Krugman's Banking Regulation Study Guide

Paul Krugman, Nobel-winning economist and columnist for the New York Times, used his column a couple of weeks ago to spell out in simpler terms--terms average people like us can understand--who is for what kind of banking reform, and what each kind of reform package looks like. Keep in mind, Krugman is a dyed-in-the-wool progressive and Keynesian (he advocated a much larger stimulus package than the one delivered in Spring 2009) and his tone and content reflect that.

On one side of the debate are those who simply won't stand for banking reform. Many of these people are conservative members of Congress. They appear so opposed to reforming the financial system, it sometimes looks as if they're (figuratively) in bed with the hedge fund managers and the CEOs of big Wall Street firms (foreshadow.......). Limit the size of big banks? No. Limit banks' risky practices? No. Make bank? We'll let the revolving door theory answer that one.

For better or worse, the pro-reform side of the issue is fractured into two main camps. The first, led by Paul Volcker (see this blog's first post), views the growing stature of big financial firms as the heart of the problem. He wants to end of the "too-big-to-fail" era by limiting their size. To take such action would presumably prevent the disastrous consequences if even one of them were to fail, and limit taxpayer "liability." Krugman, who disagrees, replies:

Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail.

Krugman forms the other side of the pro-reform crowd. His plan is "to update and expand old-fashioned bank regulation."

What ended the era of U.S. stability was the rise of “shadow banking”: institutions that carried out banking functions but operated without a safety net and with minimal regulation. In particular, many businesses began parking their cash, not in bank deposits, but in “repo” — overnight loans to the likes of Lehman Brothers.

These "shadow banks are the keys to Krugman's reform ideas. Regulators should be able to seize failing shadow banks, he says, and put strict limits on their activities and their influence in the banking system.

Krugman followed up with a couple of brief notes on his NY Times blog. To the dissenters who say that deposit insurance will keep us truly safe, he responds that the deposits are not the source of our problems. Our banking system has "grown up" and now plays with more sophisticated and dangerous toys like "repo and other forms of short-term borrowing." These are the devices that took down Lehman Brothers. And for Krugman, they could do it again.