Crisis Economics Part 10

Why this patchwork quilt? It's partly an outgrowth of the federal system of government, which purposely divides power between the states and the nation at large. And it partly reflects the regulatory agenda of the New Deal, which, for all its radical expansion of government, divided regulatory authority among multiple inst.i.tutions. The gaps and inefficiencies a.s.sociated with this system only increased over the years with the rise of new kinds of financial firms and new financial instruments. Various "reforms" that deregulated the financial system in recent years created other gaps.

These problems notwithstanding, many policy makers have defended this overlapping, layered regulatory regime. Having so many different regulatory bodies, they argue, introduces beneficial "compet.i.tion" that will lead to the wider adoption of the best, most effective regulatory practices. Unfortunately, financial firms aren't looking for the best regulation; they're looking for the least regulation, or regulation that doesn't restrict the activities that are at the core of the banks' business.

This wouldn't be a problem if banks had no choice over who regulates them. But under the present system, they do have a choice. It grows out of how they opt to incorporate themselves. A commercial bank, for example, could choose to charter itself under a particular state's law rather than under federal law. It would then need to choose whether to become a member of the Federal Reserve System. Those choices would effectively dictate whether it fell under the regulatory umbrella of the Office of the Comptroller of the Currency, the Federal Reserve, and the FDIC, not to mention selected state regulators.

Banks don't make these choices at random. There's considerable evidence that U.S. commercial banks, for example, change regulatory jurisdictions to take on more risk. This should come as no surprise: banks are looking to maximize returns, and they would have no reason to voluntarily submit to rules that put them at a compet.i.tive disadvantage. As a consequence, there's a "race to the bottom," as banks and other financial firms search for the regulator that will regulate them the least.

Regulators may have exacerbated the problem in recent years. Here's why: when banks choose their own regulators-and gravitate toward those that promise the least oversight-more rigorous regulatory agencies may see their domain erode. And a regulator with no one to regulate has no reason to exist. So regulators have every incentive to be lenient in order to attract more financial inst.i.tutions into their regulatory nets. Here too we have a race to the bottom. Such is the paradox of choice or "regulatory shopping."

In 2009 the Obama administration proposed a serious overhaul of financial regulation. It included creating three new federal regulatory agencies: the Financial Services Oversight Council, which would serve as a kind of uber-regulator, coordinating regulation across agencies, eliminating gaps, and working to identify inst.i.tutions that might pose a systemic risk to the financial system; a National Bank Supervisor, which would oversee all banks with a federal charter; and an Office of National Insurance, which would take on responsibility for regulating insurers.

This is all well intentioned, and some version of it may receive legislative sanction in 2010. But it's worrisome that the proposals on the table do not address the underlying problem, the existence of a confusing patchwork of state and federal regulation. It would add regulators and consolidate others, but its net effect would be to leave the existing crazy quilt unchanged, even if it adds a "council" to oversee this mess.

Rest a.s.sured: maintaining the status quo would be very much in the interest of the financial services industries. If the past few decades have taught us-and them-anything, it's that firms thrive in the interstices of the regulatory structure. The existing system offers firms plenty of regulatory nooks and crannies where they can dodge effective oversight.

When pondering how to reform this system, it's worth considering the model offered by the United Kingdom's Financial Services Authority (FSA). This organization, born in 1997, effectively put a host of regulatory regimes under a single roof. The FSA handles the regulation of banks, insurers, securities, derivatives-even mortgages. Regulators in different departments ultimately answer to the same leaders.h.i.+p, and in theory, this kind of centralization prevents the arbitrage and "cherry picking" that the more fragmented, decentralized U.S. system allows.

There's one fly in the ointment. By a.s.suming such sweeping powers, the FSA has removed responsibility for regulating banks from Britain's central bank, the Bank of England. This is potentially problematic: given that central banks serve as lenders of last resort, they have historically retained regulatory authority over banks and other "systemically important" financial firms. If central banks are going to cede this authority along the lines of the FSA model, they and the new regulatory authority must coordinate their activities and maintain a proper exchange of information.

That said, the FSA model is superior to one where regulatory powers are dispersed among many different competing inst.i.tutions. While nothing comparable will likely be adopted in the United States anytime soon-the long-standing tradition of power sharing between national and state governments rules that out-some significant consolidation and centralization is desirable and necessary. While it might not prevent the kind of regulatory arbitrage that helped create the recent crisis, it would certainly make it far more difficult.

Unfortunately, financial firms have another way to circ.u.mvent regulations. In this kind of "jurisdictional arbitrage," financial firms pick up and relocate to places that have fewer regulations and restrictions. In an era of financial globalization, mobile capital, and a lack of capital controls, firms can pull this off relatively easily. While some regulators may find it tempting to say good riddance and let some of the reckless firms responsible for the recent crisis depart for other, more hospitable climes, this will do little to prevent future disasters.

