Krugman: Too Big to Fail Will Always Be With Us
One thing I’ve been inclined to say ever since the financial crisis hit is that rather than trying to rely on superhuman supervisory regulators to keep “too big to fail” financial institutions out of trouble, it would make more sense to use regulation to simply prevent financial institutions from getting too big to fail. Paul Krugman says that’s a pipe dream:
Citigroup Center, New York (Wikimedia)
They certainly were worried about systemic risk in 1982, when I had something of a front-row seat. There were fears that the Latin debt crisis would take down one or more money center banks — Citi, or Chase, say. And policy was shaped in part by the desire to make sure that didn’t happen. Bear in mind that this was in the days before the repeal of Glass-Steagal, before finance got so big and wild; the New Deal regulations were mostly still in place. Yet even then major banks were too big to fail.
So I think of the pursuit of a world in which everyone is small enough to fail as the pursuit of a golden age that never was. Regulate and supervise, then rescue if necessary; there’s no way to make this automatic.
Relatedly, while I’m very happy to be extremely skeptical about the virtues of the past 25 years’ worth of “financial innovation,” it is true that when the American banking system was extremely fragmented there were real economic costs. On page 332 of A Farewell to Alms, for example, Gregory Clark observes the distorting impact of the very low-performing capital markets in the mid-19th century United States:
In the 1860s, for example, as the central valley of California was being settled, mortgage loans were made at the rate of 26 percent per year at a time when mortgages in Boston were offered at 6 percent. Rates fell rapidly in California, but in 1889 West Coast interest rates were still 4-6 percent above those in the Northeast.
This is because the then-severe restrictions on interstate banking made it hard to move capital from where the rich people looking to save were (northeast) to where the people who wanted to borrow money from are.
Long story short, supervisory regulation is the best we can hope for, so we’d better try to make it work. Count me as skeptical that congressional modifications to Obama’s proposals will be aimed at making things work better.
27 Responses to “Krugman: Too Big to Fail Will Always Be With Us”
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June 19th, 2009 at 12:58 pm
Of course some of us have been making similar points in Matt’s comment sections, but admittedly to my knowledge none of us have Nobel Prizes in Economics. Anyway, I am glad Krugman has helped get Matt’s eyes firmly on the ball.
June 19th, 2009 at 1:09 pm
You just have to make it hard for them to fail–regulation that ensures that big companies are adequately resistant to shocks. Turn your skyscrapers into pyramids.
June 19th, 2009 at 1:10 pm
Weren’t there all sorts of other reasons why capital would be more expensive on the West Coast in the 1800s? For instance, the speculative nature of the whole settlement enterprise compared to lending for, say, a long-settled community in New England.
June 19th, 2009 at 1:16 pm
Just because you can’t make them too big to fail, doesn’t mean you can’t still make them smaller so that when they fail it doesn’t require such copious bailouts. There is still value in shrinking these institutions, even if we can never get away from their failure posing systemic risk.
June 19th, 2009 at 1:26 pm
How about this, banks: Let little guys like me borrow money from banks in Japan, India, China etc. without government restriction… and you can get as big as you like (assuming you could compete).
June 19th, 2009 at 1:26 pm
I do like the solution here – raising capital requirements relative to size will make being large less of a competitive advantage. It discourages large bank mergers and opens the door for a broad new competitive class of medium sized banks.
June 19th, 2009 at 1:28 pm
The overriding imperative in all this is the need to limit access to public funds to commercial banks only.
Any financial entity that speculates should be barred from doing so with our money. This means that commercial banks should be tightly controlled, but investment banks, hedge funds, private equity funds, etc. can do pretty much what they want – just not with money from commercial banks.
This requires a new Glass-Steagal and explicit laws (not just regulations) that limit leverage and ban certain “innovations” like CDSs that distort useful products.
Paul Volcker’s views support this position:
http://www.newdeal20.org/?p=2603
June 19th, 2009 at 1:29 pm
This is because the then-severe restrictions on interstate banking made it hard to move capital from where the rich people looking to save were (northeast) to where the people who wanted to borrow money from are.
