The Regulators’ Dilemma

Listening to the chatter about the economy, one could be excused from concluding that the problem is that Americans both do not save enough and do not consume enough. While we are taken to task for our low savings rate, arguments rage about how much of a tax rebate will be spent and, therefore, “stimulate” the economy. The politicians hope rebates will be spent, and the personal finance columnists urge that individuals use them to increase savings or pay down debt.

Remember the discussion of the “paradox of thrift” and the “fallacy of composition” in the Samuelson economics textbook that used to have a near monopoly for introductory economics courses. If each person acts in his best interest, this may not always serve the common good, it was argued. An example is everyone standing up to watch a critical play at a sporting event.

These concepts can be imported to the current banking situation. While part of the blame for the current financial crisis is ascribed to banks for lowering their credit standards and making risky loans, the banks are now being urged to make more loans. From the point of view of any particular bank, however, lending has gotten riskier given the state of the economy. Hence, having been burned on some of the loans and investments they made when times were good, they are understandably cautious in their lending activities now. The economy, though, could benefit from increased lending, thus serving to lower the overall default rate.

Given this, what is the federal government and the numerous regulators of banks supposed to do? Should they crack down on lending practices to make sure their charges do not get into further trouble, or should they somehow encourage increased lending? This dilemma may have been avoided if the regulators had been tougher when times were good, but then most people thought things would never get this bad.