cato-journal-v34n2

The Free-Market SolutionMarket DisciplineWhat is the solution? My solution is pretty radical and is outlinedin my recent book (Allison 2012). First, I would get rid of governmentdeposit insurance. Bert Ely (1994) has developed a conceptthat would work for the privatization of deposit insurance for smalldepositors, which is the proper role for deposit insurance. Second, Iwould get rid of the Federal Reserve because the volatility in theeconomy is primarily caused by the Fed. Sound money matters.When the Fed is radically changing the money supply, distortinginterest rates, and overregulating the financial sector, it makesrational economic calculation difficult. Markets do form bubbles, butthe Fed makes them worse.We need a private, free-banking system based on a market standardsuch as gold. If the United States had continued with the classicalgold standard instead of having instituted a government moneymonopoly in 1913, we would have learned through experimentation,as all markets do, and would have a radically better financial systemand higher economic growth today.In the absence of ending the Fed, the United States should raisecapital standards for banks to 15 to 20 percent of assets. Prior to theFed, banks maintained a 20 percent capital ratio. In the recent crisis,banks with strong capital positions practically never failed. We shouldraise capital standards, but it is even more important to eliminateburdensome regulations—including Dodd-Frank, the CommunityReinvestment Act, and Truth in Lending. About 25 percent of abank’s personnel cost relates to regulations. Banks cannot pay theregulatory costs and have high capital standards. That’s why Dodd-Frank cannot work. Regulators want banks to raise their capital standardswhile simultaneously complying with a vast array of costly newregulations. Ironically, this is killing community banks. Bureaucratsare forcing consolidation in the banking industry—because eventhough in theory small banks are immune to many regulations, inpractice regulators are not going to let a small bank do what big bankscannot do.I would raise capital standards and let markets discipline banks.Those reforms—not more regulation—would reduce volatility,incentivize rational risk-taking, and thereby create better economicgrowth. Free markets work; why wouldn’t they work in the bankingbusiness?351