A financial fix, but for better or worse?

Market Beat

In the name of avoiding another catastrophic financial crisis, Congress and the Obama administration have crafted a new law thousands of pages in length and dealing with every nook and cranny of the banking business.

But the financial-system meltdown had one root cause, and by now we all know what it was: Too many people, businesses and governments took on too much debt over nearly 30 years. Resolution of that debt remains the slow-motion crisis that threatens the health of the financial system and the economy.

The reform bill obviously doesn’t make troubled loans go away. There are millions of mortgages, for example, that are larger than the value of the homes they secure.

Meanwhile, there is a risk that the bill’s new restrictions and oversight of banks could make lenders less willing or able to extend new credit to borrowers who have productive uses for the money, and can afford it.

That could leave the economy with two debt problems: too much bad credit, and not enough new good credit to grease the wheels of production and consumption.

The American Bankers Assn. wasted no time on Friday attacking the bill and predicting painful fallout on Main Street.

Major and minor provisions in the legislation “will have a very negative impact on traditional banks, on consumers and on the broader economy,” said Edward Yingling, president of the bankers group. “Loans are going to be harder to get and more expensive,” he said, as banks deal with a wave of increased regulation, including new reporting requirements on small-business lending and restrictions on fees.

Although the group may be overreacting for effect, the bankers’ concerns probably aren’t entirely bogus. Any legislation this sweeping is going to have unintended consequences. It’s only a matter of degree.

Meanwhile, consumer advocates almost universally have hailed the bill. They believe it will restore the financial system’s health by restraining the kind of speculative abuses epitomized by the subprime mortgage debacle.

By limiting big banks’ ability to essentially use federally insured deposits for risky securities trading, for example, the bill partly restores some of the safeguards in place before 1999, when the Depression-era Glass-Steagall Act was repealed.

“To a large degree this legislation revives old ideas that were foolishly dismantled,” said Damon Silvers, general counsel at the AFL-CIO in Washington.

As for the ABA’s assertion that banks will make credit and other services more expensive to make up for lost earnings elsewhere or for regulatory costs, Silvers sees it as a hollow threat.

“The cost of credit will be higher for things where the cost of credit should be higher — speculative activity,” he said.

It matters who’s right on this issue. The U.S. economy already is decelerating from its initial rebound in the second half of last year, when the brutal recession’s grip eased. On Friday, the government reduced its estimate of first-quarter real economic growth to 2.7% from 3%.

If for whatever reason the financial reform bill is a further drag on growth, it will leave the economy more vulnerable to falling back into recession if some other shock hits.

What’s more, if growth slows further, the bad-debt problem will become even more burdensome on the economy. If job growth in the private sector fails to pick up, more unemployed homeowners are likely to fall into foreclosure. Without significant sales and profit growth, more small businesses will fail, further compounding banks’ bad loan troubles, leading to more lender failures.

There’s another serious debt-related headwind blowing in from Europe.

There, as in the U.S. and Japan, governments’ response to the financial-system meltdown of 2008 — and to the deep recession that followed — was to borrow heavily and spend to support their crumbling economies, their tottering banks and their growing ranks of unemployed workers.

In other words, governments shifted part of the private-sector debt problem to themselves — which is to say, to taxpayers.

But over the last six months, owners of European government bonds have become increasingly fearful that the debts have become so onerous they won’t be repaid. That in turn has fueled worries that Europe’s banking system is at risk of another crisis, because the banks own a large chunk of their governments’ bonds.

Europe’s response over the last two months has been a commitment to austerity: Government spending is being slashed, not just by fiscally weak nations like Greece but even by relatively healthy states, including Germany and France.

The Obama administration believes the Europeans risk overreacting, and triggering a new global economic downturn by removing government support too soon. That will be a key topic at this weekend’s meeting of the leaders of the G-20 developed and developing nations in Toronto.

Yet more members of Congress, too, believe the time has come to pare deficit spending, despite the pain that would inflict. This week the Senate voted down a bill that would have kept jobless benefits flowing to 1.3 million long-term unemployed.

For those people, the cut-off of aid will mean that any debt burden they carry suddenly may be too much. The financial-reform bill can’t help them. If they don’t find work, their spending power will evaporate, and if they own a home they may find themselves that much nearer to foreclosure.

Allen Sinai, head of Decision Economics in New York, believes politicians in the developed world are right to focus on spending cuts to avoid further inflating the debt balloon. But eliminating aid to the hard-core unemployed isn’t the answer, he said.

“It’s a tragedy for that to happen in our society,” Sinai said. “It’s a sign of the erosion of the standard of living of the U.S.”

But that’s the ultimate price of the borrowing binge of the last three decades. In effect, we stole consumption from the future. Now the bills are coming due. Either borrowers can’t pay — resulting in more losses to the banks and investors who hold the debt — or they’ll pay, but at the expense of current economic growth by limiting their consumption of other goods and services.

Democrats say this reform bill will mean no more financial crises.

The truth is, the one that launched this bill is far from over.