With Financial Reform, Washington Again Flees

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Apr 21st, 2010 In the name of compromise, Congress and the Administration are once again shelving the obvious, the prudent, the manifestly best option, and going instead for something that may or may not properly address a huge problem. Last year’s foolish shelving involved health reform, where a single payer approach would have provided the desired universal coverage while dramatically reducing costs. This time around the foolish shelving of the obvious, prudent and manifestly best option involves reforming Wall Street without breaking up its biggest banks.

A complete financial reform would involve doing many things. The absolute best way to start, however, is to break up the big Wall Street banks that have only gotten bigger since they very nearly destroyed the world economy awhile back. Making these too-big-to-fail financial institutions less big is common sense. But inside the looking glass world of the Beltway, where they never fail to seek out the count-intuitive alternative to common sense, this step is deemed both politically and economically the wrong way to go.

Forgetting the politics here for the moment, politics that would require trashing that counter-intuitive Supreme Court-based idiocy — money is free speech — let’s just look at the economic reasons given for not breaking up too-big-to-fail banks. Several arguments against doing so are offered from time to time, but the main one is that doing so would not really prevent another financial meltdown — that even if the biggies were each forced to become several smaller entities, and only the traditional banking end of their businesses were officially and publicly covered by federal bailout guarantees, the unofficially covered pieces would still have to get bailed out in a pinch because failure to do so would still bring down the entire economic house.

Tim Geithner at Treasury is reported to hold this view, which right away should tell you its inherent merits. Beyond this predictable backing from Goldman’s Boy, however, this argument’s inherent flaw is clear. The argument has got things backwards.

Financial pieces (like derivative peddlers) that would not be covered by government guarantees after a big bank break-up would NOT still be so big they couldn’t be allowed to fail because, quite simply, they would become a lot smaller. Once an explicit or even implicit guarantee for these frequently cuckoo financial deals were eliminated, far fewer people would be inclined to buy into them. There would be very real risks involved that would outweigh any hoped for rewards.

How can this not be obvious, even inside the Beltway bubble? Before a bank or any other lender will make a conventional loan, they require collateral. The derivative market’s ultimate collateral today is the U.S. Treasury. Take away that fail-safe backing, fewer derivatives get peddled, fewer get bought. There’s no longer a too-big-to-fail possibility. They fail, some people lose money. So what?

Banks and other conventional lenders, of course, also make loans with no collateral backing via credit cards. But the interest rates charged are very high. Another sure-fire guarantee that too-big-to fail derivative products would not be spun off and purchased by the trillions.

We got a health care reform that was an improvement over the past, but not nearly as good as it should or been and could of been. It now looks like we’ll get the same with a financial reform bill.

Wouldn’t it be nice if we had a government that somehow, sometime, got it right all the way? Alas, that ain’t likely to happen any time soon.
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