Why an American Recovery Matters

MILAN – It is hard to be optimistic about America at present. With the help of crucial government support in the crisis, the US financial sector (or at least parts of it) has bounced back, while America’s real economy struggles with high unemployment, discouraged labor-force dropouts, and damaged balance sheets.

So it is no surprise that the American public and the US Congress are angry. The focus of that anger has been the massive and unwise financial-sector bonuses. As a result, regulatory reforms have thus far consisted of, first, a threat to the Federal Reserve’s autonomy, and, second, a tax on bonuses.

The first idea is a bad one. The latter may be politically mandatory and marginally beneficial in fiscal terms. Its effects on risk-taking are debatable. But the much-needed structural reforms to limit leverage and contain the risks that the financial system periodically imposes on the real economy – and the public purse – have only belatedly gotten off the to-do list, and the prospects of enacting them are difficult to estimate.

In fairness, the new rule proposed by former US Federal Reserve Chairman Paul Volcker to separate financial intermediation from proprietary trading is not a bad idea. Combined with elevated capital requirements for banks, it would reduce the chance of another simultaneous failure of all credit channels. But it is not sufficient. Hedge funds can also destabilize the system, as the collapse of Long Term Capital Management in 1998 demonstrated. So they also need clear, albeit different, limits on leverage.