Hirsh: Still Undone: Remaking the Financial System

Economist Stanley Fischer was Ben Bernanke's thesis advisor at MIT; he knew better than most that his former student had the right stuff to avert a depression. Bernanke was an "expert" at injecting liquidity into a sinking economy, Fischer said last year before the markets took their frightening plunge. Fischer had no doubt that Ben would do what it took (Ben did, earning himself a second term as Fed chairman this week). But serious questions remain in the minds of Fischer and other critics whether the most serious problem of the financial crisis—the too-big-to-fail issue—is proving too big for Bernanke and Washington's power elites to handle.

Fischer was not only Bernanke's teacher; he was also one of the preeminent economic officials of the '90s, the era of the "Washington consensus" bias in favor of deregulation. After leaving the IMF he became vice chairman of Citigroup—the corporate embodiment of the too-big-to-fail problem. So it was all the more remarkable to hear Fischer apparently jumping to the other side of the issue and chiding his former student at the annual Jackson Hole, Wyo., conference for central bankers last week. Fischer also seemed to take aim at his former allies from the deregulatory '90s, Larry Summers and Tim Geithner. "We seem to be taking it for granted that we should go back to the structure of the financial system as it was on the eve of the crisis," said Fischer, who is now the governor of the Bank of Israel.

This is still the central pathology of our economic era. We have a free-market system dominated by institutions so huge and "systemically important" that they don't have to play by free-market rules. Excessive risk-taking is built into the system because bailouts are; the promise of the latter begets the former. And as The Washington Post reported Friday, the problem is getting worse rather than better: nurtured by government bailouts and a hands-off approach to their size, the biggest banks are getting even bigger and, therefore, harder to control. Both Bernanke and the Obama administration are acutely aware of this "moral hazard" problem and have sought to address it. But the biggest undercurrent of worry at Jackson Hole was that reform efforts were getting bogged down in political bickering, and nothing would happen this year. With each passing month—it's nearly the first anniversary of the Lehman Brothers collapse—the memory of how close we came to the abyss recedes and the impetus for radical change loses force. "I think the concern was that the administration was focusing on too many different things at once and [regulatory reform] was getting pushed to the bottom," says Mark Gertler of New York University, Bernanke's longtime academic collaborator.

A Treasury Department spokesman, asked to comment, says the administration still believes financial-reform legislation will pass by the end of the year. But many at Jackson Hole talked about resistance on Capitol Hill, which is particularly susceptible to Wall Street lobbying. Treasury Secretary Tim Geithner has also been embroiled in an angry dispute with regulators, especially FDIC chair Sheila Bair, over whether the Fed should play the role of systemic risk regulator or that more of that task should fall to a council of regulators. Geithner wants the Fed to do it, but Bernanke has pushed back against taking on the whole job. He sometimes seems to side more with Bair and SEC chairwoman Mary Schapiro, along with Gary Gensler, chair of the Commodity Futures Trading Commission, who all want a piece of the regulatory action.

It's a major mess, in other words, and Fischer has reason to worry. He's hardly alone. It is no accident, perhaps, that Fischer has been a member of the Group of Thirty, the financial advisory panel chaired by Paul Volcker. And Volcker, the former Fed chairman, has also been trying to push the Obamaites and Bernanke in the direction of more fundamental reform. Among other things, Volcker wants to bar federally insured commercial banks from proprietary trading so that the Citigroups and Bank of Americas of the future cannot again become the systemic risks they have been. But he, too, has been ignored, even though he gets to talk to Barack Obama on occasion as head of the president's largely cosmetic financial-recovery advisory board.

Oddly enough, the too-big-to-fail problem is one of the very few in Washington that seems to unite the left and right sides of the political spectrum. Renowned economist Joseph Stiglitz, who has been the left's most prominent voice since the '90s, has criticized the administration's proposals as too meek. Rather than breaking up the big banks that failed, "the Obama administration has actually expanded the notion of 'too big to fail,' " Stiglitz told me in June. Now giant institutions like Citigroup, he says, are considered "too big to be financially restructured." On the other side of the aisle, Nicole Gelinas of the Manhattan Institute recently complained that the administration's June financial-regulatory proposal actually "formalizes" the too-big-to-fail pathology by providing loans, purchasing assets, guaranteeing liabilities, and making equity investments in faltering giant firms. She says the proposal does nothing about making sure that bondholders and other uninsured lenders take losses.

Bernanke believes that an expanded "resolution authority," of the kind the FDIC now has to take over and break up troublesome firms, will be effective in restraining them. Perhaps he's right. But Congress still has to say yes to such new powers—whoever it is that eventually wields them. Bernanke himself has undergone something of a battlefield conversion. Once an devotee of Milton Friedman's free-market economics who was expected to follow in Alan Greenspan's footsteps, he was praised by Obama on Monday for his "bold, persistent experimentation"—the quote is from FDR in 1933—in saving the economy from a depression. The president also said the Fed would help to lay the "foundation" for the future, and that "part of that foundation has to be a financial regulatory system that ensures we never face a crisis like this again." But with the administration now bogged down in so many different issues—health care being only the latest—is that foundation really getting put in place?