Fault Lines: How Hidden Fractures Still Threaten the World Economy (33 page)

Deposit insurance does help keep small, undiversified banks in business. To the extent that these small banks are important in making loans in the local community—to the local bakery or toy shop—they have some economic and social value. One possibility is to retain deposit insurance for small and medium-sized banks in return for their paying a fair insurance premium, but to reduce it progressively for larger banks until it is eliminated.

Clearly, if banks are seen as too big to fail, eliminating deposit insurance is moot, as the bank will be bailed out anyway. The United Kingdom deposit insurance system, which was partial, did not prevent Northern Rock from getting into trouble or the government from coming to the rescue. The point of eliminating deposit insurance, however, is to make depositors think before they make a bank too big. Unlike depositors in the United Kingdom (where all bank deposits were partially insured, and therefore depositing in a large bank was significantly safer), depositors in large banks under my proposal would have the choice between being fully insured in a small bank and largely uninsured in a large bank. Such a measure would place some constraints on the growth of seriously mismanaged larger banks while also leveling the playing field.

Phasing out deposit insurance does not mean doing away with regulation. Because the government will continue to step in when the financial sector gets into deep trouble, it will have to regulate financial institutions. But it can regulate large institutions more uniformly, based on their capital structure (their capital and short-term debt) and the nature of their assets (their holdings in illiquid securities and, in illiquid loans) rather than on the basis of whether they have a banking license.

It is not easy to contemplate doing away with deposit insurance. Few depositors today can recall a time when deposits were not insured. Yet uninsured banks existed for centuries. With alternative ways of ensuring the safety of household investments (such as money-market deposits) and safe payments, and with banks already protected enough from discipline because of recent events, perhaps it is time we did away with an archaic privilege.

Before concluding, I raise a final issue. I have focused on ways to ensure that the government is not easily drawn into supporting specific markets or private institutions. I have assumed that the government, like Caesar’s wife, is above suspicion. The public has widespread concerns that it is not, as a quick survey of the blogosphere and cable news networks (admittedly not an unbiased sample of the public) suggests, and some of these concerns are justified. When a U.S. Treasury employee goes directly from running the biggest bailout fund in history to work for a company that runs the biggest bond fund in the world, and when another Treasury employee goes from organizing financial-sector rescues directly to running one of the banks that is most in need of rescue, the public’s trust is strained. No matter how honorable the intentions of the individuals in question (and I have no doubt that they are honorable) or how careful the new employer in avoiding conflicts of interest, the deals, to put it mildly, stink.

Even as the private financial sector has displayed a tin ear for the political consequences of such behavior, its alumni in the government apparently fail to understand the difficulty. In normal times, the revolving door between government and the private sector has enabled governments around the world to attract tremendous talent, even while underpaying grossly. And in normal times, the conflicts of interest inherent in the revolving door are small. In downturns, however, they may be enormous: the government’s coffers are fully open, and a stroke of a pen or a key can send billions of dollars of public money in one direction or another. The rules governing the revolving door have to be reexamined.

There is a broader question of whether government action is influenced excessively by Wall Street. I believe that when Wall Street alumni occupy powerful positions in the government or the Federal Reserve, they do what they think is best for the United States. But what they think accords with their Wall Street training and with the opinions of the people they talk to—and these people also are all largely from the Street.
Cognitive capture
is a better description of this phenomenon than crony capitalism.
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The nexus needs to be broken, possibly by recruiting talent from outside Washington and New York, and even from outside finance, to staff critical positions in the Treasury—former career regulators, corporate executives with finance experience, and, dare I say, academics. Diversity will be key to improving trust.

How do we preserve the benefits of the democratization of finance while ensuring that the system does not permit excessive risk? The answers I propose in this chapter are not so dramatic as doing away with the private sector or gagging and binding it, as suggested by Progressives, or doing away with all government and regulation, as suggested by the ideological Right. The problems emanated at the interfaces between the private sector and the government—the location of the fault lines—but since we cannot do away with either side, realistic reforms have to work on managing the interface. We are, however, in the position of someone asking for directions and getting the response, “Well, I wouldn’t start from here.”

The supercharged financial sector, having taken full advantage of the implicit guarantees embedded in the government’s desire to push housing credit and promote employment growth, has ended up flat on its back. The government has then delivered on the guarantees to the best of its ability and, in fact, done more. It now has the task of convincing the financial sector that it will not do so again.

But the government has not withdrawn from housing finance: in fact, it is even more tightly enmeshed now. Even if it were to take care of the political compulsions that draw it in to supporting some markets and hence the financial sector, it still has to convince the financial sector that no entity is too systemically important to be allowed to fail. So the key question in financial sector reform is, How do we get the private sector to price risk properly again, without assuming government intervention? The proposals in this chapter offer a path.

The thrust has to be using transparency to draw the interested public into monitoring the relationship between the government or regulator and the financial sector. Much of what I propose falls short of the dramatic remedies that some desire. But the words of Justice Louis Brandeis, from a letter of 1922, are as apt for financial-sector reform as elsewhere: “Do not believe that you can find a universal remedy for evil conditions or immoral practices in effecting a fundamental change in society (as by State Socialism). And do not pin too much faith in legislation. Remedial institutions are apt to fall under control of the enemy and to become instruments of oppression.”
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His proposed alternative was what we would now call transparency, which he referred to as publicity: “Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policemen.”
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I now turn to the reforms that are needed in the U.S. economy, focusing on how to improve access to quality education and how to strengthen the safety net.

