Bubbles & Banks – Krugman

Bubbles and the Banks
January 8, 2010
Paul Krugman wrote recently that his upcoming columns in the NY Times will be focusing on banking reform. He starts by asking a question:

“What should reformers try to accomplish?”

He starts out by making an observation.

“A lot of the public debate has been about protecting borrowers.”

“But consumer protection, while it might have blocked many subprime loans, wouldn’t have prevented the sharply rising rate of delinquency on conventional, plain-vanilla mortgages. And it certainly wouldn’t have prevented the monstrous boom and bust in commercial real estate.”

“Reform, in other words, probably can’t prevent either bad loans or bubbles. But it can do a great deal to ensure that bubbles don’t collapse the financial system when they burst.”

Think about it. One of the top economists in the US is stating that you can not prevent bad loans or bubbles. We have to accept that both will happen and it is not practical to create regulations to stop either condition.

A bit later in the article Krugman compared the dot.com meltdown when the losses experienced by stock investors was largely the same in magnitude as the losses that have happened as a result of the housing meltdown. If both events were equal in magnitude why the difference in terms of the impact to the US economy?

“The short answer is that while the stock bubble created a lot of risk, that risk was fairly widely diffused across the economy. By contrast, the risks created by the housing bubble were strongly concentrated in the financial sector. As a result, the collapse of the housing bubble threatened to bring down the nation’s banks. And banks play a special role in the economy. If they can’t function, the wheels of commerce as a whole grind to a halt.”

“Why did the bankers take on so much risk? Because it was in their self-interest to do so. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn’t the bankers’ problem.”

So what is the solution Krugman is proposing. He only provides the high level as the real details will be shared in future columns. Below is a quick summary of the main points.
“The test for reform, then, is whether it reduces bankers’ incentives and ability to concentrate risk going forward.”

“Transparency is part of the answer. Before the crisis, hardly anyone realized just how much risk the banks were taking on. More disclosure, especially with regard to complex financial derivatives, would clearly help.”

“Beyond that, an important aspect of reform should be new rules limiting bank leverage.”

I am not a fan of Krugman when it comes to the more populist or political points of view. I do think he clearly articulates some of the key issues using language many can grasp. As a way to get a dialog going Krugman makes it pretty easy.

-John Corey