Business As Usual
The Next Wall Street Collapse
Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. Vintage, $15.95 (paper).
Richard A. Posner, A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression. Harvard University Press, $23.95 (cloth).
Nouriel Roubini and Stephen Mihm, Crisis Economics: A Crash Course in the Future of Finance. Penguin Press, $27.95 (cloth).
Joseph E. Stiglitz, Freefall: America, Free Markets, and the Sinking of the World Economy. W.W. Norton, $16.95 (paper).
The economy teetered on the brink but did not fall into the abyss. The bailouts, the stimulus, and adequate international political comity—each imperfect, even ugly—nevertheless prevented what was otherwise very likely: another Great Depression.
But the collective sigh of relief and overconfident pronouncements emanating from Wall Street and Washington obscure the fact that we have done little to avert an even worse crisis in the future. We may have stanched the bleeding, but the underlying disease—a culture, ideology, and political economy of uninhibited finance—remains. Indeed, by tiptoeing around the real issues we may ultimately make things worse.
The roots of our current problems trace to the 1970s, when decades of heavy regulation and boring banking (and a quarter century of unprecedented economic growth) gave way to a liberation of international capital flows and, later, successful experiments with microeconomic deregulation. The Reagan revolution of the 1980s unwisely applied this deregulatory zeal to the financial sector. Banking became exciting again—so exciting that, amid fraud and excess, 2,000 banks failed. The Savings and Loan Crisis was the first American banking crisis in 50 years; it was contained by a massive government bailout.
The Clinton ’90s added bipartisan fuel to this combustible heap. Domestic financial deregulation, unsupervised derivative markets, and dismantled capital controls were all pushed aggressively from the White House by Treasury Secretaries Robert Rubin and Lawrence Summers; championed by such congressional allies as Senator Phil Gramm, who authored the signature bill that undid the protective firewalls built during the Great Depression; and blessed by Federal Reserve Chairman Alan Greenspan. An Ayn Rand acolyte, Greenspan was so enthralled with the magic of the free market he thought it would even prevent, unaided by government, financial fraud.
The Bush administration followed with further deregulation and an ethos that led federal agencies to decline the limited supervisory capacity they had left. Greenspan, ever present in the rogues’ gallery, opportunistically endorsed the Bush tax cuts—which left a mountain of debt that has made today’s problems more difficult to address—and presided insouciantly over the housing bubble.
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None of this has been undone, so the economy is poised to head down the same road that led to the recent collapse. This is the dispiriting conclusion of four recent books by particularly well-positioned observers. Nouriel Roubini can take credit for getting the crisis almost exactly right, long before it hit; this alone should make his Crisis Economics (coauthored with Stephen Mihm) required reading. Nobel laureate Joseph Stiglitz reprises his role as one of the world’s foremost critics of “market fundamentalism” in Freefall. Richard Posner is closely associated with the free-market “Chicago School” of economics, and, as such, his bracing and intellectually admirable A Failure of Capitalism demands attention. (Posner explores similar themes in a recent academic work, The Crisis of Capitalist Democracy.) Simon Johnson, former Chief Economist at the International Monetary Fund (IMF), and James Kwak, a businessman and consultant, wrote the best book of a fine bunch. Their 13 Bankers is a brilliant, important, and extremely unsettling work. Four big lessons emerge from these analyses.
Keynes was right and classical economics wrong. The economist John Maynard Keynes argued that the market has its limits. Most markets work well most of the time, but financial markets left alone are prone to dysfunction, and an economy stuck in a rut can stay in a rut for some time. Thus the necessity of the stimulus.
It is now clear that two foundations of anti-Keynesianism—rational expectations and the efficient-markets hypothesis, both of which are embraced by mainstream economics despite the absence of empirical support—are simply wrong. Market actors do not efficiently and hyper-rationally process all available information in the context of well-defined risks and with a shared knowledge of the correct underlying model. Instead, they have what could be called “realistic” expectations. They do the best they can to process information guided by the psychology and instincts that Keynes called “animal spirits,” making guesses about the sentiment of the crowd in an environment characterized by uncertainty. And asset prices are not always and everywhere “accurate.” Rather, as Johnson and Kwak explain, it turns out “prices could wander far away from fundamental values for indefinite periods of time.” Stiglitz and Roubini, too, are Keynesian in their thinking, and particularly worth tracking down is Posner’s clear-eyed and admirably open-minded essay “How I Became a Keynesian,” in which the dyed-in-the-wool conservative concludes that Keynes was “the best guide we have to the crisis.”
