‘KRUGMAN ON FINANCIAL REGULATION, ‘ by James Kwak at baselinescenario .com.

In Uncategorized on April 4, 2010 at 17:25

Krugman on Financial Regulation

Posted: 03 Apr 2010 12:46 PM PDT

By James Kwak

Several people have asked us to comment on Paul Krugman’s op-ed yesterday (both by email and in our bookstore event yesterday), in which he contrasts the Paul Volcker school (“limiting the size and scope of the biggest banks”) with the other school (“the important thing is to regulate what banks do, not how big they get”). Krugman says he is in the latter group. But Mike Konczal* beat me to it:

“For me, it’s not an either/or but a both/and question. I think we should do both (a) and (b), impose a hard size cap of $400 billion to $500 billion and then expand regulation over all the broken-up shadow banks. If you look at the conclusion of 13 Bankers, I think Simon Johnson and James Kwak are in a similar boat.”

The short answer is what Mike said. We don’t think limiting size and scope is a sufficient solution. This is what we say on page 216 of the book:

“To be clear, size limits should not replace existing financial regulations. A world with only small banks, but small banks with minimal capital requirements and no effective oversight, would not be dangerous in the same way as today’s world of megabanks, but it would be dangerous nonetheless; it was the collapse of thousands of small banks that helped bring on the Great Depression. . . . Therefore, enhanced capital requirements and closer prudential regulation, as proposed by the Obama administration, are also necessary.”

We don’t spend a lot of time on the smarter/better regulations because we think they are relatively uncontroversial, and the administration is already pushing for them. We emphasize the size constraints precisely because those are more controversial and the administration is not pushing for them (unless you count the 10 percent limit on bank liabilities, which currently would affect exactly no one, according to the Treasury Department).

We’ve written several times about why smarter/better regulations alone are not enough, but I think the most basic point is simply that regulation always fails — companies always find a way around it — and the costs of failure will be lower in a world with smaller banks than in a world with bigger banks. Yes, it is possible that several smaller banks could act in a way that is highly correlated and essentially mimic one larger bank; but it is not a foregone conclusion that this would happen, among other reasons because the more actors you have, the more likely they are to take differing positions on the market. (I believe the system was safer because Goldman and JPMorgan Chase became skeptical about the housing market around 2006-2007; imagine if there were just one gigantic investment bank, and it behaved like Bear, Lehman, or Merrill.)

So I actually don’t think there’s much of a debate here. Or, more precisely, there is a debate about whether to have size and scope constraints, but you don’t have to pick between size and scope constraints on the one hand and closer prudential regulation and resolution authority on the other hand.

  1. It is unfortunate to see such intelligent people take their eye off the ball in such dramatic fashion. The two key elements of true financial “reform” (I cannot put enough irony on that word) are excluded from the legislation.

    First, credit default swaps continue to be unregulated. The banks will continue to make exorbitant profits from these “weapons of financial mass destruction” while incurring no risk knowing that Helicopter Ben Bernanke will shower them with taxpayer dollars from the sky should the bets go wrong.

    Second, the proscription against naked short selling has not been included. This little trading trick that involves not only shorting stock but also shorting an amount of stock in excess of the amount of stock that a company has outstanding enabled someone to make over $200 million shorting Lehman in under 24 hours.

    In light of these omissions, the debate about size vs. regulation is as interesting as a debate between Johnson & Johnson about Band-Aids.

    You have to fight the madness.

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