Krugman's View

By PAUL KRUGMAN, Published NYT and FT, January 7, 2010
Health care reform is almost (knock on wood) a done deal. Next up: fixing the financial system. I’ll be writing a lot about financial reform in the weeks ahead. Let me begin by asking a basic question: What should reformers try to accomplish?
A lot of the public debate has been about protecting borrowers. Indeed, a new Consumer Financial Protection Agency to help stop deceptive lending practices is a very good idea. And better consumer protection might have limited the overall size of the housing bubble.
But consumer protection, while it might have blocked many subprime loans, wouldn’t have prevented the sharply rising rate of delinquency on conventional, plain-vanilla mortgages. And it certainly wouldn’t have prevented the monstrous boom and bust in commercial real estate.
Reform, in other words, probably can’t prevent either bad loans or bubbles. But it can do a great deal to ensure that bubbles don’t collapse the financial system when they burst. Bear in mind that the implosion of the 1990s stock bubble, while nasty — households took a $5 trillion hit — didn’t provoke a financial crisis. So what was different about the housing bubble that followed?
The short answer is that while the stock bubble created a lot of risk, that risk was fairly widely diffused across the economy. By contrast, the risks created by the housing bubble were strongly concentrated in the financial sector. As a result, the collapse of the housing bubble threatened to bring down the nation’s banks. And banks play a special role in the economy. If they can’t function, the wheels of commerce as a whole grind to a halt.
Why did the bankers take on so much risk? Because it was in their self-interest to do so. By increasing leverage — that is, by making risky investments with borrowed money — banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn’t the bankers’ problem.
Of course, that conflict of interest is the reason we have bank regulation. But in the years before the crisis, the rules were relaxed — and, even more important, regulators failed to expand the rules to cover the growing “shadow” banking system, consisting of institutions like Lehman Brothers that performed banklike functions even though they didn’t offer conventional bank deposits.
The result was a financial industry that was hugely profitable as long as housing prices were going up — finance accounted for more than a third of total U.S. profits as the bubble was inflating — but was brought to the edge of collapse once the bubble burst. It took government aid on an immense scale, and the promise of even more aid if needed, to pull the industry back from the brink.
And here’s the thing: Since that aid came with few strings — in particular, no major banks were nationalized even though some clearly wouldn’t have survived without government help — there’s every incentive for bankers to engage in a repeat performance. After all, it’s now clear that they’re living in a heads-they-win, tails-taxpayers-lose world.
The test for reform, then, is whether it reduces bankers’ incentives and ability to concentrate risk going forward. Transparency is part of the answer. Before the crisis, hardly anyone realized just how much risk the banks were taking on. More disclosure, especially with regard to complex financial derivatives, would clearly help. Beyond that, an important aspect of reform should be new rules limiting bank leverage. I’ll be delving into proposed legislation in future columns, but here’s what I can say about the financial reform bill the House passed — with zero Republican votes — last month: Its limits on leverage look O.K. Not great, but O.K. It would, however, be all too easy for those rules to get weakened to the point where they wouldn’t do the job. A few tweaks in the fine print and banks would be free to play the same game all over again. And reform really should take on the financial industry’s compensation practices. If Congress can’t legislate away the financial rewards for excessive risk-taking, it can at least try to tax them.
Let me conclude with a political note. The main reason for reform is to serve the nation. If we don’t get major financial reform now, we’re laying the foundations for the next crisis. But there are also political reasons to act. For there’s a populist rage building in this country, and President Obama’s kid-gloves treatment of the bankers has put Democrats on the wrong side of this rage. If Congressional Democrats don’t take a tough line with the banks in the months ahead, they will pay a big price in November.
