This week’s Democratic debate produced a striking new reality: The entire spectrum of the party, from center to left, liberal to democratic socialist, agrees that more must be done to reduce economic risk from the financial industry. In perhaps the most extended discussion of financial reform on a national stage since the passage of Dodd-Frank, Hillary Clinton, Bernie Sanders and Martin O’Malley all agreed there were gaps in the current system. The only difference was one of degree.
In Washington, the last five years have been oriented toward defending what the Obama administration supported and passed. But everyone striving to lead the party now acknowledges: That structure will not prevent another crisis from forming, nor will it arrest the creeping financialization of our economy, which sees the trading of paper take up more of our gross domestic product year after year.
To listen to the candidates onstage, you would think that the main question over financial reform today is whether or not to reinstate the Glass-Steagall firewall between investment and commercial banking. This leads us down well-worn paths of arguing whether Glass-Steagall’s repeal caused the crisis and whether its restoration should be at the center of renewed efforts. I addressed that myself back in August here at The Fiscal Times.
But I think focusing on Glass-Steagall in particular gets the actual debate entirely wrong. Just because this is an area where Hillary Clinton differs with her top contenders doesn’t necessarily make it the locus of reform. To use an analogy, just because Clinton and Barack Obama had one major disagreement in the 2008 primaries about the individual mandate in health care reform didn’t make it the most important element of that policy. It was just a piece of it, as Glass-Steagall restoration would be.
It’s more useful to step back and ask what reformers should actually target. Is it the size of our financial institutions? Is it their status in the eyes of the government as too big to fail? Is it the risk they generate? Or is it something else?
John Kay, a professor at the London School of Economics and weekly Financial Times columnist, has a new book called Other People’s Money that addresses this topic. And his unique perspective really crystallizes the debate.
First of all, Kay believes we have far too much trading activity, which serves no purpose to the real economy. The four ways in which finance actually contributes to society — running the payments system, matching lenders with borrowers, managing other people’s assets and insuring risks — make up around 10 percent of total financial sector activity, Kay writes. “The growth of financial activity has come from a massive expansion in the packaging, repackaging and trading of existing assets.”
Second and perhaps more important, Kay looks at finance as a system, the way an engineer would. And he finds the system too complex and too interconnected. For example, Lehman Brothers, the investment bank whose failure led to the credit crisis, was not a particularly important financial institution, with its functions repeated by numerous other market participants. But it was systemically important, because it did business with hundreds of other firms. This created the contagion, spreading from Lehman across the industry.
To redesign the system, you must remove this complexity and interdependence, and allow for firms to fail without taking down everybody else. You must remove the “tight coupling” between financial institutions, which leaves no tolerance for error, where a lowly Lehman Brothers can toxify every major financial institution on the globe.
So how do you establish such a robust system? A lot of it comes from separating out these interconnected activities, Kay writes. We must “ring-fence the deposit channel,” savings handed to banks by consumers, to ensure that those funds “cannot be jeopardized by the failure of financial conglomerates.” Specialist institutions should handle other financial functions, like asset management, issuance of securities and advising corporations. Right now these activities are often housed in the same firm — the investment bank — but they all should be separated out. If you’re selling securities and advising companies and individuals on what securities to buy, there’s an inevitable conflict.
In other words, Glass-Steagall is not enough to fragment the system, according to Kay — we must go much further. And similarly, we must deprive the parts of the system that generate expanded trading by denying government support, subsidy and guarantees, along with retail deposits. Hedge funds can trade but on their own dime with fully disclosed risks and a prescribed duty to their investors.
That will ultimately reduce trading volumes and channel them toward only necessary activity, with clean lines of distribution. A homeowner should know who owns his mortgage. An investor client should know the custodian of her money. There should not be so many intermediaries in between, facilitating more unnecessary trading, hedging and gambling. “The trading floor of the investment bank is not the epitome of the market economy, but the excresence of it,” Kay writes.
If you take this as a model, you see the real cleavage when it comes to financial reform: Between technocratic regulation that requires the checking of boxes and a systemic redesign that can be more easily monitored. I believe Glass-Steagall restoration is part of that redesign, because it quite literally fragments a system that’s too interconnected. Maybe you think raising capital requirements, and allowing market pressures to force big bank downsizing and the selling off of business lines, is part of that framework. Maybe we should ban trading with no productive purpose and where the party doesn’t even own the underlying security, like the thinly veiled gambling that is naked credit default swaps.
But I don’t see those ideas in tension as much as I do the battle between technocracy and overhaul. Because regulating the system we have doesn’t protect us from another crisis as much as it ensures that another will come around.
Since we’re in a position, with Republican control of Congress, where it matters most to put ideas on a shelf that can be pulled down after the next crisis, getting the debate right between fixing the system we have and creating a new one is critical. That should be the measuring stick for whether candidates are serious or not about financial reform.