Friday, April 23, 2010

Several Players Caused The Financial Crisis

While many are focused on figuring out who to blame for last year's banking crisis, the real question should be on how the bubbles could have been avoided. Wall Street's greed, politicians desire to promote faux prosperity for the purposes of maintaining a happy and passive electorate, and individuals own desires for the trappings of prosperity - despite their lack of ability to afford it - are all to blame for the current disastrous state of the US financial system. See the following post from The Mess That Greenspan Made.

One look at yet one more story about how the world should assess and assign blame for the ongoing financial crisis, this one appearing over at the Wall Street Journal Real Time Economics Blog the other day titled No Resolution in Sight in Fed Blame Game, has belatedly brought me to the conclusion that, for years now, nearly everybody has been asking the wrong question about blame for the financial crisis.

Of course there was no one person or one group that was primarily responsible for the financial crisis - clearly it took many players to cause a mess as big as the one that we now have on our hands.

Yet, that’s the question that everyone seems to want answered in recent years.

Who caused it?

Which individuals, what organizations?

If ever there were a good example of a group effort, the housing and credit market bubbles and their inevitable demise were surely it and seeking to find the one group that was most responsible is really an exercise in futility because no one fits that bill.

Ultimately, it’s not a very productive exercise either, save for the astonishingly consistent repetition by the nation’s central bank that low interest rates were not to blame. That, by itself, speaks volumes about where we are in the process of understanding what has happened since 2008 and fixing it.

Maybe a better question to ask is, who could have prevented it or stopped it?

After all, there is merit to the argument that capitalism is, by its nature, prone to bubbles, so, maybe it would be a good idea to learn how to stop them.

What individual or group had it in their power to prevent the financial market meltdown but, for whatever reason, chose not to?

Who’s to blame for allowing it to get so bad?

While one could argue that these two are the same question – who caused it versus who could have stopped it – for all practical purposes, the list of candidates for the former is far bigger than the latter and, without doubt, the answer to second question is far more important for the future, that is, if anyone in government or industry is seriously interested in preventing this sort of thing from happening again, something that appears to be in question given the progress on financial market reform so far.

In the West, the powers that be may already understand – either consciously or subconsciously – that financial bubbles are about all that’s left to offer the masses the illusion of prosperity, actual prosperity now seeming to slip further and further from our collective grasp with each passing year.

Consider how many aspiring retirees who resisted the temptation to sell their stocks a year ago may now be looking at their investment portfolio thinking that, maybe, just maybe, things really are turning around?

Despite the growing fears that, at this very moment, policymakers are in the process of blowing more bubbles, a shrewd 401k investor might now understand that the nation’s economic problems can only be postponed – not fixed – and that they just might be postponed long enough for them to cash out in another year or two with a decent retirement stash.

It’s become clear to millions of Americans that the Washington-Wall Street connection isn’t really working in their interests anymore (if it ever did) and that, perhaps, neither group has any real interest in real reform because they know it will be the end of business as they’ve come to know it.

Pretending to fix problems in Washington while remaining loyal to vested interests on Wall Street seems to be a much surer way to extend and enrich careers, respectively, and little else seems to matter.

Casting aside the unpleasant possibility that, in the end, it may be pointless to ask a better question about who to blame for the financial crisis, let’s go ahead and try anyway.

Realistically, who could have or should have prevented the financial crisis?

Wall Street? Sure, if you just fell off the turnip truck

The folks on Wall Street could have kept things from getting out of hand, but why would they? Especially the biggest firms who, as we’ve all learned, are too big to fail. Had they eschewed the madness that was business as usual during the middle of the last decade they may have gone out of business for lack of business. Motivated by earning good bonuses – not by doing good deeds – precludes this cast of characters from doing anything that will not fatten the bottom line and that includes putting the firms very existence in jeopardy.

It’s really as simple as that and that includes the rating agencies.

Every business wants happy customers or it knows the customers will go elsewhere – that includes Goldman Sachs if you’re John Paulson or Moody’s if you’re Goldman Sachs.