Finance is inherently risky, and garden-variety financial crises are the historical norm.
Unregulated finance is inherently prone to crisis. Roubini and Mihm’s Crisis Economics is especially convincing about the normalcy of financial crises. The authors don’t mince words about the politics of insisting that crises are aberrations: if each such crisis is “a singular, unprecedented event,” like a plane crash, “horrific but highly improbable and impossible to predict—there’s no point in worrying about them.” But the business of finance is intrinsically rife with risk for individuals, firms, and, worse, the whole economic system. Gambles made by firms can inadvertently produce intolerable systemic risks, something unaccounted for on individual balance sheets. The ephemeral value of financial assets, “rational” herding behavior, and the lure of speculative profits are perennial, and garden-variety financial crises are the historical norm.
All four books appeal to Charles Kindleberger’s classic work on this subject, Manias, Panics, and Crashes (1978). They also routinely invoke the new, comprehensive, and invaluable study, This Time Is Different: Eight Centuries of Financial Folly, by Carmen Reinhart and Kenneth Rogoff. This Time Is Different is summarized by the intended irony of its title: this time was not different, and it almost never is. Reinhart and Rogoff reveal that the United States has suffered fifteen major banking crises since 1800 (about the same number as Denmark, France, Italy, Britain, and Brazil). Only two of these have happened since World War II, both recently, in the age of deregulation. The exceptional interlude was the result of regulation. As Johnson and Kwak put it, the Glass Steagall Act of 1933 ushered in an era during which “banks gained government protection in exchange for accepting strict regulation” which was “the basis for half a century of financial stability.”
Reinhart and Rogoff also show that “periods of high international capital mobility have repeatedly produced international banking crises” throughout history. What’s worse, as This Time Is Different hammers home, is that before most crises, investors and speculators convince themselves that it can’t happen again. In 2006 the IMF proclaimed:
The rapid growth of credit derivative and structured credit markets in recent years, particularly among more complex products, has facilitated the dispersion of credit risk by banks to a broader and more diverse group of investors . . . [which] has helped to make the banking and overall financial system more resilient and stable.
As Posner explains, “I don’t think we realized that . . . the riskiness of banking could facilitate a global financial crisis. That was a big oversight.”
The financial sector has become too big. By any measure—size, concentration, political influence—banking has grown too big for our own good. From 1980 to 2002, manufacturing fell from 21 percent of GDP to 14 percent, while finance grew from 14 percent to 21 percent. In 2007 finance accounted for 47 percent of U.S. corporate profits. Finance has also become more concentrated, with fewer, bigger firms dominating the market. And it has become, of course, riskier. Roubini reports that from 1981 to 2008 financial-sector debt increased from 22 to 117 percent of GDP. All this left dangerously interconnected giants that were indeed too big to fail and resulted in what we used to call, when pointing fingers abroad, “crony capitalism.” At home we called it the “American model,” which in practice meant massive profits that bought political influence, revolving doors from executive suites to the executive branch, and virtually free reign within the financial industry to regulate (and deregulate) itself.
How big is too big? It’s hard to say, but today’s numbers fail the “write it down and push it across the table” test. You can always find someone who will look at the status quo and find it reasonable. But had that person been asked ten or twenty years ago to write down what number would have been “too big” and slide that paper across the table, chances are the figure would be well below what we see now. The same exercise can be performed today. Goldman Sachs grew from $178 billion in assets in 1997 to over $1.1 trillion at its peak; Morgan Stanley went from $302 billion to $1 trillion. Is that too big? Johnson and Kwak propose that no financial institution should be worth more than 4 percent of GDP (about $570 billion) and no investment bank more than 2 percent (Goldman Sachs and Morgan Stanley passed this threshold in the late 1990s); at that point, they argue, the systemic risk is too great.
