Governments do not stabilize markets

Free market advocates are sometimes seen as unrealistic ideologues, obsessed with issues such as moral hazard at a time when financial markets need to be stabilized. In fact, seemingly pragmatic interventionists are being simplistic, as they ignore the long-term effects of their actions. Each bailout encourages more risk-taking, making the financial system more volatile.

In some cases, advocacy of intervention is based on a misreading of history. The financial instability experienced in the United States prior to 1933 was not caused by laissez-faire, it was caused by a combination of bank branch restrictions and unstable monetary policy. And even then, the big banks survived a collapse in NGDP that would have wiped out the entire modern global banking system. Canada’s system was much less regulated than America’s and had relatively few problems during the Great Depression. Before the FDIC, financiers behaved more responsibly.

Bloomberg There’s a good piece explaining how the Bank of England is creating more moral hazard, extending bailouts beyond the banking system:

So when the gilt market wobbled last week, there was no one left but the Bank of England with the firepower to intervene.

Fortunately, the BOE has already laid the groundwork. In January 2021, its executive director for markets, Andrew Houser, gave a speech in London outlining a case for a role as a “market maker of last resort”. Central banks have already expanded their focus from backstopping banks to backstopping markets. But given the shifting sands under the overall system, he warned that momentum could increase: ‚ÄúThere is every reason to believe that, in the absence of further action, we will see markets increasingly dependent on households and firms. “

And this problem goes beyond the financial system. Unfortunately, the government is increasingly determined to protect people from their folly, whether it’s borrowing a lot of money to get a useless college degree or building a house in the path of a hurricane. These protections allow people to behave more stupidly. Then we will be told of the need for more control, to protect us from even more foolish behavior. Perhaps I should use scare quotes for “stupid”. Given government protection, most behaviors are privately beneficial while socially destroying resources.

At a deeper level, this is part of what Hayek called Fatal pride, the view that the government could control the economy. Instead, the government should focus on avoiding actions that destabilize the economy. Hayek believed that the best way for the government to avoid destabilizing the economy was to target NGDP. When NGDP stabilizes, we no longer need to fear that the failure of a large financial institution (or a large decline in asset prices) will lead to high unemployment. NGDP targeting makes laissez-faire policies more attractive.

Rest assured. some people They wrongly suggest that the Diamond-Dybvig model of bank runs justifies government deposit insurance. George Selgin did an outstanding job (here And here) to explain why it does not.

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