Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

Recent debate at the state and national level has focused on whether to enact a climate policy to control greenhouse gas emissions such as carbon dioxide.  The fact is, however, that we already have policies that affect such emissions, whether we like it or not.  Such policies can be coordinated and rational, or they can be piecemeal, inconsistent, and counter-productive.  Almost any policy designed to improve energy security, for example, would likely affect oil prices and energy efficiency, just as any policy to encourage alternative fuels would also affect energy security, electricity prices, consumer welfare, and health!  Here is a guide for thinking about how some of these policies work, and which combinations might work better than others.

The most obvious existing policy that affects carbon dioxide emissions is the gasoline tax that applies both at state and federal levels.  If that tax encourages less driving and more fuel-efficient cars, then it also impacts urban smog and global warming as well as protecting us from the whims of oil-rich nations with unstable governments.   In fact, with respect to the price at the pump, a tax on emissions would look a lot like a tax on gasoline, and vice versa.  Averaged over all state and federal taxes, the U.S. gasoline tax is about $0.39 per gallon, far less than around the rest of the world.  Most countries in the OECD have a tax over $2/gallon.

For the most part, the U.S. has chosen to avoid tax approaches to energy and environmental policy and instead uses various mandates, standards, and subsidies.   Cars sold in the U.S. are required to meet emission-per-mile standards for most local and regional pollutants like fine particles, sulfur dioxide (SO₂), nitrous oxides (NO_X), and volatile organic compounds (VOC) that contribute to ozone smog.  Those rules make cars more expensive but have successfully cleaned the air in major cities and around the country.  They also have the side effect of reducing greenhouse gases.  Another mandate is the “Corporate Average Fuel Economy” (CAFE) standards that require each auto manufacturing company to meet a minimum for the average miles-per-gallon of their fleet of cars sold each year.  For each big gas-guzzler they sell, the company needs to sell more small fuel-efficient cars to bring the average back down.  To meet this standard, every car company must raise the price of their gas guzzlers (to sell fewer of them) and reduce the price of their small fuel-efficient cars (to sell more of them).  The effect is the same as having a tax on big cars and subsidy on small cars.

These energy and environmental policies are also intricately related to other tax policies, as well as government spending!  For any chosen size of government and overall tax bite, any dollar not collected in gasoline tax is another dollar that must instead be collected from payroll taxes, income taxes, corporate profits tax, or state and local sales tax.  When looked at through that lens, gasoline taxes may not be that bad – or at least not as bad as some of those other taxes we must pay instead. 

Every state and local government is also worried about the pricing of electricity by huge electric companies that might naturally have monopoly power over their customers.  Production efficiency requires a large plant, so a small remote town might be served only by one power company (with no competition from neighbors far away, since too much power is lost during transmission).  So the public utility wants to regulate electricity prices, perhaps with block pricing that helps ensure adequate provision to low-income families.   Yet the pricing of electricity inevitably affects electricity use, which affects coal use, urban smog, and greenhouse gas emissions.  These policies are intricately related.

And these policies are related to government spending, since they affect car and gasoline purchases and therefore required spending on roads and highways as well as train tracks and mass transit in cities.  These environmental and energy policies affect human health, and therefore health spending by government – as necessary to pay for additional illness caused by emissions from cars, power plants, and heat from burning fossil fuel. 

We have no way to avoid these inter-connections.  You are a consumer who wants lower gas taxes and electricity prices, but you also own part of the power company and auto manufacturers through your mutual fund or pension plan.  You pay other taxes on income and purchases, and you breathe the air, so you are affected by emissions and need health care.  We might as well think holistically and act for the good of everybody, because we are everybody!

Earlier this month, despite desperate appeals to reverse his execution order, Lennox, a simple family dog from Belfast (UK) was killed (source).  The Belfast City Council (BCC) in Northern Ireland had condemned Lennox to death for the crime of resembling a pit bull.  The BCC’s justification was compliance with the “The Dangerous Dogs (Northern Ireland) Order 1991”, which defines any dog deemed to have pit bull “characteristics”, as inherently dangerous and bred for fighting.  The law requires the seizure and destruction of such dogs.