The fault lies not with our bankers, but with ourselves. Wall Street certainly has problems, especially with the rise of a bonus culture that encourages a short-run mindset and rewards increased risk taking. But greed is nothing new. People don’t work in high finance in order to make the world a better place. They do it for the same reason that Willie Sutton robbed banks: because that’s where the money is.
The embrace of rational expectations and the efficient-markets hypothesis contributed to the ideational environment that led us off this cliff.
Thus Posner assigns responsibility for the crisis to the financiers, but he withholds “moral censure.” One could no more “blame a lion for eating a zebra.” They have not changed; what has changed is our relationship with them: the diffusion of the ideology of finance, the bipartisan embrace of deregulation, the collapse in national savings, the consumption binge on leveraged credit, the lure of big money. Forty percent of Princeton students graduating between 2000 and 2005 went into the financial sector. Johnson reports that “Operations Research and Financial Engineering” became the most popular major at Princeton’s School of Engineering. According to Roubini, 58 percent of men who graduated Harvard in “2007 were bound for jobs in finance or consulting. Main Street values went awry; indeed, Posner is hopeful for a silver lining—that the crisis “will channel some of these people into less lucrative but socially more productive jobs.”
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Roubini and Mihm locate these four broad lessons in a compelling narrative about what went so horribly wrong this time around. Three interrelated problems “made the entire financial system dangerously fragile and prone to collapse.”
First, the financial innovation of securitization—slicing up, repackaging, and selling mortgages and other instruments—changed the model of banking. Banks used to follow an “originate and hold” model, which meant they would retain the mortgages they issued until maturity. In the new model, “originate and distribute,” they would pass along these assets to other investors. This meant that issuing banks no longer would bear the costs of defaults, so their incentive to weigh risk was dramatically decreased.
A second problem that emerged in the contemporary financial sector was complexity. A given financial instrument may be composed of many individual assets, and this complexity allowed financial engineers to add dollops of risky assets to an otherwise worthy one. Ratings agencies looked the other way as this alchemy was performed, and then they gave the finished products their seals of approval—AAA ratings, in the language of finance—designed to assure investors that the asset was as safe as could be. The ratings agencies could have resisted these practices. But in one of many astonishing conflicts of interest, as Stiglitz observes, the agencies were “being paid by the banks that originated the securities they were asked to rate.” Instead of protecting investors, the ratings agencies rubber-stamped the products of their benefactors, always with an eye toward future business and the fear that their competitors might be even more accommodating.
Third, Roubini and Mihm note that the bonus system and “the skyrocketing ratio of bonuses to base pay” generated pernicious incentives. By placing increased value on the present rather than the future, the system was rigged to reward short-term performance and “encouraged risk taking and excessive leverage on a massive scale.”
None of the books considered here deviates far from the narrative and interpretations laid out in Crisis Economics, but there are differences of emphasis. Stiglitz places greater onus on an abetting government, which was practically falling over itself to give the industry what it wanted. He reminds us of when Summers “proclaimed that one of his great achievements as Secretary of Treasury” was ensuring that the mushrooming derivatives market would not be regulated. That achievement was founded in part on Summers’s willingness to bully into irrelevance those underlings who raised concerns about the risks involved.
Posner indicts the same financial-industry and anti-regulation culprits and dispassionately deconstructs the problematic short-term mentality of Wall Street. On this crucial point, his analysis accords with important work by anthropologist Karen Ho, whose Liquidated: An Ethnography of Wall Street describes an “obsession with immediate results” and a culture in which performance is measured “according to the number of deals executed,” leaving investment bankers “motivated to milk as much money out of the present as possible.” Additionally, with Stiglitz, Posner brings the economics profession to task. The embrace of rational expectations and the efficient-markets hypothesis, and the tendency of the discipline to reward impressively sophisticated and utterly implausible models, contributed to the ideational environment in both business and government that led us off this cliff.
