Paul Krugman: Bubbles and the Banks

What should be done to reform the financial system?:

Bubbles and the Banks, by Paul Krugman, Commentary, NY Times: Health care reform is almost (knock on wood) a done deal. Next up: fixing the financial system. ...

What should reformers try to accomplish? A lot of the public debate has been about protecting borrowers. Indeed, a new Consumer Financial Protection Agency ... is a very good idea. ...

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...?

The short answer is that while the stock bubble ... risk was fairly widely diffused across the economy..., 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. ... If they can’t function, the wheels of commerce ... grind to a halt.

Why did the bankers take on so much risk? ... 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...

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 ... to pull the industry back from the brink.

And here’s the thing: Since that aid came with few strings ... 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...

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 ... complex financial derivatives, would clearly help.

Beyond that, an important aspect of reform should be new rules limiting bank leverage. ... 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 ... 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.