Thursday, May 13, 2010

The Goldman Sachs hearings missed the point - PART 4

Sorry for the delay. I have waited to finish these last few posts on the financial crisis (for a while at least) until I finished the book 13 Bankers. And by the way, I just cannot possibly recommend it more to those interested and willing to take the plunge head-first down the rabbit-hole that is our broken financial system. It is a fascinating and well-written book by some really brilliant guys. here's a short, convenient summation of what I went through in the last 3 parts (quoted from 13 Bankers):
The end result was a gigantic housing bubble propped up by a mountain of debt - debt that could not be repaid if housing prices started to fall, since many borrowers could not make their payments out of their ordinary income. Before the crisis hit, however, the mortgage lenders and Wall Street banks fed off a giant moneymaking machine in which mortgages were originated by mortgage brokers and passed along an assembly line through lenders, investment banks, and CDOs to investors, with each intermediate entity taking out fees along the way and no one thinking he bore any of the risk. 
So, as we all know, the bubble did end up bursting and today we are continuously faced with the consequences in the form of high unemployment, cuts in government services, etc. But you might ask yourself...didn't we learn our lesson? Well, I wish that I could say 'yes' but I'm afraid we, as a country, are not even close to learning the larger lessons of this crisis.

The way the current financial system is structured, a future president (regardless of ideology or party) will inevitably look over the edge into a dark abyss of economic chaos and face the same decision that the Bush administration faced in the fall of 2008 after an asset bubble burst (this last time it was housing, the time before it was dot-com's, the next time...who knows?):
  • let the mega-banks fail and cause a banking crisis that would lead to another Great Depression (many, many times worse than the current economic recession) OR 
  • pledge an enormous amount of taxpayer money to bail out the mega-banks.
Both of these ideas are horribly unsustainable. Another Great Depression would dramatically change the world's economic status. It would be absolutely devastating. Another Huge Bailout for banks would funnel more money away from taxpayers to the financial elite plus it would dramatically increase the government's debt burden (with the worst consequences experienced by future generations). So that's why we cannot let this moment just pass and say 'Boy...that was close...we sure did learn our lesson...that shouldn't ever happen again.'

We have not truly come to grips with this crisis as a country. Those that are unemployed or otherwise severely affected by this recession are undoubtedly hurting and very interested in solutions but, as a whole, we are poised to repeat this mistake again. (See this new data on the decrease in the savings rate for a taste of this idea). More people need to be told about how close we came to plunging into a Great the commercial paper market (the short-term loans that companies depend on to cover payroll) momentarily froze in September 2008 (the This American Life episode on this is great...the very first story beautifully explains the commercial paper market). This is all poised to happen again.

Alright...splendid. What to do? Now...on to the actual financial reform ideas.

I think it's easiest to just break it up into two basic strategies: 1) Increasing the transparency of financial transactions from the credit-card consumer-level to the hedge fund-level, and 2) breaking up the "Too-Big-To-Fail" banks.

#1: Increasing transparency of financial transactions

A fundamental assumption of a fully-functional capitalist market system is that everyone has the correct information available to them and then they use that information appropriately and efficiently to make a "correct" economic decision. But the critical lesson of the crisis is that this assumption is totally bunk. People are irrational and information is conveniently and strategically hidden from those who are being duped.

This has been happening at all levels of the financial system but most people are much more familiar with the credit-card side of things. I think most of us would agree that credit card companies have become exceptionally good at deceiving people into high interest loans and charging for hidden fees. This has got to stop. But it's not at the heart of the crisis.

The other side of the system is where the huge problem that maze of crazy acronyms that is the complex financial products for the "sophisticated" investors; a market that became a house of cards, which then imploded to trigger the meltdown. While greed was definitely a primary driver on both sides of each transaction, lack of information was surely another. As was argued recently, it is clear that some people knew much more about the complexities (and associated risks) of these financial instruments than others. Firms like Goldman Sachs manufactured these products, had contact with the individual lenders that fed into the products, and were able to "negotiate" (i.e., pay for) good ratings from the agencies responsible for assessing these products. Therefore, they are at a distinct advantage when compared with the average (even sophisticated) investor.

