The theory of social costs: Why markets cannot discipline financial institutions

By L. Randall Wray

I recently came across a video of one of my talks on the Global Financial Crisis, or, Global Economic Crisis, that provides a clear antitdote to orthodox thinking. You can view it here:

“The Financial Crisis Viewed from the Perspective of the Social Cost Theory”, Social Cost Workshop, Wright State University, Ohio, April 27, 2012; video here here (begins approximately at the 23 minute mark) :

Here is a summary of the argument, and a link to a relevant paper is at the bottom. This is perhaps my clearest presentation on the topic.

Mainstream economists have developed theories in which financial markets are “efficient,” pricing financial assets according to fundamental values. Indeed, if finance is efficient in the manner described by orthodoxy, it does not even matter. This is a logical extension of the neoclassical conclusion that markets efficiently allocate real resources to the financial sector. In the form of rational expectations it led to the conclusion that no individual or regulator could form a better idea of equilibrium values than the market.

This led to Chairman Greenspan’s famous excuse for not intervening into the serial bubbles that preceded the global financial crisis that began in 2007. And it was this theory that provided the intellectual underpinning of the behavior of market participants as well as regulators that led to the current crisis in financial markets. Yet, it is clear that financial “markets” did not “efficiently” price assets. The continuing crisis makes it clear that “finance” does matter. This is now  recognized by virtually all observers. However, most policymakers are simply focused on “getting finance flowing” again—as if we just need to take a big plunger to a blocked financial toilet—and on ensuring that asset prices more correctly reflect fundamental values. No fundamental changes are required—we just need to “make markets work.” I argue that the orthodox approach to finance is useless because the market metaphor is particularly inapplicable to finance. Ronald Coase argued that while free markets might be the most efficient form of economic organization, the majority of economic transactions take place outside the market, which calls into question the role of markets as the organizing structure of capitalism.

Thus, following the example previously set by Keynesians and Institutionalists, even Coase leaves an opening for institutions, including the state, in formulating rules and providing regulation and supervision. These institutions will not arise endogenously out of market processes; they must be imposed on the market. One could go even further and argue that the market, itself, is an institution—created and regulated through human agency.

These objections are even more relevant to the sphere of finance. At the most basic level, banking is concerned with building a relationship that allows for careful underwriting (assessing creditworthiness) and for ensuring that payments are made as they come due. Long-term relations with customers increase the possibility of success, by making future access to bank services contingent upon meeting current commitments.

Further, within the bank itself, a culture is developed to provide and enforce rules of behavior. Relations among banks are also extra-market, with formal and informal agreements that are necessary for mutual protection—banks are often forced to “hang together, or all will be hung separately” because of the contagion effects of runs on their liabilities.

Further, social policy promoted the use of bank liabilities as the primary means of payment. This is not something that arose naturally out of markets. A well-functioning payments system requires par clearing—the US’s long and sordid history of nonpar clearing by “free” banks stands out as singularly unsuccessful. For that reason, par clearing was finally ensured with the Federal Reserve Act of 1913, which created a central bank for the United States whose original primary purpose was to ensure par clearing of bank demand deposits. However, there was a glitch in the system because the Fed’s role was limited to lending to solvent banks against good assets. Hence, the payments system collapsed in the 1930s, when runs on banks returned as depositors rightly feared insolvent banks would never make good on their promises. For that reason, Congress created the Federal Deposit Insurance Corporation (FDIC) to “insure” deposits (with similar guarantees on deposits at thrifts and some other types of institutions). This effectively eliminated runs on banks (although later runs returned on other types of bank liabilities, such as brokered CDs).

The combination of access to the Fed as lender of last resort, par clearing, and deposit insurance provided very cheap and stable sources of finance for banks. In addition, Regulation Q limited interest on deposits (set at zero for demand deposits) to keep interest costs down. Banks could charge fees to handle deposit accounts. All of this made it possible for banks to operate the payments system while shifting most costs to consumers and government. Further, because these bank liabilities are guaranteed, bad underwriting leads to socialization of losses as the FDIC makes the deposits good.

Clearly, operation of the payments system has not been left to “free markets.” While it now seems natural for banks to run payments through nominally private banks, there was no reason to combine lending (predominately commercial lending) and the payments system in this manner. An alternative arrangement would have been to separate the two—with the government operating the payments system as a public good (for example, through a postal savings system) and banks focusing on underwriting loans while financing positions in assets by issuing a combination of short-term and long-term liabilities. If these were not the basis of the payments system, there would have been no reason for the bank liabilities to maintain par—nor even any reason for them to circulate.

