– John Kemp is a Reuters columnist. The views expressed are his own –

Economic history is the only field of human endeavor where the past changes as much if not more than the present and the future. Policymakers and practitioners struggle to define and write a “narrative” of the past as a means to control how policy responds to current and future problems.

The debate now over financial reform is a case in point. Even though the banking system has only just emerged from the most severe shock since the 1930s, the battle over how to define the events of the last 18 months, and what they should mean for investors and regulators in future, is already well underway.

Contrasting speeches last week by Federal Reserve Governor Kevin Warsh and Bank of England Governor Mervyn King illustrate the two extremes around which the debate is polarizing:

* Warsh speech

* King speech PDF

The financial sector will exploit these differences to derail any fundamental overhaul of regulation.

Warsh’s speech characterized the crisis as the “panic of 2008″ and set it in the context of the previous two decades of rapid non-inflationary growth, implying the crisis was an irrational aberration in an otherwise well-functioning economic and financial system.

In effect, Warsh reprised a philosophy associated with former Fed Chairman Alan Greenspan: occasional, wrenching crises are a price worth paying for an innovative, dynamic and wealth-generating form of capitalism. Policy should focus on ameliorating the after-effects rather than risk stifling growth by aiming to prevent crises altogether.

In contrast, King made the case for fundamental reform. He highlighted the real costs which a crisis that originated in the financial system is imposing on the real economy, as well as the more intangible but no less profound impact on attitudes towards wealth-creation, reward and regulation.

While noting there was no support for “excessively bureaucratic regulation”, King made clear “change to the structure, regulation and indeed culture of the banking system is necessary. Blaming individuals is no substitute for acknowledging the failure of a system, of a certain type of banking.”

STABILITY VERSUS GROWTH

King’s speech echoes the famous analysis set out in Hyman Minsky’s “Stabilising the Unstable Economy”. Minsky made a compelling case that periodic crises were an essential part of a financial-capitalist system in which massive long-term investment projects were financed by issuing large volumes of debt. By breeding over-confidence and increasingly risky capital structures, periods of stability laid the seeds of their own destruction.

But unlike Greenspan, Minsky argued such crises were not a “price worth paying”. Appropriate regulation was both necessary and desirable to constrain risk-taking to an acceptable level, and could be achieved without sacrificing growth. King’s speech appears to be advocating something similar.

Warsh is re-fighting an old debate between “stability-first” and “growth-first”. It is a false choice, as a closer look at the historical record suggests.

The problem with his speech is its truncated view of history. He notes U.S. output (measured by real GDP) grew at an average rate of more than 3 percent a year between the mid-1980s and 2007, and was significantly less volatile than in earlier periods. Unemployment averaged less than 5.75 percent, a full percentage point lower than in the previous 15 years.

But this is a tendentious use of dates. Warsh has picked the start and ends points to support a pre-determined conclusion. It specifically excludes the last two years of underperformance (2008 and 2009) from the period of the Great Moderation (as if the current problems had nothing to do with the policies pursued in the preceding years).

And by choosing the start point as the mid-1980s, then going back 15 years, it lumps both the Volcker recession of 1980-1982 and the oil shock of 1973 into the same base period for adverse comparison. With a selective use of statistics like this, it is possible to prove anything.

It is worth looking further back, in a more neutral manner. The attached PDF chart shows annual GDP growth since 1930 and the average rates for 20-year periods (1930-1949, 1950-1969, 1970-89 and 1990-2009).

While annual GDP growth was certainly less volatile during the most recent period, the average growth rate (2.5 percent) was not especially high compared with the previous 20 years (3.2 percent) or the two decades of the 1950s and 1960s (4.3 percent).

Warsh focuses on the undoubted benefits that openness to trade and rapid financial innovation delivered during the 1990s and the first part of the current decade, describing them as the principal achievement of the Great Moderation. Minsky’s own golden era was the 1950s and 1960s, when relatively conservative bank balance sheets and strict regulation appeared to tame the violent boom-bust cycle of the pre-war years while still enabling brisk growth and unprecedented prosperity.

But it is not obvious from the historical record whether macroeconomic management has been superior over the last 20 years to the 1950s and 1960s. Nor is it obvious policymakers have to choose between financial stability and economic growth. It is possible to have respectable growth and stronger financial supervision.

