Due Diligence

For Full Recovery, Spank Banks, Take Prisoners

American economist, professor and author James K. Galbraith writes in The New Republic that the financial crisis is far from over, and the only way to shore up the economy is to restore the "rule of law" in the banking system. The current reform bill, he says, does not do that. What's needed is a response similar to the one we had after the Savings and Loans cleanup, when a thousand or more industry insiders went to prison. "Bankers must be made to feel the power of the law in their bones," he writes.

There are plenty of liberal economists and thinkers who will agree with him and plenty of libertarian and free-market thinkers who will not. Who is right? I tend to believe that free markets work, sometimes, but that good regulation and enforcement are essential to make sure that they are in fact free and open and transparent and that bad incentives don't screw them up.

There probably won't ever be a satisfying answer to the question of how much regulation is enough and how much is too much, because it is impossible to prove either way when you're dealing with something as enormous and untidy as an entire financial system. Markets are too messy, government regulation is too messy, and human beings and the systems they create are fallible.

From Galbraith's column: "To restore the rule of law means first a rigorous audit of the banks and of the Federal Reserve. This means investigations—Representative Marcy Kaptur has proposed adding a thousand FBI agents to this task. It means criminal referrals from the Financial Crisis Inquiry Commission, from the regulators, from Congress, and from the new management of troubled banks as they clean house. It means indictments, prosecutions, convictions, and imprisonments. The model must be the clean-up of the Savings and Loans, less than 20 years ago, when a thousand industry insiders went to prison. Bankers must be made to feel the power of the law in their bones."

He continues, "How will this help the economy? The first step toward health is realism. We must first stop pretending that bad assets can be made good, that bad loans will someday be repaid, and that bad people can run good banks. Debt crises are resolved when debts are written down and gotten rid of, when the institutions that peddled bad debts are restructured and reformed, and when the people who ran the great scams have been removed. Only then will private credit start to come back, but even then the result of bank reform is more prudent banks, by definition more conservative than what we've had."

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