Wednesday, May 13, 2009

Martin Wolf and Paul Krugman share a worry: will Obama funk reform?

Martin Wolf's assessment today of Obama's handling of the banking crisis follows the same curve as Paul Krugman's last week. Both note Obama's essential conservatism, his wish to reform with as little upheaval as possible. Both allow (Krugman grudgingly) that the sequence of bailouts, stress tests and capital raisings, coupled with cheap money from the Fed, may have saved the 19 biggest banks, providing space for them to grow their way out of crisis. Both worry that preserving the status quo will lead to another blowup. Both wonder whether Obama has the chops to impose structural reforms.

The conservatism, in Krugman's eyes, is pusillamity; Obama has decided to "muddle through the financial crisis." Wolf has a more positive view:
“If we want things to stay as they are, things will have to change.” Thus wrote the Sicilian writer Giuseppe di Lampedusa, in The Leopard. This seems to me the guiding principle of the Obama presidency...In his own way, Mr. Obama is following the path trodden by Franklin Delano Roosevelt.
On the possiblity of short-term success, here's Krugman:
It’s a strategy that might work. After all, right now the banks are lending at high interest rates, while paying virtually no interest on their (government-insured) deposits. Given enough time, the banks could be flush again... maybe we can let the economy fix the banks instead of the other way around.
And Wolf:
The purpose of the exercise was indeed conservative: to make it credible, though not certain, that the existing banking system and assets can survive the likely battering. This has been done well enough to satisfy the markets. But these banks will also be unable to expand their balance sheet significantly in the near future.
Interestingly, both identify the chief long term danger as failure to reform. Krugman thinks that the banks see Obama as King Log, not King Stork:
...while the Federal Reserve and the Obama administration continue to insist that they’re committed to tighter financial regulation and greater oversight, Wall Street insiders are taking the mildness of bank policy so far as a sign that they’ll soon be able to go back to playing the same games as before.
Wolf cites more structural reasons to be skeptical that we'll get change we can believe in:

Ensuring the rescue of a financial system packed even more than before with complex and “too-big-to-fail” institutions may well be the cautious response to this crisis. But it leaves the government with the even more onerous task of imposing effective regulation in future. Unhappily, the record of regulation of generously insured financial systems is extremely poor. The mobilised self-interest of highly rewarded players easily overwhelms the constraints imposed by far less well-rewarded and almost certainly less able regulators.

The more the crisis unfolds, the more evident it is that incentives in the financial system were (and are) badly distorted. I sympathise with the conservative approach to crises, but not if it leaves in place the plethora of perverse incentives that created them. At the end of this, then, there will be one big test: will the number of institutions thought “too big to fail” be as large as now and, if so, how will they be controlled? If the answers are still not clear, there will need to be yet more change.

On the day this was published, the WSJ reported, "The Obama administration has begun serious talks about how it can change compensation practices across the financial-services industry," and Federal regulators outlined plans to regulate derivatives. First steps on a long road.

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