Bank Reform: Contingency Planning
A couple of days ago I gave the thumbs down to the Dodd bank reform proposal, but in the past couple of days it has become clear I wasn’t sufficiently open about why.
One reason: bank behavior is not our only problem. Bank size is too.
Maybe one way to get at why this is so important is simply yo return to aspects of the crisis. There was no explicit taxpayer guarantee of AIG, but we bailed it out anyway. We allowed Bear Stearns to be pushed into a merger, yet we allowed Lehman to go out of business altogether. In short there was muddle and confusion everywhere, with ad hoc decisions being the order of the day rather than the execution of a well known and well rehearsed rescues plan.
Plus, and this is where I am most adamant, the crisis revealed the extraordinary size of the contingent liability the government has.
I find it odd, no positively annoying, that people who decry the use of off balance sheet accounting by the banks would then condone off balance sheet accounting by the government. Yet that is exactly what our continued guarantee of the banks amounts to. The way I see it is that the extension of a taxpayer safety net is a liability that taxpayers take on, and so should be added to the sovereign debt burden of the country. When a government bails out a bank it is converting a private debt into a public debt. Naturally it only does this in the event of a bank crisis, so the obligation is contingent. It is a real debt nonetheless.
Setting aside for the moment the efficacy of such a conversion – and the moral hazard it involves – the existence of a huge potential debt obligation needs to be factored into the risk profile of the national debt.
Why does this matter?
Because we are piling up liabilities at a prodigious rate. The national debt is growing rapidly as the result of our need to prime the economy, and our need to fund entitlement payments even while government revenues suffer a cyclical decline. This growth is causing consternation in the more right wing elements of the financial media because there is a fear we may eventually be charged more for the debt we issue. So far there is no sign of that happening: the government seems to have easy access to a large enough flow of funds, which indicates that the debt fear argument is more ideological than economic. Nonetheless it goes on.
My point then becomes this: our debt burden is growing and is making fiscal policy difficult over the medium term. We will no doubt have to resort to a combination of tax increases and spending cuts to get the budget back in line. Crucially: this adjustment period will be a highly sensitive one. We will have little room for maneuver should another crisis erupt. This lack of wiggle room is the basis for my continued criticism of the Reagan/Bush strategy of starving the government of revenues. No one is seriously going to slash spending on entitlements in the midst of a crisis – cutting them would exacerbate the drop in demand, and the existence of entitlements adds a huge ballast to the economy offsetting the volatility of the private sector. One overlooked aspect of the crisis is the value social programs play in keeping cash flowing in the face of a freeze up of private spending.
But the lack of wiggle room is made much worse by the continued contingent liability we have to bail out the banks. The implied addition to our debt load overhangs any ‘on the books’ policy decisions. Put another way: the bank bail out liability could serve as pressure to cut social spending in order to free up debt room for the banks.
In that light I wanted to see strong measures in the reform that would cut back the contingency.
One way, which is included in the proposal, is to force the banks to pay an up front fee that is set aside as a ‘rainy day’ fund for the government to dip into when it needs bail out cash. I am skeptical about this fund, not because it will not exist, but because it looks insufficient at $50 billion. This insufficiency stems from two weaknesses in the reform proposal: the sheer size of the industry dwarfs $50 billion so a systemic failure would flow straight into our debt burden; and even if the problems were contained to individual banks, those banks are still behemoths, each quite capable of absorbing $50 billion – the cost of saving AIG was much more than that.
And this is my central criticism of the proposal. It leaves the banks too large. It contains fine words about establishing a process to dissolve big banks, and to suggest limits on them. But this puts the burden of change on the shoulders of the regulators, a group prone to capture and intimidation by the industry.
Proper reform, in my view, would have included some form of cap on bank size, backed by the Volcker rule to eliminate over-entanglement and unmanageable complexity.
The contingent liability implied by ongoing taxpayer support should have provided a rallying point for fiscal conservatives to support the establishment of size limits – one way to reduce future budget deficits and limit the fiscal risk of the country is to limit the size of our banks.
Such is the power and importance of the banking industry that we need to take both its instability and incompetence into account as we manage our way out of the hole it dug for us in this crisis. Which is why any reform has to have a harder edge than the Dodd proposal has. So far at least.
