Paul Krugman is Wrong About the Big Banks

I rarely accuse Paul Krugman of failing to think clearly, but I think he's missed the mark with his his argument [1] against breaking up the U.S. too-big-to-fail financial oligarchy.

Here's Krugman's core objection:

Breaking up big banks wouldn't really solve our problems, because it's perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that's precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.

The same would be true today. Breaking up big financial institutions wouldn't prevent future crises, nor would it eliminate the need for bailouts when those crises happen.

Krugman is leaving out the most important part of the 1930s story here. The mass failure of small banks in the Depression was an economic disaster because it wiped out the deposits of citizens all over the country. It wasn't just that the banks were being wiped out, it was that people's savings were being wiped out with them. The government solved this problem when it invented deposit insurance. And as a result, when small banks go down, it doesn't wreak havoc on the economy. Literally thousands of small banks failed during the savings and loan crisis, but depositors didn't lose a dime. The S&L crisis wasn't good, but it was never a problem that threatened to bring down the entire economy. This is not the case when large banks fail today, as evidenced by the quagmire following the collapse of Lehman Brothers.

Krugman is undoubtedly correct to state that breaking up the big banks would not prevent future crises, but that's not the point. No reform can eliminate the business cycle. What we can do is create meaningful regulations and restructure our markets to ensure that future crises are not total catastrophes. Part of this will mean, as Krugman suggests in his column, regulating what banks do. But part of it will also mean making sure that when regulators screw up [2], the result isn't economic Armageddon. The only way to do that is to break up the big banks.

Two other points are worth mentioning. First, as Simon Johnson [3] and others have noted, the principal problem with Wall Street is not economic, but political. There's a reason why banks were able to secure their bailouts within a matter of weeks, but we've had to wait nearly two years for regulatory reform. The banks have been lobbying hard against any reform whatsoever, and for the most part, they've been successful. Even today, it's not obvious that any financial reform package, however weak, will get through Congress.

If Congress does find the will to enact stronger regulations, but doesn't break up the banks, it's very likely that the major banking conglomerates will be able to push regulators around and dodge the enforcement of those new rules. The only way to mitigate this political influence is to cut banks down to size.

Second, even if Congress establishes a new FDIC-style "resolution authority" for the shadow banking system—and I agree with Krugman that it should—the credit markets simply won't take it seriously. The biggest banks—Citigroup, Wells Fargo, J.P. Morgan, Goldman Sachs, etc.—will still be able to raise money at low interest rates based on the presumption of a government bailout. That injects a costly inefficiency into the financial system—Dean Baker estimates that it results in $34.1 billion a year [4] in misallocated funds, all of which could be supporting small businesses or creating jobs.

But the lure of low-cost funding also encourages banks to get bigger. Right now, every significant incentive in the banking system is pushing banks to grow, grow, grow. If we do not break them up, the threat they pose to the economy is only going to be exacerbated over time. The largest U.S. banks currently hold about $2 trillion in assets. Does anybody, including Paul Krugman, really want us to confront the next crisis with a handful of $10 trillion or even $30 trillion banks?