In the last two weeks, President Obama finally proposed tough new restrictions on the big banks, and then he underlined them in his State of the Union speech. It's a start.
The one thing economists agree on is that incentives matter. Unless incentives and constraints are changed through regulation, it is unlikely that behavior on Wall Street will change. And once again, our financial system, our economy and the taxpayer will be in jeopardy.
"Too big to fail" banks have a strong incentive to gamble: If they win, they walk away with the profits; if they lose, the taxpayer picks up the tab. The bailouts blindly saved big banks while smaller banks went bankrupt -- 140 in 2009 alone -- leading to an even more concentrated banking system.
The new rules the administration is proposing are not intended to punish the big banks but to create a sounder financial system. Because the big banks are, effectively, insured by the government, they have had a competitive advantage that isn't based on greater efficiency but on implicit subsidies and political connections. They are not only too big to fail, they are too big to manage; they are, in fact, too big to be.
Two weeks ago, Obama called for a new tax on the 50 largest U.S. financial institutions. The idea is to discourage excessive risk-taking, to re-balance a tilted playing field and to generate needed revenue.
Yet even if Congress goes along, it won't be enough. The executives who run these institutions are likely to force shareholders to bear the burden of the tax, while they just keep on much as before. Shareholders have already suffered as the executives undertook mergers, paid out bonuses and took other actions that have diminished shareholder value. Indeed, a new tax would give the bankers one more excuse not to restart lending.
On Thursday, Obama made a second, more direct proposal: to use regulations to restrict the way the big commercial banks operate, in order to curb their size, their risk-taking, their conflicts of interest and their ability to abuse the privileges afforded by access to government guarantees and funds through the Fed. Under this proposal, banks would not be allowed to run hedge funds or to engage in proprietary trading -- which is to say, they would not be able to use funds to trade on their own behalf. There was never a good justification for the commingling of these activities. Reinstating such restrictions won't diminish the ability of the financial system to provide key financial services, though without the implicit government subsidy, their costs may go up.
As always with regulation, however, the devil is in the details. Poorly written or inadequately enforced regulations cannot save the taxpayer or the economy from jeopardy. As important, these initiatives are just the beginning of what needs to be done. They don't solve the problem of derivatives, which caused AIG's implosion and cost $180 billion in taxpayer bailout funds. The administration says it plans to encourage the movement to an exchange-traded, standardized derivative market, to enhance competition and transparency in these complex, intertwined, high-risk investments.
But will these efforts, as well-intentioned as they may be, really work? If they don't -- if nontransparent, complex, nonstandardized over-the-counter trading by the too-big-to-fail institutions continues -- the danger of creating another too-intertwined-to-fail situation remains palpable. Enhanced competition and transparency will lower risks -- but it will also lower the big banks' profits. Moreover, so far there is little assurance that the exchanges will be adequately capitalized -- we may simply create a need for another massive bailout.
A better solution is to bite the bullet. It makes no sense for the government to underwrite these risks. The big banks should not be allowed to trade in these products, and those who participate in the derivatives market should be made to pick up the tab for any losses their trades incur, without the option of turning to the government. The derivatives market would no doubt shrink; it thrives today partly on the basis of the implicit government subsidy.
If we allow the big banks to continue operating as they have been, they could once again hold the country hostage in a time of crisis, combining their favorite weapon -- fear -- with their political clout to extract money from the rest of us.
Well-written, enforceable regulation, combined with making the financial sector pay its own way, hold the prospect of redirecting Wall Street's creative energies. Perhaps it will then do a better job in its core functions of managing risk, allocating capital and running an efficient, sound payments system.
Obama's proposals are only a good beginning.
Joseph E. Stiglitz is the winner of the 2001 Nobel Prize in economics. He served as chairman of the Council of Economic Advisors from 1995 to 1997. He is the author of the just-published book, "Freefall."