All roads lead to reform

These are remarkable times. There has been the build-up of a historic asset bubble followed by a global financial collapse, unparalleled since the Great Depression. As many have noted, a key characteristic of the crisis has been the fact that it was caused largely by the financial system itself (rather than an exogenous shock), through the actions of individual agents coupled with failures of regulation, corporate governance, policy and politics. The breadth and inter-connectedness of these failures has made it increasingly clear that we will need wholesale reform: not just recapitalization of those institutions in the worst trouble, but changes to major parts of the financial system, including firms and their governance, the regulatory framework, as well as the broader culture and norms of the financial sector (the latter being perhaps the most challenging).

If this sounds exaggerated, consider where we are, how quickly we've got here, and how ridiculous it would have seemed, even a year ago, that any of this would come to pass. Indeed, both Obama and Gordon Brown (in the UK) pay at least lip service to the need for this sort of wider reform. Their substantive actions to date have not matched the rhetoric, either because they are hoping it will all "blow over", or (optimistically) perhaps because they intend to really proceed on these issues once things have stabilized a little.

I want to make the case that despite the politicians' evident reluctance, major reform will almost certainly be needed. The only real question is whether we get round to it sooner or later. Given the rapidity with which crisis can spread and deepen (making "contagion" a very apt metaphor), I think it is very much better if we act sooner. This would not be pre-emptive by any means: it would be in response to what is already a crisis of historic proportions (rather than waiting for something even more extreme.)

To get some sense of what might happen next, it is helpful to think of a tree of possibilities. For simplicity, let's restrict this to two possibilities at each stage. First, the Geithner plan (or some minor modification of it) can either succeed or fail: either the injection of government funds (essentially via non-recourse loans) is sufficient to restore the system to some semblance of normality, or not. If the plan is successful (as it might be, in this narrow sense, even if you object to its unfairness and lack of transparency) there are two further possibilities. Either the administration presses on with systemic reform (this is the optimistic view) or it decides that the worst is over and that minor, even cosmetic, changes will be enough. In the latter case, I would expect to see a replay of the crisis, perhaps during the following Presidential term (in this scenario, the bailouts did indeed work, so it would perhaps be a second term for Obama). Even if this sequel was not as bad as the cataclysm I fear, coming on the heels of this crisis, it would, I think, make reform unavoidable for even the most reluctant administration. And if the current bailout doesn't work? If it's a clear failure? This is not a pleasant scenario. Things will be even uglier than at present (unemployment is already touching double figures with U-6 at around 15%) and the calls for fundamental reform almost impossible to dismiss. This covers all the leaves of the tree: it therefore seems very likely that however things play out with the administration's short-term plans, the need for reform will at some point become too obvious to ignore.

System-wide reform cannot be avoided for the same reason bubbles have to burst: reality can be wilfully ignored for some time, but not forever. Clearly the political obstacles in the way of wholesale reform are formidable, and in that sense some reluctance on the part of the administration would be understandable. So the question for Obama and his team is this: do you start on reform now, or wait for even stronger evidence of its necessity? And when the weaker evidence is the present state of the economy and the associated human costs, do you really want to wait for more?