Some people are offended if you say “happy holidays” and others are offended if you say “merry Christmas.” Some people are offended if you are offended by one greeting or another, and some people are offended by efforts to explain why some people are offended when other people are offended by one greeting or the other. Makes one’s head spin. So let’s change the subject.

Megan McArdle disagrees with “a very common” point I made in an earlier post: that banking regulation is necessary because of moral hazard that results from deposit insurance (both formal FDIC insurance and the informal insurance where authorities end up compensating creditors not covered by the FDIC program). Yes, it’s a very common point, but it turns out to be wrong, she says:

Almost everything in the world has negative and/or positive externalities. But despite this, we do not intervene to subsidize everything with good negative externalities, or punish everything with bad. That's because things with substantial negative externalities often contain sufficient punishment to deter the individual; likewise, things with positive externalities often carry enough reward to produce a socially optimal amount. For example, if I am a bus driver, the negative externality of my suddenly jerking the steering wheel to the left and driving the bus off a cliff is much higher than the cost to me--many lives against my one. But my own life is very valuable to me. The threat of its loss is enough to deter such behavior 99.9999% of the time.

The problem with this example is that in the real world the bus driver has a continuous range of options as to how much care to take. Suppose, for example, that he slept badly the night before and knows that he will not be able to drive very attentively. He may well decide to drive even though he would not if he fully internalized the risk of harm to the passengers. We have all done this, and all kinds of laws and regulations, with the tort system as an overall backstop, attempt to deter people from acting in this way. McArdle continues:

Bankers take risk in order to make money, and they control risk in order to avoid losses. But the losses they are most interested in are not to their shareholders. Rather, they are worried about the loss of their jobs. As long as the bank regulators fire any managers who put the bank in receivership, I can see no difference between an unregulated private system without deposit insurance, and a system with. That isn't to say that there is enough regulation in either situation. But if there is a problem, it is that bankers have a socially less-than-optimal risk appetite, or that the punishment for driving a bank into insolvency is insufficient. The moral hazard from deposit insurance doesn't much enter into it.

In a world with bank insurance but without regulation [corrected, thx to traveler456], I would start up a Posner bank, ask you for a deposit, and then use your money to buy lottery tickets. If I win the lottery, I pay you back; if I don’t, I dissolve the bank and you go to the government for your funds. I wouldn’t bother to hide my investment strategy from you; you wouldn’t care because you would be paid in any event. I would set up hundreds of banks and give the managers a salary that they would receive if and only if they collect deposits and use them to buy lottery tickets; otherwise, they are fired. (Corporate law junkies will point out that the government will pierce the corporate veil and go after my lottery winnings, but in the real world, with thousands of shareholders and not-lottery but still risky investment schemes that unfold over decades during which dividends are paid and the money spent, that’s not so easy.) McArdle continues:

The moral hazard for depositors may be large. But I doubt it. Most depositors are not capable of determining whether a bank is faulty or sound, and they weren't in 1830, either.

This can’t be true. In the nineteenth century, elaborate efforts were made to keep track of bank risk. Merchants discounted bank notes after consulting books that compiled risk estimates. The notes of larger and more stable banks were discounted less. Since people often made payments with bank notes, they must have had a sense of how risky different banks were, and taken the risk into account when making deposits, to say nothing of common memory about which banks have stayed in business and for how long. Today, people don’t pay attention to bank risk because of deposit insurance; but people certainly think about risk when they make uninsured investments, for example, when they buy stocks or corporate bonds or, for that matter, stereos and personal computers. She concludes:

The reason that deposit insurance requires tighter regulation is that the government wants to minimize the cost to itself--not society, for whom the losses would be the same whether the government or the bank paid them. I think this is wise, for many reasons. But not because of moral hazard.

The argument here seems to be that we should distinguish the perverse incentives of depositors and of bankers. Depositors have a perverse incentive to ignore the riskiness of a bank; ironically, the government does little to counter this incentive aside from capping the insurance payout (and not very credibly). One could imagine a different system where the government tried to regulate depositors the way insurance companies normally regulate insured parties—by demanding that the insured bear some of the risk with a copayment or deductible and take other actions to minimize the potential loss.

Instead, the government goes after the banker. This would be like an insurance company trying to regulate the activity of people who impose risks on insured parties rather than on the insured parties themselves. Imagine that I have health insurance and the insurance company tries to shut down the local polluter so as to minimize its expected insurance costs. Our system of banking regulation resembles this approach.