For that reason, regulators must coordinate any reforms with those under consideration in other countries. This is easier said than done: the infrastructure for such coordination is even less developed than what exists for dealing with other global problems like terrorism and climate change. Frustrated by the lack of coordination, some leaders have argued for the creation of a "global superregulator" that would serve, as German finance minister Peer Steinbruck put it, as "an international authority that will make the traffic rules for financial markets."

This idea sounds appealing but is hugely impractical. It's one thing for an international body like the Basel Committee to issue recommendations that national regulators implement; it's far more difficult to get all those regulators-and the legislators that created them-to relinquish some or all of their sovereignty to a single, all-powerful regulator. In fact, more modest versions of this idea have gone nowhere: attempts to make the European Central Bank the uber-regulator for the member nations of the EU, for example, failed to gain traction. For now, responsibility for regulating European banks remains in the hands of the various nations' central banks.

Even if all the major advanced economies could agree on the creation of a global superregulator, it's probably not a good idea anyway. While the system in place in the United States-scores of regulatory authorities-isn't ideal, the opposite extreme carries its own risks. Putting all the regulatory eggs in one basket would place too much faith in a single body, whose uber-regulators may or may not be up to the task before them.

That raises a final issue: the best, most coherent, and most comprehensive regulations mean nothing if they're poorly enforced. Put differently, regulations are only as good as the regulators who implement them. How should we deal with that?

Quis Custodiet Ipsos Custodes?

An old Latin phrase captures this most modern dilemma: Quis custodiet ipsos custodes? Or to paraphrase a little, "Who will regulate the regulators?" Who will ensure that those who are given the power to police society will perform their duties effectively and selflessly?

It's not a new problem. Plato acknowledged this predicament in the Republic, though he was talking about a society's guardians or stewards, not its financial regulators. (Derivatives were still a long way off.) Plato's solution was an intriguing one: the guardians-and the people generally-would be told a "n.o.ble lie," or useful myth, that the guardians were more virtuous than other people. Convinced of their own goodness, they would scorn private gain and instead look out for the welfare of the republic. The illusion of virtue would be its own reward.

This vision is apt to prompt snickers today, but it highlights an unsettling truth. Consider what happens if the guardians or regulators are not permitted to believe in their own superiority but are derided as incompetent and corrupt. This is a different kind of lie, but we've been encouraged to believe it in our own time. Until very recently, regulators have been told they're chumps for not going to work in the private sector. They're fools who can't compete with the financial geniuses on Wall Street. Worse, they're an impediment and an obstacle to the brave new world of financial innovation.

This lie, spread by fanatics of laissez-faire, deserves refutation. It has been challenged before: in the 1930s, the newly created SEC (as well as other regulatory agencies) attracted plenty of bright, capable, idealistic people who in a different era might have landed on Wall Street. Instead, they ended up regulating Wall Street and, not coincidentally, presiding over several decades of unprecedented financial stability, as well as steady, solid economic growth for the nation at large.

There's no reason that this can't happen again. But it would mean changing the reputation of regulators and regulation. That's a tall order, but that process can begin with the way the federal government recruits regulators. The people who staff these positions have the power and the responsibility to prevent another financial crisis. That's a pretty big responsibility, and it should be reflected in how the job is portrayed and sold to prospective employees. If that's a "n.o.ble lie," so be it. But without some change in our perception of careers in regulation, attracting the qualified people we need in these positions is going to be hard.

Regulators also deserve better compensation. Here we part ways with Plato; after all, you're reading a book written by economists, not by philosophers. And look at the facts: until relatively recently, the SEC was one of the worst-paid agencies in the entire federal government. Even today, it's hard to find an SEC employee who's paid over $100,000. While how much salaries can be raised is obviously limited-the secretary of the Treasury makes slightly less than $200,000-the people charged with overseeing the stability of the global financial system should reasonably be paid more than a receptionist at Goldman Sachs.

Some reformers have tried to address this problem by suggesting that regulators' compensation be pegged to their performance. In other words, the more fines they collect and the more insolvent banks they close, the more they get paid. This may sound like a good idea, but it's not. The potential for abuse is too high. Think of how well a police force would work if officers got paid by the number of arrests they made, or the number of traffic tickets they issued. Doubtless they would be more aggressive in enforcing the laws, but whether they would be fair or honest is another matter.

It's better to deal with the problem of recruitment in other ways. For starters, keep in mind that the federal government can offer something that Wall Street can't: job security. Given the number of unemployed former bankers and traders in the post-crisis years, the prospect of guaranteed employment may be particularly appealing. It will be especially appealing to the veteran traders and bankers who may be nearing retirement. These individuals have seen it all, and many of them are now collecting unemployment benefits. Let them finish out their careers working for the SEC and other regulatory agencies as rank-and-file regulators.

