“Populism” and further crisis

Simon Johnson, in a recent post titled “Populism” , addressed our current economic situation and stated that the language being used to discuss the issues we now face “reveals a complete misunderstanding of our current situation.” This assertion is based around the banks that have now been deemed “too big to fail;” and how, despite the efforts to correct the problem, these banks have increased in size due to government investment of bail out money. Resulting in a commitment to engage in a cycle, which Johnson describes as “repeated boom-bust-bailout,” that only adds to the problem. Failing to address the actual issues that led to the current financial crisis, the commitment to this cycle only sets us up to face similar problems in the future

The investment of federal funds in financial institutions deemed “too large to fail” addresses none of the issues that caused these institutions to be on verge of failure to begin with. The failure of these institutions, the banks in specific, was not a result of an initial lack of capital. Instead the consequence of policies based on the assumption of continued boom that, when faced with the bust of an industry, caused the collapse of the institutions’ ability to cover their commitments. Simply providing the capital for these institutions to cover their debts serves only to create a safety net which allows the continuation of current policies.

Such a solution, which allows current policies to continue unregulated, addresses none of the issues which created the financial crisis; in-fact, the problem is exacerbated because a precedent is set. Establishing a precedent that suggests a federal bailout to failing institutions makes our problem worse because it serves to provided incentive for companies to resist change that might make them more accountable. Increased accountability becomes undesired as it would imply that the federal safety net would no longer protect companies against their own mistakes and flawed policies. Furthermore, the amount of capital invested in the companies solely because they were “too big to fail” only serves make these institutions larger, and increases the publics stake in their fate. Meaning that a future failure would be even more costly for the public; making the problem worse not better. Consequently, bailing out institutions who are “too big to fail” is not a viable solution. There is instead a need to focus on shrinking these companies, regulation their actions, and making them more accountable.

The current financial crisis can be looked at as the result of poor policies within institutions whose massive size guaranteed that their failure would be extremely detrimental to the public. Instead of simply covering the debts of these companies, and tweaking the regulations already in place, there is a need for new regulations that make the individual institutions accountable for their actions. In addition, the failure of a company can not be prevented by the federal government simply because of their size. Doing so allows companies to continue to act as they have been without need for a change. The possibility of failure must be present because it gives troubled institutions motivation to significantly change the policies that could lead to their collapse.

As to the size of these institutions, the reason their failure would have a large and significant impact on the public, further regulation is also necessary. The truth is that these companies are very large, massive in-fact, and attempting to reduce their size alone would not fix all the problems. However, new regulations restricting how these large institutions invest their capital, and how much of a large institution can be devoted to one form of investment, offer a solution to the failure of these companies. New regulations along these lines would mitigate the damage of a bust in a single industry. If large companies are forced to keep from being overly invested in one industry, or form of investment, the bust of that industry or investment would have a significantly less damaging effect. Protecting against the failure of large institutions by keeping them from being too vested in the fate of one industry. One way or another, it is clear that simply bailing these companies out is not a viable, long-term, solution and that there is a need for change.


5 Responses

  1. Haven’t finished your post yet, but I saw this op-ed by Krugman. Thought you might like to see it as it is on topic of banking reform.

    Boring is good in banking.

    • He makes a real good point, the idea of the boring but safe bank is something that the US financial sector could learn from. Regulation again comes up as key to reducing risk and protecting against future failure; but again it seems like there is a political commitment against reform. I think it might be interesting to address why, and how this needs to change if we want to avoid this situation again in the future.

      • Of course, there is also the question of what kinds of regulation. What goals do we seek and who defines those? here again politics comes up.

        Why do you think there is a political commitment against reform?

  2. I think there seems to be a political reform because even in light of our economy’s recent troubles, the federal government has been slow to issue new, targeted, regulations. Instead the policy has been to throw money at the issue and tweak the regulations already in place. I honestly thinks this resistance stems, in part, from an unwillingness to admit the faults of the current structure of the economy. There seems to be this view that the current crisis is not a fault of the system, but of extreme circumstances. Shifting the blame from the system’s faults to a series of events, and preventing the issue from really being addressed.

  3. […] on financial reform Posted on February 21, 2010 by derek One of my previous posts dealt with the issue of financial reform and the idea of “too big to fail” companies. […]

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