Monday, March 28, 2011

Saving Capitalism From Wall Street--And Washington

In her introduction, Gelinas compares the market failures of 2008 with those of the 1930's.  Back then, Washington and the public understood that the calamity was "not a sudden outbreak of greed and immorality, but the systemic failure of financial capitalism to regulate itself."  Finance, she believes, threatens the free market itself if left completely unrestrained.  Prior to the Great Depression, financial firms lent freely to investors for the purpose of speculating in securities, thereby allowing short-term gyrations to distort the long term business of borrowing and lending.  "Infusing credit creation with excessive speculation...made the entire economy vulnerable to a financial crisis."  Since bankers had used the public's savings to engage in financial experimentation, they lost the trust of depositors, whose abandonment of neighborhood banks disintegrated the infrastructure of money and credit.

FDR and his policy wonks set about to protect financiers from themselves, and to protect the economy by "building the consistent rules that free financial markets need to function effectively and support a free economy."  Among them were (1) mechanisms for bad banks to fail in an orderly fashion without imperiling the rest of the economy; (2) the Federal Deposit Insurance Corp (FDIC) to insure the public's deposits; (3) the separation of commercial from investment banking, which afforded deposit-taking banks some insulation from the gyrations of economic cycles; and (4) "clear, consistent limits on risk-taking in the securities business," such as limiting the percentage of a securities purchase that could be made on credit, and imposing an obligation to disclose information fully and fairly.  "Taken together, these regulatory reforms enabled the financial and business worlds to continue to innovate and take risks..."  

This regulatory structure, Gelinas believes, started to decay in the 1980's.  First, the government bailed out Continental Illinois, a large commercial bank, in 1984.  It was deemed "too big to fail."  Consequently, all of its lenders, and big depositors--whose deposits far exceeded the FDIC's insurance limit--were made whole.  The consequence was that "uninsured lenders to big banks no longer worried that they would lose their investment...  As a result, financial innovations proceeded without the natural checks and balances of market forces."  Banks, which had purposely been insulated from disorderly failure, were now inadvertently insulated from market discipline as well.

Secondly, the line drawn in the 1930's between the banking and securities industries was blurred by financial innovation, especially in the world of credit.  Long term debt, such as the home mortgage, was converted into tradable securities (securitization), once again exposing the vital business of credit creation "to short-term gyrations between optimism and pessimism."  Early warning signals regarding the conversion of long-term debt into tradable securities--such as the collapse of Drexel Burnham Lambert (junk bonds) and Askin Capital Management (mortgage backed secirities)--were dismissed as aberrations and addressed with one-off, extraordinary solutions.   

Thirdly, derivatives were created to circumvent borrowing limits and disclosure requirements.  The combination of "unbridled derivatives creation and speculation on long-term credit" nearly enabled Long Term Capital Management to take down the financial system in 1998, and resulted in Enron's demise in 2001.

For 25 years, "the financial world operated increasingly freely under a long-running illusion that elegant modern theories and technologies made the creation of nearly all manner of credit...perfectly safe."  Suffering under this delusion, financiers created mountains of debt, and persuaded ordinary Americans to depend more on borrowing.  This merely made them more vulnerable to a contraction in credit markets.  Bankers thus created danger out of safety (rather than vice-versa), turning even people's homes into risky bets.  Unsustainable price inflation came along with easy credit to buy homes.  The illusion created conditions for a collapse.

Gelinas believes that because financial markets became too free, they destroyed themselves and damaged the economy.  The government was obliged by the specter of cascading failures among financial firms, and the economic damage they would cause, to force taxpayers to effectively assume all of the risk in the financial system.  The financial crisis was "the natural result of two and a half decades of decisions and non-decisions that made the financial regulatory system irrelevant."  She believes that the same regulatory philosophy that saved us from the Great Depression will save us from the Great Recession.  She counsels (1) that a suitable mechanism imposing losses on bondholders (lenders) as well as on stockholders be developed to permit financial firms to go out of business in an orderly fashion; (2) insulating "long-term borrowing and lending" from short-term excesses (presumably by reestablishing some separation between commercial and investment banking); (3) well-defined limits to borrowing for speculative purposes; and (4) extending the reach of disclosure requirements, to prevent financial markets from becoming too opaque.

Gelinas writes that "consistent, predictable regulation of financial firms and markets is prerequisite for a free-market economy, not a barrier to it."  She believes that the government's new power over financial markets and credit extension--claimed by virtue of its extraordinary interventions during the crisis--poses a threat to the market economy.  Financiers cannot correctly judge the risks and rewards of extending credit if they implicitly understand that the government will save them from their poor decisions.  The distortion of market incentives, caused by a belief that the government will once again save the industry in the next crisis, harms "the private sector's free assumption of financial and economic risk."  Moreover, "the global perception that investors in America can expect fair treatment according to a predictable and consistent rule of law" has been damaged.  Arbitrary interventions such as those at General Motors and Chrysler, "upsetting precedents for treating creditors to bankrupt firms that date back centuries," fuel a perception that "personal contacts and political power matter more than laws and rules."

Ordinary citizens have consistently defended free enterprise and opposed bailouts.  "Americans enjoy seeing success rewarded with great wealth--as long as they aren't forced to subsidize failure."  What they want is for the financial system to manage the process of credit allocation, and for the government to rationally regulate financial markets.  Unregulated financial capitalism caused the crisis, which could have been prevented.

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