Cartoon: Too Big to Fail

Too Big to Fail

New Financial REgulations Won't Fix Anything

The financial reform bill currently working its way toward President Barack Obama's desk for signing is being touted as the biggest overhaul of the banking and investment sectors since the Great Depression.

But the new regs won't be any more effective than the ones they replace in fixing anything or preventing the next major panic for at least three reasons.

1. New Watchdog, Old Tricks

They create a new watchdog consumer agency designed to protect consumers from their own supposed stupidity. You'll now be facing fewer choices when it comes to getting credit cards, loans, and doing other basic financial transactions.

2. Never Too Big To Fail

They replace "Too Big to Fail" with... "Too Big to Fail." One of the reasons why major financial institutions played Russian Roulette with the economy was because they were betting they would get bailed out. Which is precisely what happened. The new rules codify the idea that the government will make sure certain institutions can never fail. And if you think the big boys won't game that system, then you don't understand how well Citigroup, Goldman Sachs, et al have come through the current meltdown.

3. Housing Bubble Trouble

The financial crisis was set into motion by government policies that encouraged people to buy homes they couldn't afford at prices that were unsustainable. Between desperate attempts to keep people in houses and to keep interest rates below an effective rate of zero, the government continues to pour more money down the same rathole.

Markets work best when the risk and reward incentives are clear cut. When investors know they really can lose it all, they act responsibly with their money. If regulators think they can create a system that cushions us from bad decisions and doesn't encourage bad behavior, it's a delusion we'll all be paying for for a very long time.

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Cartoon: Too Big to Fail

Cartoon: Too Big To Fail

Financial Crisis and Too Big to Fail

[T]he financial crisis that began in the summer of 2007 has posed a major problem. We had grown rather accustomed to singing the praises of free financial markets. The crisis threatens to discredit them.

But this crisis was not the result of deregulation and market failure. In reality, it was born of a highly distorted financial market, in which excessive concentration, excessive leverage, spurious theories of risk management and, above all, moral hazard in the form of implicit state guarantees, combined to create huge ticking time-bombs on both sides of the Atlantic. The greatest danger we currently face is that the emergency measures adopted to remedy the crisis have made matters even worse...

Economists have long held that bank failures pose a "systemic" economic risk, because failed banks are associated with monetary contractions for the economy as a whole. There is therefore a presumption that, if big banks are threatened with liquidity or solvency problems, they should be bailed out by the action of the central bank or government. Despite much pious talk of "moral hazard" prior to 2007, little was done to disabuse big financial institutions of this notion. They could and did assume that they enjoyed an implicit government guarantee...

During the crisis it was often said that officials at the Federal Reserve and Treasury would do "whatever it takes" to avoid a Great Depression. Now they must do whatever it takes to address one of the key causes of the financial crisis: the existence of financial institutions that consider themselves too big to fail – but which are run in such a way that they are bound to do so.

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