What Larry Summers Won't Admit About Financial Reform

Last Updated May 24, 2010 3:36 PM EDT

Larry Summers, President Obama's chief economic adviser, inadvertently nails exactly what's wrong with the Administration's approach to financial reform:
Our assessment was that the deepest problems seemed to be associated with failures of regulation, and that's why strengthening regulation is the approach that we chose to take.
That statement is wrong on several levels. First, financial regulations didn't fail. They were systematically shot full of holes, over some 40 years, by economists, banks, lawmakers and government officials.

Semantics? Nah. Framing the financial crisis as a mere regulatory lapse wrongly suggests that future collapses can be averted by tightening the rules. They can't. Rules have a way of getting untightened, sometimes even before the screws are applied.

Second, financial regulations are better at correcting past mistakes than in preventing future ones. Conditions -- in the economy, the political sphere and in people's heads -- change. Today's rules are tomorrow's loopholes, not to mention the following week's financial "innovations." As Harvard economist Kenneth Rogoff tells the NYT:

The financial industry always finds ways to stay ahead of the regulators. Whatever law they design today, if it's not updated in 15 or so years, it will be completely ineffective, completely irrelevant.
Third (and this relates to No. 1 and No. 2), a good regulator is hard to find. For every Brooksley Born, there are many more John Dugans and Alan Greenspans. The financial crisis was less a matter of inadequate regs than of a willful effort to ignore or eliminate the rules already on the books.

Fourth, regulations have unintended consequences. The reforms enacted following the Great Depression made the financial system safer. But they didn't quell Wall Street's appetite for risk. Shining a light on banks ultimately led to the creation of shadow banks, where risk could frolic under the cover of darkness.

None of this is to say that strong financial regulations aren't critically important. It's a truism to acknowledge that they are. But to end the discussion there is to sidestep deeper problems. Because as we've seen repeatedly over the years, good rules are inadequate in the absence of structural changes to the financial system.

What kind of changes? Breaking up big banks and banning certain financial products, for a start. "I think what the President will sign into law will be financial reform 1.0," says Jennifer Taub, a lecturer at the University of Massachusetts's Isenberg School of Management, by email. "We will need more structural change. We may need a financial reform 2.0 and perhaps even a 3.0."

According to the Times, Summers compares the government's approach to financial reform to making highways safer by implementing seat-belt laws and building guardrails. Yet that analogy presumes that drivers are willing to stay on the road and observe the speed limit. As he certainly knows, the history of finance is one of various economic actors gunning it through the grass.

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