Monday, January 4, 2010

More Financial Crisis Talk

I've been following Simon Johnson's blog here quite a bit over 2009, and he's been a pretty consistent critic of how we've dealt with the financial crisis that began in 2008. His main criticisms are very valid, that we are now left with fewer, much bigger banks that are really, really too big to fail and they know it. Having this sort of knowledge and special privilege - they get all of the upside and get bailed out on the downside - gives them more incentive to take on greater risks to get bigger profits. Combine that with built-in financial incentives to promote this risk (year end bonuses that are tied to stock performance for that year - which incentivizes short term profits over long term stability), and we're at serious risk for additional future bubbles, something Simon Johnson refers to as the doom loop.

His proposals, if I understand them correctly, involve tighter regulation and more aggressive control by the Federal Reserve and other governmental agencies to limit what the banks can do. This I generally agree with, and its basically this point of view and the point of view that the general philosophy of Bernanke (and Greenspan before him) that helped cause the crisis to begin with and is why the Senate should vote no on confirming Bernanke.

But I don't quite see eye to eye with this point of view. In my endless debates on the way the financial crisis was handled, here's a very high level summary of how different partisan views interpret the crisis and by extension how they want the government to shift in response:

1) The libertarian point of view: The crisis was caused by the Federal Reserve dropping interest rates too far for too long and the government's sponsorship of Fannie Mae and Freddie Mac, whose mission was to try to extend housing mortgages to more people, caused this crisis.

Their view of course, is that most bad things happen by the government and that we would be much better off if we got the government out of our way. So, Ron Paul publishes the the best seller "End the Fed". So, under this view, not only should Bernanke not get nominated, but we should get rid of the entire institution altogether.

Obviously, ending the federal reserve is never, ever going to happen, and this is a pretty extreme view. A more moderate view would be to keep the Fed's meddling to a minimum and let the markets sort it out.

2) The progressive point of view: The crisis was caused by greedy bankers and investors on wall street. The Bush and Obama administration bailed out those greedy bankers and investors because of their strong ties to our government and the bailout was paid for with tax payer dollars putting the lion share of the pain of this global recession on the backs of the every day worker - you and me. And we're paying dearly for it, primarily through steep declines in our home values and in extensive and long-lasting unemployment.

This point of view calls for stronger regulation. People in this camp would have preferred wholesale nationalization of the failing banks. Where the management is fired, the assets are controlled by the government until they can be turned over to a new bank run by a different set of managers.

3) The view in the middle - this is my view really, and I believe its also the Bush/Obama view. This view believes the causes of the crisis was complicated. Low interest rates had a role, sure, but how much? To quote Bernanke himself (who is quoted here:

"[T]he most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates."

So, this statement would lead someone to believe that the reality lies within 2) above. But I don't fully believe it. I believe we had massive regulatory failures during the housing bubble. The problem was massive and systemic. I'm not sure whether its too much to ask for our government especially on the back of a massive, long-lasting economic boom (beginning in the mid-1990's) in which the entire world and its economy revolutionized, to stay on top of it in a scale large enough to deal with the massive global bubble and subsequent burst.

Simon Johnson dismisses repeatedly the role the global imbalances played in this crisis. And I've never heard him (or anyone else for that matter) address how what happened in the world, starting in 2000 where our world economy was turned upside down through globalization and never before seen technology, had a role in this crisis. A role that would have been difficult for anybody or anything to control or prevent. Actually, I have heard this point of view, on This American Life where they describe how the global amount of money in savings all over the world doubled from 2000 to 2006. And how a big portion of this money came pouring into the US real estate market. Tell me how in the world any governmental agency, especially an agency that is directly influenced through winning short term elections every 2 to 4 years is going to stop a tsunami of money rushing into our markets.

I think the reason Bush and Obama responded the way they did is because there really wasn't any easy villains or at least there wasn't any one. By and large, almost all of us got caught up in the hysteria to one degree or another. Some benefited much more than others. Many of these villains also benefited on the downside as well, which gets a lot of people really, really angry.

But how do you really respond? The economy was on the verge of cratering. You can't just fire everyone and turn the entire world economy over to the handful of people left who were prescient enough to see it from the beginning.

By and large, I think Bush and Obama did what they had to do to get the economy back on the right footing. I don't think its incredibly useful to blame Bernanke or Greenspan or Paulson or any one person for the bubble. But I do think we need to think seriously about how we should fix things going forward. In this regard, Simon Johnson does have some compelling points of view - instituting policies that try to fix the "too big to fail" conundrums. But we live in a rapidly changing world. By and large, yesterday's ways of handling things may not work to solve tomorrow's problems. And our institutions have to recognize that fact. I want an ideology of humility. Recognizing that while we should do our best at all levels to do the right thing, chances are we won't. And I'm suspicious of any quick fixes. I sincerely doubt we'll have a bubble as massive as this last one any time soon, but I'm sure we have another one in the future at some point.

Which leads me to my next point: in the longer term, I believe we need to invest more in our infrastructure, institute policies that will encourage more of our brightest to enter engineering and other "make and design real products" sort of fields and discourage fewer of these people to get into financial engineering type of professions. And of course, we need to make a gradual shift from a spend more than you make attitude and increase our propensity to save and invest. Both at the household level and in our government. (Preferably this shift happens after we're well on our way toward a recovery and not before, otherwise we can forget about another bubble, we'll just be in a massive neverending downturn). We need to cut spending before we cut taxes. We need to increase taxes before we increase spending. This is really hard to do, of course, but hopefully voters can get smarter about the mantra that there is no free lunch. And this Republican ideology that when you cut taxes you always get an automatic boost in GDP that makes up for the tax cut needs to die a quick and painful death.

And of course, we need to focus on better, smarter regulation, I'm just not sure our regulatory system will ever be nimble of innovative enough to keep up with our rapidly changing world. Given that, bailouts are probably inevitable going forward. Having a more financially stable government will go a long way toward softening the bubbles as they happen and dampening the damage of a crash.

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