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.
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.
2. Bank size is a political issue, not an economic one. As I wrote yesterday, you could still have financial panics with many small banks instead of several giant ones. The question is whether we want to live in a society where a few big banks exert tremendous control over the financial sector and political life. The debate over the size and concentration of American financial institutions is long-standing. Put me down on the side that supports dispersed power, local control, and the inability of Goldman Sachs to dictate how it ought to be regulated.
3. Resolution Authority is not the same as a bailout. When the FDIC seizes a failed bank, do we say that the bank has been bailed out? Of course not. So creating a mechanism by which the government can put into receivership a financial institution that is not a bank, but has bank-like characteristics, is not the same thing as mandating endless bailouts. As Sheila Bair wrote in yesterday's Journal, "The disorderly Lehman collapse and the AIG bailout cannot be our only models. The FDIC-style process represents a proven, third way." We should try to emulate it as we deal with the problem of Too Big to Fail.
4. Financial reform is not necessarily a big government issue. The American people are increasingly disenchanted with the Obama Democrats' approach to public policy. The public rightly believes the stimulus failed to achieve its goal of job creation. The public opposed health care reform as a risky and costly attempt to alter arrangements that satisfy the great majority of Americans. A center-right coalition has emerged that disapproves of this president and cannot wait to throw the Democrats out of Congress. Republicans are understandably thrilled. For the first time in a long time, they feel the wind at their backs.
Because the Republicans have paid no cost for opposing this president, they may be tempted to stand athwart any financial reform bill that comes up for a vote, no matter how sensible some of its ideas may be. That would be misguided. The public may not like the solutions the Democrats have put forward to address America's problems, but that does not mean it suddenly has fallen in love with Vikram Pandit, Jamie Dimon, and Lloyd Blankfein.
When Joe Six Pack reads the paper, he learns about a group of insiders at one end of the DC-NYC megalopolis bailing out insiders at the other end. He has little affection for both. If the GOP is serious about becoming the party of the people, serious about shifting power from Washington and New York, serious about unleashing competition and favoring the innovator over the incumbent, why not back free-market measures against an entrenched financial elite?