Knights Who Say…

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Financial Times columnist Martin Wolf catches up with meBernanke, Yglesias, Paulson, Spitzer, Klein, Volcker, Johnson, Bair, Kwak, Marshall, A New Way Forward, and the Wall Street Journal.

Wolf, writing about the UK, says the financial sector has become a dangerously large piece of the nation’s economy, and must be shrunk.  It imposes too many negative externalities on the rest of society.  He offers an interesting conceptual framework for thinking about the problem:

So how should one manage a sector that produces such “bads”? The answer is: in the same way as any polluting activity.

Pollution is, in economic terms, exactly the same as taxpayer bailouts: a large negative externality; a cost created by an industry that isn’t borne by that industry, but instead imposed on someone or something outside.  As Wolf points out, if the financial sector’s negative externalities were internalized — that is, born by the financial sector that created them — the whole industry would probably be insolvent.

That puts us in a bind.  Nobody likes externalities.  They’re economically inefficient, distort  incentives, and are unjust.  When we find them, it’s best to fix them.  But we do need a financial sector of some kind, to move capital around efficiently; we don’t want them reduced to insolvency.

What do we do when we want to discourage pollution?  Yes, we write regulations and put regulatory agencies in place to enforce them, but gradually and inevitably, the regulators fall behind the regulatees and the externalities return.

What to do?

Well, often, we tax them.  If we can’t maintain a regulatory system that effectively limits the externalities, we put a tax in place to recover at least some of the social costs of those externalities.  A tax usually also has the effect of keeping the industry from getting very large.

And that’s what Wolf proposes for the financial sector.  A tax to recover the cost of their externalities, and to shrink the industry so that it can no longer create such enormous externalities in the first place.

No more too big to fail.

h/t Ezra Klein

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2 Responses to “Knights Who Say…”

  1. jazzbumpa Says:

    We used to have functioning regulatory agencies, due to the lessons of the 30’s – which were dim memories by the 80’s, forgotten in the 90’s, and victims of historical denialism in the brain-dead noughts.

    Why does the right wing hate regulation so much? Well, for one thing, it worked.

    Damn – where are my pearls?

  2. Knights Who Say… « Hungry Hungry Hippos Says:

    […] Who Say… By urbino Paul Krugman, sadly, declines to join me, Bernanke, Yglesias, Paulson, Spitzer, Klein, Volcker, Johnson, Bair, Kwak, Marshall, Wolf, A New Way….  He says preventing banks from getting too big to fail just isn’t […]

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