Bad underwriting would first hit equity holders and then would reduce the value of the liabilities. Losses would not be automatically socialized. There might then have been some discipline on banks to do good underwriting. Of course, Glass-Steagall did segregate a portion of the financial sector from the payments system: investment banks were allowed freer reign on the asset side of their balance sheets, but they could not issue deposits. Their creditors could lose. Creditors were protected mostly by the Securities and Exchange Commission (SEC)—which provided regulations primarily on the “product” or liability side. Investment banks (and other nondeposit taking financial institutions) were largely free to buy and hold or trade any kinds of assets they deemed appropriate. They were required to “mark-to-market” and to provide reports to creditors. Other than rather loose rules requiring them to ensure that the products they marketed were “suitable” for those who purchased them, it was expected that “markets” would discipline them. As we will see, that did not work, even for the less-protected institutions that did not have bank charters. And when the financial system collapsed, the remaining investment banks were handed charters so that they could access the payments system.

Over the past half century, there has been a trend toward reducing relationship banking in favor of supposedly greater reliance on “markets.” This is reflected in the rise of “shadow banks” that are relatively unregulated, that in many cases are required to “mark-to-market,” and that have successfully eroded the bank share of the financial sector. It is also reflected in the changing behavior within banks, which largely adopted the “originate to distribute” model that is superficially market-based. This shift was spurred by a combination of innovation (new practices that were not covered by regulations), competition from shadow banks with lower costs, and deregulation (including erosion of and finally repeal of Glass-Steagall). It also reflects the changing views on the efficacy of markets. However, the move to increase reliance on markets is more apparent than real. As we shall see, the new innovations such as asset backed securities (ABS) actually increased institutional linkages even as they reduced the free market competitive pressures imagined by orthodoxy. And the prices to which asset values are marked reflect neither “fundamentals” nor “markets”—rather, they result from proprietary models developed (mostly) in-house and thus reflect the culture and views of teams working within institutions.

At the same time, these trends reduced “social efficiency” of the financial sector, if that is defined along Minskyan lines. Minsky (1992a) always insisted that the role of finance is to promote the “capital development of the economy,” defined as broadly as possible. Minsky would agree with Institutionalists that the definition should include enhancing the social provisioning process, promotion of equality and democracy, and expanding human capabilities. Instead, the financial sector has promoted several different kinds of inequality as it captured a greater proportion of social resources. It has also promoted boom and bust cycles, and proven to be incapable of supporting economic growth and job creation except through the promotion of serial financial bubbles. And, finally, it has imposed huge costs on the rest of society, even in the booms but especially in the crises.

Indeed, the continuing attempts to rescue the financial sector (especially in the United States) have laid bare the tremendous social costs created by the way finance dominates the economy. If anything, the various bailouts have actually strengthened the hands of the financial sector, increasing concentration in a small number of behemoth institutions that appear to control government policy. Meanwhile the “real” economy suffers, as unemployment, poverty, and homelessness rise, but policymakers claim we cannot afford to deal with these problems. Their only hope is to gently prod Wall Street to lend more—in other words, to bury the rest of the economy under even more debt. The rescue of Wall Street displaces other fiscal policy that would lead to recovery.

What I am arguing is that the financial sector has not been operating like a neoclassical market. In spite of the rhetoric that deregulation improved efficiencies by replacing government rules with market discipline, markets have not and cannot discipline financial institutions. Rather, we reduced regulation and supervision by government that was supposed to direct finance to serve the public interest. This was replaced by self-supervision for private profit that generated huge social costs. Financial institutions do not even pursue “market” interests (of shareholders, for example). Instead, they have been largely taken over by top management with personal enrichment as the goal.


This post first appeared at my EconoMonitor blog “Great Leap Forward

Randall Wray


L. Randall Wray is a professor of economics and research director of the Center for Full Employment and Price Stability at the University of Missouri–Kansas City. His current research focuses on providing a critique of orthodox monetary policy, and the development of an alternative approach. He also publishes extensively in the areas of full employment policy and the monetary theory of production. Wray received a B.A. from the University of the Pacific and an M.A. and a Ph.D. from Washington University, where he was a student of Hyman Minsky.