Regulation? What Regulation?

Being the smartest guys in the room doesn’t prevent you from making bad decisions.

This is the lesson Paul Krugman offers in his recent NY Times column. “Even supposedly smart bankers must be sharply limited in the kinds of risk they’re allowed to take on,” Krugman writes.

The key to solving this conundrum, in Krugman’s mind, is smarter regulation.

In the wake of JP Morgan’s recently announced loss of $2 billion, Krugman offers a brief lesson in economic history, noting that what we saw in 2008 and what we’re seeing now are just “the 21st-century version of a Gilded Age banking panic, with terrible consequences.”

The heart of the problem is that key financial institutions don’t operate in a vacuum – their bad bets create significant externalities for the economy and for taxpayers who end up holding the bag. And as Krugman notes, “institutions playing a key role in the financial system have no business making such bets, least of all when those institutions are backed by taxpayer guarantees.”

The problem is not that a few bets gone bad is an exceptional occurrence. It’s that it’s become business as usual. “Businessmen are human — although the lords of finance have a tendency to forget that — and they make money-losing mistakes all the time,” Krugman writes. Unfortunately, this admission flies in the face of recent financial sector arguments against increased regulation – arguments that were spearheaded by JP Morgan CEO Jamie Dimon, who has tried to say that “everything’s under control.” This brand of orthodox economic thinking may have worked in the past, but it doesn’t face up to the realities of the 21st century, where the ones who pay the full price aren’t the ones taking the risk.

Socialized losses and privatized gains aren’t free markets, and the socially and economically significant nature of key institutions means that they need to be limited in the risks they take. As Krugman succinctly puts it, “The truth is that we’ve just seen an object demonstration of why Wall Street does, in fact, need to be regulated.”

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