Tyler Cowen’s essay on the inequality generated by the political economy of finance has received deserved attention. I think Tyler is exactly right that financiers are going short on volatility, that this is hard to detect and therefore regulate, that politicians have incentives to bail out the banks following increases in volatility, and that it leads to severe problems.
Please excuse the self-congratulation, but as far as I can tell, I am the only person to propose a reform that could plausibly reduce this problem. In April, I wrote,
[A]n important factor in the stability of the financial sector is its degree of globalization…
The second and deeper reason for more financial globalization is political. The doctrine of Too Big to Fail creates a moral hazard problem: banks reap the benefits of successful investments but don’t suffer the losses of failed investments, so their incentive—whether conscious or evolved—is to take a lot of risk. Politicians, as much as they claim to want to enact market discipline, face a time-consistency problem. They want banks to be sound, but they lack the political will to let unsound banks and their creditors suffer when the time comes to feel the pain.
Greater globalization reduces the time-consistency problem. American voters do not want to pay taxes to bail out banks that operate just as extensively in Europe, Asia, and Latin America as in the US. The fact that a bailout would convey these uncompensated externalities would strengthen the political will to let unsound banks fail. This is not to say that I hope lots of banks fail—rather, I want politicians to be able to make more credible claims that Too Big to Fail is over, so that banks take note and invest accordingly. In equilibrium, there would be fewer bank failures, not more of them.
My claim is not that globalization of banking is a panacea. But to extent that we can reduce the time-consistency problem that politicians face, we can reduce the incentive that financiers face to write naked puts on volatility.