But moral hazard is the right term. Economists use the term moral hazard to refer to the perverse incentives that arise when a principal pays an agent to act in a certain way that benefits the principal where the agent would rather act differently, but cannot observe the agent’s action, so the agent acts in a way that ends up hurting the principal relative to a baseline of optimal behavior. There are various ways of mitigating moral hazard: one is to share risks, but another is to confine the agent’s choice set. That is what government banking regulation does. It reduces moral hazard by depriving insured depositors of the option of investing in a risky bank, which would presumably offer a high interest rate or other advantages.

“Happy Holidays” irritates Eugene. He says that the generic quality of the greeting gets under his skin; “Merry Christmas” is fine with him. But why should the generic quality of a greeting bother him? What could be more generic than “Hello”? But I bet that “Hello” does not bother Eugene.

I suspect that what annoys Eugene is that the person who says “Happy Holidays” to him is afraid of offending him. The person knows or suspects that Eugene is Jewish and worries that “Merry Christmas” would offend a Jew. Odd to think that you can irritate a person by trying not to offend him! But the key here is the presumption that Eugene is religious and, more to the point, thin-skinned about his religion. The person who says “Happy Holidays” to Eugene reveals that he believes that Eugene is thin-skinned and priggish and presumes that Eugene is religious when Eugene in fact is a relaxed and good-natured fellow and not religious at all (or so I assume). No wonder Eugene is annoyed.

The problem for the interlocutor who perhaps does not know Eugene well is that some people would be offended by “Merry Christmas.” That greeting also presumes a great deal—namely, that the addressee is Christian or relaxed about religion or thinks of Christmas as a secular holiday. When that presumption turns out to be wrong, offense occurs. There is no doubt that “Happy Holidays” is a lower risk greeting than “Merry Christmas. The flight to generality occurs when people know each other less well and thus know less about their religious views and overall temperament. All in all, “Happy Holidays” is less presumptuous than “Merry Christmas;” so why does it annoy Eugene?

The answer is that more generic greetings (and other practices such as gift-giving) reflect social distance (as Eugene, says a way to "play it safe"); generic greetings should really only annoy when they are conveyed by people who are close to us. If a person who celebrates Christmas receives a greeting of “Happy Holidays” from his spouse or child or friends, the greeting would seem a bit chilly, and one would suspect that something is wrong. And if you celebrate and care about Christmas, a hearty “Merry Christmas” from a stranger sounds warmer than “Happy Holidays” because, it turns out, the stranger has something more in common with you than the stranger who says “Happy Holidays.” The stranger is engaging in a high-risk, high-return strategy; a generic “Happy Holidays” is less likely to offend a non-Christian even if it sounds chilly.

Eugene might have had in mind someone who knew him well when complaining about “Happy Holidays,” perhaps a colleague or student. Otherwise, he’s being a bit hard on people. Or perhaps he is annoyed by the general tendency for people to adopt increasingly bland and, sometimes, euphemistic terms in order to avoid the risk of offense in all circumstances. The fear of giving offense—especially to ethnic and religious minorities, and people who do poorly for various reasons (uneducated, lower class, disabled, and so forth)—is ubiquitous in our society, but we should be used to it by now. Social distance is the price we pay for diversity. We avoid excluding some people by being remote to everyone.

This term cropped up on in a recent NYT article which blames the financial crisis on Bush administration policies, including its advocacy of an ownership society. The article goes too far: the financial crisis is the result of bipartisan regulatory decisions going back decades and the Fed’s easy money policies—and it is important to understand that financial crises will almost certainly occur even when government regulators do everything right. They are like hurricanes: we can blame the government for failing to build strong levees but not for failing to stop the hurricane from forming over the Atlantic ocean. If the hurricane is bad enough, even strong levees will do no good. (A lot of people also blame market actors but that does not make much sense. People act rationally or greedily or stupidly, as they always have, and blaming them for the financial crisis is just another way of arguing that government regulation was inadequate. Might as well blame hurricanes for destroying cities.)

But what is the “ownership society,” anyway? It is a political slogan that the Bush administration apparently first used in 2003 to refer to three of its policy goals: (1) privatization of Social Security; (2) the creation of private health care accounts; and (3) subsidization of home ownership. The underlying theme is that it is better if people own than if they do not own, but what does this mean? Ownership compared to what?

