Paul Krugman: Another Temporary Fix

Paul Krugman says “financial regulation needs to be extended to cover a much wider range of institutions” if we are to avoid “even bigger future disasters”:

Another Temporary Fix, by Paul Krugman, Commentary, NY Times: So the big housing bill has passed Congress. That’s good news: Fannie and Freddie had to be rescued, and the bill’s other main provision — a special loan program to head off foreclosures — will help some hard-pressed families. …

But I hope nobody thinks that Congress has done all … of what needs to be done.

This bill is the latest in a series of temporary fixes to the financial system … that have, at least so far, succeeded in staving off complete collapse. But those fixes have done nothing to resolve the system’s underlying flaws. In fact, they set the stage for even bigger future disasters — unless they’re followed up with fundamental reforms.

Before I get to that, let’s be clear…: Even if this bill succeeds…, it … will, at best, make a modest dent in … foreclosures. And it does nothing … for those who aren’t in danger of losing their houses but are seeing much if not all of their net worth wiped out — a particularly bitter blow to Americans … nearing retirement…

It’s too late to avoid that pain. But we can try to ensure that we don’t face more and bigger crises in the future.

The back story to the current crisis is the way traditional banks — banks with federally insured deposits, which are limited in the risks they’re allowed to take and the amount of leverage they can take on — have been pushed aside by unregulated financial players. We were assured by the likes of Alan Greenspan that this was no problem: the market would enforce disciplined risk-taking, and anyway, taxpayer funds weren’t on the line.

And then reality struck.

Far from being disciplined in their risk-taking, lenders went wild. … Lenders ignored … warning signs because they were part of a system built around … heads I win, tails someone else loses. Mortgage originators didn’t worry about the solvency of borrowers, because they quickly sold off the loans they made, generally to investors who had no idea what they were buying. Throughout the financial industry, executives received huge bonuses when they seemed to be earning big profits, but didn’t have to give the money back when those profits turned into even bigger losses.

And as for that business about taxpayers’ money not being at risk? Never mind. …

Meanwhile, those traditional, regulated banks played a minor role in the lending frenzy, except to the extent that they had unregulated, “off balance sheet” subsidiaries. The case of IndyMac — which failed because it specialized in risky Alt-A loans while regulators looked the other way — is the exception that proves the rule.

The moral of this story seems clear…: financial regulation needs to be extended to cover a much wider range of institutions. Basically, the financial framework created in the 1930s, which brought generations of relative stability, needs to be updated to 21st-century conditions. …

If the government is going to stand behind financial institutions, those institutions had better be carefully regulated — because otherwise the game of heads I win, tails you lose will be played more furiously than ever, at taxpayers’ expense.

Of course, proponents of expanded regulation, no matter how compelling their arguments, will have to contend with very well-financed opposition from the financial industry. And as Upton Sinclair pointed out, it’s hard to get a man to understand something when his salary — or, we might add, his campaign war chest — depends on his not understanding it.

But let’s hope that the sheer scale of this financial crisis has concentrated enough minds to make reform possible. Otherwise, the next crisis will be even bigger.

Originally published at Economist’s View and reproduced here with the author’s permission.

2 Responses to "Paul Krugman: Another Temporary Fix"

  1. akmi   July 31, 2008 at 5:24 pm

    Will we ever learn from our mistakes? Can we ever escape the boom-bust cycle? Previous crises have led to better disclosure, prudential controls and risk management but 1980s deregulation scrapped away the advances we made towards ensuring financial stability. Furthermore, the government acts late – it doesn’t prevent asset bubbles because it believes in free markets (except when they’re falling, then they don’t believe markets should run freely). Also, as Mishkin believes, it’s difficult to identify bubbles in the first place. So rather than just responding to the crisis with more of the same palliatives used in past crises – better disclosure, prudential controls and risk management – let’s try these other long-term fixes: * Eliminate pro-cyclical incentives in the banking system. Capital requirements should not only be counter-cyclical but also related to the rate of change of bank lending and asset prices * Tackle maturity mismatches and leverage among banks and other financial institutions * Create emergency bank debt insurance and require banks to pay an insurance premium to taxpayers * Consolidate or restructure the various regulatory agencies of depository institutions, insurance companies, rating agencies * And, regarding the root of this specific crisis, ban speculative loans (that rely on home price appreciation) for primary residences