Krugman: The financial sector is simply too big

I don’t link to Paul Krugman as much as I might, because I assume that if you’re interested enough to read this blog, you’re already reading Krugman. But everyone ought to be sure to read his Friday column, which steps back from particulars for a moment and takes a big picture look at the oversized role that the financial sector has come to play in our economy and our politics.

Some highlights:

The market mystique didn’t always rule financial policy. America emerged from the Great Depression with a tightly regulated banking system, which made finance a staid, even boring business. Banks attracted depositors by providing convenient branch locations and maybe a free toaster or two; they used the money thus attracted to make loans, and that was that.

And the financial system wasn’t just boring. It was also, by today’s standards, small. Even during the “go-go years,” the bull market of the 1960s, finance and insurance together accounted for less than 4 percent of G.D.P….

It all sounds primitive by today’s standards. Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.

After 1980, of course, a very different financial system emerged. In the deregulation-minded Reagan era, old-fashioned banking was increasingly replaced by wheeling and dealing on a grand scale. The new system was much bigger than the old regime: On the eve of the current crisis, finance and insurance accounted for 8 percent of G.D.P., more than twice their share in the 1960s. By early last year, the Dow contained five financial companies — giants like A.I.G., Citigroup and Bank of America….

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.

Nobody else writes about economics as clearly or compellingly. Not even close. But you knew that, right?

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Comments (3)

  1. Submitted by Glenn Mesaros on 03/27/2009 - 08:35 am.

    How About Galbraith? He exposes the “recovery this year” hoaxes of the Federal Reserve System.

    The Bush-era disasters guarantee that these happy patterns will not be repeated. For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years. Apart from cash — protected by deposit insurance and now desperately being conserved — the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare — illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.

    In addition, some of the biggest banks are bust, almost for certain. Having abandoned prudent risk management in a climate of regulatory negligence and complicity under Bush, these banks participated gleefully in a poisonous game of abusive mortgage originations followed by rounds of pass-the-bad-penny-to-the-greater-fool. But they could not pass them all. And when in August 2007 the music stopped, banks discovered that the markets for their toxic-mortgage-backed securities had collapsed, and found themselves insolvent. Only a dogged political refusal to admit this has since kept the banks from being taken into receivership by the Federal Deposit Insurance Corporation — something the FDIC has the power to do, and has done as recently as last year with IndyMac in California.

    Geithner’s banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.

    James Galbraith “This Crisis is Way Bigger than Dead Banks and Wall Street Bailouts”

  2. Submitted by dan buechler on 03/27/2009 - 08:58 am.

    You forgot to include real estate which is part of Finance Insurance Real Estate. Once upon a time real estate was more concerned with farmland and small homes via the credit unions. Once again how are we going to employ all our people or at least provide a decent living standard? Recently a U.K. politician said that their country would have to undergo severe population downsizing in order to be sustainable.
    Perry I would like you to write on education sometime I remember some of your past writing on that being outstanding!!

  3. Submitted by Doug Cole on 03/27/2009 - 09:26 am.

    We have to keep in mind that the psychology of the market is a factor. I think supporting the ‘hot shot’ financial idiots is part of this new policy. With any luck we will get them to fix some things and then we can give them an unemployment form. I’m waiting for the next policy on private hedge fund regulators, it is just one more step in fixing this ‘legacy’ mess.

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