Commentary Type

The Republican Bankruptcy Illusion


There is now near-unanimity that the United States' Dodd-Frank financial reform legislation, enacted in 2010, did not end the problems associated with some banks being "too big to fail." When it comes to proposed solutions, however, no such consensus exists. On the contrary, financial regulation has become a key issue in November's presidential and congressional elections.

So who has the more plausible and workable plan for reducing the risks associated with very large financial firms? The Democrats have an agreed and implementable strategy that would represent a definite improvement over the status quo. The Republican proposal, unfortunately, is a recipe for greater disaster than the United States (and the world) experienced in 2008.

On the Democratic side, Hillary Clinton's campaign materials and the party platform point to a detailed plan to defend Dodd-Frank and to go further in terms of pressing the largest firms to become less complex and, if necessary, smaller. Banks must also fund themselves in a more stable fashion. If Clinton wins, she will draw strong support from Congressional Democrats—including her rival for the Democratic nomination, Bernie Sanders, and his fellow senator, Elizabeth Warren—when she pushes in this direction.

Some commentators claim that Clinton has been "pulled to the left" on financial regulation during the campaign. But if you look carefully at her statements during this election cycle, they have been, from the very beginning, almost identical to what Warren has been seeking for the past half dozen years. And these goals are perfectly aligned with what all responsible officials want. Everyone in their right mind wants to prevent the largest banks from getting out of control, shifting risk into shadowy, unregulated activities (on or off their balance sheets), and fleecing consumers.

This is an entirely responsible and sensible agenda. It is opposed, of course, by people who are paid—one way or another—to represent the largest banks.

On the Republican side, Donald Trump's precise intentions are less clear, though he proudly calls himself the "king of debt," which is not particularly encouraging. Huge mountains of debt may help enrich individual property developers or financiers, but they typically add up to trouble for the macroeconomy. It was precisely those mountains that collapsed on the US and global economy in 2008. Many were buried in the Great Recession that followed; many more are still digging out.

Unlike Trump, House Republicans have formulated and published detailed plans that can fairly be compared to what the Democrats have presented. And, in the event of a Trump presidency, financial policy would likely be crafted in large part by the House Financial Services Committee, whose chairman's clearly stated priorities are to reduce consumer protection and remove any effective constraints on big banks' activities.

At the heart of the House Republican strategy is a simple idea: All financial firms should be able to go bankrupt without damaging the rest of the economy and without the government becoming involved. That is fine as a campaign slogan. But there is a major problem with the logic.

In September 2008, Lehman Brothers did go bankrupt—and no form of government support was provided. There were catastrophic consequences for the rest of the financial sector, for the nonfinancial economy, and for employment.

The House Republicans propose to fix that by amending the bankruptcy code. This, too, sounds good, but what exactly does it mean?

Just promising not to provide a bailout is not credible. The United States is a large and powerful country and, when danger hits, investors buy up federal government debt—driving down interest rates. America has a "fortress" balance sheet, as well as one of the most credible central banks in the history of the world.

If the policymakers of the moment think that government or central-bank support will help prevent a global economic meltdown, they will act accordingly. That is what Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, and President George W. Bush (all Republicans) did after the full impact of the Lehman collapse became apparent.

The viability of the Republican bankruptcy proposal boils down to this: Who will provide financing to a large complex financial institution—operating globally—while it is being restructured in bankruptcy? The private sector won't provide it. The courts themselves cannot borrow. If there is no financing, the scheme collapses—and we have another "Lehman moment," or worse.

So we must be talking about a scenario in which some part of the federal government, with or without express legislative approval, scrambles to provide an ad hoc loan in the range of tens or hundreds of billions of dollars, via a judge. This is mind-boggling and deeply disturbing.

Think of the business mistakes that will be made and the political backlash. Add the economic distortions implicit in providing so much free downside insurance.

The Democrats are lined up behind an approach to finance that will make the financial system safer, so that it never comes to this point again. The Republicans' plan would only help too-big-to-fail banks. And that help would make them more dangerous.

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