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Will financial reform end big bank bailouts?

Lawmakers are pledging to end bailouts in the financial reform bill that the Senate is considering now. But many experts say bank bailouts can and will occur again.

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At the other end of the spectrum, some economists say the opposite: The law may succeed at preventing bailouts – and that this is a bad thing. You don't want to tie regulators' hands in a crisis or possibly make a crisis worse by moving to dismantle large firms.

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A middle view is that the legislation strikes a reasonable balance. These financial experts say the bill puts investors in failing firms on notice that they will bear losses when a firm gets in trouble, while also giving regulators the flexibility to contain any economic ripple effects from a firm's failure.

"A lot of the discussion has been overly simplistic," says Dean Baker of the liberal Center for Economic Policy and Research in Washington. For all the talk about the need to end bailouts, he says, the bills still give "relatively open-ended authority" to government officials in a crisis. "I'm not upset that they have that option," he says.

In the 2008 crisis, the recession might have become much worse without the safety net provided by that $700 billion Troubled Asset Relief Program and extraordinary Federal Reserve lending activities, for example.

In this light, the question of "bailouts" versus "liquidation" is not just one of fairness to taxpayers. The larger question – the issue that's ­fueling the drive for financial reform – is how to protect the economy from financial crises. The economy needs a healthy financial industry, not one that's prone to booms and busts.

Most of the financial reform package in Congress consists of provisions intended to prevent another financial crisis, such as tighter oversight of banks. But the second level of reform – focused on how to deal with large failing firms – ties back to the first issue of crisis prevention.

Bailouts create what's called "moral hazard," because government aid saves risk-takers from the consequences of their risky behavior. That can encourage future bad behavior, setting the stage for another crisis.

How tough is too tough?

The debate on the Senate floor is not all about election-year political posturing and the influence of bank-lobby dollars – though there's plenty of that. It's also that these are tough regulatory challenges to resolve.

"There are elements of flexibility [in the bill], but there is a clear effort to force these firms toward ­liquidation," worries Douglas Elliott, a Brookings Institution expert who has worked on Wall Street.