Okay...so 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.
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 Depression...how 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 is...in 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.