these banks.

I bet that works out well.