Last week, an amazing thing happened: Free markets did their job of disciplining finance. That should happen more often. The reason it doesn’t is that neither party in Washington is willing to make it happen.
The first victory: Former New Jersey Gov. Jon Corzine’s MF Global, a smallish Wall Street outfit, went bankrupt. MF made a stupid decision in hiring Corzine, who admitted upfront that he knew nothing about the business.
The second victory: Bank of America disavowed its plan to charge customers $5 a month to pay with debit cards. BofA didn’t backtrack because of government browbeating. Rather, its customers spoke, many with their feet, just as movie-rental firm Netflix’s customers similarly fled last month when it hiked fees.
The problem in the financial world isn’t that companies screw up; it’s that the government too often protects firms from their folly. Why is AIG, which messed up way worse than MF Global a few years back, still in business?
For that matter, if Goldman Sachs, Corzine’s old employer, were on the brink of failure, Washington might protect its investors, at least its bondholders. If all of BofA’s customers left, the feds might protect its bondholders, too, from big losses.
Yes, it’s sad when a company goes under. Good people — including people who don’t pull down six, seven or eight figures — lose their jobs. But without failure, the economy is gummed up by companies that should have failed, so other parts of the economy don’t get the private investment they need to grow.
So how can Washington ensure that markets let a Goldman Sachs or an AIG go bankrupt?
One good way would be to limit borrowing — so that any one firm can’t pile up so much debt that it can bring down the financial system.
One way that financial firms can take on too much debt is through derivatives — a fancy way of making promises that you might not be able to keep. Regulators long ago realized that derivatives are a problem and forced firms to put some of their own money behind their bets.
In fact, that’s partly why MF Global could fail. It mostly dealt in well-regulated derivatives, so when it went under, the companies that handled its trades had a cash cushion to work with, and the rest of the markets knew that.
(Yes, MF Global may have broken another rule, one that required it to keep its customers’ money separate from its own money. But a broken regulation doesn’t show that regulations don’t work, any more than a murder shows that laws against murder don’t work.)
But Wall Street, to escape the rules limiting borrowing, created new kinds of derivatives. It “worked,” from Wall Street’s perspective; firms borrowed heavily and made huge profits. In 2008, when the risks some firms took finally threatened to bring them down, Washington saved them from bankruptcy. The feds felt obliged to save AIG, for example, because the insurer had borrowed so much through new-style derivatives that its bankruptcy might have sent the economy into a deep depression.
So why don’t we fix the problem? It’s not that hard; regulators are trying, sort of.
The Dodd-Frank law that President Obama signed last year was supposed to fix the problem. Unfortunately it gave lobbyists and politicians too much time and leeway to make a genuine fix.
Savvy financial firms and their big-business clients are using a rule-writing period built into the law to lobby for loopholes. Corzine himself discouraged regulators from enacting a rule this summer that would have prohibited MF from borrowing from its clients. Had the rule been in place, it might have saved MF’s customers a big headache.
Big companies, in fact, prefer that the taxpayers pay the real cost of derivatives through bailouts. Otherwise, the companies would have to pay the cost upfront so that such bailouts aren’t needed.
Unfortunately, President Obama and too many members of both parties like things the way they are now: The more uncertainty there is on Wall Street, the more Wall Street firms will spend lobbying, contributing to campaigns and hiring Washington veterans.
It’s great for the economy that Corzine has managed the rare feat of failing in finance. The public needs to push our leaders to give more members of the financial elite a chance to achieve such “success.”
Nicole Gelinas is a contributing editor to the Manhattan Institute’s City Journal.