By Arnold Kling
A reader asks,
With regard to the recent financial crisis and current economic recession – if you were given the power to go back in time and change only one thing in an effort to prevent the crisis and recession, what year would you choose, and what one thing would you change?
Here are a few choices, in order of preference, along with my doubts about whether my ideas would have prevented a crisis:
1. 1995. Discourage–rather than encourage–mortgage loans with down payments of less than 20 percent. I am confident that this would have moderated the housing boom and bust. I am less confident that the propensity to take financial risk would have not found another outlet.
2. 1989. Take the advice of the Shadow Regulatory Committee and instead of relying on risk buckets to determine bank capital require banks to issue subordinated debt. The idea is to use market measures of risk. We know that the risk bucket system was completely gamed, through regulatory capital arbitrage. What we don’t know is how subordinated debt might have been gamed. Certainly, if the debt were priced under “too big to fail” assumptions, it would lose its value as a market signal.
3. 1990. Limit the size of financial institutions to those whose failures can be resolved quickly without bailouts. This deals with the political economy problem that large banks are able to influence public policy to subsidize risk taking and provide bailouts when they go bad. It does not address the problem that small banks could still take risks that are highly correlated with one another.