Welcome to our new video series titled "New Economic Thinking." The series will feature dozens of conversations with leading economists on the most important issues facing economics and the global economy today.
Rarely in America’s history have Congress and the White House had the fortitude to impose on American bankers and financiers a set of regulations sufficiently stringent to prevent them from pushing us into destructive panics and recessions. And as Simon Johnson has forcefully noted in his book, Thirteen Bankers: The Wall Street Takeover and the Next Financial Meltdown, we are well on the way to making the same mistakes again.
Commercial bank capital requirements during the height of the bubbles were absurdly low and the capital requirements for investment banks, Fannie and Freddie, sellers of CDS protection, monoline insurers, and mortgage banks were farcical. The capital requirements for U.S. primary dealers and the largest commercial banks were reduced sharply during the expansion phase of the bubble. The reduction in the capital requirements for Europe’s largest commercial banks was far more severe than in the United States, so we had the equivalent of a regulatory race to the bottom during much of the past 15-20 years.
Markets, as the events post the Lehman bankruptcy have illustrated, are not self-correcting. Left to their own devices, bankers at the biggest institutions can’t seem to stop themselves from speculating with borrowed money until they inevitably crash the system.
Even though governments around the world today are much more involved in the economy than was the case in the period preceding the Great Depression (which has allowed debt-deflation tendencies to be short-circuited more readily), the availability of a safety net through big government and big banks has not been matched by a regulatory oversight that could prevent the growth of moral hazard and the loosening of lending standards.
Not only did the deregulatory wave that started in the financial industry at the beginning of the 1980s continue during the Great Moderation, but as Simon Johnson has argues here, the philosophy of policymakers also changed dramatically and altered what regulators and supervisors could do given the political climate.
Regulators and supervisors became more and more skeptical about the usefulness of their role in promoting a safe and sound financial system. This change in the philosophy involved three main aspects: the primacy of profitability as a measure of soundness, the sacrosanct role of innovation, and the promotion of self-regulation via risk-management techniques. In order to cope with the resulting instability, bigger and bigger government financial rescues have been necessary, but the long-term effectiveness of these government interventions has declined because, given the absence of effective regulation and supervision, they have promoted moral hazard.
In Johnson’s view, any of the “too big to fail” financial institutions that needed funding should have been required to submit to Federal Reserve oversight. Top management should have been required to proffer resignations as a condition of lending (with the Fed or Treasury holding the letters until they could decide which should be accepted—this is how Jessie Jones resolved the bank crisis in the 1930s). Short-term lending against the best collateral should have been provided, at penalty rates. A comprehensive “cease and desist” order should have been enforced to stop all trading, all lending, all asset sales, and all bonus payments until an assessment of bank solvency could have been completed.
The FDIC should have been called-in (in the case of institutions with insured deposits), but in any case, the critically undercapitalized institutions should have been dissolved according to existing law: at the least cost to the Treasury and to avoid increasing concentration in the financial sector.
As Johnson’s interview makes clear, this solution would have left the financial system healthier and smaller. It would have avoided the moral hazard problem that has grown over the past three decades as each risky innovation was validated by a government-engineered rescue. And it would have reduced the influence that a handful of huge banks have over policymakers in Washington. Instead, we have “thirteen bankers” yet again illustrating the dangers, recognized as early as Jefferson, of the baleful influence concentrated banking power can have on our national policy making apparatus.