After nearly a decade of crisis, bailout and reform in the United States and the European Union, the financial system — both in those countries and globally — is remarkably similar to the one we had in 2006. Many financial reforms have been attempted since 2010, but the overall effects have been limited. Some big banks have struggled, but others have risen to take their place. Both before the 2008 global financial crisis and today, just over a dozen big banks dominate the world’s financial landscape. And yet the ground is shifting beneath the financial sector, and big banks could soon become a thing of the past.
Few officials privately express satisfaction with the progress of financial reform. In public, most of them are more polite, but the president of the Federal Reserve Bank of Minneapolis, Neel Kashkari, struck a chord recently when he called for a reevaluation of how much progress has been made on addressing the problem of financial institutions that are “too big to fail” (TBTF).
In recent years, parts of the financial sector have behaved badly — and holding the relevant executives accountable has not been a strong suit of the Obama administration. So financial reform is an important issue for the country, and whoever wins the Democratic Party presidential nomination will find that it resonates with many voters in the general election.
All of them also agree that the 2010 Dodd-Frank Act moved some issues in the right direction but there remains a substantial and important, unfinished agenda. The principal disagreement among the three camps comes down to this: what is the structural problem with our financial system, and how should we fix it?
Senator Sanders and Governor O’Malley correctly point out that in recent decades some banks became very large and the crisis did nothing to shrink their balance sheets. These banks are commonly and accurately regarded as “too big to fail,” meaning that they benefit from an implicit government guarantee. This is a dangerous and unfair subsidy.
A major shift in American politics has taken place. All three of the remaining mainstream Democratic presidential candidates now agree that the existing state of the financial sector is not satisfactory and that more change is needed. President Barack Obama has long regarded the 2010 Dodd-Frank financial-reform legislation as bringing about sufficient change. Former Secretary of State Hillary Clinton, Senator Bernie Sanders, and former Governor Martin O’Malley want to do even more.
The three leading Democratic candidates disagree, however, on whether there should be legislation to re-erect a wall between the rather dull business of ordinary commercial banking and other kinds of finance (such as issuing and trading securities, commonly known as investment banking).
Supporters of the Trans-Pacific Partnership (TPP), a trade agreement under negotiation between the United States and 11 other countries, make this case: Trade between countries is always good, and more trade with more countries is even better. Harvard economist Greg Mankiw goes further in a recent New York Times piece, arguing that anyone opposed to trade deals does not understand elementary economics.
The arguments made by these advocates do not match the reality of the modern world and are not helpful for thinking about what is at stake in the TPP. It’s not a question of understanding economics. It’s a question of knowing precisely what we’re agreeing to when we sign the TPP.
In the simple models of introductory textbooks, countries improve their respective economic outcomes by specializing in their “comparative advantage” — the goods they produce more efficiently than their trade partners — thereby increasing the supply of goods and lowering prices. No government subsidy is involved, nobody cheats, everyone is well-informed about the nature of the deal, and pretty much all parties come out ahead. If anyone loses their job, in those models either they get another good job or they can be fairly compensated by the people who gain extra income.
Financial shadows are dangerous. Even more dangerous are interactions between poorly understood shadows and essential financial intermediation activities. And most dangerous is when officials and private sector executives encourage a class of transactions that supposedly provide modest risk mitigation, while really building a disguised form of systemic risk on a grand scale.
It was not mounting losses at Countrywide, the failure of Lehman Brothers or the imminent collapse of AIG that spelt disaster in September 2008. It was the connections between those lightly regulated businesses and Citigroup, Bank of America, Goldman Sachs, Société Générale, Barclays, UBS and Deutsche Bank.
Where is the next generation of systemic risk hiding in plain sight? Look carefully at central clearing counterparties, or clearing houses, which are expanding due to the post-crisis requirement that standardised swaps – derivative transactions, including credit default swaps, that have standard terms along important dimensions – be cleared centrally.