Let me answer Robert Samuelson’s presumably rhetorical question at RealClearMarkets, “Are we prepared for the next financial crisis?” No, we’re not. He lists four propositions:
- Another financial crisis is inevitable.
- Financial crises are not self-correction.
- Only the federal government has the power and resources to deal with a financial crisis.
- Paradoxically, Dodd-Frank has crippled government’s ability to defuse future financial crises.
The colossal irony of the financial crisis of 2007 is that we responded to serious problems fomented by misconduct at a handful of very large institutions by refusing to punish any miscreants and further centralizing the banking system.
I think that Voltaire’s wisecrack from Candide about the military, “Dans ce pays-ci, il est bon de tuer de temps en temps un amiral pour encourager les autres” (“In this country it’s good to kill an admiral from time to time to encourage the others”) is just as true for the financial system.
Let us begin with this quote from the article,
and if we want to be more accurate, let us change containing to contributing. At the NY Fed, Mr. Geithner was a fool at best. He was a textbook case of regulatory capture. Upon becoming Secretary of Treasury, he began working to restore the bonuses to Wall Street.
1. Another financial crisis is inevitable.
Mr. Geithner notes that if pushed too hard the financial will turn to unregulated activities.
This is nonsense. Banks engage in unregulated activities because they can. This was discovered 84 years ago, and measures were taken to fix or contain the problem. For those who have not guessed, I am talking about Glass-Steagall, but what is new?
For what were once called Investment Banks, they were competing against other entities legally engaging in unregulated activities, and they needed to be able to compete. They were mostly unregulated or lightly regulated, but they had no direct access to the Fed.
For what were once called Commercial Banks, they were old fuddy-duddies respectable enough to walk down Main St. Like their Investment cousins, they were still animals, but they walked upright and tipped their hats to the ladies rather than eat them. Because they were willing to act civilized in mixed company, the US government agreed to back them as long as they followed certain rules.
With G-S repealed, we have well behaved poodles, dolphins, and panda bears mixed together with lions, bears, and rattlesnakes. Somehow, this is not seen as a problem. According to the experts, it is possible for grandma to have afternoon tea with a rattlesnake as long as the rattlesnake has been trained well enough and signed the correct papers.
When grandma is found dead with two puncture marks on her and all the signs of some type of toxic injection, the smartest people in the whole wide world begin an investigation into the tea and how it was made and where the leaves originated. After wasting time and money, it is determined that grandma was killed by tea that had enough toxic substances in it to kill her if she drank ten barrels a day for 268 years.
2. Financial crises are not self-correction.
The article quotes Mr. Geithner … The resulting “fire-sale prices . . . make large parts of the financial system appear to be insolvent.” Someone or something must intervene to stop the spiral. …
The problem with a fractional reserve banking system is that it is designed to be insolvent. Otherwise, it is fully reserve banking. A fractional bank with $100 does not lend $90. It lends $900, but because the loan is deposited into an account, the bank is considered solvent. The bank has $1000 in deposits and $900 in loans with $100 in reserve.
The system works because the US government directly through the FDIC and indirectly through the Fed are a guaranteed backstop for all regulated banks. When a “run on a fractional bank” begins, the majority of people will lose their money. This is how fractional banking works. Under G-S there were no “runs on Commercial banks” because they were practically solvent.
Regulations that are not based upon this simple fact will fail or will strangle the banks. G-S provided a working solution.
3. Only the federal government has the power and resources to deal with a financial crisis.
I assume Mr. Samuelson is paraphrasing Mr. Geithner. … Absent this torrent of emergency credit, it’s not clear what would have happened.
Only the federal government has the power and resources because it is the federal’s power and resources that allowed the system to exist in the first place. See number 2. With the repeal of G-S, Investment banking (and Wall Street in general) had almost the same direct access to the federal government’s and the Fed’s backstopping mechanisms.
For the fully regulated banks and the regulated portions of other entities (AIG’s insurance), it is quite clear what would have happened – nothing, and if the money market accounts had been brought under an FDIC-like entity, nothing would have happened to them. If the failing MBSs had been required to be marked-to-market, the federal government could have bought them at a fixed percentage above fire-sale prices.
Mortgages could have been re-worked without any principle forgiveness. The new mortgages could have been sold back into the market. Obviously, it is a little more involved than this, but it is quite feasible.
What would have happened to a large section of the visible and the opaque part of the financial system would have collapsed. This portion would have been the investment (gambling) section. These are financial investments in the financial industry. They do not contribute to production.
4. Paradoxically, Dodd-Frank has crippled government’s ability to defuse future financial crises.
Dodd-Frank tries to regulate away points 1, 2, and 3. To recap, a fractional reserve banking system is insolvent by design; only the federal government can magically transform insolvent banks into solvent ones; therefore, only the federal government can solve the problem it has created or allowed to be created.
Dodd-Frank is internally inconsistent. The three points above are not understood or repudiated. Either way, any attempt to resolve the situation will fail. The problem is like trying to divide by zero. Claiming that everything will be fine the next time because this is a really big zero is meaningless, and this is basically what Dodd-Frank does.
In the second to last paragraph, Mr. Samuelson writes, “The real Dodd-Frank scandal is that this misinterpretation of events, widely embraced by both parties, has been allowed to stand. …”
He is quite right, but his version is just as misguided. If he had a better understanding, he would have seen how allowing the unproductive investments of the financial industry to collapse would have been a good thing. It would have allowed the table to be re-set. An updated version of G-S could have been enacted.
Instead, the unproductive financial sector grows because of government intervention, and additional governmental intervention will not fix the problem.
The way to ensure that grandma does not get bitten by rattlesnakes is to keep them out of the areas humans inhabit. Rattlesnakes should be allowed to act like rattlesnakes elsewhere, and if grandma decides to play with rattlesnakes, it is her problem if she gets bitten.