In suggesting that former traders join the government, we are by no means counseling a continuation of the high-level "revolving door" that connected some of the biggest financial firms with the regulatory establishment in Was.h.i.+ngton. Goldman Sachs is particularly infamous for this practice: several CEOs of that firm have held senior positions in the U.S. government, while scores of other Goldman executives have held high-level government jobs too. Creating countless conflicts of interest, these and other executives move seamlessly from the private sector to government, where they serve as allies rather than regulators of their former employers. Many of them then move back to the private sector and use their government connections to lobby in favor of looser regulation and more lax supervision of financial firms.

This problem, known as "regulatory capture," remains as troubling as ever. In the fall of 2009, for example, the SEC announced with great fanfare that it was hiring a managing executive for its newly created Division of Enforcement, which would necessarily keep an eye on big firms like Goldman Sachs. That hire was none other than a twenty-nine-year-old with limited experience, save for serving as an executive at Goldman Sachs.

There are ways to deal with regulatory capture and revolving-door appointments. One, the lobbying activities of former government employees, particularly those who serve in senior positions, should be significantly restricted. Reforms introduced by President Obama in early 2009 have banned government employees from lobbying activities for two years. That's a start, but the time frame should be extended to four or five years, if not longer.

It's also necessary to limit the lobbying power of financial firms. That's obviously a tall order. Politicians batten on the financial sector for the simple reason articulated by bank robber Willie Sutton: because "that's where the money is." They insulate the financial system from regulatory meddling and starve agencies of the taxpayer funds necessary to implement regulations. In exchange, financial firms funnel ma.s.sive amounts of money toward candidates-$311 million in 2008 alone.

It's hard to choke this flow off. It requires political will, and that's in short supply, if what happened in 2009 is any indication. Over the course of that year, many recipients of TARP money spent tens of millions of dollars successfully lobbying Congress against caps on executive compensation and all manner of tougher financial regulation, including rules governing derivatives. They also managed to persuade Congress to lean on the Financial Accounting Standards Board, which suspended so-called mark to market accounting rules. This enabled the banks to magically return to health-at least on paper. It also permitted them to begin returning TARP funds-but not before they lobbied Congress to cut the penalties for doing so.

As long as this incestuous relations.h.i.+p between finance and politics remains unbroken, the perverse exchange of favors that fosters deregulation, a.s.set bubbles, crises, and moral-hazard-ridden bailouts will continue. Only significant restrictions on the ties between political inst.i.tutions and financial firms will curtail this mutually destructive relations.h.i.+p. As it now stands, politicians have tremendous power over the scope of regulation as well as the regulators themselves. That is not a good thing. Legislatures hold the purse strings, and agencies that fail to do the politicians' bidding can be punished for their independence.

One proposed solution is to make regulators in the United States and elsewhere more independent. This independence can take different forms: regulators might be given more discretion over how they implement legislative directives. Alternatively, regulators can be given political and even budgetary independence.

There are different ways of doing so. In the United States, the Federal Reserve is largely independent of the executive and legislative branches of government and is "self-funded," meaning that it does not rely on taxpayer money. (Contrary to popular perception, the Fed is not part of the federal government. Rather, as the Fed itself announces on its Web site, it is "an independent ent.i.ty within the government, having both public purposes and private aspects.") Moving responsibility for regulation to the Fed would in theory make regulators more independent. Another model is the FSA in the UK. Though answerable to ministers in the government, it is operationally independent. And like a central bank, it takes no money from taxpayers; rather, it gets all of its funding from fees a.s.sessed on the firms under its aegis.

Like so many sweeping solutions, these have serious shortcomings. In fact, cutting regulation loose from direct government control does not alone guarantee better regulation. The FSA didn't do much to antic.i.p.ate or forestall the recent crisis. In the United States, even the nominally independent Federal Reserve, responsible for regulating banks and even mortgages, failed to use its powers. It then had to compensate by serving as a lender of last resort on an unprecedented scale.

Moreover, the problem of regulatory capture doesn't disappear just because an agency has been removed from accountability to legislators. For example, significant power centers within the Fed-most notably, the board of directors of the Federal Reserve Bank of New York-are effectively controlled by banks on Wall Street. That political independence doesn't necessarily translate into regulatory independence is a point worth considering when contemplating sweeping structural reforms.

Given these flaws, it's probably better to approach the corrupt nexus of finance and politics from another direction. There's a very simple way to curtail the power of the big firms that helped cause the crisis: break them up.

Breaking Up Is Hard to Do.

The recent crisis highlighted what's increasingly known as the "too-big-to-fail" problem. The collapse of Lehman Brothers and the resulting cardiac arrest of the global financial system revealed that many financial inst.i.tutions had become so large, leveraged, and interconnected that their collapse could have systemic and catastrophic effects.

