Many economists are advocating for regulation that would make banking“boring” and uncompetitive once again. After a crisis, it is not uncommon tohear calls to limit competition. During the Great Depression, the head of theUnited States National Recovery Administration argued that employers were beingforced to lay off workers as a result of “the murderousdoctrine of savage and wolfishcompetition, [of] dog-eat-dog and devil take the hindmost.”He appealed for a more collusive businessenvironment, with the profits made from consumers to be shared betweenemployers and workers.

Concerns about the deleterious effects ofcompetition have always existed, even among those who are not persuaded thatgovernment diktat can replace markets, or that intrinsic human goodnessis a more powerful motivator than monetary reward and punishment. Where thedebate has been most heated, however, concerns the effects of competition on incentives to innovate.

The great Austrian economist Joseph Schumpeter believed that innovationwas a much more powerful force for human betterment than was ordinary pricecompetition between firms. As a young man, Schumpeter seemed to believe thatmonopolies deaden the incentive to innovate –especially to innovate radically. Simply put, a monopolist does not like tolose his existing monopoly profits by undertaking innovation that would cannibalize his existing business.

By contrast, if the industry were open to new players, potential entrants,with everything to gain and little to lose, would have a strong incentive tounleash the waves of “creative destruction” that Schumpeter thought soessential to human progress. In a competitive industry, only paranoid incumbents – those constantly striving forbetterment – have any hope of surviving.

As an older man, Schumpeter qualified his views to argue that some degreeof monopoly might be preferable to competition in creating stronger incentivesfor companies to innovate. The rationale is simple: If patent protection werelimited, or if it were easy for competitors to innovate around intellectualproperty, a firm in a competitive market would have very little incentive toinvest in pathbreaking research and development. After all, the firm would gainonly a temporary advantage at best. If, instead, it withheld spending, andsimply copied or worked around others’ R&D, it could survive perfectly well– and might be better off. Knowing this, no one would innovate.

But if the firm enjoyed a monopoly, it would have the incentive toundertake innovations that improved its profitability (so called “process”innovations), because it would be able to capture the resulting profits, ratherthan see them be competed away. A “boring” bank, shielded from competition andknowing that it “owns” its customers, would want to go the extra mile to helpthem, because it would get its pound of flesh from their future business.Customers can be happy even when faced by a monopoly, though they would grumble far more if they knew how much they were payingfor good service!

An analogy may be useful. A monopoly is like running on firm ground.Nothing compels you to move, but if you do, you move forward. The faster yourun, the more scenery you see – so you have some incentive to run fast.

Competition is like a treadmill. If youstand still, you get swept off. But when yourun, you can never really get ahead of the treadmilland cover new terrain – so you never run faster than the speed that is set.

So which industrial structure is better for encouraging you to run? Aseconomists are prone to say, it depends.

Perhaps one can have the best of both worlds if one starts on a treadmill,but can jump off if one runs particularly fast – the system is competitive, butthose who are particularly innovative secure some monopoly rents for a while.This is what a strong system of patent protection does.

But patents are ineffective in some industries, like finance. Theoverwhelming evidence, though, is that financial competition promotesinnovation. Much of the innovation in finance in the US and Europe came afterit was deregulated in the 1980’s – that is, after it stopped being boring.

The critics of finance, however, believe that innovation has been theproblem. Instead of Schumpeter’s “creative destruction,” bankers have engagedin destructive creation in order to gougecustomers at every opportunity while shielding themselves behind a veil ofcomplexity from the prying eyes of regulators(and even top management). Former US Federal Reserve Board Chairman PaulVolcker has argued, somewhat tongue-in-cheek, that the only useful financialinnovation in recent years has been the ATM. Hence, the critics are calling forlimits on competition to discourage innovation.

Of course, the critics are right to argue that not all innovations infinance have been useful, and that some have been downright destructive. By andlarge, however, innovations such as interest-rate swaps and junk bonds havebeen immensely beneficial, allowing a variety of firms to emerge and obtainfinance in a way that simply was not possible before.

Even mortgage-backed securities, which were at the center of the financialcrisis that erupted in 2008, have important uses in spreading home and autoownership. The problem was not with the innovation, but with how it was used –that is, with financiers’ incentives.

And competition does play a role here. Competition makes it harder to makemoney, and thus depletes the future rents (and stock prices) of theincompetent. In an ordinary industry, incompetent firms (and their employees)would be forced to exit. In the financial sector, the incompetent take on morerisk, hoping to hit the jackpot, even while theregulator protects them by deeming them too systemically important to fail.

Instead of abandoning competition and giving banks protected monopolies onceagain, the public would be better served by making it easier to close bankswhen they get into trouble. Instead of making banking boring, let us make it anormal industry, susceptible to destruction in the face of creativity.