The Bailout Has to Come With Regulation

Dear Dr. Dollar:
Isn't the "bailout" of Wall Street like having a rotten tooth extracted? The extraction is very unpleasant, but it beats the alternative. Even if the dentist charges an unreasonably high fee, I am still going to pay and have the job done. Later I will worry about taking better care of my teeth. So shouldn't people quit complaining about the bailout, suck it up, and get the job done? -- Peter Wagner, Weston, Mass.

I do like thinking about the mess in the financial markets as a "rotten tooth," for something is certainly "rotten" in the current situation. And there is a way in which the analogy is useful: just as we are heavily dependent on the dentist to deal with our teeth, we are heavily dependent on the banks and other financial institutions for the operation of our economy. But if we are going to use the dentist-finance analogy, we need to take it a bit further.

In particular, if the dentist who tells me I need my tooth yanked out in an emergency extraction is the same dentist who for years has been telling me that my teeth are fine, then I get suspicious. This dentist has been making money from me all along, and now, when the crisis of a rotten tooth emerges, the dentist stands to make more money while I incur the pain. The situation is similar to the bailout of the financial system: the banks keep their profits in good times, but the losses are imposed on the rest of us in bad times. At the very least, when the people responsible for a problem -- dentists or bankers -- tell me to solve the problem in a way that benefits them, I want to get a second opinion, figure out the options, and proceed with caution.

As we have been learning in recent weeks, there is more than one option for dealing with the "rotten tooth." In part because of public pressure (i.e., complaining), the Treasury shifted away from its initial plan to buy up the bad assets in the financial system and is now taking partial ownership of the banks by providing them with capital. Not only is the second plan more likely to work (in the sense of preventing a breakdown of the financial system), but it is also more likely to cost the rest of us less over the long run (because as the banks recover and start to earn profits, the government will share in those profits).

There are other options that the U.S. government might follow as well. For example, the main reason we care about what happens to the banks is that their failures could spread to the rest of us, causing a severe depression. But instead of working simply from the top down, the U.S. government would do well to work from the bottom up -- by focusing on the problems of people losing their homes due to foreclosures and by providing a large economic stimulus program through spending on schools, infrastructure, health care, and other real economic needs.

And, just as with my tooth, if the problem really did arise because of the bad practices of those who were supposed to take care of the situation (wasn't this the dentist who had been telling me all was well?), then we should give some immediate attention to proper regulation. The current financial crisis could have been avoided but for the deregulation craze of recent decades. Fixing the deregulation disaster should not be put off to the distant future.

Regulation is not a panacea. There can certainly be bad regulations, sometimes brought about by the firms themselves in an effort to use regulation to secure their power and profits. Establishing good regulations is a constant battle, as the large firms devote huge amounts of their resources to get deregulation or to shape regulation in their favor. Yet without regulation, markets -- especially financial markets -- are prone to instability, and at times that instability can have severe impacts on the rest of us.

While the dentist analogy may be incomplete, it does bring out a very important point. Because we are excessively dependent on the operations of a relatively small number of very large firms, when they get in trouble, we can be forced to bail them out. Not a good situation. Indeed, the situation is made worse as the current crisis is leading to more consolidation of the banking industry; with the encouragement of the Federal Reserve and the Treasury, big banks are being taken over by even bigger banks. At the very least, if we are going to allow some firms to become "too big to fail," then we would do well to watch them pretty carefully -- that is, to regulate them and thus do all we can to prevent them from operating in ways that put us all at risk.

[Full disclosure: Last month I had a tooth extracted and it wasn't all that bad -- certainly not as painful as the current Wall Street bailout! -- A.M.]

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