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Wednesday, March 25, 2009

The Geithner paradox

There's no chance it will work. I'm not even sure it's intended to, as it could merely be intended to pave the way for eventual nationalization. But Michael Barone offers what is perhaps the most succinct explanation of its inherent inconsistency:

I have noticed what I think is a paradox in the Geithner plan. He is asking the most unregulated parts of the financial system—hedge funds, private equity firms—to bail out the most regulated part of the financial system—the banks.... Democrats like Barack Obama and Barney Frank, at least on the campaign trail or in sound bites, have portrayed the financial crisis as the product of deregulation. The solution, they say, is more regulation. In that vein Frank, one of the brainiest members of Congress, is proposing that the Federal Reserve become a regulator of systemic risk, with the power to regulate firms that because of their size or strategic position are of systemic importance.

My American Enterprise colleague Peter Wallison has argued powerfully that this is a bad idea. Neither the Federal Reserve or other regulators identified the systemic risk which caused this crisis. Neither did most financial institutions or investors.

And yet, this systemic risk was obvious back in 2002! Of course, it wasn't exactly difficult to know that any system which relies upon a combination of leverage and permanently rising home prices was going to blow up sooner or later.

"[T]here can be little doubt that the implosion of the equity markets will soon be followed by the pricking of the credit and real estate bubbles. As great financial houses such as Citigroup and JP Morgan Chase teeter on the edge of bankruptcy, it is well within the realm of possibility that the triple whammy of the equity, credit and real estate implosions will lead to the collapse of the entire global financial system."

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