The Social Security example suggests one interpretation: ownership compared to government sponsorship. In one scenario, people earn wages, a portion of their paycheck goes to the government, and then, much later, they receive money back from the government. They don’t own anything, though they might have a reasonable expectation that the government will eventually pay something that bears some relationship to the payroll tax. In the ownership scenario, the sum of money that would otherwise be used for Social Security can be invested in securities. Note an odd feature, from a market or libertarian perspective: people don’t have true ownership rights in their labor; they are obligated to put a portion of the return on their labor into an account. Their “ownership” of securities in that account therefore does not reflect a commitment to a free market in some pure sense. What is true is that risk and return is increased, which is a normal feature of ownership. If you invest unwisely, or wisely but unluckily, you will end up impoverished when it comes time to retire. As a result, people have strong incentives to think about retirement, and to inform themselves about financial instruments and the likely future of the economy. Whatever you might think of this outcome—some people find it appealing, others do not—the odd thing is that if you like the idea of people having control over their finances rather than being dependent on the government, then you should want to do away with Social Security altogether rather than privatize it. Let people decide how much to spend and how much to save, as well as how they save their money. The ownership society in this setting boils down to the claim that we should subsidize investment and penalize consumption. If that is really the goal, why not just advocate a consumption tax and do without the ownership metaphor?

Let’s turn to home ownership. Here, the compared to what question seems to be—compared to renting an apartment or perhaps renting a government-subsidized apartment or living in public housing. If government subsidizes home mortgages, then people who would otherwise rent or live in public housing are more likely to buy their own home. Again, the effect of channeling people into ownership is to increase the risk and the payoff. If you rent an apartment, and its value appreciates, you don’t obtain the return—your landlord does. If its value declines, you aren’t hurt—your landlord is. Finance theory tells us that investments have higher payoffs when they are riskier, and this is true for owning a home just as it is true for owning a piece of stock in a business. It was also thought, as in the case of Social Security privatization, that people who own homes will end up being better citizens: they will invest more in their homes, which will improve the neighborhood and hence the home values of others; they will care more about the future and therefore they will inform themselves about politics and vote responsibly; they will join the rentier class and become Republicans.

The problem with this theory, as I noted yesterday, is that ownership does not have any intrinsic value. It is often wise to rent rather than own, as everyone understands from everyday life, and we might think that low-income people who chose to rent apartments rather than buy them knew what they were doing. Home ownership has some attractive features—you needn’t fight with your landlord, or worry that he will terminate the lease—but it is basically an enormous financial gamble that many people, particularly low-income people, shouldn’t make. Your neighborhood, for reasons outside of control, could become worse over the years; in addition, you might find that you need to move for family or employment reasons. If you are a low-income person, most of your savings will be tied up in your home, which means that you will be inadequately diversified against these future risks. These basic truths were obscured for many years because home prices tended to increase and not to collapse during recessions, but home ownership is just a kind of investment and does not enjoy immunity from the business cycle.

Home ownership policy of the Bush and Clinton administrations was, in essence, an attempt to pay low-income people to make a risky investment that they would otherwise rationally avoid. I cannot understand why anyone would think that such a policy would be sensible. In some cases, these people will do well and enjoy the upside of their investment, but in other cases they will do poorly, with the result that they will be worse off than ever.

Ilya says no; others say yes. The question is not a good one, however, because libertarianism, in any meaningful philosophical sense, hasn’t influenced financial policy in decades. One might as well ask whether the financial crisis has discredited Jeffersonian republicanism or nineteenth century rural populism.

The real question is whether the financial crisis has discredited the pro-market, deregulatory movement in a general sense, or banking deregulation in particular. Neither Weisberg nor Huffington know enough to answer this question, which is extremely complicated, and will be the subject of debate for decades. A few preliminary thoughts here:

1. Americans reject unregulated banking, as have people in every country around the world. A truly “libertarian” or free market system would lack deposit insurance and a central bank—a system that existed in the United States in the nineteenth century. Such a system is certainly possible—it did exist—and it may even be optimal in some long-term-we’ll-all-be-dead sense. But it creates extraordinary volatility that people greatly dislike. If you lend to (that is, deposit with) an unregulated bank, you might get a good interest rate, but you have no remedy if the bank becomes insolvent. This gives rise to bank runs, financial contagion, and panic. Most people simply don’t want to take the chance that the place where they park their money will vanish and take their funds with it; hence the popularity of the government guarantee. In addition, because banks borrow from each other, the collapse of one can lead to the collapse of others, drying out credit, and harming the real economy. A government backstop is and has been political bedrock for decades. The government acts as lender of last resort through a central bank, depository insurance, and the rest. No serious person rejects this system in any modern economy.

