Who Killed Wall Street? by Dani Rodrik CAMBRIDGE– You don’t have to break a sweat to be a finance skeptic these days. So let’s remind ourselves how compelling the logic of the financial innovation that led us to our current predicament seemed not too long ago. Who wouldn’t want credit markets to serve the cause of home ownership? So we start by introducing some real competition into the mortgage lending business. We allow non-banks to make home loans and let them offer creative, more affordable mortgages to prospective homeowners not well served by conventional lenders. Then we enable these loans to be pooled and packaged into securities that can be sold to investors, reducing risk in the process. We divvy up the stream of payments on these home loans further into tranches of varying risk, compensating holders of the riskier kind with higher interest rates. We then call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in. In case anyone is still nervous, we create derivatives that allow investors to purchase insurance against default by issuers of those securities. If you wanted to showcase the benefits of financial innovation, you could not have come up with better arrangements. Thanks to them, millions of poorer and hitherto excluded families became homeowners, investors made high returns, and financial intermediaries pocketed the fees and commissions. It might have worked like a dream – and until about a year and a half ago, many financiers, economists, and policymakers thought that it did. Then it all came crashing down. The crisis that engulfed financial markets in recent months has buried Wall Street and humbled the United States. The near $1 trillion bailout of troubled financial institutions that the US Treasury has had to mount makes emerging-market meltdowns – such as Mexico’s “peso” crisis in 1994 or the Asian financial crisis of 1997-1998 – look like footnotes by comparison. But where did it all go wrong? If our remedies do not target the true underlying sources of the crisis, our newfound regulatory zeal might end up killing useful sorts of financial innovation, along with the toxic kind. The trouble is that there is no shortage of suspects. Was the problem unscrupulous mortgage lenders who devised credit terms – such as “teaser” interest rates and prepayment penalties – that led unsuspecting borrowers into a debt trap? Perhaps, but these strategies would not have made sense for lenders unless they believed that house prices would continue to rise. So maybe the culprit is the housing bubble that developed in the late 1990’s, and the reluctance of Alan Greenspan’s Federal Reserve to deflate it. Even so, the explosion in the quantity of collateralized debt obligations and similar securities went far beyond what was needed to sustain mortgage lending. That was also true of credit default swaps, which became an instrument of speculation instead of insurance and reached an astounding $62 trillion in volume. So the crisis might not have reached the scale that it did without financial institutions of all types leveraging themselves to the hilt in pursuit of higher returns. But what, then, were the credit rating agencies doing? Had they done their job properly and issued timely warnings about the risks, these markets would not have sucked in nearly as many investors as they eventually did. Isn’t this the crux of the matter? Or perhaps the true culprits lie halfway around the world. High-saving Asian households and dollar-hoarding foreign central banks produced a global savings “glut,” which pushed real interest rates into negative territory, in turn stoking the UShousing bubble while sending financiers on ever-riskier ventures with borrowed money. Macroeconomic policymakers could have gotten their act together and acted in time to unwind those large and unsustainable current-account imbalances. Then there would not have been so much liquidity sloshing around waiting for an accident to happen. But perhaps what really got us into the mess is that the US Treasury played its hand poorly as the crisis unfolded. As bad as things were, what caused credit markets to seize up was Treasury Secretary Henry Paulson’s refusal to bail out Lehman Brothers. Immediately after that decision, short-term funding for even the best-capitalized firms virtually collapsed and the entire financial system simply became dysfunctional. In view of what was about to happen, it might have been better for Paulson to hold his nose and do with Lehman what he had already done with Bear Stearns and would have had to do in a few days with AIG: save them with taxpayer money. Wall Street might have survived, and US taxpayers might have been spared even larger bills. Perhaps it is futile to look for the single cause without which the financial system would not have blown up in our faces. A comforting thought – if you still want to believe in financial sanity – is that this was a case of a “perfect storm,” a rare failure that required a large number of stars to be in alignment simultaneously. So what will the post-mortem on Wall Street show? That it was a case of suicide? Murder? Accidental death? Or was it a rare instance of generalized organ failure? We will likely never know. The regulations and precautions that lawmakers will enact to prevent its recurrence will therefore necessarily remain blunt and of uncertain effectiveness. That is why you can be sure that we will have another major financial crisis sometime in the future, once this one has disappeared into the recesses of our memory. You can bet your life savings on it. In fact, you probably will. Dani Rodrik, Professor of Political Economy at Harvard University’s John F. Kennedy School of Government, is the first recipient of the Social Science Research Council’s Albert O. Hirschman Prize. His latest book is One Economics, Many Recipes: Globalization, Institutions, and Economic Growth. Copyright: Project Syndicate, 