In the United States, when your garden-variety bank fails, the FDIC a.s.sumes control via a receivers.h.i.+p process. But the ranks of too-big-to-fail inst.i.tutions-the TBTF club-contain few such traditional banks. Instead, most TBTF inst.i.tutions belong to another species: big broker dealers like Morgan Stanley and Goldman Sachs; AIG and other sprawling insurance companies; government-sponsored enterprises like Fannie Mae and Freddie Mac; and hedge funds like Long-Term Capital Management.

While the crisis left fewer such firms intact, those that remain are often larger, thanks to the waves of consolidation that followed the panic. JPMorgan Chase took over Bear Stearns and then Was.h.i.+ngton Mutual; Bank of America absorbed Countrywide and then Merrill Lynch. Finally, Wells Fargo and Citigroup fought over who would gobble up Wachovia, an enormous but otherwise insolvent bank. Why do such a thing? The cynical interpretation is that both firms recognized that whoever acquired Wachovia (Wells Fargo eventually triumphed) would be perceived as an even bigger risk to the financial system and could thus earn more bailouts and more forbearance.

We are now in the worst of all worlds, where many TBTF inst.i.tutions have been bailed out and expect to be bailed out in any number of future crises. They have as yet faced no sustained regulatory scrutiny, and no system is in place to put them into insolvency should the need arise. Even worse, many of these inst.i.tutions-starting with Goldman Sachs and JPMorgan Chase-are starting to engage once more in "proprietary trading strategies," which are complicated bets on stocks, bonds, commodities, and derivatives driven by algorithms devised by the firm's traders. Some of these "prop trading" strategies are risky, yet firms have resumed them while remaining under the protective umbrella of a dozen different government support programs.

Policy makers are tackling the TBTF problem in several ways. For example, they're looking at how to make the shock waves produced by the failure of these firms less disruptive and destructive to the rest of the financial system. During the recent crisis, the looming collapse of these firms prompted two equally problematic responses aimed at limiting this collateral damage: a full bailout of the creditors and counterparties of a large financial firm (as in the Bear Stearns and AIG cases) and a disorderly bankruptcy (as in the Lehman case). We need a third way that would provide government authorities with the powers to wind down these firms in an orderly fas.h.i.+on.

One way of achieving this would entail requiring TBTF firms to adopt "living wills" that would kick in should they find themselves incapacitated. Like a doctor fulfilling a dying patient's wishes, the government would step in and implement the terms of this legal doc.u.ment, making the firm's death throes a little less disruptive, painful, and expensive. That way a firm's demise would not play out in a disorderly, destructive fas.h.i.+on as it did in the case of Lehman Brothers. Call it death with dignity.

Another, related solution would entail the creation of a special bankruptcy regime for these sorts of firms. Rather than having them plunge into bankruptcy under Chapter 11 proceedings, which has proved disruptive, it may be appropriate to create an alternative mechanism for winding down these firms. One option would be some kind of conservators.h.i.+p, comparable to what the federal government has used with Fannie Mae and Freddie Mac. Alternatively, a government ent.i.ty endowed with the power to place a firm in receivers.h.i.+p-much like the powers possessed by the FDIC-might be preferable. Both ideas would replace the chaos that comes with a Chapter 11I filing, s.h.i.+fting the action from a federal court to a more powerful federal body. In contrast with a bankruptcy trustee, a federal receiver or conservator would have greater powers to determine how the liquidation of a firm would proceed, could curtail disruptive litigation, and could take other measures to prevent liquidation from becoming too disruptive.

There are some shortcomings in these ideas. As critics of the living will concept have pointed out, various interested parties may not permit such a death to happen. Like some irate family member who refuses to let a DNR (Do Not Resuscitate) order be carried out, bank executives and politicians who have a vested interest in the continued survival of a bank in question might interfere with this process. Tens of thousands of jobs in someone's congressional district might be at stake, as would be generous donations to political campaigns.

Both ideas also have the drawback of putting the government in the role of deciding how much to pay the bondholders as it winds up the concern. Paying too much would send the message to the markets that moral hazard is going out the window. On the other hand, paying too little-or more accurately, less than what the markets expect-could trigger more panic throughout the financial system. These inst.i.tutions are not small: the kind of losses or "haircuts" that bondholders take will have systemic effects. When that happens, even the most artfully designed protocol for winding down these firms may unravel, increasing the temptation to take the path of least resistance-a bailout.

Finally, some policy makers want to adopt a concerted international approach to supervising TBTF inst.i.tutions. An international college of supervisors made up of regulators could monitor firms operating on a global scale. These individuals would confer on the status of these mega-inst.i.tutions and basically keep an eye on them. It's a nice idea, and we have no objections to it. But it's not clear whether this kind of tracking would do a whole lot to prevent a crisis: it's hard enough for shareholders and senior management to antic.i.p.ate fatal flaws in their firm; it may be even harder for a small band of regulators charged with monitoring the world's financial behemoths.

