Paul Krugman writes today about financial services reform and the debate among those who support it over whether "too big to fail" is the real issue. Krugman comes down on the side that TBTF isn't the issue, that the real problem is the lack of regulation. On the other hand, Krugman notes that former Fed Chairman Paul Volcker believes that the rise of megabanks has created the problems that led to the crisis of 2007-8.
Those who want to understand financial reform should read Simon Johnson and James Kwak's new book, 13 Bankers , which suggests that both issues need to be confronted. The rise of the megabanks evolved out of a constant loosening of bank regulation over the period from the mid 1970s onward, sped by the Reagan Revolution and a financial industry intelligentsia that believed in free markets as the answer to any question. These minds had the attention of the Reaganites, who wanted to unleash the power of the markets in all areas and hated regulation per se.
Out of this era, we got a constant drip of new products like derivatives and "innovative" mortgages, securitization of mortgages, eventually leading to "synthetic" securities, that related to the price of real securities based on real mortgages no longer held by the banks who lent the money originally. No one really tightened up on any banking activities, even after the savings and loan crash of the 1980's, when the regulatory agency that let the S&Ls run amok was replaced by another regulatory agency that let their successors run amok.
But then the whole banking industry changed even more since the 1990's, when the financial moguls were allowed to merge all of the operations of investment houses and old-fashioned retail banking into the megabanks. The combination of the companies we used to know in the United States into six enormous financial services giants has now been accomplished. What's more, their share of the economy has increased to the point where there is more activity around money than is healthy for a nation built on industry, not banking. It's not surprising that a sector that's become too large to serve the real economy has to create more and more complex products (like those that brought down the markets), in order to sell them to an economy that, relative to banking, isn't growing.
So, in a nutshell, Johnson, the former head economist at the IMF, and his colleague Kwak, an economist and former McKinsey and Company consultant, argue that both old-fashioned regulation and limiting bank size are necessary together. While Krugman would argue in favor of regulation alone, Johnson and Kwak point out that regulation works less and less well as the regulated industry grows bigger and more powerful. In our case, financial services fees actually fund the regulators, while companies have a choice as to which of the many agencies they'd like to be regulated by, making it nearly impossible for the agencies to get tough on their funders.
What's needed, Johnson and Kwak say, is a new turn in our economic and political belief system, similar to the one Teddy Roosevelt pushed a century ago, when he argued for breaking up the trusts. If the US moves towards a system of well-regulated and boring banking, like the kind we had for half a century in the post-depression economy, coupled with a willingness to limit the size of any banking institution to that which is less than "too big to fail," we may once again step back from the brink of bubble and bust economics.