Banking reform probably can't prevent bad loans or bubbles, only lessen the damage they do, writes Nobel Prize Winning economist Paul Krugman.
In his recent column in The New York Times, Krugman, a professor of economics at Princeton University, notes reform should focus on ensuring that bubbles don’t destroy the U.S. financial system when they burst.
“Bear in mind that the implosion of the 1990s stock bubble, while nasty — households took a $5 trillion hit — didn’t provoke a financial crisis,” writes Krugman.
“The short answer is that while the stock bubble created a lot of risk, that risk was fairly widely diffused across the economy. By contrast, the risks created by the housing bubble were strongly concentrated in the financial sector.”
As a consequence of this concentration, the collapse of the housing bubble had the potential to slay the nation’s banks.
“Banks play a special role in the economy. If they can’t function, the wheels of commerce as a whole grind to a halt,” writes Krugman.
“Why did the bankers take on so much risk? Because it was in their self-interest to do so. By increasing leverage — that is, by making risky investments with borrowed money — banks could increase their short-term profits.”
These short-term profits were rewarded by large individual bonuses.
“If the concentration of risk in the banking sector increased the danger of a system-wide financial crisis, well, that wasn’t the bankers’ problem,” writes Krugman.
“Of course, that conflict of interest is the reason we have bank regulation. But in the years before the crisis, the rules were relaxed.”
Some experts agree with Krugman that reform is needed, but reckon that since the banking committee’s chairman is retiring, any new rules for the financial industry are likely to be less potent, reports MarketWatch.
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