On Bargains Coaseian and Faustian

My colleague Steph Miller recently wrote about why some industries may get bailed out regularly. Drawing on the work of Earl Thompson and…

My colleague Steph Miller recently wrote about why some industries may get bailed out regularly. Drawing on the work of Earl Thompson and Joshua Hendrickson, Steph pointed out that some industries may be supported because they provide something useful or essential to support government policy, and the government subsidizes the firm or industry to make certain there is capacity when it is needed. In the words of Hendrickson, this reflects a “Coaseian Bargain” between the public (through their political representatives) and industry. Steph pointed out that one negative effect to this is that certain industries may be bailed out regularly, which is offensive to both a belief in progress through creative destruction and our general sense of fair play. However, this arrangement is potentially problematic for another reason. The interrelation between industry and government allows one side or the other to misuse their position to exercise undue power, turning the Coaseian bargain into a Faustian one.

Arguably banking reflects a Coaseian Bargain. Banks enjoy a “regime of privilege” from public policy, including barriers to competition, exclusive access to valuable services provided by the government, and protection from failure. In theory at least this policy isn’t meant to benefit the banks per se but rather the underlying policy goal of facilitating economic growth and commerce, protecting bank customers, and protecting the broader economy from collateral damage wrought by a bank failure.

Of course, that doesn’t mean banks don’t benefit from all of these, well, benefits. As discussed in more detail in this paper, barriers to entry have historically reduced bank entry and competition, access to deposit insurance lowers rates banks need to pay depositors, access to the Federal Reserve’s payments system and legal advantages granted to banks compared to nonbank competitors funnel lending and payment business through banks, and all too often the way the government has dealt with the risk posed by bank failure is to simply not let (certain) banks fail.

This could still be consistent with a Coaseian Bargain. Maybe this is the best way to maintain a stable financial system in an imperfect world. It isn’t a stretch to argue that a modern economy needs intermediaries that perform the functions banks provide, and banks are an efficient vehicle of those functions. No, it isn’t consistent with the concept of a “free market,” but in the real world maybe this is about as good as it gets. And besides, even if this isn’t the absolute best way, it is the way we have chosen, piece by piece, and we have to deal with the world as it is. Banks get protection, people get necessary financial services and efficient allocation of capital, leading to economic growth, government gets employed population and growing economy, fin. Or at least that is the hope.

But what are the other implications of this relationship? There is a lot of government-granted privilege being provided for the benefit of an industry, and the industry is highly beholden to the government. This seems like a risky situation that might give rise to something like what Jane Jacobs called a “Monstrous Moral Hybrid” in which the ethos of government and market get mixed up resulting in an actor displaying the problems of both.

And sure enough, examples abound. The most high-profile example is of course Operation Choke Point, where the Department of Justice and FDIC used their ability to regulate banks, and the leverage that being the banks’ insurer provided, as tool to harm downstream industries. Instead of a straight up fight involving votes, comment periods, and the other procedural and substantive safeguards that accompany government action, we got the government micromanaging businesses to pursue regulatory purposes. (For more on Operation Choke Point and the dangers of allowing the government to regulate a bank’s reputation see Prof. Julie Hill’s excellent article Regulating Bank Reputation Risk.)

While Choke Point illustrates how the bargain can go bad against banks, banks can also become monsters. Remember, banks enjoy a suite of benefits and powers because (at least in theory) we want banks to serve as intermediaries to facilitate lawful commerce. But what if industry refuses to use its power for the purpose intended? What if instead they try to use their privileged position to impede lawful commerce when they (or a powerful constituency who can influence/coerce them) believe the government isn’t regulating the people enough? It’s been known to happen. What should our response be if we aren’t dealing with just any private actors in just any regular market but rather firms imbued with a privileged position who use that privilege in ways that frustrate the original intent for granting it?

These are questions we will need to face, especially as efforts to use financial services as a tool for broader social control intensify. This will require honest appraisals (and perhaps reappraisals) about the proper role of all the actors involved and the proper venue for resolving contentions questions. Being clear-eyed about these issues and how to navigate them will be critical, otherwise we may find ourselves traveling down a road paved with the best of intentions, but with an unpleasant destination.