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The pre-crisis financial environment was close to a libertarian's ideal, although it might not have seemed so at the time. Now, we need to add to the basic function of sound government in a modern economy rules and conditions to reduce the risk of financial crisis. Two such rules would be a subordinated debt requirement for banks and the end of tax incentives for households and businesses to accumulate debt. Given current directions it will take painful future events to persuade Congress to adopt more market-friendly approaches. How these events will play out is highly uncertain. Surprises are inevitable. Unfortunately, most of the surprises will be unhappy ones.
Before the financial crisis, U.S. financial markets were highly competitive and relatively free of intrusive federal controls. The pre-crisis financial environment was close to a libertarian's ideal, although it might not have seemed so at the time.
Now, the banking sector is beholden to the federal government. Before the crisis, "too big to fail" was a theory; now, it is a fact for large banks and perhaps certain other large financial firms as well. The federal government will likely bail out any large financial firm in trouble. Likewise, prior to the crisis, banking regulation was settled and stable. Now, many regulatory issues are unsettled. Worse yet, regulation through informal and unlegislated congressional pressure is significant.
The fundamental change in the status of the banking system is a consequence of the near failure of most large banks. The banks would have failed without liquidity and capital support from the federal government, including the Federal Reserve. Equally important, the view among the general public and in Congress is that the big commercial and investment banks caused the crisis. That view is not unjustified, although the federal government does deserve much of the blame.
Congress has not passed new financial-sector legislation as of this writing, but enough is known about its probable direction to conclude that the legislation will not address the fundamental problems that created the financial crisis. A future crisis is being designed into the system. What is needed is to increase market discipline on banks and reduce the incentive for excessive debt across all sectors of the economy.
The first objective can be realized by requiring...