The Order is an example of breed-specific legislation (BSL) in effect across many jurisdictions around the world.  Pit bulls often are the target of BSLs, but other breeds are affected too, such as Rottweilers and German Shepherds (source).  Many major cities in America have BSL that outlaw pit bulls, including Denver and Miami (source).  The idea behind BSL is to reduce dog bites and subsequent death in humans from these “dangerous” breeds.

Do these BSLs work?  The answer is no.  A study by the U.S. Centers for Disease Control and Prevention (CDC) that reviewed a large sample of human dog bite-related fatalities over a 20-year period found, “Although fatal attacks on humans appear to be a breed-specific problem (pit bull-type dogs and Rottweilers), other breeds may bite and cause fatalities at higher rates.”  In other words, it is a common misperception that pit bulls are inherently more dangerous than other dogs.  Furthermore, analyses of specific BSLs find them to be ineffective, such is the case of the pit bull ban in Prince George’s County, MD (source).

In fact, all BSLs do is punish law-abiding citizens with harmless companion animals, as in the case of Lennox.  Criminals use pit bulls for fighting, but that is neither the fault of those dogs specifically, nor the breed in general.  Instead of BSLs, experts recommend breed-neutral legislation that focus on the deeds instead of breeds, as well as preventative measures such as mandatory spaying/neutering and compulsory leash laws  (source).  Poorly socialized, vicious dogs do exist and need to be taken seriously, but steps should be taken to protect the public in accordance with breed-neutral laws already on the books.

Finally, on a personal note, my partner and I have two beautiful pit bull mixes.  Lucy and Emmy are two wonderful and loving ladies.  Every once in a while, they steal food from the table, but then again what dog doesn’t?!

Anyone struggling to understand the LIBOR scandal could do worse than observe the way the Peloton behaves in this year’s Tour de France. All riders in the Peloton receive the same time at the end of the race. It’s like everyone getting the average rate in LIBOR rate benchmark setting. Furthermore it leads to the similar collusive behavior.

Sometimes the collusion is used to good, or at least gentlemanly, effect, such as waiting for Mark Cavendish and others who were victimized by the “tack” attack. At other times it negates the race by turning it into a rest period – a parade.

But presumably the Tour officials instituted the “same time” rule to avoid worse behavioral consequences – a scramble to the finish with attendant increased probability of crash and injury among bunched riders. Possibly it was originally also because of the difficulty of measuring individual times.

Analogous difficulties, rationales and discussions were present when the Chicago Mercantile Exchange introduced the Eurodollar futures contract in 1981. It was the first contract cash-settled to an index, LIBOR, rather than a deliverable deposit. The Exchange conducted its own standardized survey of banks for LIBOR settlement. The seemingly superior alternative, a deliverable instrument, was exposed to have its own problems when the failure of Continental Bank and the delivery of its certificate of deposit caused the failure of the domestic CD futures contract in 1984.

The BBA formalized its LIBOR calculation in 1985 in part because of the success of the Eurodollar contract itself. The exchange switched from CME calculated LIBOR to the BBA LIBOR for settlement purposes after 1997.

No doubt it is time to improve BBA the calculation. It has been gamed and gamers should suffer the consequences – that includes the calculation agent.

However, when there is an illiquid market, or when a market becomes illiquid, there are pluses and minuses to index settlement or transactional delivery. There are almost certainly better ways to provide a benchmark, but it remains the case that there is no perfect way. When changes are made or suggested lets game them in advance to anticipate behaviors. Radical changes may precipitate even worse practices.

No doubt the Tour de France officials feel the same way about the Peloton time calculation.