KEEPING OPTIONS OPEN

Minsky attributed the stability of the 1950s and 1960s to the impact of wartime finance, which had swapped a large part of the private securities on bank balance sheets for government debt, increasingly their liquidity, coupled with the development of a more extensive system of lender-of-last-resort, deposit protection and bank regulation.

Much of that framework of prudential oversight and conservative balance-sheet management has been swept away in the last 20 years as policymakers have relied more heavily on “market discipline”. The debate is how far to go in trying to recreate it.

Bank of England Deputy Governor Paul Tucker has already suggested banks should be forced to hold a greater cushion of highly liquid assets (for which read government debt) to reduce liquidity risks. In his speech, King reiterated the point.

He went on to suggest it was unsustainable that banks could take highly risky investment strategies while backed by an implicit (and free) state guarantee. Either regulation must be tightened, banks must pay for the guarantee, or it must be restricted to a range of “narrow banks” performing utility-like payments and basic lending services.

Rather than a set of detailed and perhaps politically unrealistic policy prescriptions, King’s speech should be seen as a plea to keep the debate and options open, not close them down prematurely and revert to business as usual.

King is right to try to encourage a deeper examination of the origins of the crisis. But radical reform seems unlikely. Wall Street and the City of London are already fielding an army of well-paid, silver-tongued lobbyists to deflect it. And as the divisions between King and Warsh reveal, regulators are too ham-strung by disagreements among themselves to force fundamental restructuring on a reluctant the industry.

– James Pethokoukis is a Reuters columnist. The views expressed are his own –

For the populists who really, really want to make Wall Street pay by slashing their pay, Treasury Secretary Timothy Geithner certainly isn’t giving them what they want.

Yes, the top executives of the remaining TARP firms seem destined to be salary serfs to the “pay czar”, Kenneth Feinberg.

Of course, it’s hard for even the most die-hard free marketeer to feel sorry for financial firms that mismanaged their businesses terribly, took government bailout money and now find themselves under Uncle Sam’s thumb.

But as for everyone else? Well, here’s how Geithner put it: “We are not setting forth precise prescriptions for how companies should set compensation which can often be counterproductive. Instead, we will continue to work to develop standards that reward innovation and prudent risk-taking, without creating misaligned incentives.”

Even worse for those who wanted the Treasury secretary to bring down the hammer, he went on to highlight how the financial sector is already making changes on pay and how he looks forward to a “continuing conversation”. Yes, self regulation in action! Hardly what the torch-and-pitchfork crowd craved to hear.

That’s just too bad. To his credit,  Geithner seemingly understands his goal isn’t to punish, but to play a constructive role in nudging financial industry compensation in a direction that better connects risk and reward.

Ultimately, it is shareholders and management who should decide what executives make. Indeed, Geithner’s recommendations centered on empowering the Securities and Exchange Commission to give shareholders a stronger say over executive pay.

And changes are taking place. Firms like Credit Suisse, Morgan Stanley and Goldman Sachs have tried to rework pay systems by allowing bonus clawbacks, for instance.

Good thing, too. Government has a terrible record in rejiggering executive compensation. Example: Legislation back in 1993 intended to rein in corporate pay by eliminating the tax-deductibility of executive compensation above $1 million unless pay was linked to performance.

But one unintended effect of the law, academics James Wallace and Kenneth Ferris have found, “was that executives’ total compensation actually increased in the post-1993 period” thanks in big part to the use of stock options.

Not surprisingly, executive pay issues moved back into the spotlight earlier this decade after Enron and other corporate scandals. One part of the 2002 Sarbanes-Oxley Act prohibited executive loans. As with the 1993 law, corporations responded in ways perhaps not anticipated by legislators.

Signing bonuses and fatter severance packages became more popular — just the sorts of things now being frowned upon.

What sort of compensation might work better to align executive compensation with long-term shareholder interests? A group of academics — Alex Edmans of Wharton, Xavier Gabaix and Tomasz Sadzik of New York University and Yuliy Sannikov of Princeton — have devised an approach based on what they call “dynamic incentive accounts.”

Unlike bonus clawbacks, this system doesn’t try to recoup money already sent out the door.

Here is how it works, according to their new study: Executive pay is escrowed into an account, a fraction of which is invested in the firm’s stock and the remainder in cash. The account would be rebalanced each month according to company guidelines — rules would certainly also vary by industry — and by how close the executive is to retirement.

