Paul Krugman wants us to believe that by making banking boring again, we can prevent another crisis from occurring in the future. Although Krugman doesn’t provide any clear definition of what it means to make banking boring again, the context suggests that he is pushing for a return to a simpler and smaller banking sector. As such, Krugman offers up a very comforting theory, since the benefits of making banking boring are twofold: ridding us of devastating downturns while simultaneously smiting those greedy bankers. So in addition to fitting nicely into the fashionable banker-bashing meme, Krugman’s argument provides comfort in that it suggests the problem has already been identified and has a simple fix. Unfortunately, making banking boring again would probably have a devastating affect on the availability of credit, particularly at the consumer level, and won’t do a thing to stop asset bubbles from occurring in the future.
Krugman paints the recent history of banking with broad strokes – in contrast to James Surowiecki’s reasonably detailed article on the subject – drawing primarily on what is little more than the coincidence of boring banking and economic stability. In essence, he claims that we did our best when banking was boring. Presumably, we are to infer that this coincidence compels us to accept that boring banking is indeed the cause of economic stability. Answering such a complex question with such a simple and obviously flawed form of argumentation would normally smack of idiocy. But in Krugman’s case, it smacks of paternalism. Krugman is undoubtedly smart enough to know that abstracting from historical coincidences is an unacceptable method of discovering theories of causation, even for an economist. So, with this, I invite Mr. Krugman to explain why boring banking is superior to interesting banking. In the meantime, here are some things to consider before smashing banking back into the Stone Age.
Securitization And The Capital Markets
Securitization takes money from the capital markets and funnels it into the consumer credit market by bundling individual loans, lines of credit, and mortgages that would otherwise be unattractive to investors on a piecemeal basis. Tremendous sums of money are funneled to consumers using this process, particularly in the mortgage space. If the boring banking regime precludes securitization, we can expect this capital to either sit idle or go elsewhere, thereby depriving consumers of credit and spending power.
Bubbles Are Nothing New
Markets experienced bubbles long before credit default swaps and securitization were even a glimmer in a greedy banker’s eye. And so stripping bankers of the tools and techniques of modern finance will do nothing to stop them from occurring again. Whether it’s tulips, internet stocks, or spec houses, humans create investment fads that skew prices upwards and create value out of thin our. Then, once the jig is up, prices tank, and those still dancing are left holding the bag. And so, every asset bubble will create a class of losers: those who bought during the boom and held on past the bust. In my humble opinion, the severity of this bust will turn on who’s in that class of losers. If that class of losers turns out to be a group of individuals or businesses that perform a vital function in the economy, e.g., lending, we should expect the effects of the bust to be pretty severe. At this juncture, a boring banking argument could be made. That is, we don’t want banks to be heavily exposed to asset bubbles popping, whether it’s through lending or direct ownership. But this is no different than saying that we don’t want banks to make too many risky investments, since systemic bank failures have severe consequences. So even in the context of bubbles, it’s not the complexity or sophistication of banking that is at issue, but rather the accuracy of valuations and the adequacy of the capital that banks set aside in anticipation of losses.
Originally published at Derivative Dribble and reproduced here with the author’s permission.