I love Paul Krugman. He outlines ideas and thoughts in easy-to-understand posts and op/eds and I've come to believe in the things he says easily and readily. He's nearly always right (as Brad DeLong says, "Rule #1 Paul Krugman is always right. Rule #2 - If you think Paul Krugman is wrong, see Rule #1). However, with all that said, I have a huge problem with his current tack on Financial Regulation and I definitely think he's wrong on his thinking about size.
Krugman believes that Too Big to Fail is not the most pressing regulatory issue, in the strictly asset-size sense. He thinks a cap on the absolute size of banks isn't necessary nor is it a key to successful Financial Regulation moving forward. In saying this, he's disagreeing with Paul Volcker and Simon Johnson, both incredibly intelligent economists in their own right. So I have a bit more comfort disagreeing with him because I believe size caps are a key to successful FinReg. In fact, size caps are just as important as limiting the predatory actions of the shadow banking sector, reducing opacity in financial products and so on.
The main reason Krugman isn't a big proponent of limiting banks' absolute size is because he doesn't view size as a major cause of the '08 crisis. He does admit that huge banks have stronger lobbying arms and are more dangerous in this way because they get to influence (or even write) legislation, but he also points out that the failure of hundreds of small banks can be just as damaging to the economy as the failure of a large bank.
Well, my response to that is, "What will happen if a bank that controls assets equal to 60% (or more) of GDP fails?"
After all, even if this hypothetical behemoth is the most regulated bank in history, subject to strict leverage limits, tougher legislation and daily government inspection, that doesn't guarantee it won't fail. We had strong legislation and regulations in place from the New Deal until 1980, and while the New Deal limited bank failures to just a handful between 1936 and the '80s it didn't eliminate them completely. There were still a handful. But FinReg also shouldn't completely eliminate bank failures anyway -- that wouldn't be a free or competitive market and it would create an implicit moral hazard in bankers as well.
So, does Krugman think the current legislation would achieve the complete elimination of bank failures and, does he think that's what we should be aiming for? Or does he not think that a bank so big it's larger than our current GDP won't be a problem if (or when) it fails?
My guess is he doesn't believe any of those. I think he's fallen into the trap of looking backwards at the '08 crisis and trying to fix the causes of that particular mess but only that particular mess (perfectly forgivable as he's been so close to the collapse; writing about it and talking about it since it happened). But what Krugman's failing to see is that proper legislation should not just be backward-looking, but forward-looking as well. As it currently stands congress has a chance to lay down rules and regulations 'post-crisis' that fix what caused this 'forseeable' panic. But they also have a chance to lay down rules and regulations that provide buffers for non-forseeable, future financial crises as well.
There are unknown unknowns out there (Taleb's Black Swans if you will) and there will always be unknown unknowns out there, so if we allow a bank to grow to such a size that the government can't perform an FDIC-style takeover because the bank is larger than the government itself (a la UBS in Switzerland), then we're just opening ourselves up to Black Swans.
I think someone needs remind Krugman of this.
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