Way back on May 18, I wrote a blog called “Why YOU may LIKE Government ‘Theft’”.  In it, I listed four possible justifications for government to act like Robin Hood, taking from the rich to give to the poor.  This combination of economics and philosophy is meant to help each of us think about what really should be the top personal marginal tax rate: should it be higher or lower than currently?  This topic is hotly debated these days in the newspapers!

In that blog, I listed all four justifications, any one of which may or may not ring true to you.  If one or more justification is unconvincing, then perhaps a different justification is more appealing.  I put off the last three justifications to later blogs and mostly just discussed the first one, namely, that some “ethicists” in the field of “moral philosophy” have found ethical justifications for extra help to the poor.  The moral justification may be the most common or usual one; you might think it morally just or fair to help the poor starving masses.  That blog describes a range of philosophies, all the way from “no help to poor” (Nozick) in a spectrum that ends with “all emphasis on the poor” (Rawls).

But that’s not the only reason to have some degree of progressivity in our income tax system (taking higher percentages of income from those with more income).  The second justification basically says okay, let’s skip the moral theorizing.  Instead, suppose the poor are not deemed special at all.  Suppose that ALL individuals receive the exact same weight.  Suppose the objective is to maximize the un-weighted sum of all individuals’ wellbeing (or what we call “utility”).  Actually, this is perhaps the view of Jeremy Bentham, who came to be considered the “founding figure of modern utilitarianism.”  His philosophy is “the greatest happiness of the greatest number”.  That is, just add up all individual utilities, without weights, and maximize that sum.

So far, that might sound like no justification for taking from the rich to give to the poor.  However, we did not say just add up their incomes, or to maximize total GNP.   Instead, one might also believe that utility is not proportional to income, but is instead a curved function, as in the diagram below.  In other words, “declining marginal utility”.  If so, then a dollar from a rich person is relatively unimportant to that rich person, while a dollar to a poor person is very important to that poor person.  In that case, equal weights on everybody would still mean that total welfare could increase by taking from the rich in order to help the poor.

The only remaining question is the degree of curvature, or the rate at which marginal utility declines.  If it is a nearly straight line, then we might not want much redistribution.  But if it has a lot of curvature, then the sum of utilities could be maximized by taking more from the rich than we do currently.

So, what do you think?  I invite your comments.

The recent weather extremes over much of the US have created a flood of articles about the link between these heat waves and climate change. Here is one example. For other examples, just go to Google news and search for “heat wave climate change”. Or you can just keep reading this blog post.

Are these recent events being caused by climate change? The answer is “maybe”. Certainly, climate change is predicted to increase the number of heat waves. But attributing a particular event to climate change is very difficult, even when the event is as extreme as the heat waves of the last two weeks. Of course, if such events are more likely under the “climate change” scenario than under the “no climate change” scenario, we should reasonably think that climate change is more likely than not. But because such heat waves are possible during the “no climate change” scenario as well, we cannot rule out that these temperatures would have occurred even if climate change were not a possibility. So all we can do is make statements like, “There’s an 80% chance that the heat wave was due to climate change, and a 20% chance that it was part of natural fluctuations.” (like this guy).

What should we do in light of this uncertainty? Pay attention to the science and the scientists rather than the weather fluctuations. 97% of scientists agree that climate change is real and caused by humans (see this paper for details). Given the high degree of consensus and the time it takes to for carbon dioxide to dissipate in the atmosphere, we shouldn’t wait until we’re sure that we’re experiencing the predicted effects of climate change firsthand. As evidenced by the deaths and misery in the past weeks (see this article for more), extreme weather still has the power to kill, even in developed nations. Trying to figure out a cost-effective way to address climate change is what we should focus our efforts on (more on that in a later post).

In 2010, U.S. researchers conducted experiments on 1,134,693 animals – including 71,317 nonhuman primates – according to U.S. Department of Agriculture data collected in compliance with the Animal Welfare Act (source).  Almost 100,000 of those animals were subjected to experiments in which researchers intentionally inflicted pain and did not administer pain relief.  These data exclude experiments conducted on birds, mice, and rats because they do not fall under the definition of “animal” used in the AWA (source), and thus the real number of animals under experimentation in the U.S. could be in the tens of millions per year.

