04/11/2016 03:40 pm ET Updated Apr 12, 2016

Yikes, Paul Krugman Really Doesn't Understand Dodd-Frank

And just a few days ago, he flubbed the history of the financial crisis.
Drawing a line between banks and shadow banks is so yesterday's regulation.
Brendan McDermid/Reuters
Drawing a line between banks and shadow banks is so yesterday's regulation.

Paul Krugman does not seem to understand the very financial regulations he claims to support.

Following up on his Friday column in which the liberal economist flubbed the basic history of the financial crisis, Krugman returns Monday with a column promoting certain rules required by the 2010 Dodd-Frank legislation. These rules are a much better approach to financial reform than breaking up big banks, Krugman argues, because they will constrain risk and excess across the entire system.

The trouble for Krugman? Those tough rules would in fact require regulators to break up big banks, if they ever got around to implementing them.

"Making the breakup of big banks the be-all and end-all of reform misses the point," Krugman writes. "What we need is regulation that limits the risks from nonbank institutions — and the 2010 financial reform tries to do just that. The way it does this is by allowing regulators to designate some firms 'systemically important,' meaning that, like A.I.G., their failure or the prospect thereof could threaten financial stability. Once an institution is so designated, it is subject to extra oversight and regulation."

There's something inherently contradictory about Krugman claiming on Friday that too big to fail is not that big a deal and insisting on Monday that it is very important to implement strong new regulations for too-big-to-fail firms. The extra Dodd-Frank oversight he applauds includes the requirement that big banks prepare "living wills" that explain to regulators how they can be safely unwound without a government bailout if they ever get into trouble. If a living will is formally rejected by the Federal Reserve as untenable, then the Federal Deposit Insurance Corp. can go about dismantling the company.

In a joint statement issued in the summer of 2014, the FDIC told 11 firms that it found their living wills "not credible" and the Fed ordered them to "take immediate action" to improve their plans. In those plans, many of the same firms that were bailed out in the financial crisis were saying they could fail safely in a future crisis, even though they are now bigger and more complex than they were in 2008.

But instead of initiating the process of dissolving the firms, the central bank just asked them to file new plans, warning that if banks failed to be "responsive to the identified shortcomings, the agencies expect to use their authority ... to determine that a resolution plan does not meet the requirements of the Dodd-Frank Act." Yet when banks refiled in the summer of 2015, the Fed did not take that action, choosing instead to sit on the plans. In November, Fed Chair Janet Yellen said that regulators were asking for "very substantial changes" to these living wills. The Fed is thereby trying to dodge some very difficult decisions. If the central bank just did its job, the nation's largest financial institutions would soon be on their way to being broken up.

So in short, Krugman is saying: Don't break up the big banks. Instead, closely follow a set of important rules that would ultimately require the big banks to be broken up.

This isn't a brilliant and unique observation on our part. Financial reform advocates have understood how these rules should work for years. Alexis Goldstein tweeted the same point to us before we got around to writing it up:

Krugman spends the rest of Monday's column fabricating controversy around the common usage of the word "bank." Breaking up "banks" misses the point, he says, because some big and dangerous financial firms technically do not have a banking charter from the federal government. This is silly, because nobody who thinks Bank of America is too big to fail is going around insisting that the government leave poor AIG alone, just because one has been formally designated as a bank holding company and the other hasn't.

What's more, Krugman's insistence that talking about big banks misses a key point itself misses a key point. The Fed has already recognized that many of those "shadow banks" from the 2008 crisis that he's concerned about need to face stricter standards previously reserved for plain old banks. The Fed now formally classifies Goldman Sachs and Morgan Stanley as bank holding companies, subjecting them to tougher rules. And Merrill Lynch was acquired by Bank of America.

So if you say, “Break up the banks,” you're also saying, "Break up some big things that used to be shadow banks, too."

And that seems like something Paul Krugman would agree with.

Clarification: A previous version of this article stated that the Fed had deemed the plans "not credible." It was the FDIC.