Free Lunch: Finance and the rule of law

Left with the market

Elizabeth Warren may not be running for president but she does not relent in gunning for Wall Street. On Wednesday she gave a speech arguing powerfully that the task of taming finance is far from finished. It is an important speech that deserves to be widely read. The location she chose to give it was, incidentally, as apt as can be. The Levy Institute has covered itself in more glory than the economics profession at large, with research less marred by the blind spots that once distracted so many economists from the looming crisis. (It was Hyman Minsky's home institution.)

Warren sets out two admirably clear - and, no doubt about it, populist - principles. "First, financial institutions shouldn't be allowed to cheat people ... Second, financial institutions shouldn't be allowed to get the taxpayers to pick up their risks." On the first, she points out quite rightly that banks have been getting away with profoundly damaging behaviour. She welcomes more "cops on the beat" than before the crisis (when president Bush thought the economy's biggest problem was "SEC over-reach"), in part thanks to her own efforts to establish a strong consumer protection agency. But she thinks the fines levied on banks - in return for escaping criminal prosecution - don't do enough to improve their conduct in the future.

On the second, she points out, again quite rightly, that many banks remain too big to fail.

What about her solutions? Many are sensible. Vox's Matthew Yglesias has picked up on Warren's proposal to deny new "deferred prosecution agreements" for banks that are already under one - two strikes and you're out, in Yglesias's crowd-pleasing labelling. A DPA is a deal by which the government shelves its criminal prosecution in return for which the accused bank pays fines and complies with agreed actions to atone for its past conduct or to prevent a repeat. But crucially, it does not have to admit criminal guilt, and nobody goes to jail. That won't do, Warren says: banks and bankers have to face more pain if they are to behave better - and indeed the same pain as small banks and their executives face if they misbehave.

Reasonable people can agree with Warren's principles while differing on the specific policy proposals. You can end too big to fail, for example, not just by forcibly making banks smaller (her preferred solution) but by getting better at dealing with a big bank's failure. One way to do that is to require them to hold much more equity capital than they do now (and Warren wants that too, in particular by reducing the tax deductibility of debt service for the most highly leveraged financial companies).

So Warren's biggest contribution lies in the fundamental diagnosis more than in her solutions. She points out what should by now be obvious: that unregulated financial markets do not produce good outcomes, and that what rules there are have often served to make the market less efficient, not more. MIT's Simon Johnson has a sharp blog post focusing on this fundamental point in Warren's argument: it's essentially an argument against cheating and for the rule of law. Warren may be seen as a leftwing firebrand but as Johnson puts it: "This is a completely centrist agenda. As a result, there is real potential here for bipartisan policy initiatives - and there are senators on both sides of the aisle who show signs of being willing to bat for exactly these kinds of sensible pro-market idea. All presidential candidates, Republican and Democrat, would be smart to embrace this agenda." Amen.

Weekend readables

Numbers news

To receive Martin Sandbu's Free Lunch by email every workday, sign up here.

© The Financial Times Limited 2015. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation