Geithner's presentation to Congress on his plan for tough new Wall Street regulation came just in time for the G20. President Obama will be able to confront the Europeans, who are convinced that his financial rescue plans are "a highway to hell", to quote the Czech EU leader, and throw down about the regulatory regime that has just been announced.
The details have not, for the most part, been worked out, including which government entity will be responsible for "systemic regulation."
Treasury Secretary Tim Geithner spent three hours Thursday giving Congress more details of his vision for regulatory reform but managed to evade the central question.
Though pressed several times, Geithner did not specify which agency should oversee companies judged to pose a systemic risk to the economy.
Ok, alright, he knows SOMEBODY needs to have that authority, but he doesn't know who yet. Give the man a chance. He wouldn't want to talk about something before he knew what he was talking about right?
There is something, though, that he did say some pretty concrete things about. Or at least one concrete thing.
You may have heard, by now, of a blog called the Baseline Scenario. There was a reclisted diary recently that highlighted an article called "The Quiet Coup" that Simon Johnson wrote with James Kwak for the Atlantic Monthly about the true nature of the economic crisis. Simon and James are the founders of Baeline Scenario, a blog dedicated to understanding the financial crisis, blow by blow.
James Kwak wrote a piece for the blog recently entitled Big and Small.
In it, he relates Geithner's plan to regulate insitutions that carry "systemic risk."
To ensure appropriate focus and accountability for financial stability we need to establish a single entity with responsibility for consolidated supervision of systemically important firms and for systemically important payment and settlement systems and activities.
To ensure appropriate focus and accountability for financial stability we need to establish a single entity with responsibility for consolidated supervision of systemically important firms and for systemically important payment and settlement systems and activities.
. . . [W]e must create higher standards for all systemically important financial firms regardless of whether they own a depository institution, to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy. We will work with Congress to enact legislation that defines the characteristics of covered firms, sets objectives and principles for their oversight, and assigns responsibility for regulating these firms.
In identifying systemically important firms, we believe that the characteristics to be considered should include: the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding, and the importance of the firm as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.
That all sounds good, right? Certainly, "systenically important firms" need supervision, standards, criteria, to ensure focus and accountability, all desirable things, no?
A famous radical said that to be truly radical is to go to the root of the question, and Kwak gets all radical on Geithner:
Given the existence of "systemically important firms," I agree they need careful regulation. But why does Geithner assume that they have to exist at all?
Kwak goes on to explain that three features of companies like AIG and Citigroup were responsible for them becoming too big too fail: their complexity, their interconnectedness, and their size. Complexity can be reduced and manged, he argues. Interconnectedness will not go away; that is just a part of the way we live now.
But size? Size can go:
But size can definitely go away, simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities). And if a highly interconnected, highly complex but small financial institution fails, the system as a whole would be fine.
What would such a world look like? There would be a lot of small- and medium-sized banks that collected deposits and lent money to households and businesses. There would be brokerage and asset management firms that you used to invest your savings. There would be hedge funds and private equity firms that rich people and other institutional investors used to invest their money. There would be investment banks that helped companies issue equity and debt securities. There would be boutique firms that did research and other boutiques that M&A advising. For any financial service anyone wanted, there would be a company that provided that service; it just wouldn’t necessarily provide every other service, and it wouldn’t have $2 trillion in assets. It would look something like the 1970s.
But, but, but....
we NEED to have great big behemoth institutions, because if we don't...
No, Kwak says:
What’s wrong with this picture? Some people would argue that it would limit financial innovation. But there is no correlation (or a negative one) between the size of a firm and its degree of innovation. Nor do you need to operate a financial supermarket to innovate: mortgage-backed securities were pioneered by Salomon Brothers, an investment bank under the old definition. Finally, perhaps we could use a little less innovation.
Some would argue that costs would be higher, because smaller firms would be less able to capture economies of scale and scope. First, casual empiricism debunks this theory immediately. When I got my mortgage on my house, I got a much lower rate at a small community bank (which holds onto its mortgages rather than reselling them) than at any national bank. National banks also typically offer the lowest rates to savings customers, except when they are about to fail and desperately need cash from depositors. Second, even if this were the case, perhaps slightly higher costs are a price worth paying for reduced systemic risk.
Kwak goes further and makes the most important point of all about big banks:
one of the "future outcomes" you have to protect against is that the firms being regulated will try to change the regulations. So one prerequisite to a successful regulatory structure is limiting the political power of the firms being regulated. This is, ultimately, the most important reason why smaller is better.
This is what made it possible to get the countrry to unlearn the lessions of the Great Depression, to get rid of Glass-Steagall, a protection put in place as a direct result of the acute pain being felt far and wide as a result of the financial collapse of that era. But even givee ALL that pain, the banks were eventually able to erode the protections that were put in place and get the country to go along for the wild and ultimately catastrophic ride.
Kwak has a charming anecdote about this process in another blog post
My two-year-old daughter loves Frog and Toad.
There is a Frog and Toad story called "Cookies." It is the only Frog and Toad story I remember from my childhood. Toad bakes some cookies and takes them to Frog’s house. They are very good. Frog and Toad eat many cookies, one after another. They try very hard to stop eating cookies, but as long as the cookies are in front of them, they cannot help themselves.
So Frog puts the cookies in a box. Toad points out that they can open the box. Frog ties some string around the box. Toad points out that they can cut the string. Frog gets a ladder and puts the box on a high shelf. Toad points out . . .
Finally Frog takes down the box, cuts the string, opens the box, and gives all the cookies to the birds.
Regulation is great, but it can always be undone, as we have all learned in an extremely bitter way. And the bigger an instituion is, the more it can buy influence to undo those protections. And a cabal of said big insitutions, well...
Krugman wrote today in his column about the period between the Depression and 1980, when the regulatory system was still intact:
It all sounds primitive by today’s standards. Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.
Things worked well in the period when things were regulated. Trouble is, they worked well when things were regulated. I had a history teacher in high school who liked to invoke a historian named Crane Brinton and his explanation for the French Revolution occurring when it did: he called it "the frustration of rising expectations." The middle class had been gaining in influence, stature, and standard of living for two centuries prior to 1789, and then, when the monarchy began to hit the brakes on that, they got, well, frustrated. The problem wasn't that people weren't doing well, A Tale of Two Cities notwithstanding, it was that they were doing well, and they wanted more.
I am sure teacherken or somebody is going to tell me that theory has been sounbdly debunked and is a lot of hogwash, but even if that happens, I still think it makes intuitive sense. And I think it accounts for exactly what started in 1980. It wasn't that Reagan and a few other Republicans imposed their wishes on the country: Reagan won by a landslide in 1980. The country liked what the Republicans were pushing. The country had seen its standard of living double over the course of the previous generation, and expectations were rising. So they elected people who would begin the dismantling of our economic protections, so that the standard of living could rise even faster. I'm not saying that the Republicans weren't bastards; they were. But they were riding a wave of a population whose appetite had been whetted for prosperity.
That is why we need a powerful new regulatory regime: the safety and eventual prosperity that we may one day see again will likely stir the same appetities and if Tim Geithner manages to implement one with teeth, he deserves credit. The devil will be in the details, so we will have to see.
But one thing is clear: big banks of systemic significance are a part of Geitnher's vision for the future of our financial system. His attention to how to regulate them indicates that he is not looking to break them up. I hope, somehow, thet the sensible musings of James Kwak reach his ears one way or another. Otherwise, whatever the new regulatory regime is, it will exist under perpetual threat from giant, wily, bullying financial Goliaths who will throw their weight around without regard to who gets in their way. And that will not be the change we need.