Paul Krugman: Financial Reform 101

Former Chairman of the Federal Reserve Paul Volcker

Former Chairman of the Federal Reserve Paul Volcker

Regulating the health insurance was a big effing deal, but reigning in the the banks is arguably far more critical to US economic stability. As usual, Economist Paul Krugman is your guide to all things economic, and today he broke down financial reform in simple and easy to understand terms.

There are three groups of people involved in this process. There are those that don’t want any regulation of any banks under any circumstances. We’ll call them Republican members of Congress. Then there are two groups that want to regulate banks but differ in how it should be done. One group we’ll call the Volckers and the other we’ll call the Krugmans.

The Volckers, named after former Chairman of the Federal Reserve Paul Volcker, want to regulate the size of banks. For them, the solution to our banking problem will be in eliminating “too big too fail” banks. The theory is that if we just break the banks into smaller pieces, and if some of them fail, the free market will kick in to solve the problem and prevent another taxpayer bailout. Unfortunately history doesn’t support this claim (e.g. The Great Depression).

The Krugmans believe that to fix our banking crisis we need to regulate what banks do – not how big they are.

Opposing the Volckers, Krugman wrote:

Here’s how I see it. Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.

Paul Krugman economist

According to the Krugmans, the same could happen today, so rather than bailing out a few big banks, the taxpayer would be bailing out lots of smaller banks. The end result would be another taxpayer bailout.

Here‘s the Krugman solution.

After all, the U.S. banking system had a long period of stability after World War II, based on a combination of deposit insurance, which eliminated the threat of bank runs, and strict regulation of bank balance sheets, including both limits on risky lending and limits on leverage, the extent to which banks were allowed to finance investments with borrowed funds. And Canada — whose financial system is dominated by a handful of big banks, but which maintained effective regulation — has weathered the current crisis notably well.

What ended the era of U.S. stability was the rise of “shadow banking”: institutions that carried out banking functions but operated without a safety ne

t and with minimal regulation. In particular, many businesses began parking their cash, not in bank deposits, but in “repo” — overnight loans to the likes of Lehman Brothers. Unfortunately, repo wasn’t protected and regulated like old-fashioned banking, so it was vulnerable to a pre-1930s-type crisis of confidence. And that, in a nutshell, is what went wrong in 2007-2008.

So why not update traditional regulation to encompass the shadow banks? We already have an implicit form of deposit insurance: It’s clear that creditors of shadow banks will be bailed out in time of crisis. What we need now are two things: (a) regulators need the authority to seize failing shadow banks, the way the Federal Deposit Insurance Corporation already has the authority to seize failing conventional banks, and (b) there have to be prudential limits on shadow banks, above all limits on their leverage.

From a banker’s perspective, they’d rather have the Volcker regulation than the Krugman one – or even better no regulation at all. Under the Volcker plan, banks merely have to break up into smaller chunks but could still do business as usual. But under Krugman’s plan, banks would have to dramatically adjust how they’ve been doing business, and that they don’t like.

The question is, can Congress fix this problem? If health care reform is any gauge, the answer is maybe.

Financial Reform 101 by Paul Krugman

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