When it comes to solutions, however, Posner travels by himself. While Stiglitz and Roubini and Mihm argue that modest reforms will not do the job—wholesale changes, in particular breaking up institutions that are too big to fail, are needed—Posner is able to run only so far with his newfound Keynesianism. He punts at the end, suggesting modest reforms that he admits are “pretty small beer.” He instinctively counsels caution: “Let the comprehensive structural solution await calmer days.”
The banks emerged from the crisis bigger, more powerful, and more systematically dangerous than ever before.
But if Johnson and Kwak are correct, Posner’s approach will prove exactly wrong. We are, Johnson and Kwak argue almost too convincingly, in the hands of an oligarchy that has used its economic power to purchase political influence that, in turn, sustains that economic power. Worse, Wall Street and Washington have become so inbred that ideological homogeneity reinforces and legitimizes an implicitly corrupt system. The crisis and the necessary bailouts presented a rare opportunity to break the iron grip of this financial oligarchy, but we failed to seize this moment.
13 Bankers presents a historical survey of the politics of American banking, through Jefferson, Jackson, and Teddy Roosevelt—we have all been here before. Banking crises in the United States were contained only by the reforms of the 1930s. Following the liberalization of the 1980s, in the ’90s Wall Street “translated its growing economic power into political power” and “the ideology of financial innovation became conventional wisdom in Washington.” From Wall Street to Washington, the money flowed like wine. The financial sector invested $5 billion in the political process from 1998 to 2008—$1.7 billion in campaign contributions and $3.4 billion in lobbying expenses. The chair of the Senate Banking Committee always did well: first Alfonse D’Amato, then Phil Gramm, and finally Chris Dodd, who received $2.9 million from the industry in 2007–8. In the first nine months of 2009, as Congress considered financial reform, the industry spent $344 million on lobbying.
Perhaps even more pernicious is the revolving door, which saw some Wall Street kingpins (such as, Robert Rubin and Henry Paulson) take on senior positions in government and, worse, government officials and regulators anticipating lucrative industry positions after their eventual exit from public service. Summers raked in over $5 million a year for a part-time job at the hedge fund D. E. Shaw and got $135,000 from Goldman Sachs in exchange for a personal appearance a few months before joining the Obama Administration. Friend-of-finance Phil Gramm left the Senate in 2002 and immediately joined the financial giant UBS, where he now sits as a vice-chairman of its Investment Bank Division. These egregious cases should not obscure the depth of the problem—the revolving door spins at every level of government. As Johnson and Kwak note:
The prospect of landing prestigious or high-paying jobs in the financial sector may have also influenced the decisions of regulators and administration officials, who may have had an incentive not to make enemies among their potential future employers.
Nor should it be surprising given this back scratching and inbreeding that a “confluence of perspectives and opinions between Wall Street and Washington” emerged.
According to 13 Bankers, this explains why no objections were raised in the midst of “an orgy of product innovation and risk-taking,” the proliferation of volume-and-fee-driven mortgage-backed securities and collateralized debt obligations, and the mixing of safe and unsafe assets blended so that ratings agencies could give their AAA blessing. And this is why the response to the crisis has been so disheartening. Massive bailout was the only option; the disintegration of the financial system would have been even more costly. But at the critical moment, there was no discussion of what a healthy financial system might look like. “In the end,” Johnson and Kwak write, “the major banks got business as usual.” Today we have fewer, larger, more powerful institutions, an arrangement that “exacerbate[s] the weaknesses and incentives that had created the crisis in the first place.”
In other words, the banks emerged from the crisis bigger, more powerful, and more systemically dangerous than ever before. They are playing by most of the old rules and all of the old norms. We are now left with six gargantuan, interconnected, too-big-to-fail financial institutions that are a threat to our economy and our democracy. Johnson and Kwak (and Stiglitz and Roubini and Mihm) believe they need to be broken up. It seems almost certain this will not happen.
Johnson and Kwak conclude by invoking Teddy Roosevelt, who dismantled the mighty Standard Oil in the public interest. Today, they insist, we must “take a stand against concentrated financial power just as he took a stand against concentrated industrial power.” Otherwise, next time will indeed be different. It will be even worse.