The second problem, again in Krugman’s words:
“The reforms currently on the table . . . only deal with part of the problem: they would make finance safer, but they might not make it smaller. . . .
“We’ve been devoting far too large a share of our wealth, far too much of the nation’s talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy.”
This is the long-term challenge (see my charts here). Finance is an intermediate input. At the margin, every little innovation that makes markets more liquid does provide a small benefit to the economy in the form of better capital allocation; but in many cases those benefits are not enough to justify their transaction costs, let alone the negative systemic externalities we saw recently. The flowering of finance in the past three decades gave us the illusion of growing real GDP — especially in the past decade, when GDP growth was dominated by finance and real estate. Now we need to rebalance the economy toward productive activities.
The bad news is that the administration and Democrats in Congress will face a strong temptation to pass the reform bill and declare victory. The conventional wisdom is that you don’t get re-elected by saying, “We passed a bill that is pretty good, but doesn’t solve the root problems, so we need to do more in the future.” It’s better politically to say you fixed the problem once and for all, then cross your fingers and hope for the best.
The good news is that there seems to be a growing number of voices saying that we need structural change in the financial sector. Besides Krugman and Arianna Huffington, Martin Wolf has chimed in as well, arguing that making the current system safer, though necessary, is insufficient:
“The financial system would remain a doomsday machine. There are three difficulties. First, there is no sound basis for deciding how much capital is enough. Second, . . . it is profitable to take risks whose upside accrues to oneself and whose downside accrues to others. So the safer regulators try to make the system, the more risk it can take on. Finally, it is easy to create the desired risk via regulatory arbitrage.”
Serious academic economics is also questioning the value of a large financial system. A paper byNicola Gennaioli, Andrei Shleifer, and Robert Vishny (cited by Krugman here) shows how excessive production of securities (the phenomenon of the past decade) can be caused by mistakes in risk perception, making the financial system more fragile as a result. (As a another result, the social benefits of innovation can be outweighed by the social costs.)
So in the long term, I agree with Krugman: “These [current] reforms should be only the first step. We also need to cut finance down to size.” Given that whatever comes out of Congress will be imperfect in anyone’s eyes, whether the Obama administration agrees will be of crucial importance."
The problem is that based on appointments and decisions I have no confidence that Obama is anywhere close to the right side on this issue. And the people and institutions that destroyed security and opportunity for most Americans, stealing it to finance their lavish lifestyle, getting bailed out while everyone else suffered, will continue to keep their wealth and power. Neither political party will do anything about it. The answer is to move the Democratic Party to the left so that it actually stands for doing something. That's the right move substantively, and it's the only way to avoid crushing defeats in the midterm. But too many Democrats are so caught up in the Wall Street Knows Best worldview, as well as the high-paying jobs in the finance sector that await them, that they won't do what's right on the merits or politically. We can bemoan this, or we can make them see the light, through organizing, primary campaigns, and advocacy.