Joe Stiglitz on Derivatives Reform and Section 716

May 14, 2010Mike Konczal

SAFER has put out a letter responding to Bernanke on Section 716, which is the Section 106 fight. This is language to remove swap dealers from Federal insurance like FDIC and the Federal Reserve discount window. This language is still in the derivative bill so far, though it has come under attack recently.

And Roosevelt Institute Chief Economist and Senior Fellow Joe Stiglitz lays out his case defending Section 716 in a 5 page letter located here. You should read both because they are the strongest defenses of this language that reformers have produced to answer the last round of critiques from the administration. Here's a quote from Stiglitz's letter:

So long as those financial institutions that have access to federal assistance (or are likely to have access in the event of a crisis) can write such contracts, the government is effectively underwriting these con-tracts. The market gets distorted in two ways: first, these institutions have a competitive advantage, not based on greater efficiency, but based on more likely access to government assistance. Second, the insurance is underpriced, because it is effectively subsidized (or, when these instruments are effectively used as gambling instrument, gambling though these instruments is encouraged). Subsidies, whether explicit or implicit, distort resource allocations and contribute to a less efficient economy. There are certain instances where the government might want to encourage certain economic activities, but those should be clearly articulated and narrowly circumscribed. I see no compelling reason why the U.S. gov-ernment should be engaged in subsidizing credit default swaps or derivatives, whether they are viewed as risk management products or gambling instruments. On the contrary, to the extent that these prod-ucts have shown that they can increase societal risk, with huge costs, these have demonstrable negative externalities, and a compelling case could be made for taxing them. The amendment does not go that far. It takes a far more modest step of ending the implicit subsidy....

It is important to realize that restricting the too-big-to-fail banks from engaging in certain activities does not mean that these services will not be provided—though without the implicit subsidies, the extent to which they are used may be reduced. No evidence has been presented that there are sufficient economies of scope to offset the systemic risk to which current arrangements give rise. (And as we have noted, the fear that these activities will move to less well regulated has little merit.)...

In short, I urge you to defend the strict derivatives regulation language in the Senate Bill, including the important Section 716.

Mike Konczal is a fellow with the Roosevelt Institute and a blogger at rortybomb.wordpress.com.

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