A Market Case For Financial Regulation

To go along with the superb point that there’s a difference between “pro-market” lobbying and pro-business lobbying, today’s Krugman column provides a pretty good starting point for the debate over financial regulatory reform as we begin to move on from healthcare. The column is premised around a historical reading of financial regulatory norms:

Some background: we used to have a workable system for avoiding financial crises, resting on a combination of government guarantees and regulation. On one side, bank deposits were insured, preventing a recurrence of the immense bank runs that were a central cause of the Great Depression. On the other side, banks were tightly regulated, so that they didn’t take advantage of government guarantees by running excessive risks.

From 1980 or so onward, however, that system gradually broke down, partly because of bank deregulation, but mainly because of the rise of “shadow banking”: institutions and practices — like financing long-term investments with overnight borrowing — that recreated the risks of old-fashioned banking but weren’t covered either by guarantees or by regulation. The result, by 2007, was a financial system as vulnerable to severe crisis as the system of 1930. And the crisis came.

I would say that this is the biggest problem for “free-market” criticisms of financial regulations. To put it very bluntly, the banking system as we know it simply wouldn’t exist without the backing of federal deposit insurance, without which banks would be too unstable to grow as large as our major banks or have anywhere near the longevity they do now. The trade-off for this, however, is certain regulations designed to limit th public’s risk in insuring bank deposits, and banks are basically willing to take this deal. But there’s no FDIC for investment banking, nor am I sure anyone is really proposing anything like it, beyond the implicit guarantee that the government won’t let large investment banks fail. But the thing to keep in mind as Republicans start screaming that new regulations are socialism or will kill the financial industry is that the government already provides the structural backbone of American banking, and that without it the industry could never exist on the scale it does.