America came out of the Great Depression with a pretty effective financial safety net, based on a fundamental quid pro quo: the government stood ready to rescue banks if they got in trouble, but only on the condition that those banks accept regulation of the risks they were allowed to take.
Over time, however, many of the roles traditionally filled by regulated banks were taken over by unregulated institutions — the “shadow banking system,” which relied on complex financial arrangements to bypass those safety regulations.
Now, the shadow banking system is facing the 21st-century equivalent of the wave of bank runs that swept America in the early 1930s. And the government is rushing in to help, with hundreds of billions from the Federal Reserve, and hundreds of billions more from government-sponsored institutions like Fannie Mae, Freddie Mac and the Federal Home Loan Banks.
Given the risks to the economy if the financial system melts down, this rescue mission is justified. But you don’t have to be an economic radical, or even a vocal reformer like Representative Barney Frank, the chairman of the House Financial Services Committee, to see that what’s happening now is the quid without the quo.
Last week Robert Rubin, the former Treasury secretary, declared that Mr. Frank is right about the need for expanded regulation. Mr. Rubin put it clearly: If Wall Street companies can count on being rescued like banks, then they need to be regulated like banks.
Mark Thoma lays out a pretty decent summary of the change in tax laws and financial regulations that brought us to where we are today (though I noticed Bill Clinton's role in repealing Glass-Steagal was not mentioned). Basically massive tax cuts for the wealthy created a wave of new money, which financial deregulation allowed to flow into new ungoverned instruments.
Pretty soon the new money was finding its way into all sorts of formerly sleepy sectors of markets chasing the next hot thing and pretty reliably creating progressively larger catastrophes. The current catastrophe in the credit markets is large enough to really hurt. Assuming we manage to deal with the crisis successfully, the prudent thing would be to establish rules and regulations to make sure such things don't happen again. Unfortunately, Wall Street has thrown plenty of payola Washington's way which has so far stifled reform. Paradoxically, a larger crisis may be in the national interest because it would change the M.O. for political survival from fund raising and not rocking the boat to making changes before the voters throw the bums out.
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