Is Larry Summers Getting Tougher?

Financial regulation is currently in no-man’s land, having emerged more or less intact from the House frying pan before facing the gauntlet of the Senate.
To its credit, the Obama administration has in recent weeks taken a firmer position: The excesses of the past decade have to come to an end. This was evident three weeks ago in the new proposals announced by the president to constrain the activities of large banks, which went beyond anything the Treasury Department had proposed last summer.
It was also evident in an interview that Lawrence H. Summers, the president’s chief economic counselor, gave to CNBC on Tuesday. (Ryan Grim has transcribed additional quotations.)
Asked whether the United States has “transitioned into a financial services economy,” Mr. Summers responded:
“The president’s been emphatic on what have been the excesses of the financial sector — irresponsibility, innovation that served no real purpose except the exploitation of customers — and that’s why the president’s pushed so hard for strengthened financial regulation. Look, a healthy financial system is crucial to a healthy economy, but we don’t need the kind of hypertrophy that we’ve seen in the financial system in recent years. . . .”
“We’re certainly emphasizing regulating the bankers now, not supporting the kind of irresponsible growth that we saw historically.”
This seems to represent another modest shift away from the administration’s position over the last year. The administration has repeatedly emphasized the need for better regulation — who could argue with that? — but was not closely linked to the idea that the financial sector is simply too big. The idea that some, if not most, financial innovation has served only to exploit customers is also a recent addition to the administration’s verbal arsenal.  (More background on this view is here.)
The fact that Mr. Summers is doing the talking may also be significant.
Although Mr. Summers, as director of the National Economic Council, is widely believed to be the administration’s chief economic policy maker, when it comes to financial regulation the front man has primarily been Treasury Secretary Timothy F. Geithner, who has been widely perceived as being overly friendly to the banking industry. By remaining out of the limelight, Mr. Summers has preserved the ability to take a tougher line on Wall Street.
That line may be emerging now, just in time for the bruising battle ahead in the Senate.
Of course, it may amount to nothing more than a new marketing campaign designed for political consumption, intended to show that the Democrats are being tough on rich Wall Street bankers. In particular, it seems that the new size limits on banks will be designed to limit growth from this point forward— implying that our current $2 trillion banks are just fine the way they are.
Still, however, the idea that the financial sector is simply too big is a clear and welcome line in the sand.
Over the past two decades, high returns in the financial sector — for shareholders but even more so for employees — have fueled the “hypertrophy” that Mr. Summers referred to.
Not only did money flow into real estate and leveraged buyouts that would have been better invested in real productive capacity, but many smart, ambitious, hard-working people took jobs on Wall Street instead of starting new companies or inventing new products. Since 2007, we have learned that those high returns were illusory: Profits gained when assets rose in value, but were matched by catastrophic losses when the bubble finally popped.
The real question, then, is what reforms the administration will fight for that will actually shrink the size of the financial sector, since there is no evidence that the sector will simply shrink by itself.
While the sector has undergone significant deleveraging, there is no reason for it not to simply leverage up again when the opportunity presents itself. So far the administration has resisted the idea of forcing large banks to become smaller; however, if it succeeds in reducing the size of the sector without breaking up the big banks, the big banks will only have even greater market share and market power.
But now that Mr. Summers has clearly pointed out the problem, we can assess in coming weeks — as the legislative debate on financial reform intensifies in the Senate — whether the administration has a workable strategy for fixing finance.
By Simon Johnson
This post previously appeared on the NYT’s Economix and is used here with permission.  If you would like to republish in full, please contact the New York Times.