Alford: Why Dismantling Too Big To Fail Firms Makes Economic Sense

[Joanne98]

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

Economists have joined the debate about the merits of requiring the downsizing of too big to fail (”TBTF”) financial firms. However, these debates have almost been devoid of theoretically based economic arguments.

Some economic analysts have argued that the TBTF institutions have captured and will manipulate the relevant regulatory and political structures to their advantage. This a political argument and economists as economists do not have any greater insight into the political dimension of issues than Joe and Mary Sixpack. Other economists have decried the TBTF institutions and their contribution to a further skewing of the distributions of income and wealth. Again, economists as economists have no greater insight in to issues of economic fairness than the next person.

With the exception of citing moral hazard incentives to greater risk taking, economists speaking as economists have been virtually silent about the fact that TBTF (and wanted-to-be-TBTF) firms were the center of a process of designing, underwriting, and issuing a variety of structured capital market products that contributed not only to redistributions of wealth in their favor, but (and more importantly to economists as economists) also contributed to the misallocation of resources on a massive scale. And the efficient allocation of resources is the sine qua non of economics.

This post outlines one line of economic reasoning that leads to the conclusion that TBTF financial firms should be dismantled on the grounds that the highly concentrated financial sector can give rise to informational asymmetries, the mispricing of risk and the misallocation of capital and other resources.
It is not a general theory of the recent crisis, but an argument suggesting that in financial markets dominated by a few large firms, those firms will be in a position to exploit informational asymmetries and enrich themselves even as their excess profits are dwarfed by the costs to society of the misallocated resources.

Informational Asymmetries
http://www.nakedcapitalism.com/2010/04/alford-why-dismantling-too-big-to-fail-firms-makes-economic-sense.html