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Stelzer: Crisis Leads to Clear Solutions

It is not often that the road to good public policy is clearly marked. But when it comes to reform of the financial sector, the guideposts are there for all who would see. Even the detours that lead to dead ends are well-marked.

[IMGCAP(1)]There will be no limit placed on the size of banks, so those who say “too big to fail— mean some banks are just too big and should be cut down to some lesser size. But they will not get their wish.

In the absence of such structural change, the road leads directly to new constraints on behavior. There will be no absolute limits on bankers’ pay, as French Prime Minister Nicolas Sarkozy demanded — at least, until his nation’s bankers dropped by for a quiet chat. And there will be no international, all-powerful regulatory body, although there might be better informal coordination to prevent a flight to the most congenial regulatory regime.

What there will be is more, rather than less, likely to be consistent with good capitalist principles — get the incentives right, set rules that correct for market failure, and let the reformed market continue to bear the burden of allocating capital to its best uses, after the Obama-expanded government has taken its share in taxes. Don’t be distracted as the various parties try to rearrange the deck chairs on this financial Titanic. The president wants to retain the existing regulatory quartet and a more powerful Federal Reserve Bank; Sen. Chris Dodd (D-Conn.) and company want a single regulator and a less powerful Fed.

Largely irrelevant. Instead, follow the abuse to a solution. Banks think it is perfectly fine to raise interest rates on credit balances incurred when they sold credit at lower prices; some regulatory body will stop that and in the process correct the information asymmetry that exists between seller (the bank) and buyer (the credit card user).

Bankers still think it is perfectly fine to harvest large bonuses when their gambles pay off and have the taxpayer pick up the tab when they end up on the wrong side of their bet. That will be ended by aligning incentives with socially acceptable performance, one of the things that periodic reforms of capitalism does best. The Fed has already announced that its new, expansive view of its responsibility for the soundness of the banking system includes seeing to it that bankers’ bonuses are paid for long-term performance, in shares rather than cash and be recoverable if things go wrong.

Banks will have to keep capital that matches the risks they take, and if they nevertheless threaten to bring the system down, will be subject to takeover. Adequacy of capital will take priority over payment of dividends in the new world of imposed prudence, and the definition of capital will be more stringent and sensible than it has been in the past.

Rating agencies that thought it perfectly proper to plaster triple-A ratings on aggregations of dicey mortgages so the securities could be marketed and they could earn a fee that would be paid only if the deal went through will find themselves subject to more competition and more scrutiny, and perhaps forced to leave some skin in the game. As will mortgage brokers: Those not arrested for encouraging straight-out fraud will find that business as usual is a nonstarter, especially in a mortgage market that for the foreseeable future will be run by the government.

The important features of all these changes are two. First, each is related to a specific abuse. Politicians will prefer to have the voters believe that these measures represent retribution for past sins by greedy financiers, but in fact they are nothing more than reforms, the necessity of which became obvious during the almost-meltdown of the financial system after the collapse of Lehman Brothers. The bankers and deal-makers pursued the incentives embedded in the system, which is what we want good capitalists to do.

The second feature of these reforms is that they go with the grain of capitalism: Monitor markets to make sure the game is not rigged, provide incentives that produce socially acceptable performance, and minimize risks to the macroeconomy.

Yes, there will be unintended consequences. There always are, even when the decided policy is to preserve the status quo.

How well these reforms will be crafted we don’t know. God, not the devil as it is fashionable to say, is in the details, and He is too concerned with more important matters to attend to the reform of money-changers just now. So we will have to rely on the merely mortal Members of Congress and on the president, who, contrary to most media reports, is similarly mortal.

Irwin Stelzer is director of economic policy studies at the Hudson Institute.

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