But that wasn’t a problem in the 50’s, Matthew.
I think Krugman is referring more to the fact that the system will tend to try and prevent the very largest banks (no matter how large) from going under. That does not mean we should not carefully segment, and that we should not enforce antitrust rules, since not enforcing them on the theory that we cannot (which is usually the argument made by rich guys) tends to result in overweening, too-powerful institutions.
p.s. It’s really kinda funny (sad, but funny) watching you let the DC Libertarians talk you around to the notion that… gee, Alan Greenspan really did do everything right! That other thing, it was uh, just an uh, accident.
max
['Yeah, yeah, invading Iraq really did seem like a good idea, didn't it?']
June 19th, 2009 at 1:39 pm
Why don’t you talk to Iceland about how well that worked out.
June 19th, 2009 at 1:42 pm
Glad to see you’ve read a Farewell to Alms, it was a long read (for me) but I found it fascinating, as long as you understand that Gregory Clark is thinking and offering, not stating and dictating.
June 19th, 2009 at 1:51 pm
> it is true that when the American banking system
> was extremely fragmented there were real economic costs.
Look at MidAmerican Federal of Chicago or Commerce Bank of Kansas City – they do fine as midsized regional entities. They support tons of small and midsized businesses, and with some backing from highly regulated money centers would be perfectly capable of handling all but the largest financial requirements.
They don’t pay their officers $20 million/year bonuses though.
June 19th, 2009 at 1:52 pm
These interest rates in California were one of the reasons why the direct proposition method was written into the California Constitution. Politicians were controlled by interest groups. The proposition system was a way to circumvent that control. California also had an anti-usury law written into its constitution. One exception: loans related to, and secured by, real property. Now we have special interest propositions being jammed down our throats rights and left.
June 19th, 2009 at 1:54 pm
“In the 1860s, for example, as the central valley of California was being settled, mortgage loans were made at the rate of 26 percent per year at a time when mortgages in Boston were offered at 6 percent. Rates fell rapidly in California, but in 1889 West Coast interest rates were still 4-6 percent above those in the Northeast.”
1860’s? The transcontinental railroad was officially completed in 1869 (Wikipedia). This meant that much of the trip was still by wagon (or boat).
Add to that the fact that California had already been through at least one Gold Rush boom, *and* that farmers were probably still getting used to California weather, *and* that doing business in California meant doing it weeks or months from the indusrtial heartland of the USA, and it’s far from surprising.
Sheesh, at least bring in a post-WWII example.
June 19th, 2009 at 1:56 pm
I think ‘too big to fail’ goes hand in glove with ‘too powerful to be shrunk’. The banks may have made some bad investments in real estate, but the money they invested in the politicians has paid off in full.
June 19th, 2009 at 2:24 pm
I guess this would be yet another of those things that were bad ideas when they were passing the deregulation the first time, but we were told we’d all be better off, and now that we’re not, we’re told that, hey, the horses have left the barn, too late to change anything now, best we can do is just lay out more money in the safety net or whatever to handle the theft and incompetence.
June 19th, 2009 at 3:41 pm
Re Krugman’s argument: “So I think of the pursuit of a world in which everyone is small enough to fail as the pursuit of a golden age that never was. ”
———–
That policy choice may be taken out of the hands of cocksucking Washington Politicians and their besotted economists in the near future.
Economists have their severe limitations. Limited knowledge of history, for example.
“Empires wax and wane;
States cleave asunder and coalesce.
When the rule of Chou weakened seven contending principalities sprang up, warring one with another till they settled down as Ts’in and when its destiny had been fulfilled arose Ch’u and Han to contend for the mastery.
And Han was the victor.”
