Government

Still Too Big To Fail? (Part II)

LOS ANGELES, CA - OCTOBER 6: Protesters march on downtown banks in Los Angeles, California. (Photo by David McNew/Getty Images) i i
David McNew/Getty Images
LOS ANGELES, CA - OCTOBER 6: Protesters march on downtown banks in Los Angeles, California. (Photo by David McNew/Getty Images)
David McNew/Getty Images

Note: This is the second of two related posts

In his latest New York Times Magazine column, Adam Davidson writes, "Failure is as important to healthy capitalism as success. The nation's handful of huge banks, however, are spared the indignity of failure."

To continue the discussion, we asked two economists on different sides of the debate — Phillip Swagel of University of Maryland and the American Enterprise Institute and Simon Johnson of MIT — to answer the following question:

Do the "big four" US banks stifle competition and innovation?

Simon Johnson's answer is below. To read Phillip Swagel's answer click here.

There's nothing wrong with gambling. Many people like to speculate on the outcome of the NCAA basketball tournament and for those wishing to bet big, we have Las Vegas, Atlantic City and other locations.

Yet even these simple forms of gambling can become additive and excessive — and ruin lives. It is not unreasonable for families thus affected to pressure the casinos and state regulators to prevent people from destroying the financial future of spouses and children.

Gambling in and around financial markets is, as Adam Davidson explains, more complex — although not as much as you might think.

The key to capitalism is failure. Alternative economic systems — involving the heavy hand of the state in some form — protect firms against failing. As a result, those firms and their managers get lazy or careless or worse.

If someone offered you a trip to Vegas and proposed that you could keep any winnings while they would cover all your potential losses, what would you do? Presumably, you accept with alacrity — and proceed to gamble as much as possible. Bigger, riskier bets would become more attractive.

This is exactly the problem with banks that are perceived to be "too big to fail" today. They have an implicit guarantee from the government: protection against downside risks through assistance from the Federal Reserve and other forms of potential help. This is not a market; this is a big, nontransparent and dangerous government subsidy scheme.

The only politician currently willing to confront this issue head-on is Jon Huntsman, former governor of Utah and candidate for the Republican presidential nomination. Writing in the Wall Street Journal recently, he argued: "Hedge funds and private equity funds go out of business all the time when they make big mistakes, to the notice of few, because they are not too big to fail. There is no reason why banks cannot live with the same reality."

To make this happen, of course, would require a major change in public policy. And this is exactly what Mr. Huntsman is proposing in his recently released financial reform program: force the banks to become smaller, through a hard size cap (relative to the size of the economy), a punitive fee, or other measures. This program does not represent any kind of reaching to the center of the political spectrum; on the contrary, Mr. Huntsman is drawing directly on some of the most serious conservative thinkers on this issue (please see my recent NYT.com column for more detail).

Mr. Huntsman's idea also reaches across the political spectrum, as I experienced at a hearing of Senate Banking Committee's subcommittee on financial institutions this week (the webcast and written testimony are available here). Senator Sherrod Brown of Ohio has long been pushing for a hard size cap on banks and the other senators present were definitely open to discussion of this issue.

The slow-burning eurozone crisis, the evident mismanagement of some of our largest financial institutions, and their increase in scale over recent years all continue to grab political attention.

The financial sector lobby is powerful and the biggest banks have deep pockets and a great deal of their compensation on the line. Political change in this sort of situation rarely comes because someone is persuasive. Usually it happens when political leadership is overtaken by events and looks for solutions – particularly any kind of proven alternative ideas. This is exactly what Jon Huntsman is offering.

Next time you gamble, don't forget that the house always wins. Or, as they say at the biggest banks on Wall Street: Where are the customers' yachts?

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