Bankers, you have nothing to gain but your chains!
Saturday, November 29, 2008 at 1:40AM BRIEFING: "A short history of modern finance: Link by link; The crash has been blamed on cheap money, Asian savings and greedy bankers. For many people, deregulation is the prime suspect," The Economist, 18 October 2008.
A good rendition of the argument that says we're at the end of an extended period of deregulation that has logically run its course.
First off, it notes that "the idea that the markets have ever been completely unregulated is a myth," pointing out the SEC example--something I see as being necessary on a Core-wide level.
But the piece notes that, over the past three decades, "each step on the long deregulatory road seemed wise at the time and was usually the answer to some flaw in the system," like Nixon being smart enough to take us off the gold standard in 1971. Then Reagan and Thatcher effectively abolish controls on financial flows, now made possible by the floating currencies, allowing insurance companies and pension funds to move money across borders--fueling globalization.
Then on to the so-called Big Bang of 1986 that allowed foreign brokerage firms into the market in Britain, following a step New York had made 11 years earlier. All those transactions reduced brokerage margins, forcing investment banks to cooperate more with commercial banks, who had the money, thus triggering the end to Glass-Steagall, the Depression-era law that had separated them. Commercial banks muscle into the underwriting of securities business, and investment banks responded by bulking up hugely.
Then we see the rise of complex instruments, like options and swaps, leading to the rise of the quants which arbitraged price differences between markets, with currency swaps leading to interest swaps to . . . finally, credit-default swaps, all featuring small initial positions with huge exposure, so regulators fall behind in the shell game. Derivatives cause occasional but big hiccups across the 1990s, but Greenspan supported them (Age of Turbulence:
Being able to profit from the loan transaction but transfer credit risk is a boon to banks and other financial intermediaries which, in order to make an adequate rate of return on equity, have to heavily leverage their balance sheets by accepting deposit obligations and/or incurring debt. A market vehicle for transferring risk away from these highly leveraged loan originators can be critical for economic stability, especially in a global environment.
True enough, it seems in retrospect, but a bit naïve given the lack of intermarket controls and transparency: high-trust, sophisticated markets selling their complex instruments to lower-trust, less sophisticated markets, and the shell game kicks into high gear in terms of uninformed risk-taking.
Securitization, or the bundling of loans, "is another child of the 1970s," like so much of our modern, globalized world. It began in U.S. mortgage markets as part of our never-ending and very good pursuit of maximally widespread home-ownership--part and parcel of our economic system.
But the system gets too cute for itself. Collateralized debt obligations (CDOs) bundle together the resulting bonds and then slice then horizontally according to the risk tolerance of the buyers.
But the big danger is that commercial banks used securitization to access new sources of lending in markets, making our banks far bigger bettors on the market's health.
The Basel accord was supposed to fix this by making banks hold more capital against such contingencies.
All this good stuff led to many more homeowners in America, but that naturally drove up prices, and that unrealized wealth was then turned into additional debt (the second mortgages--an incredibly common sin to which I confess).
But the train kept rolling with America's implicit Marshall Plan spend-to-fund-globalization strategy across the 1990s, aided by technological advances and India's and China's emergence.
Then it all comes falling down, starting in spurts in 2007 but for real over the past few months.
The verdict from the Economist:
Amid the crisis of 2008, it is easy to forget that liberalization had good consequences as well: by making it easier for households and businesses to get credit, deregulation contributed to economic growth. Deregulation may not have been the main cause of the rise in living standards over the past 30 years, but it helped more than it harmed. Will the new, regulated world be as benign?
Indeed.
Reader Comments (6)
First, most types of domestic manufacturing lost investor and labor to foreign competition as American companies used more computerization and overseas labor to produce parts, and later assemble consumer and industrial items, as well as clothing and appearance products. American sponsored international standards for digital parts descriptions for manufacturing were an important factor.
So then domestic capital, and the next generation of domestic labor youth moved toward IT related products and services. Like Adam Smith said, the early high returns from the new economy angle drew far too much investment and labor. It was the next bubble to burst.
Before that time, Robert Reich wrote books showing how America should have reacted by using the techniques of the previous noted economic/technology changes to move towards smaller, responsive, mass customization businesses for domestic, and then global needs. I used Reich's books in classes I taught. I was disappointed later when some of my students could not get positive responses from his Labor Department to get support for retraining of displaced industrial workers, or get support for emphasizing the new ideas and techniques in K-12 curriculum. Much of the bureaucracy didn't 'get' the implications of Reich's ideas, and the industry, labor, and academic communities had vested interests to resist change.
Then a big domestic housing push with a huge financial capital and labor support structure was seen as a panacea by the economic elite to the problems of the earlier two changes. After all (they said) this will keep capital and labor at home, and any foreign capital joining us will only help us, without harming our production resources. Then the process was both accelerated and obscured by the finance gimmicks noted in the Economist article and Tom's comments. Tangible investments like energy modernization and nano-technology products and services could never reach the quick investment results, and cycle speed, of those new intangible financial toys.
Well, darn, didn't the establishment have the right intentions? So we will decide no one is to blame for unintended consequences.
Sorry for long babble, been irritated for a long time.
That's inevitably more regulation in the economic sphere, focused mostly on cleaning up and creating transparency--like it did in the U.S., and regrading the competitive landscape.