Supporters of Capitalism Should Support Capital (Requirements)

Supporters of Capitalism Should Support Capital (Requirements)

In his annual report, J.P. Morgan Chase CEO Jamie Dimon gave a full-throated defense of the free-market capitalist system:

There is no question that capitalism has been the most successful economic system the world has ever seen. It has helped lift billions of people out of poverty, and it has helped enhance the wealth, health and education of people around the world. Capitalism enables competition, innovation and choice.

Hear, hear. But what troubles me about his report is his criticism of current capital requirements, and the implicit argument that higher capital requirements would be detrimental to J.P. Morgan and the economy at large:

When the next real downturn begins, banks will be constrained – both psychologically and by new regulations – from lending freely into the marketplace, as many of us did in 2008 and 2009. New regulations mean that banks will have to maintain more liquidity going into a downturn, be prepared for the impacts of even tougher stress tests and hold more capital because capital requirements are even more procyclical than in the past. Effectively, some new rules will force capital to the sidelines just when it might be needed most by clients and the markets. For example, in the next financial crisis, JPMorgan Chase will simply be unable to take some of the actions we took in 2008, as described in the sidebar above.

Even though increasing capital requirements would, strictly speaking, be an increase in the regulatory burden in the financial sector, there are two key arguments for why increasing capital requirements (and thus financial stability) would make the market system freer.

First, without higher capital requirements, the risk of a financial crisis that would require a government intervention in the form of a bailout (one of the most extreme ways the government could interfere with the functioning of a free market) is significantly greater. The Minneapolis Fed estimated that the status quo (as of 2016) had a 67% of a downturn requiring a bailout in the next century. Imposing the capital requirements proposed by the Plan would decrease that to 9%.

While it is tempting to argue that we should remove financial sector’s safety net and let it de-leverage out of self interest, this argument fails for two reasons. While it is likely true that if banks knew that the cavalry wouldn’t come if they became insolvent they would change their behavior, we cannot dismiss the fact that bankers are humans and thus subject to all the same cognitive shortcomings as the rest of us; the population of jackalopes and homo economici is roughly the same.

Additionally, all of this is something of a moot point, as government simply cannot credibly promise to not bail out troubled banks during a financial crisis.

The second point is more political than economic. In the context of a 2008-style economic catastrophe, bailouts of large financial institutions may be necessary. But this comes at the cost of significant outrage from (and accompanying radicalization of) the free-market right, as we saw with the Tea Party movement in 2008, and the socialist-leaning left, as we see with the Democratic Socialists and their fellow travelers today.

Rent-seeking, not capitalism per se, is the disease plaguing the U.S. economy. Even so, assistance to the already rich and powerful has been confused with a truly free-market system. This conflation, though incorrect, is an understandable reaction. Another financial crisis will only fan these populist flames, making it all the more important to fireproof the financial sector.

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By |2019-04-16T07:30:48-07:00April 16th, 2019|Blog, Financial Regulation|