Indeed, these sorts of solutions avoid acknowledging the elephant in the room: not only are such firms too big to fail; they're too big to exist, and too complex to be managed properly. Frankly, they shouldn't exist-at the very least, they should be pushed to break themselves up.

One way of doing this would be to impose higher "capital adequacy ratios," which is a fancy way of saying that these inst.i.tutions should be forced to hold enough capital relative to all the risks posed by their different units. This requirement would reduce leverage and, by extension, profits. Ideally, sending the message that bigger isn't better would lead these firms to break themselves up.

In order for this to happen, capital ratios-like the one established by Basel II-would have to be increased substantially. By just how much is hard to know. For example, Switzerland recently tried to deal with the TBTF problem by unilaterally doubling the Basel capital ratio from 8 to 16 percent for two of its biggest firms, UBS and Credit Suisse. So far, these firms have managed to raise their ratios without shedding any units. That suggests that capital ratios may have to be increased even higher, perhaps to 20 percent or more. Only such draconian measures would force them to fragment into smaller, less dangerous ent.i.ties-or so we hope.

Such aggressive action will prompt howls of protest from the TBTF firms, which consider themselves essential to the day-to-day operation of the world economy. Thanks to their scale, we're told, they offer "synergies" and "efficiencies" and other benefits. The global economy can't function without us, they'll say. In fact, without the kind of one-stop shopping that financial supermarkets like Citigroup provide-well, without them, the global economy would suffer terribly.

This is preposterous. For starters, the financial supermarket model has been a failure. Inst.i.tutions like Citigroup became gargantuan monsters under the leaders.h.i.+p of empire builders like Sanford Weill. No CEO, no matter how adept and visionary, can manage a global financial inst.i.tution that provides thousands of kinds of financial services. The complexity of these firms, never mind the exotic financial instruments they handle, makes it mission impossible for CEOs-much less shareholders or boards of directors-to keep tabs on what's going on across every division and at every trader's desk. That's hard enough to do with any bank; it's impossible with a firm like Citigroup, which at its height employed more than 300,000 people.

Others will argue that only the big financial conglomerates can offer the kind of one-stop shopping that big corporations need to operate in the twenty-first century. This too is risible. No corporation does business with only one firm. For example, corporations issuing bonds on the international market usually rely on a dozen or more banks in several countries to underwrite these offerings. It's clear that a global system of smaller, more specialized financial inst.i.tutions can more than meet the needs of even the largest, most sophisticated firms.

But let's a.s.sume for the sake of argument that gigantic conglomerates like Citigroup, ING, and other megabanks do manage to provide services a bit more efficiently than smaller firms. Even if that were true-which it isn't-are those minor efficiencies really worth holding the global financial system hostage to giant firms whose failure can have catastrophic effects? By that logic, one might build a gigantic nuclear power plant that's a hundred times the size of Chern.o.byl, simply to gain some minor economies of scale. That's nice-until there's a meltdown.

Another reason to contemplate breaking up the TBTF firms is that many of them wouldn't even exist were it not for heavy helpings of government largesse. Take Citigroup. Over the course of the last eighty years, this bank has repeatedly overextended itself and teetered on the brink of insolvency, only to bounce back thanks to government forbearance, rescues, and bailouts. It has arguably happened four times: during the Great Depression; in the wake of Mexico's default on debts owed the bank in the early 1980s; after the commercial real estate bust a decade later; and now in the wake of the recent financial crisis. Any bank that needs that much help doesn't deserve to exist, and while it's now in the process of breaking itself up, the bits and pieces that emerge from the wreckage may be TBTF too.

Citigroup is hardly the only TBTF firm that should be dismembered. Even nominally "healthy" firms like Goldman Sachs pose a threat by virtue of their continued existence. Not that you would know it listening to the firm's CEO, Lloyd Blankfein, who in early 2010 defended handing out record bonuses by claiming, "We're very important. We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. We have a social purpose."

Spare us. Like other broker dealers, Goldman Sachs has a long history of reckless bets and obscene leverage. It was at the center of the investment trust debacle that exploded in 1929, ushering in the Great Depression. It learned from that mistake and spent the succeeding decades operating in a relatively prudent fas.h.i.+on, following a strategy that scorned short-term profits in favor of long-term revenue for its increasingly wealthy partners.