The gradual vesting of the account — cash from a sold stock cannot quickly withdrawn — even after retirement, “allows the CEO to consume while simultaneously deterring myopic actions.”

In other words, the goal is to promote long-term thinking over short-term manipulation.

For instance: If company’s stock soared, the executive could sell, though the proceeds would say in the account. If the stock then dropped, that money would have to be used to buy more stock. He couldn’t just take the money and run.

Is this the best system out there?. Maybe, maybe not. Or maybe for some firms or sectors and not for others. But that is why you don’t want a one-size-fits-all plan devised in Washington, particularly one with political rather than economic goals. That is a pothole that Barack Obama and Timothy Geithner have so far avoided.

– James Saft is a Reuters columnist. The opinions expressed are his own –

A look at credit insurance prices for U.S. banks shows that market thinks the government’s mouth is writing checks its body can’t or won’t cash.

Despite a blistering rally in bank shares and Herculean efforts by the U.S. to build confidence in its financial sector, the price of insuring some leading banks’ debt against default has increased markedly in recent weeks.

That tells us that bond investors have serious doubts about the popular perception that the United States won’t allow systemically important institutions to fail, or in saving them in some form won’t make bond holders take substantial losses.

Since the KBW index of bank shares began a 65 percent rally on March 6 the cost of insuring Citigroup for five years via a credit default swap has risen to an annual payment of 627 basis points from 470, meaning it costs 6.27 cents to insure every dollar. Wells Fargo 5-year CDS stand at 292.5 basis points, as against 240 on March 3 and 120 at the end of December, while Bank of America’s ended last week at 355, exactly where it was on March 6 but 50 above its March 3 level.

The people buying this insurance fear if a big bank fails over the coming five years, or needs further buttressing with public money, the bill will be too large for the U.S. to bear, either politically or otherwise. That implies that there could be burden sharing by creditors, either through some sort of divvying up of the remaining assets or through forced or government orchestrated conversions of debt into equity.

OPTIONS

The options for the U.S. aren’t particularly attractive. As pointed out by Tyler Cowen in the New York Times here for the U.S. to simply fess up and say it stands behind all bank debt is to take on a gargantuan liability and to effectively neuter bond holders as a force for market and company discipline.

If the U.S. were to allow someone big to go down and make bond holders suffer too, there is a legitimate fear that creditors to the banking system would stage a disorderly wildcat strike which could bring down many healthy institutions.

It is very similar to the situation last year when the U.S. took Fannie Mae and Freddie Mac into government conservatorship and did everything short of explicitly guaranteeing the two mortgage lenders’ debt. But that wasn’t enough for the markets, specifically the Chinese, who lightened up on Fannie and Freddie bonds, making mortgage rates higher than they otherwise would have been and hampering monetary policy. Ultimately the U.S. was forced to use the Federal Reserve to buy up Fannie and Freddie debt directly as a means of keeping mortgage finance flowing.

BURDEN SHARING

Remember too that these are 5-year credit default insurance contracts, so the same cast of characters might not even be in charge when the bills come due. The range of outcomes is pretty wide and so it’s no surprise people want insurance.

It is possible too that the CDS market is distorted or deluded; after all these might be the same people who are paying good money to insure against U.S. sovereign default, an event that might happen but would surely leave very few counterparties with the ability to make good claims.

To be sure, this doesn’t create funding problems for banks at this stage. They are able to sell bonds backed by the Federal Deposit Insurance Corp’s rather hopefully named Temporary Liquidity Guarantee Program. If those CDS spreads don’t come down it isn’t going away any time soon. It has already been extended into 2012 and I’d expect more in due course.

So, the U.S. is likely to continue to make soothing noises to bank creditors while saying nothing too specific or legally enforceable, all the while hoping that something, anything, turns up. That might work.

COSTS

However, the current fudge imposes its own costs. Banking is a long-term business built on trust. The very existence of concerns among creditors will breed them among clients and will tend to undercut a bank’s ability to get new business and hold on to the old. Lack of trust is a vicious cycle.

So should the U.S. force creditors to pay their share if a major bank needs rescuing? My heart says people should bear responsibility for their decisions and pay the costs. But even the most puritanical capitalist should be extremely worried about what holding this particular group of vested interests responsible for their mistakes might mean for the rest of us.

Remember too that the rather successful Swedish bank bailout made creditors whole, but hit equity holders and management. I’d settle for that.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –