Public Banking Hurts Economic

Mark A. Calabria, a former senior aide to the Senate Committee on Banking, Housing and Urban Development, is the director of financial regulation studies at the Cato Institute.

October 1, 2013

After the financial crisis, it is natural to look for alternatives to our current system. We’d be irresponsible if we didn’t. And although it may sound like an attractive alternative, direct government ownership would actually be worse than our currently flawed system.

Before we turn to theoretical concerns, we can look at concrete ones: what actually happens when the government owns banks. The most comprehensive study finds “that higher government ownership of banks is associated with slower subsequent development of the financial system, lower economic growth, and, in particular, lower growth of productivity.” Keep in mind that productivity is ultimately what drives wage growth. This research has been extended in a recent paper that attributes much of the worse outcomes to political interference in bank lending decisions.

What the American banking system needs is market discipline, which means letting banks fail.

When the government owns the banks, lending decisions become increasingly driven by politics, rather than economics. Resources flow to those with influence. Government-owned banks also tend to under-price risk in order to buy votes. If there is one lesson we should take away from the recent crisis, it is that when you intentionally under-price risk, bad things happen.

Some might point to the Bank of North Dakota, currently the only state-run and state-owned American bank. Of course that ignores that in the 1800s there were a number of state-owned U.S. banks. They all failed miserably, and at great expense to the taxpayer. They were also magnets for corruption. But that’s history. Currently the Bank of North Dakota is generally a well-run institution. It is also a massive subsidy to the fossil fuel industry. One need only look at its annual reports to see that the bulk of its below-market lending has been to the fossil fuel industry. It’s a case in point, illustrating that government-owned banks will tend to subsidize the powerful.

Contrary to the conventional wisdom, the problem with American banking is too much government influence rather than not enough. Our banks are massively regulated and have been so for almost all of American history. Rather than more of the same, we should maybe try something new, like competition and market discipline – which requires letting banks fail.