Dreams are not reforms

K-thug addresses his commenters who believe that they key to financial reform is to break up the big banks so that there are none "too big to fail." Execs at smaller institutions will know, then, that they won't get bailed out if they run excessive risks. Not gonna happen says Krugman, and besides, it wasn't the big financial institutions that caused the run on the system in the 30s.

In fact, we know what a system in which banks are allowed to fail looks like: that’s how the US banking system worked before the creation of the Fed. And you know what? It wasn’t a smoothly functioning system, with sound banking enforced by market discipline; it was a system periodically wracked by “panics” that destroyed peoples’ savings and plunged the economy into recession.

Finally, because that’s what really happens when banks are allowed to fail freely, promises not to bail out banks in the future aren’t credible. Fail to reform finance now, and there will be two, three, many TARPs in our future.

What is true is that there are bailouts and then there are bailouts. What has to be protected in a crisis are bank deposits and things like bank deposits — basically, bank-created money. Money market accounts and “repo” — very short-term loans in which businesses often park their funds — have to be protected to avoid 1930-31-type collapses. On the other hand, bank shareholders and long-term bondholders can be made to pay a price without collapsing the system.

Now, in 2008-2009 the shareholders were not cleaned out, and the bondholders left untouched; in part this was a policy decision, but it was also influenced by the lack of “resolution authority”: there was no clean, well-established route for seizing complex financial institutions. We can fix that, and deal with future Citigroups (one of which, given history, is likely to be … Citigroup) the way the FDIC deals with smaller banks: protect the depositors, clean out the shareholders.

But just letting banks fail isn’t going to happen — nor should it. In practice, talking about doing so is just an excuse to avoid real reform.