Distributive effects of financial deregulation

19 Jan, 2015 at 19:57 | Posted in Economics | Comments Off on Distributive effects of financial deregulation

One of the greatest sources of wealth for the top 0.1% class of super-rich is Wall Street, and Wall Street is also the source of the financial crisis that inflicted much economic pain on the bottom 90% in recent years. This has understandably led to a widespread feeling in American society that the rules governing Wall Street are stacked in favor of a small elite, at the expense of Main Street.

However, much of the recent academic work in economics ignores the distributive effects of financial regulation and focuses solely on efficiency. By contrast, our recent paper on “The Redistributive Effects of Financial Deregulation” in the Journal of Monetary Economics puts the focus squarely on distributional considerations.

obama-financial-regulationOur analysis is based on the observation that losses in the financial sector can impose massive costs on the real economy … During the 2008 financial crisis, banks took large losses which raised interest rate spreads and lowered access to credit for the real economy, which in turn reduced the earnings of workers. When financial institutions decide how much risk to take on, they do not take into account these losses. Instead, they take on more risk than is good for the rest of the economy …

We argue in the paper that the most insidious consequence of bailouts is not that they lead to an explicit transfer from Main Street to Wall Street but that they could lead to an even larger implicit transfer by encouraging greater risk-taking and thereby exposing the economy to more credit crunches. Moreover, it may be difficult to commit to not providing bailouts once a financial crisis has occurred because the real sector may prefer to provide a bailout rather than suffer a severe credit crunch. By contrast, regulating risk-taking directly does not suffer from this commitment problem …

How can we better protect Main Street from the externalities of Wall Street? The simplest way is to regulate risk-taking by banks, whether by increasing their capital adequacy requirements, separating risky investment activities like proprietary trading from systemically important traditional banking, limiting payouts that endanger the capitalization of the financial sector, or using structural policies including limits on asymmetric compensation schemes to reduce incentives for risk-taking. Unfortunately, the current movement towards rolling back financial regulation may serve the interests of Wall Street well but continues to expose Main Street to the risk of financial meltdowns.

Anton Korinek & Jonathan Kreamer

Blog at WordPress.com.
Entries and comments feeds.