2. If you have government-supplied insurance, then you have to have government regulation of people’s financial activities. There is no way to avoid this conclusion. In a world without such regulation, banks would make excessively risk loans because they get the upside and the taxpayer bears the cost of the downside. Banks would also keep insufficient capital on hand to pay off depositors. And depositors, unlike ordinary creditors, would have no reason to investigate banks and ensure that they are operated safely. Although many people have criticized Depression era banking regulation—especially the constraints on the geographic reach of banks and the division between regular and investment banking—no serious person denies that if the government insures banks, then it must regulate them. The least controversial type of regulation is the minimum capital adequacy requirement, which obliges banks to keep a certain amount of cash or other liquid assets on hand to meet spikes in withdrawals. Unfortunately, there is nothing simple about these rules: in principle, the amount of capital kept on hand should be a function of the riskiness of the bank’s portfolio. In practice, this is hard to do. But the basic principle is undisputed.

3. Over the years, there has emerged an academic and political debate about the optimal amount of banking regulation. Again, no serious—or, at least, influential—person taking part in this debate has disputed the need for some kind of insurance or lender-of-last-resort function. And no serious person has disputed the need for restrictions on what banks and other financial institutions that benefit from insurance can and cannot do. The debate was about a matter of degree. One camp believed that existing regulation was excessive; another camp believed that existing regulation was either adequate or insufficient. The two sides converged on many issues: for example, geographical restrictions did not reduce the riskiness of banking but in fact made it harder for banks to spread risks. So both sides could agree on this type of “deregulation.”

4. The current financial crisis suggests, to the extent that one can draw inferences from one observation, that deregulation did go too far. Regulators and (probably) market actors appear to have overestimated the extent to which people could protect themselves from risk by purchasing various types of credit insurance on the market and in other ways diversifying their assets. Regulators may, alternatively or in addition, underestimated the extent to which government insurance caused people to engage in risky behavior by taking advantage of financial innovations that allowed them to evade minimum capital requirements and other regulations—on banks, insurance companies, and investment banks. If you are more heavily regulated if you own 30 years loans and less regulated if you own equivalent mortgage-backed securities, then you will sell the former and buy the latter, and take on more risk. There is certainly reason to think that some tweaking, perhaps serious tweaking, is in order. But it is tweaking nonetheless.

5. As Ilya notes, the Bush administration did contribute to the crisis, but not by promoting free market ideology or “libertarianism.” Instead, it foolishly advocated what it called an “ownership society,” one in which people would be encouraged to own homes (and health care accounts and retirement funds), through, as it turned out, artificially cheap credit, subsidies, and the like. There is no reason in the world to think it is better, in some abstract sense, to own your home than to rent it—any more than it is better to own DVDs than to rent them from Netflix. For some people, ownership is better; for others, renting is better. There was tremendous intellectual confusion here: there is a difference between helping the poor (for example, by giving them money) and rearranging the legal relationship between them and the goods and services they use (for example, paying them to own rather than rent). The main effect of this policy was to subject lower-income people to more risk—of the upside, to be sure, but also of the downside. When the housing bubble pops, and the economy tumbles into recession, any serious commitment to the idea of ownership requires that our new owners suffer their losses. But the Bush administration could not sustain the harsh implications of its philosophy, especially because it was complicit in encouraging people to take on risk who might otherwise have been more cautious.

The Bush administration pursued a two-track policy, then, one that both cut back on financial regulation and channeled financial activity toward the housing sector. The latter most definitely contributed to the financial crisis, though it is unclear how much. The former may well have but this question is even more difficult. Deregulation may have been hasty or ill-considered; that is not the same thing as saying that it could have been done better, and that therefore the lesson of the financial crisis is not that deregulation is bad but that the particular deregulatory approach of the Bush administration (and Congress, and the Clinton administration, etc.) was poorly thought out—a point that could be made about the deregulation of the S&L industry in the 1980s, which was also poorly thought out and disastrous as a result, and yet the more-or-less elimination of that sector was sensible. Deregulation may also have gone too far, which is not the same as saying that some degree of deregulation was sensible—a position that is held by most economists.

6. The moral of this story is that we live in a society with a highly regulated financial sector. It will remain highly regulated in the future, and the difficult problem now is to determine what the optimal type and level of regulation is. This is mostly a technocratic question that rests atop a rough social consensus that the government should trade off risk/volatility and growth. True libertarianism has made no headway against this consensus; it remains as irrelevant today as it has been since the 1930s.