Not many people like the idea of breaking up financial institutions, but if I have to be part of a tiny minority, I’ll take this one:
“People say I’m old-fashioned and banks can no longer be separated from nonbank activity,” Mr. Volcker said, acknowledging criticism that he is nostalgic for an earlier era. “That argument,” he added ruefully, “brought us to where we are today.”
He may not be alone in his proposal, but he is nearly so…
Still, a handful side with Mr. Volcker, among them Joseph E. Stiglitz…“We would have a cleaner, safer banking system”
Is separating Boring from Exciting finance really that difficult?
Here is the counterargument, from Alan Greenspan himself:
No form of economic organization can fully contain bouts of destructive speculative euphoria.
You know it’s Al, because the protagonist’s peroration is obscured by unusual verbiage and syntax to provide an intellectual imprimatur on a Republican hack.
But hell, let’s take it seriously, since it’s the same argument Larry Summers would make. It is no more intellectually rigorous than saying that because man has been killing man since the dawn of time, and remains fully capable of killing with his bare hands, we should have no nuclear arms control whatsoever since no system can absolutely prevent murder.
All of man’s systems can and will fail. This isn’t just a matter of economics; in the early 1930s, Germany’s entire society failed so catastrophically that people who had lived in prosperity and civilization for centuries decided to barbarically slaughter millions of their own citizens while launching total war in every direction. Man is a very fallible creature.
Still, the great aspect of civilization is that we are able to make plans in advance that we hope will cushion our passions in desperate times – and, especially, keep us out of those times altogether. We have done far more difficult work; it was hardly obvious, in 1787, that democracy was a viable system, yet the decisions made that summer in Philadelphia cushioned the madness of the subsequent years. By creating multiple centers of power the Founders gave us the resiliency to endure the moments when a John Calhoun or Joe McCarthy or Huey Long or George W Bush might come along. If we had even a ministerial system Social Security would have been privatized four years ago.
The financial system is inherently about networks. You can build a car on a desert island, given enough tools. You cannot have a bank. And activities that involve networks entail risks that problems in one part of the network are transmitted to the rest of the network. We have computer viruses as surely as we have finance panics.
The key to defending a network is to ensure enough redundancy and separability that a problem area can be abandoned like a gecko’s tail. A system that places all its emphasis on one fortress that must be defended at all costs is at tremendous risk from the outset, however impregnable it might appear (cf Maginot Line).
Too Big To Fail institutions will only grow. Their very TBTF nature causes this – they are more profitable than ordinary institutions, for they are essentially sovereign credits. Sooner or later they will reach a size and importance where bailing them out will tax the resources of the nation; indeed, that is the only true upper bound to that status. In ordinary times, by the way, it is perfectly possible to go well past that point – just look at Iceland, or, but for the cascade of Eastern European defaults that never happened, Switzerland. The US, by virtue of global belief in its unsurpassed wealth, can go quite a ways into the unsupportable category; we had no practical ability to redeem all of our outstanding currency for gold well before we formally abandoned convertibility, but it took a long time for pressure to build to a point we could not ignore it.
Eventually, though, it happened. And the same thing will happen with this round of financial consolidation. At some point some large entity will make a serious mistake, or have its true condition revealed despite FASB’s best efforts (come on, a giant retail bank has the bulk of its assets in residential and commercial real estate loans in LA, SD, SF, PHX, and LV issued 2003-7 and you tell me it does not have negative equity – even if every single loan were 80/20 and issued at a then-accurate appraisal, how?), and the government is going to have to step in at a time when there is a doubt it can do so. Or domestic priorities simply do not allow it. That moment – that time the government fails to bail out an acknowledged Too Big To Fail – is going to be the disaster Paulson insisted was happening last year. It won’t be a run on GS, it will be a run on the US.
And it is entirely unnecessary. Not only can we break up financial institutions, we did it once already. It worked. Not spectacularly well; we ended up with a bunch of redundant costs and a fair amount of friction. But all of the extra costs of 1934-99 regulation probably didn’t add up to the Treasury/Fed outlay of September and October 2008, and there was no need to panic. Goldman Sachs actually did nearly blow itself up in 1994, going hat in hand to the Kamehameha Schools precisely because it had no expectation of government help. That safer world is well within our reach, and it shouldn’t take a random blogger – or the finest Fed chairman in history and a two-time Nobel Prize winner – to point this out. It should already have been done.