07/04/2010 05:12 am ET Updated May 25, 2011

13 Bankers : Why It's Essential That Universities Return To Teaching Economic History

I was at a conference a few weeks ago at King's College in Cambridge, England hosted by the Institute for New Economic Thinking. Simon Johnson was there as well. The topic of the conference was "The Economic Crisis and the Crisis in Economics." During one of the sessions, a speaker asked the audience -- most of whom were economists from the top schools in the world -- if their departments included the history of economic thought as core part of their graduate curriculum. Nobody raised their hand.

The number of economics programs offering history of thought as a field, or as part of the core program, has diminished over time. Some programs still teach the history of thought (though not always at the graduate level), so it's not gone altogether, but it has become rare.

The situation is even more dire for American economic history which has all but dropped off the map in many programs. That is unfortunate. If economists had studied U.S. financial history in depth, they might have been able to recognize that past patterns were repeating themselves. They might have foreseen that we were headed for trouble. Instead, we missed some fairly obvious similarities between events prior to the crisis and events of the past that should have alerted us to the potential danger ahead. To a large degree, we have lost our historical perspective.

Why have these classes been dropped from graduate programs? I tried to answer that question here by arguing that the technical demands of modern economics crowded these courses out of graduate programs, but it was more than that. There was also a sense that we had solved the macroeconomic problem using a highly mathematical, scientific approach, or at least made enough progress to bring about a "Great Moderation." There was little to learn from macroeconomists of the past, or so it seemed, and that overconfidence turned out to be costly when the crisis hit. Many of the hard learned lessons of the past had to be relearned once again.

Thus, one answer to the problem of regulating the financial sector is to make sure that economists know the history of their field, including US economic history and all of the financial turmoil of the 1800s and early 1900s. That is where 13 Bankers is so valuable. The book begins with an overview of U.S. financial history, and it includes a readable explanation of the economics and politics behind the financial events of the past. This is essential reading for any economist who wants to understand what triggered financial panics in the past, what policies worked or failed and why, and how it relates to today.

The second part of the book talks, among other things, about how to insulate the financial system from problems in the future. One of the primary recommendations is to reduce the size of "too big to fail" banks. I am in agreement with the main arguments made in the book, but I have a different emphasis, particularly on what should types of regulatory changes are most important.

There are two separate issues that regulators must address. The first is to try to prevent financial collapses from happening at all, and the second is to try to minimize the effects of a collapse if it occurs despite our efforts to prevent it.

No matter what we do, I don't think we can ever guarantee that the financial system will be safe. There is always the danger that problems could suddenly occur. We should do our best to prevent collapse, of course, but we also need to insulate ourselves from damage if a meltdown occurs anyway. Since leverage ratios are a key factor determining the severity of a collapse -- the larger the ratio the more there is to unwind and the larger the downfall -- I believe we need strict limits on leverage ratios.

We should also limit bank size, but the main reason is not because it will help to prevent breakdowns of the financial system. Past experience shows that many small banks can fail just as easily as a few big banks and do every bit as much damage, so size alone does not appear to be the most important factor. But if the term size includes the notion of connectedness among banks, then I think that making banks smaller, i.e. less connected, is useful for both limiting the chance of a collapse, and for reducing the damage if a collapse occurs. So the connections between banks (and within large banks if they are allowed to exist) are an important factor for regulators to take into account.

There is, however, an important sense in which size is important. When financial institutions reach the scale of operation of the largest banks of today, they have substantial economic and political clout. That clout leads to what economists call "regulatory capture," a term that describes the way in which politically powerful firms can influence legislation and create a culture that allows them to escape regulatory oversight. Legislators and regulators end up serving in the firms interests, usually at the expense of the public.

The manner in which this increase in political and economic power within the financial industry happened in recent decades, and the consequences of this change, is another theme of the book. It's not healthy for the economy when individual firms have so much political and economic power -- it is far from the idealized competitive markets in textbooks that have such nice properties -- and I fully agree with the conclusion that the banks need to be scaled down.

I have not seen a convincing argument that there are substantial economies of scale from having banks so large, so there is no compelling reason for the existence of mega-banks. But there are good reasons for scaling them back. Unfortunately, one of the main worries from having banks that are so large, excessive political power, may make it difficult for legislators to reduce the scale of firms within the financial industry. But reducing the political and economic power these banks have is important, and people like Simon Johnson and James Kwak are right to keep pushing hard for legislators to operate in the public interest and put strict limits on bank size.

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