–San Kuo Chih Yen-I
June 19th, 2009 at 3:42 pm
See “Divided We Stand” at
See “Divided We Stand” at
http://online.wsj.com/article/SB10001424052970204482304574219813708759806.html
June 19th, 2009 at 3:43 pm
Justin Fox acknowledges Krugman’s point, but also said that the “regulators”, are often irrational – just like markets, just like players IN the market.
So his preference was “brute force dumb rules”. Meaning, a limit on leverage, applied across the board. Hard rules that everyone must pretty much follow, like larger capital requirements, as suggested above.
June 19th, 2009 at 3:47 pm
When Peter Schiff shows up on the Daily Show and is CHEERED Obama should realize that the Tide is starting to go out on the Ob..Er..Geithner Plan.
http://www.fundmymutualfund.com/2009/06/peter-schiff-on-daily-show.html
June 19th, 2009 at 3:57 pm
Telling a bunch of overpaid bankers that if they get into trouble again, they can count on the US taxpayer to save them is not a very good idea. Beware of unintended consequences. Look at it this way.
If you’re investing in a financial services firm, would you go with the small one that has no government guaranteed backstop or the one with an implicit government guarantee? Financial services firms will all soon become big enough to qualify for this implicit guarantee. They’ll have to in order to survive. We will have solved the problem of what to do about Citibank by creating several more Citibanks, all with the expectation that should they run into problems, the fed will bail them out. Nothing good comes from sheilding Wall Street from the consequences of their actions.
June 19th, 2009 at 4:06 pm
“They don’t pay their officers $20 million/year bonuses though.”
Exactly. The regional banks don’t exist to Tim Geithner.
June 19th, 2009 at 4:08 pm
Peter Schiff this week:
“Obama proposes to entrust the critical job of “systemic risk regulator” to the Federal Reserve, the very organization that has proven most adept at creating systemic risk. This is like making Keith Richards the head of the DEA.”
————-
Er.. I think Peter needs to find a better metaphor. I would LOVE to have Keith Richards be the head of the DEA.
June 19th, 2009 at 4:11 pm
But the primary argument Peter Schiff makes is sound:
“The proposals most notably involve extra regulatory oversight of financial entities that the government deems “too big to fail.” This implies that it is desirable to have such entities in the first place, and that the government will continue to back those large organizations that fall under its protection. These “too big to fail” firms will enjoy a competitive advantage over smaller firms in attracting capital, as lenders will perceive zero risk in extending them credit. This will cause these firms to grow even larger, producing even greater systemic risks and larger losses when the next round of bailouts arrives. Meanwhile, smaller firms which seek to expand, and which propose no systemic risks, will face greater challenges as higher capital costs render them less competitive.
If the government did not provide these bailouts or guarantees, then the market itself would ensure organizations did not grow beyond their ability to attract capital. It is only when market discipline is overcome by government guarantees that systemic risks arise. ”
Best fix: Ban Campaign contributions by corporations. I think we are starting to realize WHY Obama was able to raise $700 Million in the last campaign.
June 19th, 2009 at 4:17 pm
“Meanwhile, smaller firms which seek to expand, and which propose no systemic risks, will face greater challenges as higher capital costs render them less competitive.”
There will be no “smaller firms”. Everyone will adjust to the new rules and quickly become “too big to fail”.
June 19th, 2009 at 4:19 pm
Well, I hope no one throws a BRIC at our glass house.
June 19th, 2009 at 6:47 pm
Capitalism is not the same as a free market: it is a relatively free market and a social and governmental system that privileges those with capital (beyond the immediate buying power that capital provides).
This implies to me that, barring great public outrage aimed squarely at Capital and a government responsive thereto, the ground state for government will be to disproportionately smooth things out for those with money, including the artificial persons it creates.
Simple translation for that long-windedness: Rich people are better people, so things should be made as easy as possible for them.
June 19th, 2009 at 8:35 pm
Most of the problem with banks too big to fail is that they employ individual bankers who are too big to fire. If bankers thought the consequences of bank failure would be their immediate dismissal without pay, and their permanent blacklisting from future bank employment, they would be more careful with other peoples’ money.