The Corner

Making Financial Markets Fool-Resistant

If you can get past the numerous factual errors — such as claims that Lehman wasn’t subject to any constraints on risk-taking — Paul Krugman does make an important, correct point in a recent op-ed: Too much of our financial regulatory system depends on having the “right” people in place. 

Of course, Krugman takes the low road of implying his opponents are fools; the truth is more subtle. After seven years as staff on the Senate Banking Committee, I learned that bank regulators sway to the wishes of Congress, within whatever discretion they have, and Congress sways to the wishes of the public. And there is nothing the public loves more than a bubble. Any regulator who has discretion will never lean against a bubble, just as any regulator in a panic will throw tax dollars at the problem. The solution, as Krugman implies, is to reduce the discretion of bank regulators.

Oddly enough, this is exactly what Senate Republicans are pushing. Senator Dodd’s bill may end bail-outs, it may impose losses on creditors, but it also may not. It’s all up to the regulators. A bill that says “no more bailouts, except under conditions A, B, C, or D,” is not a bill that ends bailouts. This is where Dodd’s bill fails. If Krugman would take a moment to remove his partisan blinders and actually ask people, such as Senator Shelby, what their concerns are, he would see that the Republicans are the only ones focused on making banking regulation “fool-resistant.”

The ultimate way to make bank safety “fool-resistant” is to increase market discipline. One reason that allowing failure is such an important attribute of markets is that it helps eliminate “fools” from positions of responsibility. Many of the fools who thought they could bet their companies on ever-increasing house prices are not out of work.

Sadly, we are still stuck with many of the same failed regulators. The Dodd bill also fails in this regard: Instead of punishing agencies like the SEC or the Fed, Dodd expands their power, rewarding “foolishness.”

Mark A. Calabria is director of financial regulation studies at the Cato Institute.

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