Over the years, Wall Street firms have proved that they’ll do everything they can to earn a buck, coming right up to that line separating what’s legal and what’s not and sometimes even crossing it.

Realistically, no commercial entity on Wall Street should be expected to do what is prudent rather than what will make the firm boatloads of money (as long as it’s legal) and anyone who thinks they would or should is naive.

Washington? Why? Faux prosperity has never worked better

Priority number one for anyone in or headed to Washington as an elected official is to remain an elected official, so, it shouldn’t come as too big of a surprise that, when homeownership rates were soaring back in the 00’s and a hundred million or so American families were getting rich beyond their wildest dreams, Congress and the White House would err on the side of taking credit for the prosperity rather than questioning its durability.

Why ruin a good thing even if you suspected it was all going to come crashing down?

In parts of the country around 2005, state and local governments weren’t citing the dangers of a housing bubble, they were railing against the “affordability crisis” where ordinary people couldn’t afford ridiculously priced housing and, instead of questioning whether home prices were too high, they looked for ways to make the monthly payment on these ridiculously priced houses manageable.

When hundreds of millions of people become wedded to the idea that rising asset prices are in the national interest, it makes little sense to think that the nation’s leaders would do much to stop those asset prices from rising, regardless of the consequences.

Individuals? Why? Faux prosperity has never felt better

At the rate we’ve been having asset bubbles over the last 10 or 20 years, it might be a good idea to start teaching high school students about them and, perhaps, the damage that they cause will be mitigated in the future. A good place to start would be to make these two books required reading in about 10th grade:

* Extraordinary Popular Delusions & the Madness of Crowds by Charles Mackay
* Manias, Panics, and Crashes: A History of Financial Crises by Charles Kindleberger

Absent this sort of common sense advice about how to avoid owing $300,000 on a house that is only worth half that amount, there is little hope that individuals will be able to avoid being pummeled by asset bubbles let alone prevent them from occurring or stop them in their tracks.

Joe Sixpack will never really understand those loan documents he’ll keep on signing and the allure of a 25 year-old mortgage broker making a half million dollars a year by burying Joe Sixpack in a loan he can’t really afford is far too powerful to resist. Besides, prosperity – however fleeting – is better than no prosperity at all.

Regulators? Maybe, but remember who they work for

Some might think that one of the policy objectives of the Federal Reserve is financial stability, but it’s not. Yes they talk about it a lot – especially in the last couple years – but, as clearly stated in the Federal Reserve Act, their objectives are limited to prices, employment, and interest rates. Yes, they watch what goes on in banks’ balance sheets but, as we’ve learned the hard way in recent years, that’s not where the real action is.

With the unstated (but widely acknowledged) additional responsibility to protect and, if necessary, bailout the biggest of the big banks, they should not be expected to bring an end to any sort of activity that benefits their owners and, at this juncture it is important to remember that the Fed is owned by the banks … literally.

The big banks will get rescued if they run into trouble, so the Fed’s position is “let ‘er rip”.

Fed chairmen who don’t do the banks’ bidding don’t last very long and those who do stick around forever – you have to look no further than former Fed chairmen Paul Volcker and Alan Greenspan.

As for the other hodgepodge of regulators in Washington, they’ll continue to trail badly the financial innovation occurring on Wall Street and will always prevent the last crisis from happening again, all of which will do nothing to prevent the next crisis.
Nobody? Unfortunately, you’ve reached the correct answer

If there is one thing that can be learned from the events of the last few years and more recent efforts to institute meaningful financial reform, it is that the system, as currently designed, is incapable of fixing itself.

Sure, there will be lots of nice speeches, in fact President Obama is making one today right there in New York, and there will be contrition from many Wall Street professionals but, in the end, the symbiotic relationship between Washington and Wall Street simply has too many incentives that are far too powerful for mere mortals to resist.

We may as well resign ourselves to even bigger and more damaging asset bubbles and financial crises in the years ahead with the next one likely already in its gestation phase.

In the West, that’s about the best we can hope for.

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.
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