The turning point came in the late 1990s, when Goldman, following the lead of other investment banks, went public. This fateful switch moved the firm from a revenue model where the partners had "skin in the game" to one in which shareholders had little ability or incentive to monitor what was going on inside the famous firm. From this point onward, Goldman helped inflate a host of speculative bubbles, ranging from tech stocks to housing to oil. After the SEC eliminated leverage restrictions for investment banks, Goldman's leverage ratios soared to all-time highs, making it extraordinarily vulnerable when the crisis. .h.i.t Wall Street. In Wall Street circles the running joke was that Goldman Sachs was just a hedge fund-in fact, the most highly leveraged of all hedge funds.

Like its compet.i.tors, Goldman was up to its neck in risky securitization, and while it's true that it saw the subprime bust coming earlier than others, its survival has little to do with its savvy traders. In the end, it lived through the crisis because the federal government propped it up again and again. Like the other broker dealers, it benefited from the bailout of the counterparties of Bear Stearns in the spring of 2008, and from the Fed's decision to provide broker dealers with lender-of-last-resort support. Likewise, it was saved during the bailout of AIG, netting a cool $12 billion from taxpayers. (No surprise there: Goldman was heavily involved in discussions about the AIG bailout during the run-up to the rescue of the ailing firm.) It netted $10 billion more after the Fed guaranteed the senior unsecured debt of banks and bank holding companies. Then there's all the indirect aid: the low interest rates that slashed Goldman's borrowing costs; and the Fed's decision to purchase $1.8 trillion in Treasury debt, mortgage-backed securities, and other instruments, propping up prices and indirectly helping the firm. All told, Goldman probably took upwards of $60 billion in direct and indirect help, then took even more after converting to a bank holding company, when it got access to TARP funds.

Goldman would be bust without this help. That it would likely have been the last of the investment banks to perish simply because it placed better bets than most doesn't alter that fact. Yet its close brush with annihilation doesn't seem to have left its ringleaders chastened-and no wonder. They now belong to the TBTF club, which apparently gives them license to do whatever they want. There seems to be no means of stopping them: they've wriggled free of restrictions on compensation by returning the TARP funds. Now they're back in business as the world's biggest hedge fund, pursuing their high-risk prop trading strategies. That's bad enough, but unlike any normal hedge fund, they've got lender-of-last-resort support from the Fed, plenty of easy money, and even the option of FDIC-insured deposits, all of which give it an unfair compet.i.tive advantage. For all these reasons, Goldman should be broken up. Or at the very least, its broker-dealer activities should be split off from the parts of the firm involved in proprietary trading, hedge funds, private equity, and other risky investment strategies.

Plenty of other TBTF firms deserve to be nudged to break up as well: Bank of America, UBS, Wells Fargo, ING, Royal Bank of Scotland, Dexia, JPMorgan Chase, BNP Paribas, and others. But despite the grave danger that these TBTF firms pose, policy makers in Europe and the United States strenuously resist the idea of dismantling them. The genie is out of the bottle, the thinking goes; there's no way to go back to a more decentralized banking system. Ma.s.sive, somewhat monopolistic financial firms are here to stay, despite the dangers they pose to the financial system.

If you believe this, we have some CDOs to sell you. Big firms have been dismantled many times before, typically by court order. In the United States, ant.i.trust laws offer the most obvious means for doing so. In the early twentieth century, Presidents Roosevelt and Taft oversaw the dismemberment of Standard Oil and other trusts; more recently, in 1982, the Department of Justice succeeded in breaking up AT&T. A similar campaign could be launched against the TBTF inst.i.tutions, which increasingly control broad swaths of the financial system.

An even better solution would be to pa.s.s legislation granting regulators the authority to break up banks and other financial inst.i.tutions that are so large, leveraged, and interconnected that their collapse would pose a danger to the entire financial system. Unlike ant.i.trust actions, this approach would make a breakup contingent on whether the bank in question is too big to fail, as opposed to monopolistic. Indeed, plenty of firms may not merit an ant.i.trust proceeding but still pose a dire threat to the stability of the global economy.

Even these approaches, however, may not yield the sort of sweeping transformation of finance that's necessary. Some firms might be broken up, while others might successfully ward off efforts to do so. This would be an imperfect solution. That's why the approaches we've discussed may work best when combined with another equally radical strategy: breaking up all the big banks.

Initially the Obama administration showed little inclination to do so. But thanks to some nudging from Paul Volcker, there are signs that senior policy makers will implement rules that may limit the potential size of the TBTF firms. If they do, they might also consider the following proposal. While radical, it would go a long way toward taming the various Brobdingnagian banks that have become too interconnected, too important, and too big to fail.

Gla.s.s-Steagall on Steroids.

In the wake of the recent crisis, distinguished thinkers like former Fed chairman Paul Volcker have argued for some kind of return to the Gla.s.s-Steagall legislation of 1933, which separated commercial banking from investment banking. This firewall eroded in the 1980s and 1990s, finally disappearing altogether with the Gramm-Leach-Bliley Act of 1999. The result was the current system, where a firm like Citigroup or JPMorgan Chase can be a commercial bank, a broker dealer, a prop trader, an insurance company, an a.s.set manager, a hedge fund, and a private equity fund all rolled into one sprawling inst.i.tution.

