Krugman: Too Big to Fail Will Always Be With Us

One thing I’ve been inclined to say ever since the financial crisis hit is that rather than trying to rely on superhuman supervisory regulators to keep “too big to fail” financial institutions out of trouble, it would make more sense to use regulation to simply prevent financial institutions from getting too big to fail. Paul Krugman says that’s a pipe dream:

They certainly were worried about systemic risk in 1982, when I had something of a front-row seat. There were fears that the Latin debt crisis would take down one or more money center banks — Citi, or Chase, say. And policy was shaped in part by the desire to make sure that didn’t happen. Bear in mind that this was in the days before the repeal of Glass-Steagal, before finance got so big and wild; the New Deal regulations were mostly still in place. Yet even then major banks were too big to fail.

So I think of the pursuit of a world in which everyone is small enough to fail as the pursuit of a golden age that never was. Regulate and supervise, then rescue if necessary; there’s no way to make this automatic.

Relatedly, while I’m very happy to be extremely skeptical about the virtues of the past 25 years’ worth of “financial innovation,” it is true that when the American banking system was extremely fragmented there were real economic costs. On page 332 of A Farewell to Alms, for example, Gregory Clark observes the distorting impact of the very low-performing capital markets in the mid-19th century United States:

In the 1860s, for example, as the central valley of California was being settled, mortgage loans were made at the rate of 26 percent per year at a time when mortgages in Boston were offered at 6 percent. Rates fell rapidly in California, but in 1889 West Coast interest rates were still 4–6 percent above those in the Northeast.

This is because the then-severe restrictions on interstate banking made it hard to move capital from where the rich people looking to save were (northeast) to where the people who wanted to borrow money from are.

Long story short, supervisory regulation is the best we can hope for, so we’d better try to make it work. Count me as skeptical that congressional modifications to Obama’s proposals will be aimed at making things work better.