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Monday, May 05, 2008

Paul Krugman: Success Breeds Failure

When duct tape won't do the job, it's time to break out the baling wire. But eventually, if real repairs aren't made, the whole system can come apart at the seams:

Success Breeds Failure, by Paul Krugman, Commentary, NY Times: Cross your fingers, knock on wood: it’s possible, though by no means certain, that the worst of the financial crisis is over. That’s the good news.

The bad news is that as markets stabilize, chances for fundamental financial reform may be slipping away. As a result, the next crisis will probably be worse than this one.

Let’s look at the story so far.

After the financial crisis that ushered in the Great Depression, New Deal reformers regulated the banking system, with the goal of protecting the economy from future crises. The new system worked well for half a century.

Eventually, however, Wall Street did an end run around regulation, using complex financial arrangements to put most of the business of banking outside the regulators’ reach. Washington could have revised the rules to cover this new “shadow banking system” — but that would have run counter to the market-worshiping ideology of the times.

Instead, key officials, from Alan Greenspan on down, sang the praises of financial innovation and pooh-poohed warnings about the growing risks.

And then the crisis came. Last August, as investors began to realize the scope of the mortgage mess, confidence in the financial system collapsed. ...

The Fed’s efforts these past nine months remind me of the old TV series “MacGyver,” whose ingenious hero would always get out of difficult situations by assembling clever devices out of household objects and duct tape.

Because the institutions in trouble weren’t called banks, the Fed’s usual tools for dealing with financial trouble, designed for a system centered on traditional banks, were largely useless. So the Fed has cobbled together makeshift arrangements to save the day. There was the TAF and the TSLF..., there were credit lines to investment banks, and the ... barely legal ... rescue not of Bear itself, but of its “counterparties,” those who were on the other side of its financial bets.

It’s still far from certain whether all this improvisation has resolved the crisis. But it was the right thing to do, and for the moment things seem to be calming down. ...

We now know that things that aren’t called banks can nonetheless generate banking crises, and that the Fed needs to carry out bank-type rescues on their behalf. It follows that hedge funds, special investment vehicles and so on need bank-type regulation. In particular, they need to be required to have adequate capital.

But while our out-of-control financial system has been bad for the country, it has been very good for wheeler-dealers... They don’t want regulations that would stabilize the economy but cramp their style.

And now that the financial clouds have lifted a bit, the pushback against sensible regulation is in full swing. ... Maybe a Democratic sweep in November can revive the cause of financial reform, but right now it looks as if we’ll soon return to business as usual.

The parallel that worries me is what happened a decade ago, after the hedge fund Long-Term Capital Management failed, temporarily causing the whole financial system to freeze up.

Through luck and skill, that crisis was contained — but rather than serving as a warning, the episode nurtured the false belief that the Fed had all the tools it needed to deal with financial shocks. So nothing was done to remedy the vulnerabilities the L.T.C.M. crisis revealed — the same vulnerabilities that are at the heart of today’s much bigger crisis.

And if we don’t fix the system now, there’s every reason to believe that the next crisis will be bigger still — and that the Fed won’t have enough duct tape to hold things together.

    Posted by on Monday, May 5, 2008 at 12:33 AM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (52)

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