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The Case for Financial Reform

Making the best of a bad situation.

1:53 PM, Apr 7, 2010 • By MATTHEW CONTINETTI
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Financial markets are necessary because they put people in need of money in touch with people who have money to lend. This is the essence of capitalism. Somewhere along the line, however, our financial system went out of whack.

The Case for Financial Reform

Lehman Brothers in 2007

David Shankbone

There were many causes. Americans were saving too little, and the Chinese were saving too much. The Federal Reserve kept interest rates too low for too long in the middle of the decade, creating a surplus of credit that went into risky investments. The housing sector ballooned out of control. A "shadow banking" system came into being that leveraged huge amounts of money with absolutely no oversight. The ratings agencies said risky mortgage backed securities were A-OK. Market agents responded to regulations by seeking out loopholes, capturing the regulatory institutions, or following the rules and creating unintended (and not always positive) consequences. The result was the financial crisis that began to unfurl in 2007 and came to a head with the collapse of Lehman Brothers in September 2008.

Remarkably, almost two years after Lehman collapsed, America has done little to correct the imbalances, address what went wrong, and fix the regulatory patchwork. Part of the reason is that we avoided armageddon: the TARP bailout seems to have forestalled a collapse of the global financial system along the lines of what happened during the Great Depression. That lulled the political class into a false sense of confidence. Since the end did not come, the president, who owes his election to the financial crisis as much as anything, believed he addressed the problem and thus could move on to building his New Foundation for the country. But he has not addressed the problem. And now it is time to take stock and assess where democratic capitalism stands, and figure out how to stabilize and strengthen the economic system that has immeasurably improved the life and well-being of the human race.

The place to start is two essays authored and coauthored by Luigi Zingales in National Affairs. In "Capitalism After the Crisis," Zingales, a professor at the University of Chicago, argues against the concentration of economic and political power in the financial sector and advocates "abandoning the notion that any firm is too big to fail, and putting rules in place that keep large financial firms from manipulating government connections to the detriment of markets. It would mean adopting a pro-market, rather than pro-business, approach to the economy."

In "Curbing Risk on Wall Street," Zingales and Harvard professor Oliver Hart propose new capital requirements for big banks and a market-based test to determine when government should intervene and put the monster into receivership. The Manhattan Institute's Nicole Gelinas has a somewhat similar idea: She wants the banks to hold a certain amount of non-leveraged capital for every financial transaction they make.

This a huge issue with vast implications. There's no way we can cover it in its entirety. But let's start by making some distinctions.

1. The TARP is not the stimulus. The TARP was an emergency measure to inject confidence into the financial system. It seems to have done its job, and the government is recouping some of the money it spent to bail out the big banks. (Problems remain with GM, Chrysler, AIG, and Fannie and Freddie.) The stimulus, however, was meant to spur aggregate demand, and thus employment, through government spending. It failed.

Liberals believe the stimulus failed because it was too small. I say it failed because it was not structured properly. The basis of the stimulus was the idea that the government could spend one dollar and magically generate an additional 57 cents of economic activity. But, as Greg Mankiw pointed out in a recent talk, the evidence is that tax policy is far more likely to create incentives to produce, spend, and invest. You can oppose the Obama stimulus while still believing financial reform is necessary.

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