How to Handle Wall Street

Here's a viewpoint by Edward L. Glaeser, a Harvard economics prof, published in the Boston Globe:

IN THE 1912 presidential election, Woodrow Wilson fought for a “New Freedom’’ and favored breaking up over-mighty businesses. One of his opponents, Theodore Roosevelt, wanted a “New Nationalism,’’ where big business would be controlled by robust regulation and a powerful public sector. Today, America is again faced with the Morton’s Fork of either regulating or dismantling financial firms that are “too big to fail.’’ For Rooseveltian regulators to succeed, they need enough information to restrain excessive risk-taking and that requires a system where financial firms reveal each other’s risks.

In the halcyon days before 2007, libertarians could argue that financial failures impose few social costs, so there was little point to either regulation or size limits. But the wrenching market turmoil that followed Lehman Brothers’s collapse shattered that illusion. The bailouts that ensued showed that taxpayer dollars would be used to stop failures of financial firms. However, it is a bad idea to have unregulated firms betting with taxpayers’ money.

Alan Greenspan, former chairman of the Federal Reserve Board, recently said that if financial firms are “too big to fail, then they’re too big’’ and suggested that they may need to be split up the way Standard Oil was split up in 1911. His reasonable view is that only the threat of failure can discipline financial firms. Other new Wilsonians have correctly emphasized that sophisticated firms will game any regulations.

But bank-busting won’t solve the problems. Lehman Brothers was no giant, and the government bailed out even the smaller Bear Stearns. Since the public sector seems unable to let even modestly-sized financial firms go belly up, hard limits on their growth will restrict creative expansion and the gains from diversification without reducing the need for regulation.

In an ideal world, the government would differentiate between entities that would receive public support under a limited set of circumstances and unprotected firms that would never be bailed out. These smaller, unprotected entities could be lightly regulated and would enjoy the advantages that accrue from unfettered innovation. The harder question is how to limit inordinate risk-taking by the protected financial firms, especially given the difficulties in evaluating the risk in their portfolios. Ideally, bigger firms that enjoy some sort of public guarantee should pay a “public insurance premium,’’ which would be a function of capital levels and risk.

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Mistakes will still be made but forcing every financial firm to be small won’t solve everything. Better regulation is the best way forward, and effective regulation depends upon the information flows that come from a system where these firms inform on each other and work for the rest of us.

If this vaguely reminds you of the FDR-era FDIC, that's because this recognizes that society has a right to regulate if they are the victims of somebody else's risk-taking. Funny... these same economists were busy arguing over the last 30 years when right wing monetarist theories (and libertarianism) was rampant that 'the only good government is no government'. At least Alan Greenspan has said "I was wrong". The whole raft of economists should be doing a mea culpa and either shut up or start putting forward recommendations for re-regulating the economy.

At least Glaeser is now talking 'light regulation' instead of 'no regulation'. And now he's willing to admit that the 'too big to fail' financial institions must be closely regulated.