2008. http://www.project-syndicate.org/commentary/rodrik24 La Strada on Wall Street by Alfred Gusenbauer VIENNA– Apologists for neo-liberalism assume not only that states should be run like companies, but also that, as far as possible, they should not intervene in the economy. The market, they insist, regulates itself. But, more than 50 years ago, the Nobel laureate Paul Samuelson contradicted this idealization of markets in graphic terms: absolute freedom for the market will lead to Rockefeller’s dog getting the milk that a poor child needs for healthy development, not because of market failure, but because “goods are placed in the hands of those who pay the most for them.” This distributional quandary lies at the heart of the capitalist system, which is one of never-ending competition fueled by the drive to maximize profits. In such a world, there is no room for a social conscience. It is the state that, to a greater extent in some societies than in others, must fill the gap. The market economy is unsurpassed as a system for creating wealth, but only social compensation ensures that this wealth is distributed in a just manner. Europe’s social-market economies, far more than the Anglo-Saxon neo-liberal model, regard mitigating the inequalities created by markets as the state’s duty. In fact, the market economy can function only if the state does intervene. The USfinancial crisis demonstrates what happens when markets are given free rein. Rather than regulate themselves, market players destroy themselves, however much they might be marveled at as golden calves. Indeed, investment bankers transformed stock markets into a surreal circus. For the most part, they resembled high-wire artists juggling borrowed money without a safety net. They threatened to crash – until the state stepped in. In Fellini’s film “La Strada,” the circus artists lived on the margins of society; in the “Wall Street Circus,” they lived like gods, making millions. That’s over for a while. Wall Street has collapsed. The present crisis, the fall of Wall Street, is to neo-liberalism what the fall of the Berlin Wall in 1989 was to communism. The global dimension of this crisis surprisingly also has a positive side. The international community is now charged with thinking about how to reorganize the financial sector and minimize the risk of similar catastrophe in the future. Until now, a major part of the problem was countries’ unwillingness to cooperate. Previous demands for stricter regulations came to nothing because of financial sector opposition. When should this stance change if not now? A start needs to be made at the European Council meeting of the heads of state and government in Brusselsin mid-October. It is crucial that the European Union accepts the challenge of the financial crisis at the highest level, draws the appropriate conclusions, and takes the logical next steps. So what lessons are to be learned from the failure of the neo-liberal economic model? First, markets need clear rules. Stronger regulation means legally binding, globally applicable rules and standards. While important areas of economic policy are subject to rules that allow penal sanctions, the financial sector has a special status that is no longer acceptable. Those areas of the financial sector that have suffered the most reputational damage are the ones least subject to regulation and supervision: the derivatives market, hedge funds and private equity funds, and the ratings agencies. Voluntary codes of good conduct have been a dismal failure. We urgently need globally applicable regulatory minimum standards similar to those, say, within the WTO. We need a democratically legitimized world finance organization, equipped with the necessary regulatory instruments, which would supervise major global financial institutions. This organization should also have authority to create conditions for greater transparency, and to implement better early-warning systems and instruments for crisis management. The newly created regulation need not apply to everyone. But only those financial institutions that subject themselves to these rules would be able to rely on the support of the public authorities in case of a crisis. This would ensure both fiscal stability and fiscal innovation – in contrast to the present situation, in which no one obeyed any rules and, when crisis erupted, taxpayers had to come to the rescue. Second, welfare-state institutions should be strengthened. The crisis has made clear that the provision of people’s elementary needs must not be made dependent on speculation and stock market curves. Expansion of public financing for pensions, nursing care, and health insurance is therefore crucial. Finally, we need a European economic stimulus program – a “Big Bargain” – and we need it now. The crisis in international financial markets has had a noticeable impact on Europe’s real economy. Some large EU countries are on the brink of recession. Japan in the early 1990’s waited too long to act and missed the right opportunity to enact countermeasures, which is why Japanhas still not recovered from its long stagnation. Public investment in infrastructure (such as a massive expansion of the European railroad network), as well as climate protection and environmental technology, will be needed. To strengthen purchasing power and to stimulate consumption, tax cuts on low- and medium-income households are essential. Of course, EU member states should determine the concrete form that such economic stabilization programs take for themselves. But that shouldn’t stop European governments from working together closely. To be effective, any stimulus program will need Europe’s nations to act in concert. ** Alfred Gusenbauer is the Federal Chancellor of Austria. Copyright: Project Syndicate/Institute for Human Sciences, 2008. http://www.project-syndicate.org/commentary/gusenbauer1
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