Another Temporary Fix

Original Link: http://www.nytimes.com/2008/07/28/opinion/28krugman.html

By PAUL KRUGMAN

So the big housing bill has passed Congress. That’s good news: Fannie and Freddie had to be rescued, and the bill’s other main provision — a special loan program to head off foreclosures — will help some hard-pressed families. It’s much better to have this bill than not.

But I hope nobody thinks that Congress has done all, or even a large fraction, of what needs to be done.

This bill is the latest in a series of temporary fixes to the financial system — attempts to hold the thing together with bungee cords and masking tape — that have, at least so far, succeeded in staving off complete collapse. But those fixes have done nothing to resolve the system’s underlying flaws. In fact, they set the stage for even bigger future disasters — unless they’re followed up with fundamental reforms.

Before I get to that, let’s be clear about one thing: Even if this bill succeeds in its aims, heading off a severe credit contraction and helping some homeowners avoid foreclosure, it won’t change the fact that this decade’s double bubble, in housing prices and loose lending, has been a disaster for millions of Americans.

After all, the new bill will, at best, make a modest dent in the rate of foreclosures. And it does nothing at all for those who aren’t in danger of losing their houses but are seeing much if not all of their net worth wiped out — a particularly bitter blow to Americans who are nearing retirement, or thought they were until they discovered that they couldn’t afford to stop working.

It’s too late to avoid that pain. But we can try to ensure that we don’t face more and bigger crises in the future.

The back story to the current crisis is the way traditional banks — banks with federally insured deposits, which are limited in the risks they’re allowed to take and the amount of leverage they can take on — have been pushed aside by unregulated financial players. We were assured by the likes of Alan Greenspan that this was no problem: the market would enforce disciplined risk-taking, and anyway, taxpayer funds weren’t on the line.

And then reality struck.

Far from being disciplined in their risk-taking, lenders went wild. Concerns about the ability of borrowers to repay were waved aside; so were questions about whether soaring house prices made sense.

Lenders ignored the warning signs because they were part of a system built around the principle of heads I win, tails someone else loses. Mortgage originators didn’t worry about the solvency of borrowers, because they quickly sold off the loans they made, generally to investors who had no idea what they were buying. Throughout the financial industry, executives received huge bonuses when they seemed to be earning big profits, but didn’t have to give the money back when those profits turned into even bigger losses.

And as for that business about taxpayers’ money not being at risk? Never mind. Over the past year the Federal Reserve and the U.S. Treasury have put hundreds of billions of taxpayer dollars on the line, propping up financial institutions deemed too big or too strategic to fail. (I’m not blaming them — I don’t think they had any alternative.)

Meanwhile, those traditional, regulated banks played a minor role in the lending frenzy, except to the extent that they had unregulated, “off balance sheet” subsidiaries. The case of IndyMac — which failed because it specialized in risky Alt-A loans while regulators looked the other way — is the exception that proves the rule.

The moral of this story seems clear — and it’s what Barney Frank, the chairman of the House Financial Services Committee, has been saying for some time: financial regulation needs to be extended to cover a much wider range of institutions. Basically, the financial framework created in the 1930s, which brought generations of relative stability, needs to be updated to 21st-century conditions.

The desperate rescue efforts of the past year make expanded regulation even more urgent. If the government is going to stand behind financial institutions, those institutions had better be carefully regulated — because otherwise the game of heads I win, tails you lose will be played more furiously than ever, at taxpayers’ expense.

Of course, proponents of expanded regulation, no matter how compelling their arguments, will have to contend with very well-financed opposition from the financial industry. And as Upton Sinclair pointed out, it’s hard to get a man to understand something when his salary — or, we might add, his campaign war chest — depends on his not understanding it.

But let’s hope that the sheer scale of this financial crisis has concentrated enough minds to make reform possible. Otherwise, the next crisis will be even bigger.