After the news broke of his firm’s (now $3 billion) loss on a hedge gone awry, Jamie Dimon quipped: “just because we’re stupid doesn’t mean everybody else was.”  Stupidity, however, is beside the point.

Jan Kregel has pointed out how a lot of the discussion surrounding this episode is designed to give the impression that this was just a matter of personal folly and bad judgment.  Get rid of a few people, tweak a model, and everything should be fine.  But there’s far more to this story, says Kregel in a new policy note.  First, the fact that management appeared not to recognize what was going on in a unit that reported directly to them suggests that JPMorgan was too big to manage.  And if it’s too big to manage, it’s too big for regulators to supervise effectively.

But simply making banks smaller won’t solve the problem either, according to Kregel—not if they’re allowed to engage in the same kinds of trades on the same kinds of assets.  Here he captures the “heads they win, tails we lose” dynamic of the post-Gramm-Leach-Bliley banking world:

[S]ince the passage of the Gramm-Leach-Bliley Act in 1999, the major activity of banks is to profit from changes in the prices of the assets held in its trading portfolio—and for JPMorgan Chase, in its hedging of its global portfolio. This activity generates little new investment and virtually no employment. If the bank guesses right, it makes capital gains for its shareholders; if it guesses wrong, and other banks have made the same guesses, the government and the general public are called upon to bear the losses. The problem is not simply that the banks are too large; it is that they generate shareholder returns by betting on changes in asset prices in their portfolios rather than by betting on investments in real productive activities that create income and employment for the economy as a whole.

The last line here is fundamental.  Dodd-Frank approaches the regulatory challenge by trying to make banks’ trading activities less risky.  But risk alone is not the issue for Kregel. The problem isn’t simply speculation or riskiness per se, but that “they are engaging,” he says, “in the wrong kinds of investments and the wrong kinds of risks.”  What Dodd-Frank fails to do is to reorient the banking system from speculating on price changes in exotic assets toward speculating on the real economy: on the ability of entrepreneurs to identify and pursue business opportunities that generate employment and real output.

Read it here.