MY COMMENT
One striking aspect of the public debate about the future of financial regulation and its restructuring is that most available experts employed by the authorities to formulate policy work for one of the major investment banks and, in respect of credit derivatives and other OTC markets, broker-dealers who are often also prime brokers responsible for feeding asset bubbles via excessive leverage (far too low risk spread-margin ratios). There are a few prominent and credible voices among people who are ex-senior bankers, Treasury, Central Bank and Regulatory officials and financial sector economists. There are also top academics like Krugman, but Government Ministers appear to often to be persuaded that they primarily need the help of experts in structured financial products, from people run M&A, underwriting and credit trading operations who cannot go on-the-record because they lack legitimacy with the general public and in the media who would be right to conclude this is akin to asking felons to dictate anti-crime legislation.
The Obama administration and UK Treasury too may be criticised from various angles for employing key advisors from the finance sector in policy-making roles. The US administration argues, 'Where else can we find people with sufficient expertise?' This is part of the very questionable assumption that private sector execs are superior to academics and is further part of a discomfort with using economists or academics generally?
As an analogy: the defense sector faced a similar problem after World War II. The fast-growing importance of new technology in combat meant that military needed highly specialist suppliers who would invest large amounts of private capital in developing tanks, airplanes, radar, space weapons and other types of equipment. But there was – and still is – the danger that these companies capture Defense Departments/ Ministries and push them, leverage them, to buy overly expensive and ever more complex systems, like IT, as if competitiveness requires continuous innovation whereby every new development rapidly becomes redundant and will be replaced as soon as money to do so is made available. There has been a similar 'arms race' in Financial markets whereby very little survives long enough to have its utility and stability determined. President Eisenhower famously warned in 1960, as he was leaving office, about the 'military-industrial complex'. Such a warning today about the 'Financial-economy complex' would surprise nobody! One can refer too to C. Wright Mills’ influential 'The Power Elite' (1956) that put weapons suppliers at the centre of US national power structure. Constraining the power of defense contractors is a hard problem – and you might say that we have not completely succeeded, depending on your view of Vietnam, Iraq, and Afghanistan. Can we be any more successful in determining how to reform global finance and then to implement reform?
At least in terms of weapons design and procurement, there was progress in developing a set of highly skilled independent engineering auditors as argued by Larry Candell in the latest issue of Harvard Business Review. The equivalent in Finance has to include independent macro-economists, such as my firm Risk Dynamics, which is the only independent risk model evaluator exclusively dedicated to this role - somewhat equivalent to a private sector financial regulator. Regulatory change needs economists who are able to analyse finance sectors nationally and globally in well-defined models - people like myself dare I say, but there are precious few of us.
Government should set up independent risk model validation labs (a role currently the responsibility of Central Banks and Supervisory Regulators, but which they cannot easily fulfill given their status as ultimate authorities) that would concentrate on testing financial products, markets and models in test bed-type settings before certifying for trading in real markets. With today’s computing resources and plenty of unemployed finance talent at hand, it is feasible to develop teams to test financial system stability. In the USA, the proposed National Institute of Finance (NIF) has such goals – the National Institutes of Health is an appealing model, like FDA and their equivalents in other countries. But, just as government agencies lose independence by employing investment bankers to advise, so to has NIF by proceeding with 'tied' industry-backing e.g., Morgan Stanley and Bank of America. We should be skeptical when absolute independence cannot be guaranteed. That said, of course, it is not always the case that University academics can evidence absolute independence. We definitely need independent experts who can be called to analyse for, report to, or testify before, legislators. They must have a deep understanding of financial markets, as well as hands-on experience with products that are dangerous to economic health.
It would be great if experts could break all ties with hedge funds, banks, or other financial institutions, who are capable and willing to step forward and contribute, but let's also recognise that many of our best experts don’t actually work for the big banks etc. Independent experts must be able to criticise major financial service firms and also the authorities. Many do so in private, but few are willing to step forward in public - this we leave precariously to journalists, and we should be thankful dor journalistic experts such as Krugman or, for example, the FT' feature writers who have done exceedingly well in documenting the crisis?