For conservatives, the financial crisis that began in the summer of 2007 has posed a major problem. We had grown rather accustomed to singing the praises of free financial markets. The crisis threatens to discredit them.
But this crisis was not the result of deregulation and market failure. In reality, it was born of a highly distorted financial market, in which excessive concentration, excessive leverage, spurious theories of risk management and, above all, moral hazard in the form of implicit state guarantees, combined to create huge ticking time-bombs on both sides of the Atlantic. The greatest danger we currently face is that the emergency measures adopted to remedy the crisis have made matters even worse.
It has often been said since the crisis began that an institution that is "too big to fail" (TBTF) is too big to exist. I agree. The question is how we can best get rid of the TBTFs without increasing the power of government in the economy still further. This should be among the first priorities of an incoming Conservative Chancellor of the Exchequer.
The past two decades witnessed an unprecedented concentration in the financial services sector. Between 1990 and 2008, the share of financial assets held by the 10 largest US financial institutions rose from 10 per cent to 50 per cent, even as the number of banks fell from over 15,000 to about 8,000.
By the end of 2007, 15 megabanks, with combined shareholder equity of $857 billion, had total assets of $13.6 trillion and off-balance-sheet commitments of $5.8 trillion - an aggregate leverage ratio of 23 to 1. They also had underwritten derivatives with a gross notional value of $216 trillion - more than a third of the total.
This was far from being a purely American phenomenon. By 2003 the five largest banking groups in the UK accounted for 71 per cent of deposits and 75 per cent of loans.
Yet concentration in banking has not gone so far as to eliminate competition. On the contrary, banking remains a highly competitive business. Indeed, it was precisely this competition that encouraged bank executives aggressively to pursue economies of scale, to increase leverage and to take on increasingly risky positions. To some extent, the excessive risks taken in the period leading up to 2007 can be blamed on defective mathematical models. However, another explanation is that big financial institutions had reason to believe that they enjoy a privileged and in some measure protected position.
Economists have long held that bank failures pose a "systemic" economic risk, because failed banks are associated with monetary contractions for the economy as a whole. There is therefore a presumption that, if big banks are threatened with liquidity or solvency problems, they should be bailed out by the action of the central bank or government. Despite much pious talk of "moral hazard" prior to 2007, little was done to disabuse big financial institutions of this notion. They could and did assume that they enjoyed an implicit government guarantee.
With the exception of Lehman Brothers, they were right. Beginning with the British Government's takeover of Northern Rock in 2007 and culminating in the US Government's vast injections of capital into AIG, Citigroup and other institutions, the Western world has witnessed a succession of government interventions in the banking system unprecedented other than in time of war. These measures can be justified on the ground that without them there would have been a banking crisis comparable with that of 1931, which did as much as the 1929 stock market crash to plunge the world into a Great Depression.
But there is a danger that justified emergency measures give rise to unjustifiable permanent conditions.
What happened last year provided a belated vindication for one of the central tenets of Marxism-Leninism: that increasing concentration of financial capital would lead ultimately to crisis, followed by the socialisation of the banking system. This was the basis for the concept of "state monopoly capitalism".
The crisis brought "stamokap" several steps closer in two ways. First, it wiped out three of the biggest US banks - Bear, Merrill, and Lehman - while at the same time condemning more than 140 (and still counting) smaller regional and local banks to oblivion. Second, because the failure of Lehman was so economically disastrous, it established what had previously only been suspected - that the survivors were Too Big To Fail.
This is moral hazard run mad - a system in which a few giant banks get to operate as hedge funds with a government guarantee that if they blow up, their losses will be socialised.
Few of the regulatory reforms proposed so far do enough to solve the central problem of the TBTFs. Consider what US Treasury Secretary Geithner proposed in his Congressional testimony of September 23:
There will be a new National Bank Supervisor. However, responsibility for regulating the TBTFs will lie elsewhere, by implication with the Federal Reserve or the Treasury.
The administration intends to "tighten constraints on leverage. by requiring that all financial firms hold higher capital and liquidity buffers". But TBTFs will be asked to do more, in at least two respects. First, they will be asked to prepare "living wills" - plans for how they should be "dismantled in case of failure". Second, they will also be subject to "very strong government oversight".
Are these measures sufficient? Britain's Labour Government apparently thinks they go too far. Speaking in the House of Commons on July 8, the Chancellor of the Exchequer declared that he feared "the consequences of telling a large bank that it is too big. In response to that, the bank might say, 'We're too big, so we'll go somewhere else.' "
Although prepared to countenance tighter regulation for big financial institutions, the Government made it clear in its White Paper of the same date that it was "not persuaded that artificial limits should be placed on firms to restrict their size or complexity".
By contrast, some continental European governments, notably the French and the German, would like to go further than the Geithner proposals. In particular, the egalitarian-minded continentals are itching to impose some kind of international cap on bankers' compensation. Another idea, floated by the head of the UK Financial Services Authority, Lord Turner, is to levy a tax on all financial transactions.
Then there are those traditionalists who would like to see a return to the separation of commercial banking and investment banking along the lines of the old Glass-Steagall Act. A case could also be made for tightening anti-trust rules for the financial services sector; this is roughly the position of the EU Commissioner Neelie Kroes. Finally, a few economists on both sides of the Atlantic have begun arguing for "narrow" or "limited purpose" banking, which would limit the ability of deposit-taking institutions to engage in risky business.
There is, however, a danger that the essential goal - the euthanasia of the TBTFs - will vanish from sight as the number of proposals increases. So let us dismiss the various red herrings. The headline-grabbing compensation issue, it should be noted, is the reddest of the lot. Million-dollar bonuses are a symptom, not a cause, of the deeper malaise. Almost as red a herring is the Turner tax. Raising transaction costs in the financial sector would help rather than hinder the TBTFs. It would be the biggest firms, exploiting economies of scale, that could most easily cope with such a change.
Also a herring, though more pink in hue, is Secretary Geithner's pledge to regulate the TBTFs more tightly. It is impossible to be impressed by such pledges when it was the most regulated institutions in the financial system that were among the most disaster-prone. The old Latin question is apposite here: quis custodiet ipsos custodes? Who regulates the regulators?
The most appealing fish on offer - but still a herring - is the idea of "narrow" banking. The problem with this is that it would turn the clock back not to the 1930s but to the 1650s - to the period before fractional reserve banking began to spread through the Western world. I remain unpersuaded that we need to jettison so much of what financial evolution has achieved over three and a half centuries, especially since two of the most systemically dangerous firms in the crisis were not deposit-taking institutions.
There is, in fact, one simple insight, buried in Secretary Geithner's testimony, upon which we need to build. As he clearly understands, the real aim of government should be to give the TBTFs "positive incentives . to shrink and to reduce their leverage, complexity, and interconnectedness".
The best way of creating such incentives is to reiterate, preferably once a week, one key point: in case of failure, "the largest, most interconnected firms" should in future be wound up "in a way that protects taxpayers and the broader economy while ensuring that losses are borne by creditors and other stakeholders".
That was the principle that was thrown overboard in the crisis, when it was decided to prevent the holders of bank bonds (apart from those of Lehman Brothers) from losing their money. Removing that protection will necessarily raise the cost of credit for the TBTFs, reduce their profitability and encourage them to split themselves up.
During the crisis it was often said that officials at the Federal Reserve and Treasury would do "whatever it takes" to avoid a Great Depression. Now they must do whatever it takes to address one of the key causes of the financial crisis: the existence of financial institutions that consider themselves too big to fail - but which are run in such a way that they are bound to do so.