Some people will just say "buyer beware" and trying to fix a problem like this with government regulation would be equivalent to a nanny state but I think this is a case where overly deceptive (and sometimes illegal as we are seeing with Goldman and JPMorgan) practices are hurting the overall machinery of the economy more than helping.

That gets me to my main point here, as wonderfully summarized (again) by 13 Bankers:
The core function of finance is financial intermediation - moving money from a place where it is not currently needed to a place where it is needed. The key questions for any financial innovation are whether it increases financial intermediation and whether that is a good thing. 
I think it can be argued that these deceptive practices and overly complex products do not do anything to move money from a place where it is not currently needed to a place where it is needed (think greasing the gears of the economy). We are no better off as an economy because of these practices/products. It is squarely the opposite...our economy is much, much more susceptible to disaster as a consequence of them.

So I would recommend increasing regulations on the complex financial products (derivatives) market to increase transparency. The assumption of abundant information is so incredibly important in this market because of the enormous risks that get compounded and correlated together with each new bet on the same set of assets.

Currently, the proposal that claims to deal with exactly these types of regulations would be in the form of the recently proposed Consumer Financial Protection Agency. While I realize that another huge bureaucratic regulatory agency is rarely a good solution to anything, what else would you propose we do in the light of what I just discussed?

Okay, I have rambled on for too long again...I will save the Too-Big-To-Fail issue for next time.


  1. Mr. Booth,

    I think that you are correct that additional government regulation of the financial sector is probably the best way to go about trying to control these immoral games that the great men of finance play to make themselves obscenely rich. However, as we both also know, for such drastic policy changes to occur in America, there needs to be an overwhelming amount of public support that slowly builds over time. For example, look at how long it took to pass health care reform. Decades. And that is something that impacts people's lives. Most Americans do not directly deal with the impacts of high finance, short of watching their 401k's decimated because a bunch of rich Ivy elites wanted to make themselves even richer on the backs of well, the entire economy of the Western world.

    I think that the most disturbing thing about this whole thing is the reaction of the financial sector. If a similar thing happened in the field of civil engineering, there would be a national investigation of what went wrong; introspective discussions about the state of the practice by university professors and professional organizations; and perhaps even changes in the actual civil engineering profession. In other words, most normal people would feel guilty about what their profession had wrought and would try to fix it.

    Did this happen with the financial sector? Ummmmmm, no. Instead, after destroying the national economy they then proceeded to go straight to the Federal government to ask for money to bail them out. And not humbly ask for bailout money, but basically say "Give us more or we'll really destroy things. You ain't seen nothing yet." I mean ... wow. The great men of finance are so elitist and so greedy that normal human feelings such as humility and repentence do not even begin to cross their minds.

    To sum up my solution to the problem, you asked earlier how we can deal with actions that are immoral but not illegal, and I say this in 75% seriousness, I think we need to bring back Michael Moore's bit from the Awful Truth about "Corporate Cops." What these people do is immoral, greedy and wrong and they should be punished accordingly, especially given that after colossally screwing up, they still haven't realized that what they have done is wrong.

  2. "For example, look at how long it took to pass health care reform. Decades. And that is something that impacts people's lives. Most Americans do not directly deal with the impacts of high finance, short of watching their 401k's decimated because a bunch of rich Ivy elites wanted to make themselves even richer on the backs of well, the entire economy of the Western world."

    I guess I didn't make myself clear enough. We all absolutely are dealing with the impacts of high finance right now. The system failures and poor policies in the financial sector are the #1 reason why we have 10% unemployment right now. I fully understand that it is difficult for people to directly relate to these financial issues, but we must try to get people to see the collective failure and consequent need for massive reform of the financial system. Otherwise, we are heading for another huge disaster that will even more intricately link everyone with the complexities of high finance. Check this out:
    Freaky stuff!

  3. The key quote from that linked post by Mike Konczal is this: "Though I'm mentioning progressives, much of this will appeal across the entire political spectrum. Because these fights aren't for fun or grudges. If we have another financial crisis within a decade, it will probably permanently wreck the wealth and happiness of a generation of Americans and perhaps even a generation of the world; this isn't a game."