What Is To Be Done?

Tyler Cowen writes a NY Times op-ed article that spells out the problems in the Obama administration's approach to the financial crisis:

If we are going to prevent an A.I.G.-like debacle from happening again, institutions like these need incentives to be more wary of their trading partners. Any new regulatory plan needs to deal with them in a sophisticated way.

That’s because even smart and honest regulators can monitor a financial firm only so well. A firm’s balance sheet doesn’t always reflect its true health, and regulators do not have an inside perspective on the firms they are supposed to secure. We do need more effective regulation, but calls for regulators to “get tough” are likely to prove effective only as long as a crisis lasts.

What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.

But in both the bailouts and in the new proposals, the government is effectively neutralizing creditors as a force for financial safety. This suggests a scary possibility — that the next regulatory regime could end up even worse than the last.

It is encouraging to see that Barry Ritholtz on The Big Picture agreeing with Tyler Cowen:

I frequently disagree with Tyler Cowen — our world economic views are quite different, as are, I assume, our politics. But his column in the Sunday Times today, I can find at least one major area where we are sympatico.

Ritholtz agrees with the need to make creditors suffer so they will take on less risk in the future. He then goes on to outline where he differs from Tyler Cowen:

• “A simple but unworkable alternative is to let major creditors make their claims in the bankruptcy courts”
  
  I totally disagree; That’s what bankruptcy courts are for. Anything else replaces the capitalist system with the worst form of Moral Hazard — a direct guarantee of all credit.


• “This suggests a scary possibility — that the next regulatory regime could end up even worse than the last.”
  
  Um, what regulation? Half of the current problems derive from an absence of any prior regulatory regime. No derivative regulation, no limits on leverage, no separation of commercial and investing banking.


• “Much went awry at A.I.G., but in the context of a bailout, the company should be thought of as the conduit for helping an entire market that went bust.”
  
  No, it shouldn’t. If we say that, then the Taxpayer is implicitly guaranteeing all credit and speculation.

One last thing: Obama administration rightly deserves criticism for this policy — but nowhere in Cowen’s article does he mention that this absurd policy is a continuation of the stupidity put forth by Hank Paulson, the Treasury Secretary under George W. Bush. That is a very unfortunate oversight in an otherwise good article.