Posted by: Dirk | April 1, 2008


The New Yorker, oddly enough, recalls the history of too big too fail (T.B.T.F.):

In 1984, Continental Illinois, then one of the country’s largest banks, found itself on the verge of collapse, after billions of dollars’ worth of its loans went bad. To avert a crisis, the government stepped in, purchasing $3.5 billion of the soured loans and effectively taking over the bank. Later that year, at a congressional subcommittee hearing, Representative Stewart McKinney summed up the lesson of the rescue effort: Let us not bandy words. We have a new kind of bank. It is called too big to fail. T.B.T.F., and it is a wonderful bank.

The nationalization of Bear Stearns has prompted a change in the way people think about the financial globalization. Paul Krugman wrote about this yesterday in his column, noting that for the first time the Fed did bail out an investment bank:

Traditional, deposit-taking banks have been regulated since the 1930s, because the experience of the Great Depression showed how bank failures can threaten the whole economy. Supposedly, however, “non-depository” institutions like Bear didn’t have to be regulated, because “market discipline” would ensure that they were run responsibly.

Apparently, markets are not the solution to everything and this means that some regulation is necessary. That regulation is very important, and we should make sure we get it right. The way monetary policy is conducted should also be reconsidered, especially the way of (not) reacting to bubbles. It could mark the end of the era of market-led financial globalization. Or the beginning of Great Depression number two if we fail.

Some afterthought: I heard that in Italy the discussion is whether to have free markets or protectionism. This is not the issue here. The issue is whether to have regulation or not, and then if the answer is in the affirmative, how much and what kind of regulation would be efficient.

UPDATE 03/04/2008: George Soros makes the same point about markets in the FT:

For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief.
Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system.

UPDATE 12/10/2008: The New Yorker has picked up the scent again, but this time it’s parody.

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