The breakdown of barriers meant that banks with access to deposit insurance and lender-of-last-resort support pursued high-risk activities that resembled gambling more closely than banking. This was bad for the financial system and for the economy at large. As Keynes rightly observed in 1936, "When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."

Many reformers have understandably counseled a return to Gla.s.s-Steagall, and as of early 2010, there are bills in Congress that would restore it in some way or another. Thanks to Volcker's lobbying, the Obama administration was considering whether to prohibit bank holding companies-which now include firms like Goldman Sachs and other major financial players-from pursuing proprietary trading, private equity deals, and any hedge-fund activity. But industry lobbying is likely to prevent the restrictions from being implemented.

These proposals are good but not good enough. What we need is a twenty-first-century version of that historic legislation that would create a number of new firewalls. It would move beyond a simple separation between commercial and investment banking and create a system that can accommodate-and separate-the many different kinds of financial firms now in existence, as well as curtail the sort of short-term lending that made the financial system "too interconnected to fail."

Accordingly, commercial banks that take deposits and make loans to households and firms would belong in one category; investment banks (broker dealers) would belong in another. In order to avoid any entanglements between the two kinds of banks, investment banks would be forbidden to borrow from insured commercial banks via the short-term, overnight "repo financing" that proved so fragile during the recent crisis. The divide between these two types of banks would thus be inst.i.tutional as well as relational.

That's a start. Given that so many of the shadow banks got themselves into trouble by borrowing on liquid, short-term bases and then sinking that money into long-term, illiquid investments, regulators must restrict their ability to do it even further. That means banning investment banks and broker dealers from doing any kind of short-term borrowing. If they're going to make long-term investments in illiquid a.s.sets, they'll have to raise money by issuing stock or long-term debt. This reform would make the financial system less interconnected, and therefore less p.r.o.ne to the kind of systemic chain reactions that lead to widespread failures.

In order to stabilize the system even further, all banks-including investment banks-should be forbidden to practice any kind of risky proprietary trading. Nor should they be permitted to act like hedge funds and private equity firms. Instead, they should confine themselves to doing what they've done historically: raising capital and underwriting offerings of securities. The kind of proprietary trading that many investment banks now do, never mind hedge fund operations, should be the franchise of hedge funds alone. But like the investment banks, hedge funds would not be permitted to engage in large-scale short-term borrowing from banks and other financial inst.i.tutions. They would have to turn to long-term funding instead.

Insurance companies and private equity firms would fall into additional categories. Neither type of inst.i.tution would be permitted to branch out into kinds of financial intermediation beyond their core activities. Insurers could not engage in proprietary trading; nor would any commercial bank, investment bank, or hedge fund be permitted to venture into insurance. Private equity would remain the province of private equity firms. A firm belonging to one category could not venture onto the turf occupied by firms in any other category. This would help eliminate the too-interconnected-to-fail problem; it would also rid these firms of the twisted conflicts of interest that invariably arise by having different units pursuing contradictory ends.

One final note: only commercial banks would have access to deposit insurance and a government safety net. Everyone else-investment banks, broker dealers, hedge funds, insurance companies, and private equity firms-would be on their own. Some of these inst.i.tutions would eventually fail. But they would not pose a systemic risk: they would not be as large or as interconnected as they are today. Finally, because they would not be permitted to act like banks-borrowing short and lending long-their demise would be unlikely to trigger the kind of panic that seized the shadow banks at the height of the recent crisis.

The financial system we're describing is compartmentalized, sanitized- and boring. And that's precisely the point. It could be made more boring by forcing banks to become "narrow banks," which can only take deposits and invest them in safe, short-term debt. Unfortunately, this kind of draconian restriction would simply chase financial intermediation into the shadows-precisely the problem that originally created the crisis.

For that reason, it's better to preserve different kinds of financial inst.i.tutions in their present forms but pursue the regulatory equivalent of divide and conquer. By unbundling the financial services now combined under one roof, we can steer the financial system away from an excessive reliance on too-big-to-fail-and too-interconnected-to-fail-firms. By returning to a beefed-up version of Gla.s.s-Steagall, and by adopting reforms aimed at moving financial activity away from opaque trading strategies and onto transparent exchanges, we can create a safer, saner financial system, with the added benefit of robbing firms of their ability to extract disproportionate profits from deluded investors.

Financial firms will howl at this prospect. Let them. For all their whining, one fact remains indisputable: these firms' reckless appet.i.te for risk helped create a crisis that has inflicted widespread suffering around the world. They are complicit in that wider disaster, and in the future they should be kept on a very short leash.

