October 1, 2013

Don’t Distort the Market Further

Hester Peirce

Former Senior Research Fellow
Summary

Only one U.S. state, North Dakota, owns a bank. But that bank has been so successful – and the financial systems elsewhere have been so problematic – that 22 other legislatures have considered starting similar state banks. Would government-owned banks distort the free market, or complement private lending? If states or the federal government set up banks, should they lend directly to consumers and businesses?

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The New York Times Room for Debate posted this question:

Only one U.S. state, North Dakota, owns a bank. But that bank has been so successful – and the financial systems elsewhere have been so problematic – that 22 other legislatures have considered starting similar state banks. Would government-owned banks distort the free market, or complement private lending? If states or the federal government set up banks, should they lend directly to consumers and businesses?

Hester Peirce provided the following response:

The lure of state-owned banks is presumably twofold: First, they would lend to customers that private banks reject. Second, a bank backed by the heft of the state could give big private banks a run for their money. Despite a superficial appeal, government-owned banks aren’t the answer. In reality, the only virtue of having government directly engaged in banking is that it’s more honest than the current system, in which government pulls the strings of purportedly private banks.

Private banks should make loans only when they anticipate the money will be repaid. Conflicting government regulations and subsidies blur this common-sense rule. State-owned banks with a mandate of making uneconomic loans would further complicate things. As the 2007-9 crisis demonstrated, encouraging lending to customers who cannot repay imposes terrible human costs. Imagine the anti-government sentiment that would be stirred up by a wave of foreclosures by the state bank, widespread write-downs on taxpayer-financed mortgages, or the revelation of sweetheart loans made by state banks to powerful politicians’ cronies. Free markets offer healthy discipline for borrower and lender alike.

Providing viable competition to big banks is also better achieved through free markets. State-owned banks could lend directly, but if experience with other government bureaucracies is a guide, customer service would leave much to be desired. And, while explicit government backing would be similar to big banks’ implicit government backing, taxpayers would more directly bear losses by state banks. Alternatively, state banks could subsidize lending indirectly by providing cheap capital to other banks, but again taxpayers would be on the hook for poor lending decisions. There’s an easier way to accomplish the same goal: eliminate big banks’ government privileges and reduce regulatory burdens that disproportionately affect small banks.

Government-owned banks would further distort the already-distorted banking markets. Reinvigorating private banking by curtailing government interference, rather than encouraging its direct participation in the markets, is the right approach to satisfying consumers’ needs.