Matt Yglesias

The Paulson/Yglesias Small Bank Plan

Hank Paulson speaking today:

We need to get to the place in this country where no institution is too big or too interconnected to fail. Because regulation alone — and I’m all for more effective, better regulation, more authorities — but regulation alone is never going to solve the problem. There’s no regulator that’s going to be so good that they’re able to deal with it and ferret out the problem. It takes a balance between the right regulatory system and authorities and market discipline.

This seems to me to be in the spirit of what I said last week:

[W]hat’s the deal with banks that are too big to fail?

If we can identify such banks, why not try to make a rule preventing banks from becoming that big? As a tradeoff, banks that rested in the small-enough-to-fail category could be allowed to operate with much, much laxer oversight and regulation since everyone would understand that if they fail they’re going to sink. Presumably, there are some efficiency gains associated with the economies of scale involved in big financial institutions. But there would also be efficiency gains associated with relaxing the regulations on financial institutions. And the only reasonable way to seriously relax those regulations would be to commit to a no-bailouts scenario. But to do that, we need to make sure the banks aren’t too big to fail. So why not focus the regulatory effort on that — on making sure that institutions don’t get so big that they need bailing out?

The difference is that Paulson is the Secretary of the Treasury and I’m just a blogger.

But Paulson’s actual policies seem to me to be pointing in the opposite direction. As we’re propping financial institutions up, we’re also encouraging them to consolidate. Beyond that, the tendency has been for the larger institutions to be the ones in the worst shape. By preventing them from failing, we’re preventing smaller but better-managed institutions from flourishing in their place. The logical endpoint of something like that would be for the entire financial sector to eventually be concentrated in the hands of four or five gigantic multi-purposes financial institutions all of which operate with implicit government guarantees and allegedly tight regulatory oversight that naturally becomes regulatory capture as soon as people stop paying attention.

A better path than the one we’re on would be to first stop spreading money around at random, and start using it to buy common stock, Sweden-style, effectively nationalizing the banks. Then we shutter institutions that are beyond repair and fix the rest. Then when we reprivatize banks, which should be done as quickly as possible, we break them up and sell them as smaller institutions. You then need regulators to, in the future, effectively cap the size of the banks so that no institution reaches a scale whereby we wouldn’t be comfortable allowing it to fail. Whatever efficiencies are lost by preventing really big banks, we can try to offset by giving them more latitude to conduct their business as they see fit.

Credit Crunch: Very Real

There continues to be a semi-popular line of counterintuitive analysis holding that the entire financial markets crisis is some kind of fraud trumped-up by firms who want to get their hands on some of the $700 billion honeypot. For anyone who thinks that, a free trip to a European country with a finance-heavy economy would be instructive. Talk to people in the finance game on this side of the Atlantic and you’ll hear a lot of displeasure with the way European governments are handling their end of the bailout. Long story short, it’s much less of a sweet deal for the firms involved than what Paulson, Bush, and co. have been doing in the United States with much more onerous strings attached. As might be expected, they think a more generous US-style approach would be better.

No reason to take them especially seriously on that. But what you should take seriously is that they very strongly favor the bad deal they’re getting to do deal at all. And that’s because the crisis is very real. The fact that the crisis is real doesn’t mean that special interests won’t try to corrupt the process and get as much as they can. But at the same time, the mere fact that special interests are trying to corrupt the process doesn’t make the underlying issue some kind of fiction. What’s needed is vigilance and good policy, not paranoia and ignorance.

Checking My Understanding

What with crises and all, I thought I should refresh my basic grasp of the issues by perusing an economics textbook. Chapter 13 of Macroeconomics by Paul Krugman and Robin Wells concerns the monetary system. It includes the following “check your understanding” question:

A con man has a great idea: he’ll open a bank without investing any capital and lend all the deposits at high interest rates to real estate developers. If the real estate market booms, the loans will be repaid and he’ll make high profits. If the real estate market goes bust, the loans won’t be repaid and the bank will fail—but he will not lose any of his own wealth. How would modern bank regulation frustrate his scheme?

Having read the chapter, the correct answer is that modern banking regulations involve capital requirements that don’t let you do this. Having watched the past six months unfold, the real answer seems to be “not very well!”

Recapitalizing

The new plan as Hank Paulson gets around to doing what liberals were generally saying he should have done weeks ago — partially nationalize the big banks in order to recapitalize them. Here’s the money involved:

To the best of my knowledge, this is the right thing to be doing. Of course there are a lot of issues with the details, and I don’t really grasp them all, like how, exactly, this tiering system that determines how much money everyone gets was worked out.

Times Change

John Quiggin observes “it’s only three weeks ago that he was opposing any kind of public equity, and only six weeks ago that he was claiming that there were no real problems.”

The New Socialism

Over the past 30-35 years or so, the world as a whole has retreated from the high tide of state management of the economy that was reached around midcentury, and moved more in the direction of laissez faire. But I think it’s fair to say that though the trend has been perfectly general, the political leadership in this movement has tended to come from Washington and London, where Ronald Reagan and Margaret Thatcher were the loudest and clearest exponents of it and their successors on the center-left tended to confirm, rather than reverse, a new Anglophone consensus. And yet:

The British and American plans, though far from identical, have two common elements according to officials: injection of government money into banks in return for ownership stakes and guarantees of repayment for various types of loans. [...] The Treasury’s openness to direct infusions of cash is a remarkable change in tone from a few weeks ago, when the Treasury secretary, Henry M. Paulson Jr., and the Federal Reserve chairman, Ben S. Bernanke, discouraged such actions in testimony before Congress. “Putting capital in institutions is about failure,” Mr. Paulson declared on Sept. 23. “This is about success.”

This is what a lot of left-of-center economists said in the first place, but the ideological taboo against nationalization was very strong. Now, though, the forces of looming collapse in the banking sector are proving even stronger. Thus, it looks like it’ll be George W. Bush, Hank Paulson, and Ben Bernanke who bring a very strong dose of socialism to the United States of America. And yet Andy McCarthy’s busy worrying if Barack Obama is a closet Maoist.

Late Night Musing

As the nation’s last two independent investment banks change status to become “bank holding companies” that can start commercial banking arms, I wonder how many members of the House of Representatives could cogently describe the difference between an investment bank and a commercial bank.