The Peltzman effect and banking regulation

I like to tell people that I prefer taxis where the driver is not wearing a seatbelt. This mostly confuses people – at least non-economists – because the general perception is that people who do not wear seatbelts are more “irresponsible”.

However, if you know about the so-called Peltzman effect you would not be surprised by my preference of “irresponsible” taxi drivers. The Peltzman effect is named after Chicago economist Sam Peltzman.

In a very controversial article - “The Effects of Automobile Safety Regulation” – in the Journal of Political Economy from 1975 Peltzman showed that contrary to what should have expected the introduction of seat belt laws in the US did not reduce the total number death accidents in traffic.

Here Russ Robert (in a blog post from 2006) explains Peltzman’s results:

“Peltzman argued that mandatory safety devices such as seat belts reduced the probability of harm to the driver if the car crashed. That in turn would encourage people to drive more recklessly. The effect on the number of deaths was an empirical question. Which effect would be larger—the harm from the increase in the number of accidents or the reduction in harm when an accident occurred?

Holding other factors constant that might change the number of accidents (and this is never easy but he did the best he could with the data at hand), Sam found that mandatory seat belts did indeed cause more accidents. But this effect was roughly the same as the effect in the opposite direction, that accidents were less harmful. So the net number of fatalities of drivers was unaffected by the law. Sam found some evidence that the effect of the law might be to reduce driver fatalities. Unfortunately, because drivers were more reckless, there were more accidents involving pedestrians and cyclists. So their death rate due to cars increased. Total deaths were unchanged.”

It is obviously that such considerations are not only relevant for road safety. In fact we should be aware of Peltzman effects in all forms of regulation. And that particularly seems to be the case for financial regulation.

Hence, what does it for example mean when we introduce deposit insurance schemes to reduce to reduce “risks” in the financial sector. Well, following the logic of the Peltzman effect deposit insurance might reduce of bank runs (“drivers being killed”), but it will also make both bank owners and depositors take bigger risks. In fact depositors would tend to prefer more risky banks because the downside is limited by the deposit insurance if the bank collapses while banks, which take larger risks will be able to pay higher interest rates on deposits.

This would also mean that the introduction of deposit insurance schemes is likely to lower the amount of capital banks chose to hold. This is exactly what Sam Peltzman is arguing a great lecture from 2011, which I stumbled upon while searching YouTube for stuff on the Peltzman effect. Take a look here. Peltzman’s account of the development in banking regulation in the US since the Great Depression is fascinating stuff.

Peltzman spelled out similar argues in his 1970 article “Capital Investment in Commercial Banking and Its Relation to Portfolio Regulation” (also from the Journal of Political Economy), in which he also demonstrates that capital ratio did indeed drop significantly in the US after the introduction of deposit insurance.

Anybody who doubt that such a Peltzman effect exists in financial regulation should study how the Icelandic banks prior to the Icelandic collapse in 2008 set-up internet based bank in countries with generous deposit insurance schemes.

PS Gordon Tulluck came up with what I believe is the best safety device for cars – a spike attached to the steering wheel (I got this example from David Friedman’s fantastic book “Hidden Order”.)

PPS I should stress that just because deposit insurance likely leads to more risk taking and lower capital ratio it still could be desirable regulation and proponents of deposit insurance will undoubtedly point to the fact that deposit insurance led to sharp drop in bank run episodes in the US after it was introduced in 1930s. Hence, it is a trade-off, which policy makers have to be aware of.

HT Blake Johnson

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Economics is not an education. Economics is a state of the mind!

Some of the most clever economists I have encountered are actually not formally educated economists. In fact a number of Nobel Prize winners in Economics are not formally educated economists. One of my big heroes David Friedman is not formally educated as an economist, but to me he is certainly an economist – one of the greatest around. Another example is Gordon Tullock  who was trained as a lawyer, but he is certainly an economist – in fact to me Gordon Tullock is one of the most clever economists of his generation and it is a complete mystery to me that he has not yet been awarded the Nobel Prize in Economics. The way I perceive people’s skills as economists has nothing to do with their formal education. To me Economics is not an education. Economics is a state of mind.

Therefore, you can easily be an economist without having a formal education as an economist. As a consequence there are also people who have been able to attain a formal title as an economist without reaching that higher state of mind that a real economist has. I have unfortunately also encountered many of this kind of “economists” – economists by title, but not in mind. Many of these people are unfortunately high ranking policy makers.

Unfortunately many universities around the world today do not educate economists to be economists. They primarily educate them in technical skills – math and econometrics. And they educate them in “soft” skills and on different applied issues. A shocking amount of formally educated economists would not be able to explain comparative advantages or marginal utility to you (don’t get me stated on monetary theory). But they might be able to tell you about VAR, ARCH or GARCH – at best. Many – especially in Europe – are just educated to become government bureaucrats.

So what is the state of mind of an real economist? If you need to have that explained you are not yet an economist, but you might still become one by trying to figuring out what Gordon Tullock and David Friedman have in common. You might also read my favourite book on the topic – James Buchanan’s What Should Economists Do? 

PS This post is dedicated to all economists without formal education in economics (I miraculously became a formally educated economist in 1995, but it was not the official curriculum at the University of Copenhagen that made me an real economist – I became that by reading Gordon Tullock and David Friedman and other real economists)

PPS Yes, it is fair enough if you call me a sectarian or a cultist when it comes to Economics as a science.

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