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New York Post

 

To Fix US Finance

October 16, 2008

By Nicole Gelinas

ON Monday, the Treasury Department essentially nationalized the risk of lending to the US financial industry. President Bush called it "an essential short-term measure to assure the viability of America's banking system"—but the long-term worry is that, after we recover from this mess, finance will work on the assumption that the taxpayers will bail it out next time.

And that will lead to riskier behavior, virtually inviting another crisis.

To realize how to fix this, we need to understand what caused it.

Fortunately, we're not seeing anything new under the sun. Today's hurricane bears a similarity to the late '20s and their aftermath.

Back then, easy borrowing had pushed stock prices up, and an assumption of ever-higher stock prices reinforced the easy lending environment. Then the inflated value of stocks and other assets went "pop," and this deflation—worsened by unwise monetary and tax policy—spread to the real economy.

Banks, having lost so much lending against inflated asset values, couldn't or wouldn't lend much new money. Not trusting the banks with what was left, individuals and small businesses scrambled to pull their money out, and these "runs" caused more bank failures. Credit dried up—and assets, with no borrowing available to buy or improve them, continued to fall in value.

When Franklin Roosevelt became president in 1933, he didn't try to rebuild the financial system by ending free-market risk-taking. But he did realize that the government had to protect the crucial supplies of money and credit from the worst excesses of future speculation.

To that end, he created the Federal Deposit Insurance Corp., which radically changed the way people thought about banking by guaranteeing small deposits at commercial banks.

Even if a bank made some crummy bets, it now had a good chance of muddling through by attracting new depositors, who wouldn't worry that they'd lose their shirts.

And when one did fail, customers could quickly get their money back. Just as important, the government would take over the bank and wind it down, so it couldn't do further harm.

Rough economic times might see the simple business of lending and borrowing slow or get pricier, but it could carry on. People wouldn't stuff their money under their mattresses.

The September failure of Washington Mutual, the sixth-largest US bank, showed how well this system works: People didn't go running to withdraw their funds from other banks.

By reducing one problem, though, the government conjured another: that the newly insured banks would feel free to take greater risks themselves - with the taxpayers on the hook. So, even as Congress and FDR devised deposit insurance, they forbade commercial banks, which dealt most commonly with average customers and average business borrowers, from lending money to purchase stock. And they forced these banks to sell their securities affiliates, so that they couldn't use customers' money to underwrite or invest in stocks.

That left the securities business to investment banks—which dealt with big institutions and supposedly sophisticated lenders, and faced looser regulation.

Today's crisis makes it painfully clear that the regulatory principle of protecting the money and credit supplies from panic hasn't diminished in importance since the '30s.

The problem is: The financial world changed so dramatically since then that the old regulations didn't work anymore.

Over the past quarter-century or so, with the modernization of the financial industry and the globalization of markets, the big investment banks became just as responsible as commercial banks for the creation of vital consumer and business credit.

When you borrowed money easily and cheaply—from mortgages to auto loans to business loans—it was, more and more often, because an investment bank had found a customer to "invest" in your debt.

y 1999, a bipartisan majority in Congress and President Bill Clinton (along with armies of bank lobbyists) decided that the lines separating the financial worlds had blurred so much that the old separations between banking and "riskier" securities businesses were irrelevant: Washington changed the law to let commercial banks back into the securities business and vice versa (though commercial banks would still operate under tighter constraints).

Some critics now charge that this was a mistake because it was too dangerous to allow commercial banks and securities banks to mix. They're wrong: The real problem is that the securities side of the business has grown just as important to the economy as is the closely-regulated banking system—while being as vulnerable to runs as pre-FDIC commercial banks.

Indeed, runs on the securities markets became more likely—because the business has grown so complex and opaque thanks to things like trillions of dollars tied up in unregulated, inscrutable credit derivatives. This gave even "sophisticated" investors really no choice but to flee at the first sign of inevitable crisis.

In today's financial run, investors have lost faith in nearly all big financial institutions and the quality of their assets—and virtually put their money under their mattresses.

Effective Monday, lenders to banks understand that the government guarantees their money. The hope is that, with this confidence, investors will put their cash back in.

The problem is this creates the expectation that the feds will be there in the next crisis. And that implicit guarantee makes it more likely that lenders, facing a choice between a complex financial firm and a complex software company, will choose the bank.

So finance—an industry that likely should get smaller and less dependent on debt—could keep growing, and become even more dangerous to the economy and, now, the taxpayer.

We now know that the markets aren't up to policing themselves. How do we put in place explicit, predictable ways to protect the economy from financial-sector failure?

For starters, we must avoid the pernicious but seductive idea that since financial-firm failure has proved so dangerous, we have to prevent it.

Original Source: http://www.nypost.com/seven/10162008/postopinion/opedcolumnists/to_fix_us_finance_133818.htm

 

 
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