Bubbles and the Banks

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The New York Times

Bubbles and the Banks

Health care reform is almost (knock on wood) a done deal. Next up: fixing the financial system. I'll be writing a lot about financial reform in the weeks ahead. Let me begin by asking a basic question: What should reformers try to accomplish?

A lot of the public debate has been about protecting borrowers. Indeed, a new Consumer Financial Protection Agency to help stop deceptive lending practices is a very good idea. And better consumer protection might have limited the overall size of the housing bubble.

But consumer protection, while it might have blocked many subprime loans, wouldn't have prevented the sharply rising rate of delinquency on conventional, plain-vanilla mortgages. And it certainly wouldn't have prevented the monstrous boom and bust in commercial real estate.

Reform, in other words, probably can't prevent either bad loans or bubbles. But it can do a great deal to ensure that bubbles don't collapse the financial system when they burst.

Bear in mind that the implosion of the 1990s stock bubble, while nasty - households took a $5 trillion hit - didn't provoke a financial crisis. So what was different about the housing bubble that followed?

The short answer is that while the stock bubble created a lot of risk, that risk was fairly widely diffused across the economy. By contrast, the risks created by the housing bubble were strongly concentrated in the financial sector. As a result, the collapse of the housing bubble threatened to bring down the nation's banks. And banks play a special role in the economy. If they can't function, the wheels of commerce as a whole grind to a halt.

Why did the bankers take on so much risk? Because it was in their self-interest to do so. By increasing leverage - that is, by making risky investments with borrowed money - banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn't the bankers' problem.

Of course, that conflict of interest is the reason we have bank regulation. But in the years before the crisis, the rules were relaxed - and, even more important, regulators failed to expand the rules to cover the growing "shadow" banking system, consisting of institutions like Lehman Brothers that performed banklike functions even though they didn't offer conventional bank deposits.

The result was a financial industry that was hugely profitable as long as housing prices were going up - finance accounted for more than a third of total U.S. profits as the bubble was inflating - but was brought to the edge of collapse once the bubble burst. It took government aid on an immense scale, and the promise of even more aid if needed, to pull the industry back from the brink.

And here's the thing: Since that aid came with few strings - in particular, no major banks were nationalized even though some clearly wouldn't have survived without government help - there's every incentive for bankers to engage in a repeat performance. After all, it's now clear that they're living in a heads-they-win, tails-taxpayers-lose world.

The test for reform, then, is whether it reduces bankers' incentives and ability to concentrate risk going forward.

Transparency is part of the answer. Before the crisis, hardly anyone realized just how much risk the banks were taking on. More disclosure, especially with regard to complex financial derivatives, would clearly help.

Beyond that, an important aspect of reform should be new rules limiting bank leverage. I'll be delving into proposed legislation in future columns, but here's what I can say about the financial reform bill the House passed - with zero Republican votes - last month: Its limits on leverage look O.K. Not great, but O.K. It would, however, be all too easy for those rules to get weakened to the point where they wouldn't do the job. A few tweaks in the fine print and banks would be free to play the same game all over again.

And reform really should take on the financial industry's compensation practices. If Congress can't legislate away the financial rewards for excessive risk-taking, it can at least try to tax them.

Let me conclude with a political note. The main reason for reform is to serve the nation. If we don't get major financial reform now, we're laying the foundations for the next crisis. But there are also political reasons to act.

For there's a populist rage building in this country, and President Obama's kid-gloves treatment of the bankers has put Democrats on the wrong side of this rage. If Congressional Democrats don't take a tough line with the banks in the months ahead, they will pay a big price in November.

Paul Krugman

Paul Krugman is professor of Economics and International Affairs at Princeton University and a regular columnist for The New York Times. Krugman was the 2008 recipient of the Nobel Prize in Economics. He is the author of numerous books, including The Conscience of A Liberal, The Return of Depression Economics, and his most recent, End This Depression Now!.

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