I
ARGUE IN
CHAPTER 1
THAT
the pressures created by relatively stagnant incomes for many in the United States mirrored those in the typical developing country; they led U.S. politicians to push credit as a palliative. Subprime mortgage lending was the symptom, dwindling economic opportunity for many the cause.

Not all forms of income inequality are economically harmful. Higher wages serve to reward the very talented and the hardworking, identify the jobs in the economy that need the most skills, and signal to the young the benefits of investing in their own human capital. A forced equalization of wages that disregards the marginal contributions of different workers will deaden incentives and lead to a misallocation of resources and effort.

However, when the only pathways to high wages are seen to be birth, influence, luck, or cheating, wage differentials may not act as a spur to effort. Why bother when effort is not the route to rewards? Indeed, as the political economists Alberto Alesina and George-Marios Angeletos argue, perceptions in a democracy as to how high wages or wealth are obtained can create self-reinforcing patterns.
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If society believes people earn high wages as a result of their training and hard work, it is less willing to tax high earners, thereby ensuring they have strong incentives to acquire skills and exert effort. If society believes people earn high wages because of connections, chance, or crookedness, then it will tax incomes more heavily, and since few of the honest will then bother to work hard, only those with influence, the lucky, or the cheats will flourish.

Indeed, one reason why the U.S. electorate today seems so receptive to proposals to make the rich pay much more in taxes is that perceptions of who is rich may have changed. Not so long ago, the prototypical rich person in the United States was the local self-made entrepreneur who owned the car dealership and the movie theater and who came from the same high school as everyone else. Today, it is the distant, overpaid CEO, the greedy banker, or the hedge-fund manager who thrives on insider trades. Stereotypes and perceptions matter: the rich are no longer us, they are
them
.

The United States needs to prevent further social polarization, both in reality and in perception. The precise way of doing this does matter. If the rise in the wage inequality most people experience stems from the relative scarcity of workers with more human capital, as I argue in
chapter 1
, then the response has to be to improve the quality of human capital of the workforce. Heavy taxation solely to equalize wages will do little to tackle that problem and will reduce incentives to work or acquire human capital. This is why I will take as a given that the best way of reducing unnecessary income inequality is to reduce the inequality in access to better human capital.

Equalizing access can head off brewing conflicts. For instance, if rich parents can pay for better schools, extra tuition, and eventually good universities for their children while poor parents cannot, the poor will become more intolerant of high incomes and wealth. Apart from increasing conflict between the haves and the have-nevers, unequal access may also increase resistance to economic reforms that expand opportunity. For instance, the poor urban worker who does not have access to a university education may care little for reforms that make it easier to open small businesses, because she has no chance of obtaining the financing to open one.
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What we prefer politically depends on where we stand: if we stand at very different places, it is harder for us to come together as a society to make mutually beneficial decisions. And more than the quality of its institutions, what distinguishes a developed country from a developing one is the degree of consensus in its politics, and thus its ability to take actions to secure a better future despite short-term pain. Unequal access, and the resulting inequality, destroys consensus. And although this chapter focuses on the United States, the issues addressed here are relevant in many countries, including developing ones like China and India.

The problem is that the political and economic costs of any effort to improve access—for instance, providing quality preschool care for poor children—are incurred up front, whereas the benefits lie in the future. It is hard to get the public, and consequently politicians, excited about such undertakings, especially at a time of straitened public finances. But if nothing is done, inequality will feed on itself. The costs of redressing deficiencies will only increase, and many citizens will be left irremediably ill-equipped for a productive life in society. Put differently, the status quo entails unacceptable and growing costs, and avoiding those very visible costs has to be part of the cost-benefit calculus.

In arriving at solutions we should resist two seemingly attractive but dangerous notions. One is that government spending will fix all problems. The truth is that money is rarely the key missing ingredient, as we saw with the growth of developing nations. Indeed, government largesse can crowd out, if not corrupt, individual and community initiative. That does not mean, however, that all societal problems will be solved by spontaneous voluntary initiative, the second dangerous notion. Government effort (and sometimes money) is needed at key leverage points to coordinate individual and community action. Again and again, we see that successes involve a coming together of key players, a broader definition of the problem (and hence solutions) than what seems apparent initially, and a restructuring of incentives such that all players work together rather than at cross-purposes.

Human capital, as described in
chapter 1
, refers to the broad set of capabilities, including health, knowledge and intelligence, attitude, social aptitude, and empathy, that make a person a productive member of society. Schools and universities play a part, as do families and communities: it does take a village to create the values and attitudes that allow children to get the most out of their education! And once individuals complete their formal education, employers play an important role in training them further and encouraging them to continue building their human capital on the job. Such on-the-job development will become more important as the length of our working life increases: the typical knowledge worker may now work for nearly half a century after formal education ends. In what follows, I describe some of the important ways the quality of human capital can be improved in the United States.
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