Making Sense of the Credit Debacle

Failure To Connect the Dots
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March 4 2009 4:52 PM

Making Sense of the Credit Debacle

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Thanks (I think) to Duff for noticing I am incapable of unadulterated positiveness. It's a psychological defect that suited me well in the last several years. I have to say that I was influenced, in an unadulteratedly positive fashion, by Gillian's indispensible reporting over the years.

I want to quickly reiterate and expand on few points on the criminality vs. stupidity and recklessness debate. And then I'll make a short comment on the media. Bankers and Wall Streeters continue to be extremely powerful political actors. Contrast the Obama administration's federal budget with its financial bailout strategy.

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The federal budget it proposed was one of the boldest political acts of my lifetime. It proposes to raise taxes (one of the great third rails of American politics) on the most powerful class in American society. It introduces a form of cap-and-trade. It begins to remedy our national health care disgrace. It wipes away myriad corporate tax dodges. It cut agribusiness subsidies. I could go on and on. Moreover, the administration is doing it while also eschewing the financial numbers games of the Bush administration. It was risky, honest, and full of hard decisions. The change from the Bush administration is head-spinning.

But then we come to the Obama administration's financial bailout strategy. Or, rather, we don't. Because what is the strategy? Here there is nothing bold, nothing risky. The administration isn't making any tough decisions; it's incremental and it protects all constituencies. Even Citigroup's shareholders still have some equity to call their own.

Why the contrast? With the budget, there are plenty of disinterested economists who have thought long and hard about what's wrong with federal outlays. But there are few experts outside of Wall Street who can talk Wall Street. The Obama administration and Treasury Secretary Tim Geithner are still inundated with advice from Wall Street. And Wall Street advice serves Wall Street.

This is a fairly long-winded way of saying that we need to diminish Wall Street's influence on the political stage. To do that, we cannot shy away from prosecuting fraudulent activity. Just to take one example: It's clear to me that Lehman was materially misleading about the state of its balance sheet, repeatedly and publicly, in the days and weeks leading up to its demise. That's being investigated. If the top executives are indeed found to have misled the public, they should face criminal charges.

We need to rip that weak spine out of the rotting corpse of our regulatory bodies, show it to them, a la Mortal Kombat, and then transplant a new, real spine into them. The SEC has been culturally inclined to allow bad actors to pay fines, often nominal ones, and reach settlements where they neither admit nor deny guilt. That has to end!

After their spinal surgery, they will need to go after big-wig wrongdoers and take them to trial. If we let the view that sees this as one giant bubble in which everyone acted more or less with equal irrationaity triumph, all will be lost. What I mean is that we jeopardize the chance for genuine structural change. Wall Street won't always be this weak politically. (Even at its weakest point, it's still extraordinarily influential, as I point out above.) If the public is allowed to see public trials in which top Wall Street executives are proved to have broken laws, they will be more eager, not less so, for sweeping financial regulatory reform.

I have suggested we adopt a Netherlands/Australian style Twin Peaks model, with a systemic risk regulator and a conduct-of-business regulator. I agree with Barry that the Federal Reserve has done a disastrous job in this cycle, especially of banking regulation. I think it should be stripped of its regulatory power and left to concentrate on monetary policy. It's hard enough as it is. I'm deeply gloomy about the prospects structural change as of now. I fear we are going to get some incrementalism, as we have with the financial bailout.

Onto the media. I have discussed this at length with my colleagues. I go back and forth on it. Did we fail or did we have no chance? I'm quoted in this good piece by Dean Starkman in Mother Jones.

My nickel version: Great job on the housing bubble, but nobody listened; awful job on the credit bubble, but it would have been extremely difficult to accomplish it with specific stories. Commentators could do it. Reporters have a much higher bar for a story, and I'm not sure they could have crossed it until, say, early 2007.

As someone who wrote many warnings before the world imploded, I will say that to a great extent, it was an intellectual failure. Mine was a failure of imagination. I wrote repeatedly about dangers in the financial system, about the mortgage bubble, the excessive leverage, the conflicts at the ratings agencies, the dangers of derivatives and the precariousness of the financial system's business models. But I never put it all together intellectually. I couldn't see that the financial world would be this fragile, even though I warned of that very thing. I guess I just thought everyone was too smart.

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