How Big Should the Banks Be?

Recently by Thomas E. Woods, Jr.: Conservatives and the Elephant in the LivingRoom

Simon Johnson has a piece at Bloomberg today that urges the Romney/Ryan ticket to make reining in the big banks a major campaign issue. (Thanks to Michael Brendan Dougherty.)

Oddly enough, Johnson makes some good points. (Forget his stuff about how great Teddy Roosevelt’s trust-busting was, and that the firms in question were exploiting the consumer; prices were falling in the industries he targeted.) The big banks do indeed receive market-distorting subsidies of various kinds, the result of which is that they grow bigger than they would otherwise be.

If anything, Johnson is being too timid. The Federal Reserve System itself is a subsidy to the banking system (what could be more obvious?), but no mainstream economist is going to say so.

Various proposals are being put forward, including raising capital requirements on the largest institutions. This would force them to rest on a sounder footing, the argument goes, and would counter the incentives to be reckless that their too-big-to-fail status encourages.

I am not sure exactly how to deal with the present condition of the banks apart from root-and-branch monetary reform, but I wouldn’t rule out a proposal like this one as a second-best alternative. No doubt some people will claim that it’s a violation of the free market to impose common-sense controls on financial institutions. But how so? These institutions enjoy various forms of government privilege, and commercial banks even have FDIC coverage. They are shielded from the free market, which means their behavior is not the behavior they would engage in on an actual free market.

To my mind, the key point involves bearing in mind the argument of Jeff Herbener, the economics professor at my Liberty Classroom. Fiat paper money cannot be regulated by profit. The production of all other goods in society is economized and regulated by the principle of profit and loss. Fiat money, propped up by legal tender laws, cannot be regulated by profit, because it is always profitable to create more. The costs of increased production are negligible.

What follows from this is that in the case of banks (which in our system can create money out of thin air by making loans and crediting the borrower with a checking account balance created out of nothing), we cannot say that existing firm size is socially optimal. In any other industry, there is a non-arbitrary test of firm size: the profit-and-loss test encourages firms to reach a size that best satisfies consumers. But there is no profit-and-loss test in the creation of fiat money. As a result, firm size is arbitrary, and does not involve passing a market test.

Reprinted with permission from