Larry Summers: Still wrong

In a PBS interview, presidential advisor (and Clinton treasury secretary) Larry Summers gave his take on financial reform. Most of the interview is unobjectionable, but this gave me (and others) pause:

Most observers who study — who study this believe that to try to break banks up into a lot of little pieces would hurt our ability to serve large companies and hurt the competitiveness of the United States.

But that’s not the important issue. They believe that it would actually make us less stable, because the individual banks would be less diversified and, therefore, at greater risk of failing, because they would haven’t profits in one area to turn to when a different area got in trouble.

And most observers believe that dealing with the simultaneous failure of many — many small institutions would actually generate more need for bailouts and reliance on taxpayers than the current economic environment.

Others think that Summers is simply lying here, and he may be. But I think it’s worse–I think he really believes it.

After all, Summers is the guy who once said, “Spread the truth—the laws of economics are like the laws of engineering. One set of laws works everywhere.” Thing is, every real-world market is different–the only case where you get one set of laws is if you have perfectly functioning competitive markets.  So Summers is, essentially, unable to distinguish between how things should work in a textbook-perfect free market and how things do work in the real world.

And yes, in a textbook market, he’s right–diversification helps individual companies stay stable.

But in the real world, especially the real financial world, it all too often does the opposite–one trader (like Nick Leeson of Barings) or a small group of traders (like the derivatives division of AIG) can bring down an otherwise stable company.

Really, smaller banks, which would have different strategies and take different risks, and which would therefore probably not all fail at the same time, are the honkingly obvious solution. Either Summers genuinely does not see that, or maybe he actually is lying. Either way, why are we listening to this guy?