If you parse all the testimony and the punditry we’ve heard in recent weeks, a common theme emerges: There is a deep philosophical divide between those who want to fix the financial house we have, and those who think we should knock down the old house and build a brand-new one—a new Wall Street, in other words. On one side: Tim Geithner and Ben Bernanke, as well as Obama-appointed regulators like Mary Schapiro of the SEC. They want serious fixes to the system—new rules to repair the old house and ensure that it is safe in the future--but they also seek to keep the old house intact. On the other side: critics such as Paul Krugman and possibly even Paul Volcker and Sheila Bair, chairwoman of the Federal Deposit Insurance Corporation, who think the old house is structurally unsound. They believe that not only can’t we solve the present crisis by merely tinkering with the old house, but we’ll assuredly find ourselves in another crisis down the line if we don’t dismantle it entirely. It’s a debate that encompasses all the back-and-forth over Geithner’s and Bernanke’s careful, intricate plan to fix the big Wall Street banks—as opposed to nationalizing and dismantling them—as well as the new, cautious regulatory scheme that the Treasury secretary laid out last week, which will be hashed over in Congress and at the G20 later this week.
I’m not sure where I come down yet, but we ought to understand, at least, the terms of the discussion. At the heart of the issue is the “too-big-to-fail” problem. What got us into this trouble wasn’t just a lack of regulation and oversight of mortgage securitization or derivatives trading. It was that Wall Street institutions were permitted to grow into global monsters that did as they pleased and then, when they failed, were too gargantuan to be permitted to disappear from the scene, which is supposed to be what happens in capitalism. Geithner and Bernanke are both acutely concerned about this problem, but neither has gone as far as, say, former Fed Chairman Volcker in calling for new rules that would prevent systemically dangerous monstrosities like Citigroup and AIG from rising again. Volcker, whom Preisident Obama named to head his Economic Recovery Board but whose influence in Washington has been hard to detect, recently proposed a “two-tier” financial system somewhat in the spirit of Glass-Steagall. He didn’t suggest that commercial banks and investment banks be separated into two worlds again, but he did propose that underwriting (as of mortgage-backed securities) be separated by law from “very heavy proprietary trading.”
The regulatory framework that Geithner laid out last week before Congress and will pitch to a skeptical G20, while impressive in its scope, does not do this. He wants a lot of useful things: higher capital requirements for bigger firms (effectively a tax on bigness); a powerful systemic risk regulator; and new oversight authorities over mutual funds and hedge funds. What he didn’t ask for is structural changes to the firms that will be subject to all this new regulation, a la Volcker. Neither has Bernanke. The bet is that these new rules, and an overarching systemic risk regulator, can keep that old Wall Street monster house from raging out of control again. But I wonder. Geithner did not even propose a serious reining in of the wild-west “over-the-counter” trading that occurs off exchanges world-wide. Instead he offered up a rather mild alternative: OTC trading for derivative contracts will have to go through a central clearinghouse that presumably will be industry-run. Geithner added, almost as an afterthought: “We will also encourage greater use of exchange-traded instruments.”
This leave-the-house-intact approach to the future is of a philosophical piece with the approach that Geithner and Bernanke have taken to the immediate crisis. Both men believe that the financial sector as presently constituted—Wall Street, in other words-- is too large and complex to be taken over and re-created by the federal government. Geithner, in an interview with me last week, approvingly cited a recent Wall Street Journal op-ed by William Isaac, the former head of the FDIC. Isaac argues like the Treasury secretary that taking over the worst big banks—nationalizing them—is just too gargantuan and risky a task. “Unlike the talking heads, I have actually nationalized a large bank,” Isaac wrote. This was the Continental Illinois Bank, the nation’s seventh-largest, which fell into trouble during the banking crisis of the 1980s. The 1984 nationalization—or takeover--worked. But it took seven years for the government to sell it off, and that was in an up-market. Why wouldn’t work today? Isaac asks. “Let's begin with the fact that today our 10 largest banking companies hold some two-thirds of the nation's banking assets, and some are enormously complex. Continental had less than 2 percent of the nation's banking assets,” he writes. Further, “who will run these companies when we dismiss the existing senior managers and board members? We had significant difficulties attracting quality people to Continental even without today's limits on compensation. …What's more, we won't be able to stop at nationalizing one or two banks. If we start down that path, the short sellers and other speculators … will target for destruction one after another of our largest banks.” Finally, the FDIC’s plan for Continental Illinois required it to shrink to half its size within three years. To do that now to Wall Street, in the middle of a severe recession “where deflation is a realistic concern,” runs against the government’s expansionary policy.
These are all good points. And Tim Geithner is a deliberate, highly capable fellow. But Geithner is rolling the dice -- betting the house, as it were-- in the greatest gamble of his life right now. He wants us to emerge from the current catastrophe and remain safe from future catastrophe while working from largely the same financial house. He has a point too. The government is already strained to the limit of its financial resources and political will – Congress would fight the kind of money needed for nationalization – in what it can do to remake Wall Street. And let’s remember that, until it collapsed of its own size and hubris, Wall Street was a great engine of growth for the U.S. and global economy. So I do hope Geithner is right. But I also fear that he may be wrong, and that even if all these new capital infusions and regulatory restraints are imposed, the old house as it stands may not be fixable. And it will, inevitably, get out of hand once again.