An Accurate Diagnosis Is Required to Solve the Problem

Paul Krugman writes that the "vampires of Wall Street" (his phrase) are trying to get their Republican friends in Congress to kill Dodd-Frank financial reforms. He starts by answering the question:

And why must Dodd-Frank die? Because it’s working.

Of course, he adds his usual caveat that it didn't go far enough. But then he makes the case for what is working. Krugman notes the success of the Consumer Financial Protection Bureau as well as the transparency injected into the derivatives market. And then he gets into the whole question of "too big to fail."

What about the problem of financial industry structure, sometimes oversimplified with the phrase “too big to fail”? There, too, Dodd-Frank seems to be yielding real results, in fact, more than many supporters expected.

As I’ve just suggested, too big to fail doesn’t quite get at the problem here. What was really lethal was the interaction between size and complexity. Financial institutions had become chimeras: part bank, part hedge fund, part insurance company, and so on. This complexity let them evade regulation, yet be rescued from the consequences when their bets went bad. And bankers’ ability to have it both ways helped set America up for disaster.

In other words, it was not just the size of these institutions, but their complexity that was the problem. I'd add to this something Paul Glastris wrote a couple of years ago about how Austan Goolsbee diagnosed the problem.

... as Obama’s former economic adviser Austan Goolsbee told journalist Michael Hirsh, “The most dangerous failures—Bear Stearns, Lehman—were not even close to the biggest. You could have broken the largest financial institutions into, literally, five pieces and each of them would still have been bigger than Bear Stearns. The main danger to the economy was interconnection, not raw size.”

Does anyone else remember what happened when Lehman Brothers collapsed? The whole house of cards teetered on the edge. So we can add interconnection to the size and complexity of financial institutions in order to get a more accurate diagnosis of how financial firms contributed to the Great Recession.

Getting back to Krugman, he goes on to talk about how Dodd-Frank is addressing the problem of complexity.

Dodd-Frank addressed this problem by letting regulators subject “systemically important” financial institutions to extra regulation, and seize control of such institutions at times of crisis, as opposed to simply bailing them out. And it required that financial institutions in general put up more capital, reducing both their incentive to take excessive risks and the chance that risk-taking would lead to bankruptcy.

All of this seems to be working: “Shadow banking,” which created bank-type risks while evading bank-type regulation, is in retreat. You can see this in cases like that of General Electric, a manufacturing firm that turned itself into a financial wheeler-dealer, but is now trying to return to its roots. You can also see it in the overall numbers, where conventional banking — which is to say, banking subject to relatively strong regulation — has made a comeback. Evading the rules, it seems, isn’t as appealing as it used to be.

When it comes to interconnection, I would submit that is something that can be monitored but not eliminated in a globalized economy. The science of everything from biological systems to family systems tells us that interconnectivity is a fact of life. This is why change is so difficult - and also why large abrupt change can lead to chaos.

A catch-phrase like "too big to fail" tends to provide people with a way to handle an issue that is fraught with complexity and interconnectivity. But the problem with it is that it doesn't provide an accurate diagnosis of the problem. That can make it much more difficult to actually solve.