Welcome back, growth. For the first time since governments massively intervened to prevent a global collapse in September 2008, it appears that an economic recovery is taking hold. Yet even as the U.S. economy emerges from its worst recession since the 1930s, the fundamental underlying economic and regulatory problems that precipitated the crisis remain mostly unaddressed.
Most important, while there are plenty of proposals for overhauling financial regulation floating around—from legislators, think tanks, and academia—little has been accomplished so far.
That's a shame. Without major reform, financiers will once again drive the economy toward the brink of destruction. After all, the lesson of the past three decades is that the government safety net has been widely extended. It won't happen tomorrow or even next year but when the good times roll again—and they will—memories will fade and profligacy will drive out prudence. Financiers will take bigger risks by borrowing way too much to speculate and gamble, well aware that the profits remain privatized while the losses have been socialized.
It's a recipe for disaster, and there's no guarantee that governments will cobble together a successful rescue plan the next time the boom goes bust.
Where to start, then? Tinkering with the existing system may be politically expedient, but it's a big mistake. Washington should pay attention to the more radical reform proposals. One of the most popular ideas has found favor with such diverse figures as former Federal Reserve Board Chairman Paul Volcker and Senator John McCain (R-Ariz.). Simply put: Separate finance into two basic units, a very safe, narrowly circumscribed banking sector and risk-taking institutions that play in the capital-market casino. It's one way to limit the risk that some banks are "too big to fail" and reduce the odds of another government bailout of the banking system.
Sound familiar? It should. A famous version of this idea is the landmark Glass-Steagall Act of 1933. It prevented bank holding companies from underwriting securities and owning other financial companies, such as insurers. Indeed, the whole financial system was largely compartmentalized in the decades following that traumatic decade, with competition extremely restricted between commercial banks, thrifts, insurance companies, and investment banks. However, the Depression-era law was repeatedly weakened over subsequent decades and it was eventually repealed in 1999. A number of prominent senators and representatives are considering bringing it back.
Bringing back Glass-Steagall is an idea well worth considering. Problem is, it may take regulatory reform in the wrong direction. Put it this way: The mistake wasn't in repealing Glass-Steagall. It was in leaving the job half-finished so that what remained was a bonus-obsessed, undercapitalized, underdisciplined, and politically savvy financial system. After all, Bear Stearns and Lehman Brothers were charter members of the casino. Yet it's their demise that almost cratered the global economy. On the flip side, Bank of America (BAC) buying Merrill Lynch actually helped shore up the system.
It's hard to imagine that financiers wouldn't eventually devise ways to recreate another shadow banking system for getting around regulatory barriers. It's in the nature of the beast. "The more drastic the regulation and the more it hurts profits, the greater the tendency to weaken the regulations in times of growth," says Raghuram G. Rajan, finance professor at the University of Chicago's Booth School of Business and formerly chief economist at the International Monetary Fund.
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