Wednesday, October 22, 2008

It's A Wonderful Life...Or Is It?

For the past 10 days, I've been reading and rereading this piece that appeared in the October 12 edition of The Washington Post. It caught my eye because it featured a large image from the Capra film It's a Wonderful Life. The photo had Jimmy Stewart's George Bailey lecturing Lionel Barrymore's Mr. Potter.

As economic and financial educators, we know and often use a different scene from that movie that features a run on Bailey's savings & loan, and his subsequent explanation of how a bank works. It's a sound, basic description of the process of changing short-term liabilities (deposits) into long-term assets (loans), and the potential problem with the mismatch.

The article in The Post attempts to lay the current financial problem
at the door of George Bailey's establishment. Easy credit for less deserving borrowers trying to grab hold of the American dream. Put that way, you may be tempted to cede the point. I've made it myself. However, one thing is missing in this analogy - a bit of institutional history.

The rule book now is different than the rule book facing Mr. Bailey and Mr. Potter. At the time Capra's film was made, both types of financial institution were tightly regulated as to rates they could pay depositors, types of loans they could make, and who held the loans. And as has been pointed out in numerous places, the establishment of agencies to subsidize and/or guarantee mortgages established different incentives for numerous parties up and down the financial line. But the tightly regulated market of the 1940s is different than the market of today. A post on this blog from last week listed a number of laws that helped change the rulebook for financial institutions. And those laws further changed the incentives and changed the market.

I agree with Ross Douthat that providing incentives for loans to riskier borrowers was a contributing factor to the current situation. But there are other parties who played a role. In each case, we need to remember a basic axiom in conomics: "People respond predictably to incentives." If a system is established that rewards risk-taking, either by borrower, lender, investor, regulator or politician; we shouldn't be surprised when the risk is taken. But we also need to remember that risk has an upside and a downside. And to that end, we may need to let things fail as well as succeed.

In conclusion, let me get back to the idea of using It's a Wonderful
in the classroom. While many of us use the "run" scene in class, it may be worth our time to use the clip of George Bailey confronting Mr. Potter and some other businessmen about home ownership, "Doesn't it make them better citizens? Doesn't it make them better customers?" I think there are still people out there; trying to meet their obligations on loans they took out just before the top. The fact that they are trying to make those loans work and keep their homes would seem to answer "yes."

I look forward to your comments.

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