Republic, Lost_ How Money Corrupts Congress--And a Plan to Stop It - Lawrence Lessig [34]
Even if the banks didn’t have to worry about rules emanating from the CFTC, SEC, or Federal Reserve, they still had to worry about the constraints imposed upon them by the competitive market. The biggest firms on Wall Street were publicly traded. Rivals thus set the baseline for the profit each firm was expected to produce. As firms started down the path of risky behavior, the competitive market within which they operated pushed them even further. A conservative and sensible strategy is punished in such a market because, by definition, it doesn’t produce the same return as a risky strategy. A risky strategy earns the market’s reward.
These new instruments thus gave Wall Street firms a new opportunity to compete like hell against one another. But as they competed, they assumed risks that, while sensible for them alone, were not sensible for the economy as a whole. That’s because, as Posner puts it, banks “do not have regard for consequences for the economy as a whole…. [T]hat is not the business of business. That is the business of government.”32
It is this gap between the interests of the banks alone and the interests of the “economy as a whole” that explains the need for regulation. “Banks,” Posner writes, “can be made safe by regulation, but that is not their natural state, and so if regulation is removed they may careen out of control.”33 Thus, commenting upon Alan Greenspan’s confession that he had expected the self-interest of Wall Street firms to be enough to induce them to behave properly, Posner writes:
That was a whopper of a mistake for an economist to make. It was as if the head of the Environmental Protection Agency, criticized for not enforcing federal antipollution laws, had said he thought the self-interest of the polluters implied that they are best capable of protecting their shareholders and their equity. They are indeed the best capable of doing that. The reason for laws regulating pollution is that pollution is an external cost of production, which is to say a cost not borne by the polluting company or its shareholders, and in making business decisions profit maximizers don’t consider costs they don’t bear. Banks consider the potential costs of bankruptcy to themselves in deciding how much risk to take but do not consider the potential costs to society as a whole.34
The banks were thus freed of the burden of federal regulation, yet driven by the discipline of market regulation to assume far more risk than was good for the economy. As Posner concludes:
Am I saying that deregulation made bankers and through them borrowers take risks that were excessive from an overall social standpoint? Yes, once we recognize that competition will force banks to take risks (in order to increase return) that the economic and regulatory environment permits them to take, provided the risks are legal and profit-maximizing, whatever their consequences for the economy as a whole.35
This was also the conclusion of the Financial Crisis Inquiry Commission: “Unchecked, competition… can place the entire financial system at risk.”36 And indeed, as the commission concluded, in this case it did:
More than 30 years of deregulation and reliance on self-regulation by financial institutions championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe.37
From the perspective of the economy as a whole, the banks thus took on more risk than was sensible. For the large banks, the risk was quite sensible—for them, at least when you count an implicit promise by the government to bail the banks out if the economy went south. Indeed, as Raghuram Rajan puts it, “What is particularly alarming is that the risk taking may well have been in the best ex ante interests of their shareholders.”38
It was clear to most that the economy as a whole had this promise from the Federal Reserve. This was the “Greenspan