What, if anything, does society gain from these experiments on animals?  The statistics say not much.

Many argue that animal experimentation is most useful in pharmaceutical research and vital to new drug development.  However, a Food and Drug Administration (FDA) study found that “92 out of every 100 drugs that successfully pass animal trials and go into human clinical testing fail during the human clinical trial phase (source/source).”   That is a lot of animal suffering for less than a 10% success rate on humans.

Question: What about the drugs that do not pass the animal testing and thus “save” humans from harm?  Answer: With such a dismal record of prediction in one direction (success on animals to success on humans), what makes us confident of our predictive powers in the other direction (failure on animals to failure on humans)?  Of course, we do not have statistics on this counterfactual and thus will never know.  Indeed, it is possible that the miracle cure for cancer in humans failed trials with mice and thus was not tested on humans.

It seems clear that pharmaceutical companies and the FDA are reluctant to drop animal testing for one important reason: liability.  They want to be able to say ‘look, we tried it on animals’ if something goes wrong in the human testing phase.  However, even after all that testing on animal, and then on humans, the FDA still has to recall from market hundreds and sometimes thousands of drugs per year (source).  Stop experimenting on animals now, it only causes suffering for them and humans do not see much benefit – if any at all.

Environmental Policy Update:  Many contributors on this blog have written about climate change policy.  With the Supreme Court’s health care ruling yesterday, I thought this piece of news might fall under the radar.  On Tuesday, a federal appeals court rejected multiple challenges to new U.S. Environmental Protection Agency (EPA) rules that would reduce greenhouse gas emissions at large sources, such as power plants and large factories.  Michael Gerrard, director of the Center for Climate Change Law at Columbia University, said the decision was exceeded in importance only by the Supreme Court ruling five years ago that greenhouse gases could be controlled as air pollutants (source).

Hot off the Internet, the Supreme Court has upheld the “Obamacare” individual mandate, which requires most people to buy health insurance or else pay a tax.  The ruling isn’t available yet, but I have to say that I’m really, really impressed by this decision because it shows that the Supreme Court was able to look beyond the politics of the situation and the poor argument by the administration in defense of the bill, and rule according to the law.

The argument against the mandate was that it violated the Commerce Clause of the Constitution in that it regulated economic “inactivity” rather than activity.  That is, it forced people to participate in the individual insurance market even if they didn’t want to.  The administration flubbed its defense on this point by failing to show how health insurance markets are different than most other markets, giving the Supreme Court a limiting principle that would prohibit the ruling from establishing that Congress can regulate anything it wants.

It sounds like the Supreme Court did not buy the argument that the indivual mandate was justified under the Commerce Clause.  But, in some sense this is all a red herring.  The individual mandate is a tax, plain and simple.  People who do not buy health insurance must pay a fine to the IRS.  A fine paid to the IRS is a tax.  The Democrats and the administration tried to hide the fact that this was a tax while rallying support for the bill for obvious reasons.  Nobody wanted to be seen as raising taxes, and President Obama had promised during the campaign that he would not raise taxes for middle income Americans.  But, just because the Democrats wanted to pretend that this wasn’t a tax, that doesn’t make it true.  It’s a tax. And, Congress has the right to impose taxes.

Despite the fact that the administration did not emphasize the tax aspect of PPACA’s indivual mandate in either its presetation of the bill to the public or in its defense before the Supreme Court, the Court was able to step beyond the narrative that was being fed to them and identify the key legal principle involved.

Whether you support the bill or not, I think that in a post Bush v. Gore / Citizens United world, when people are wondering whether the Supreme Court really is an impartial arbiter of the law, you have to see this as a great moment for the Court.  Hooray for them.

More after I have a chance to look at the ruling.

Today’s Wall Street Journal carried a piece called “Should Tenure for College Professors Be Abolished?”  It pitted two individuals with strongly held views against each other on the issue.  As so often happens when people are advocating rather than analyzing, both sides selectively examined the issue.

In favor of abolishing tenure, the WSJ featured Naomi Schaefer Riley, a critic of the tenure system who appears to believe that teaching is the only worthwhile activity in which academics engage.  It was a bit ironic for me to read this on a day in which I am sitting at an academic conference on consumer financial decision-making in Boulder, exchanging ideas with some of the nation’s top scholars from a diverse set of fields (including law, economics, marketing, psychology, law and public policy) regarding new research that is both widely read and enormously impactful in the real world.  As but one example, the conference was kicked off yesterday by Shlomo Benartzi at UCLA, who reminded audience members how academic research led to a revolution in retirement policy in the U.S., improving the retirement security of millions of Americans by increasing participation and contribution rates to 401(k) plans by leveraging the insights of psychology and behavioral economics.  Apparently, Ms. Riley does not believe that such activities add much value and that we academics should just stay on campus and teach.

Defending the tenure system was Dr. Cary Nelson, an English professor at my own academic institution (the University of Illinois) and President of the American Association of University Professors.  Dr. Nelson seems to believe that tenure is “the ultimate quality check” and that academic freedom would crumble if people were not granted lifetime tenure.  I am unaware of any compelling evidence supporting such claims, although I cannot refute them either.

As an economist, I think that both authors – neither of whom I found particularly persuasive – missed an obvious way to frame this issue.  Namely, tenure is a form of insurance.  And like any insurance, it has both positive and negative effects.  Here are a few:

1. Tenure reduces the cost of hiring faculty.  Tenure – insurance against job loss – is highly valuable, and therefore substitutes for other forms of compensation. In a competitive labor market (and, contrary to what many non-academics believe, the market for faculty is extremely competitive), tenure means that institutions do not have to pay faculty as much in the form of cash or benefits.  If we abolish tenure, the new market equilibrium would result in higher average salaries, thus further increasing the cost of education.
2. Tenure creates moral hazard:  Moral hazard is the well-established phenomenon that people behave differently when they have insurance than when they do not.  Because tenure provides insurance against the loss of a job  – in spite of Dr. Nelson’s protests to the contrary – tenure can have the effect of making some faculty members reduce effort.

To be clear, I honestly do not believe this reduction in effort is the case with the vast majority of the tenured faculty members that I know – in fact, most of us lament the fact that, post-tenure, our work hours and the demands on our time increase.  Indeed, I think the selection effect is huge – gaining tenure is so difficult at the top institutions that the only people who make it are, by their nature, extremely driven individuals.  Most of these people do not shut-down after tenure – it is simply not in their DNA.  So, one way to view the tenure process is that it creates enormously strong incentives to excel for during the probationary, pre-tenure period (that typically lasts anywhere from 6-10 years).  This is not all that different from many partnerships – law firms, accounting firms, etc. – that work their junior associates to the bone in exchange for eventually becoming a partner.  I am not suggesting that partners have indefinite tenure, only that the incentive effects early in one’s career make untenured assistant professors some of the hardest working people I have ever met.

However, although it is the exception rather than the norm, all of us in the academy know members of the faculty – thankfully, far fewer in numbers than most non-academics imagine – that take advantage of their protected status by slacking.  Their research productivity declines, they spend less time preparing for classes, and they are less engaged in their departments and professions.  This “dead wood” – while not exceedingly common – is exceedingly costly when it occurs.  Most of us in universities would love to rid ourselves of this problem.

I may be in a minority of faculty, but I would personally not mind having a conversation about abolishing tenure and replacing it with a system of, say, 5-year renewable contracts, but not for the naïve and misguided reasons that Ms. Riley states.  Rather, I believe that for the highly productive among us, our salaries would increase and we would have an effective tool for eliminating the deadwood in our ranks.

Granted, the “tenure as insurance” framework is far from the only set of factors that ought to be considered.  Some of the issues raised by Ms. Riley and Dr. Nelson – how tenure affects risk-taking, teaching quality, and so forth – are incredibly important considerations.  It would just be nice to have some solid empirical evidence on the size and direction of these effects before taking a final stand on the issue.  Until I see it, I am going to head back downstairs to the behavioral decision-making context to see some of the research that I honestly believe is going to help improve lives.

Cigarettes are heavily regulated in America. Federal and state cigarette taxes account for 44% of the retail price of cigarettes (Tax Burden on Tobacco 2011). This percentage is even higher if one accounts for local taxes like New York City’s $1.50 per-pack tax. (A pack of cigarettes retails for $6.01 on average.) Many local and state governments have also banned smoking in bars, restaurants, and workplaces.

Some libertarians oppose these taxes and regulations. They argue that consumers should have the freedom to make their own choices without interference from the government. Many public health officials oppose this viewpoint in the case of cigarettes. They argue that many consumers do not properly account for the negative future consequences of their smoking behavior, which causes them to consume too many cigarettes. In addition, second-hand smoke is a negative externality that annoys and potentially harms others. Finally, cigarettes may raise the cost of government healthcare systems like Medicaid and Medicare. These are all important points, but today I will focus on the last one.

Calculating the costs that a smoker imposes on society is difficult because we do not know for certain what would have happened if she were not a smoker. For example, smokers who die from lung cancer impose large costs on Medicaid and Medicare. However, if those individuals had never begun smoking then they may still have imposed costs on government healthcare systems by contracting a different disease such as Alzheimer’s. The analysis becomes further complicated if we try to account for the fact that smokers die about seven years earlier than non-smokers and thus tend to collect fewer social security payments. This is a morbid observation but it must be accounted for in order to estimate properly the effect of smoking on government spending.

These issues are addressed in a recent report from the Congressional Budget Office (CBO) that analyzes the effect of a hypothetical cigarette tax increase on the federal budget. The main effect is a large increase in excise tax receipts: a total of $38 billion within the first ten years. Because an increase in the cigarette tax decreases the smoking rate, and thus increases the health of the population, the researchers at the CBO also account for the tax’s effects on Medicaid, Medicare, and Social Security spending. They estimate that total government spending would decrease in the short run, mostly due to Medicaid savings resulting from better health among pregnant women and young children.

In the long run, however, the report estimates that the increase in longevity due to less smoking will cause a nontrivial increase in annual government spending equal to 0.012 percent of GDP ($1.8 billion using 2012 GDP) by 2085. The CBO’s finding that a reduction in smoking would actually increase spending on Medicare and Social Security is consistent with economist Kip Viscusi’s finding that smoking does not have negative financial externalities. The annual excise tax receipts are estimated to equal 0.018 percent of GDP ($2.7 billion using 2012 GDP), however, so the proposed tax is beneficial overall for the government’s budget.

Although it does not appear that cigarette smoking creates negative financial externalities for the government, there may be other reasons (mentioned above) to tax and regulate smoking. Regardless, Americans have largely accepted cigarette taxes and smoking regulations and thus these are likely to remain in place.

The issue of whether and how to best regulate consumer health, however, will continue to resurface for other products. For example, Mayor Bloomberg’s recent proposal to ban sugary drinks in containers larger than 16 ounces is justified by many on the grounds that consumers lack self control when making dining decisions and that obesity imposes costs on the government. (Sound familiar?) Sugary drinks, of course, are not the same product as cigarettes. There is no such thing as “second-hand drink” and the health effects of drinking soda every day are not as well known as the effects of smoking every day; quantifying the effect of a sugary drink ban on the government budget is therefore difficult. I expect we will see more research (and more debate!) on this topic in the future.

Despite being in a Department of Finance, my own background and research is in economics and public policy (hence the “Center for Business and Public Policy” in our department).  I don’t claim expertise in finance, per se.   On the other hand, it seems that both sides of the JP Morgan debate are using discussion of the Volcker Rule and their other financial expertise to obscure the basic logic of government bank regulation.  It is a basic logic of incentives, which does not require expertise in finance!

JP Morgan wants to make money; we can hardly blame them for that.  In economics generally, we let companies try to make money, as they have the expertise in their own line of business to determine the risk-reward tradeoff.  If they lose money, then they lose money.  They might even be able to buy various kinds of insurance – that’s between the company and their insurer.  A person or company with insurance might have incentive to undertake riskier activities, since any gains are retained, while losses go to the insurer.  But the insurance company might enter the deal willingly, to charge premiums, especially if it can require the company or person to limit some of their riskier activities.  Your auto insurance has co-insurance and deductibles, to make you pay at least part of a loss and to restore some of your incentive for precaution.  

But when a bank becomes “too big to fail”, the U.S. government is thrown into the role of insurer, without being able to collect premiums, co-insurance, or deductibles.  It is not a “deal” between the bank and their insurer, because the government has no choice.  Because of financial contagion, a single major bank failure could bring down the whole system and cause horrific recession.

Given that the bank’s biggest losses must be covered by their insurer (the U.S. government), the bank has more incentive to undertake even riskier activities: they get any profits, and they don’t suffer the worst losses.   Any private insurer would require the bank to limit their riskiest activities, in order to be willing to sell that insurance.  But the government is the insurer by default, with no private “deal” allowing the government to require limits on the riskiest activities in order to be willing to offer that insurance.

To be sure, the bank still must be careful about some risks, as many different kinds of losses would reduce their profits without requiring government bailout.  The recent JP Morgan case did not create danger of bankruptcy or bailout, because their $2 billion loss on that one operation only offset part of their positive profits!  But any bank that is “too big to fail” has less incentive to avoid the really big losses that could cause bankruptcy, because that would require the government to bail them out.

The government could pass laws and regulations to limit the banks’ riskiest activities, and that is the purpose of the much discussed Volcker Rule.  I will leave the discussion of the details to the experts in finance.  For example, the Volcker Rule may or may not be the best way to regulate banks.  The effects depend a lot on the rule’s design, implementation, and enforcement!  Maybe some other rule or incentive-management would be better.  I will leave those details to the experts.  Instead, the point here is just the simple logic that the government is not a private insurer who would require limitations on risky activity to be willing to sell insurance.  The government must provide insurance, so they must have some kind of regulation to limit banks’ risky activities: higher capitalization requirement, Volcker rule, or other regulations.   

I did in fact talk to some of the finance department’s experts, like Jeff Brown and George Pennacchi.  George notes that “the incentive to take big risks declines as a bank finances itself with more shareholders’ equity (capital), and in JPMorgan’s defense they are one of the most highly capitalized banks, which helped them survive the crisis.”  He adds that “If banks carry government deposit insurance, whether explicit or implicit due to Too-Big-to-Fail, then the government should limit their activities to protect taxpayers from losses.”  Moreover, “it is noteworthy that, prior to the establishment of deposit insurance in 1933, banks had much greater capital (financing via shareholders’ equity) and made much less risky loans. … Indeed, there are several recent “narrow bank” proposals to greatly limit the activities of banks that issue insured deposits.”  He has a review of the topic on his website (forthcoming in the Annual Review of Financial Economics).

The bottom line is that in a private deal between a bank and its insurance company, the bank would have to agree to limit risky activity in exchange for being able to buy this insurance.  With government as insurer, they get the insurance regardless.  So just look at their incentives!  The banks have incentive to make money, and so they have incentive to take more risks since they can keep any profits and not cover the biggest losses.  AND they have incentive to lobby Congress to avoid government regulations.  We switch from a private market “deal” to the world of politics!  If they can get Congress to limit regulation of banks, they can make riskier investments, make more money, and not have to cover the biggest losses.

So just think about those incentives, next time you hear a bank executive use the jargon of financial expertise to make the case against “unfair interference by government regulators into the private market”.