text: I HAVE been meaning to summarise my thoughts on financial regulatory reform in the wake of the Hyman Minsky conference on same. I have to say, it has left me with a sense of resigned cycnicism. I'll get to details in a moment, but I think that the most important thing to understand about financial reform is that its dynamics are simply too complicated to lend themselves to good policy. As Paul Krugman said during his talk on Thursday, financial reform is totally different from health care reform. There the crises are clear—coverage and costs—and the policy positions were clearly defined and coherent. On financial reform, no one really agrees about anything. If you were to sit down a group of progressive economists and ask them about health care, they'd all say more or less the same thing. Ask them about financial reform, on the other hand, and you're likely to get wildly different answers. No one can agree on the underlying causes of this latest crisis, or on why the world managed to avoid crises in the postwar decades, or on what steps should be taken to make financial systems more secure. While I think there are good regulatory ideas out there, I'm increasingly of the opinion that if the bill that passes ends up being an effective change to the regulatory environment, it will mainly be by accident.
  I've also found myself thinking that if financial sector growth is so good for the real economy it ought to be easier for its defenders to demonstrate this empirically. Sure, one can find financial innovations that seem helpful and posit how the general process of groth and innovation in finance could be good for growth, but the costs of a large financial sector are extremely apparent while even the most ardent backers of financial innovation have a difficult time explaining how economic performance would have been harmed by restrictions on financial activity. Obviously, finance has made a lot of people rich, but that's not the same thing as being good for growth on net. It shouldn't be that hard to tease out some evidence of truly positive effects, and yet no one is out there making a compelling quantitative case. That should probably tell us something.
  On to more specific thoughts. The Federal Reserve is very unhappy with the prospect of losing its regulatory authority over all but the largest financial institutions. The four Fed officials to speak at the conference all made this extremely clear. The four regional Fed presidents were also quite strident in their advocation of an end to too-big-to-fail. Kansas City Fed president Thomas Hoenig, who spoke at the conference, has an op-ed in the New York Times outlining his thoughts, which were basically reflected by the other Fed presidents to attend. I found this all to be exasperating. None of the attending presidents adequately explained how a Fed that completely failed to prevent dangerous consolidation before the crisis should now be viewed as a credible enemy of too-big-to-fail after the crisis. None of the attending presidents provided tangible evidence of internal changes designed to make the Fed a more credible regulator. Each was asked about the odd disconnect between the Fed's pre-crisis actions and its post-crisis rhetoric, and each responded by saying little more than "we've learned our lesson, now trust us". And none of the attending presidents made a real case for why ending too-big-to-fail should be the cornerstone of reform and how it might be accomplished. The Fed should lead by example. If it believes it can regulate most effectively, it should be explicit about how it might do that. We're all good economists here. If the incentives were in place to turn a blind eye before, and little has changed, then "we've learned our lesson" will not make for a sustainable model of competent regulation.
  Second, it does seem that there is agreement on smaller regulatory measures that are worth adopting, and these should be the focus of a regulatory bill. A central derivatives clearinghouse, for example, is a commonsense reform. Assuming that too-big-to-fail is irreparably baked into the system, moral hazard should be addressed through regular payments into an insurance or resolution fund; in other words, the government should try to make the banks pay ex ante for the bail-outs they're likely to receive. Clear resolution authority is also needed. It might not be used in a crisis period in which there is widespread insolvency, either from a common shock to banks or common bad behaviour by banks. It could and should be used at other times, and the occasional orderly winding up of a failed institution may well impart some market discipline on other large institutions. It's possible that a constituency could be built for more aggressive reform (though given the nature of the debate, as described in the first paragraph, I doubt it), but if that doesn't happen and the above changes are made, then the bill will be a good thing on net.
  Third, I'm increasingly of the belief that the best thing that might come out of the crisis would be the use of public anger to change the culture of Wall Street. It's hard to see how the world would be a worse place if outlandish bonuses were met with vocal public scorn, or if the brazen pursuit of financial wealth were looked down upon, or if regulatory weakness in the face of Wall Street pressure were greeted with hooting derision. Greed can be good. Markets thrive on it. It has driven people to build better technologies and devise better supply chains and make better movies. On Wall Street, greed has driven firms to move their offices a few miles closer to an exchange so that their online trades can be executed nano-seconds faster than their competitors'. It has generated innovations in the construction of personal financial products so that fees can be better hidden. Markets work when the pursuit of self-interest generates societal benefits, which is why we generally praise the self-made man or woman. They've done well for themselves while doing well for the rest of the country. Wall Street should be held to the same standard. If financial executives are going to behave as parasites, they should be shamed as parasites. Maybe nothing will change as a result, and they'll comfort themselves by drying their tears with gold leaf. But maybe it will have an effect.
  Next, Mr Krugman had another interesting thought that I've been musing on for a couple of days. He said he'd been having the uncomfortable feeling that the crisis-free years of the postwar period had little to do with any particular financial regulation and a lot to do with the franchise value of banks. The banking sector, at that time, was highly uncompetitive. The lack of competition made bankers fat, happy, and risk averse. When the banking sector was deregulated, banks had to work for their money. This led to some improvements in customer experience, but it also made bankers more aggressive in their pursuit of new profits (particularly as public ownership of large financial companies became more common). This increased the involvement of big banks in dangerous financial activities, which led to growth in systemic risks. This could put the administration's attitude toward breaking up the banks in a new context. An oligopoly of hugely profitable mega-banks seems both obscene and dangerous in light of the crisis, and yet the administration hasn't really thrown its weight behind a plan to chop up the biggest banks. It's possible that some have concluded that since any such plan would be a political impossibility, the best thing to do is to try and recruit the big banks to the side of stability—to put them in a situation where they will support restrictions on certain activities so long as their status as cash-printing money machines seems safe. I don't know if that's right, but it's an intriguing argument.
  Finally, several of the conference's speakers made the point that regulators had about 90% of the tools they needed to prevent a serious crisis before the crisis hit. They just didn't use them. A lack of needed tools is a convenient excuse for everyone who failed to do their job before the crash, which is everyone, and so you see the reform debate focusing on which new rules or institutions or regulators or authorities are needed that weren't previously around. In some cases, the new tools argument makes sense, but most of the time the real problem was that the people in charge were unwilling to do their jobs. To generate different results moving forward, what's needed isn't new councils or abilities, but new incentives and better oversight. Incentives and oversight could be changed via legislation, but they don't have to be. Cultural shifts, or a press given less to financial cheerleading could make a meaningful difference.
  So those are my thoughts. As financial reform proceeds, it's always worth asking whether the changes in the law would have prevented the crisis or reduced its severity. At this point, I'm not sure the conversation in Washington is really focused on that question.
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  Published since September 1843 to take part in “a severe contest between intelligence, which presses forward, and an unworthy, timid ignorance obstructing our progress.”