Let's not forget one final point. The financial firms could have been stopped from going down this destructive path. The most obvious way would have been better regulation and supervision. Sometimes, though, even that is not enough; a more systemic solution is needed, like using the power of central banks to prevent bubbles from forming in the first place.

Banis.h.i.+ng Bubbles.

In 1996 Alan Greenspan gave a speech that warned of the dangers of "irrational exuberance." Market watchers who dissected Greenspan's every utterance immediately concluded that he was on the verge of raising rates, and global stock markets plunged. Chastened, Greenspan never again issued any public warnings as the tech bubble grew to monstrous proportions. Aside from a token interest rate hike of one quarter of one percent in 1997, he did not raise interest rates again until the middle of 1999; following the LTCM near collapse, the Fed actually cut the Federal funds rate by 75 basis points, thus further inflating the tech bubble.

The bubble eventually burst in 2000, and Greenspan's Fed responded by slas.h.i.+ng interest rates by 5.5 percentage points-from 6.5 percent to 1 percent-between 2001 and 2004. The rising tide of easy money helped cus.h.i.+on the bursting of the tech bubble, but it fed another bigger bubble in housing. Here too the Fed stood by and did nothing. Despite mounting evidence that the market was spinning out of control, Greenspan and then Bernanke kept interest rates low, raising them too slowly and only when it was far too late. The bubble burst shortly thereafter, and the result was the financial catastrophe of 2007-8. This prompted yet another round of dramatic rate cuts, bringing borrowing costs close to zero.

There's a familiar pattern here: the Fed stands by and does nothing as bubbles form and a.s.set prices go through the roof; then when the bubble bursts, it tries every trick in the book to alleviate the damage done. This approach is wrongheaded and wasteful. Central bankers do not seem to buy the old adage that an ounce of prevention is worth a pound of cure. Like a doctor who will do nothing to stop a patient from smoking but will aggressively treat him for lung cancer many years later, central banks have taken a halfhearted, "asymmetric" approach to dealing with bubbles.

In all fairness, the reluctance of central banks to prevent bubbles from forming reflects the fact that the idea remains controversial in academic and policy circles. Unfortunately, much of that controversy emanates from the writings and speeches of Alan Greenspan and Ben Bernanke, who along with a handful of other economists have argued that central banks cannot do much to control bubbles; they can only clean up in the aftermath. As Greenspan argued in 2004 in reference to the tech bubble, "Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose . . . to focus on policies 'to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.' "

This strategy is strange. For starters, it generates moral hazard on a grand scale. Watching the Fed over the past two-plus decades, investors now have every reason to conclude that central banks will do nothing to stop a speculative bubble from forming and growing-and in fact may even encourage it, becoming cheerleaders for the "new economy" or the virtues of home owners.h.i.+p-but will do everything in their power to limit the damage. This is extraordinarily problematic. If investors believe the Fed will save them, they'll take even more risks the next time around. Likewise, they'll know that when the other shoe finally drops, the Fed will slash interest rates to rock-bottom levels, creating opportunities to speculate in some even bigger bubble.

Bernanke and other apologists for the status quo have countered by arguing that central banks can't possibly intervene against rising a.s.set prices because of "uncertainty." This is nonsense: all monetary policy decisions are plagued by uncertainty. Uncertainty doesn't stop central bankers from targeting inflation; it shouldn't stop them from countering bubbles either. Moreover, policy makers have available certain tools that can at least give some measure of whether a.s.set prices are spiraling out of control. And let's face it: models aside, there's always common sense, an a.s.set in short supply among policy makers in recent years. If central bankers look at share prices of tech stocks doubling and tripling within the s.p.a.ce of a few months and still can't see a bubble-well, perhaps they should consider another line of work.

Other arguments often get trotted out in favor of central bank pa.s.sivity in the face of a.s.set bubbles. Some economists claim that bubbles aren't bad for the economy; therefore central banks shouldn't mess with them. This claim is patently ridiculous: a vast body of historical evidence ama.s.sed over centuries shows that when bubbles burst, the larger economy suffers tremendous collateral damage that can linger for years.

Yet another argument holds that any hike in interest rates meant to p.r.i.c.k an a.s.set bubble risks triggering a ma.s.sive recession. In other words, the risks outweigh the potential benefits. By that logic, it's better to do nothing at all. Proponents of this point of view believe the Fed's decision to raise interest rates in 1929 caused the crash, much as the Bank of j.a.pan's attempt to control that country's a.s.set and real estate bubble caused the crash in 1990. These and other examples provided by the "p.r.i.c.k-the-bubble-crash-the-economy" pessimists conveniently ignore the fact that in both cases the central bank aided and abetted speculation in the bubble's critical earlier stages, taking away the proverbial punch bowl long after the party had gotten out of control.