Monday, October 10, 2011

Paul Krugman and Adam Smith on Bank Crises

Why laissez-faire does not works for banks.Excerpt (but the whole article deserves a read):

First of all, bank regulation is important even in the absence of bailouts. Don’t trust me, trust Adam Smith. Scotland invented modern banking; it also invented modern banking crises; and Smith, having witnessed such a crisis, favored bank regulations, declaring that

Such regulations may, no doubt, be considered as in some respect a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as or the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed

Second, there are in fact very good reasons to intervene to support banks during a financial crisis. Bagehot knew it; Diamond and Dybvig showed it theoretically; and it remains true. Letting a financial crisis spread is very dangerous.