The Bubble Next TimeRegulations that will stop us from acting crazy next time there's an irrational boom.
Posted Saturday, Feb. 28, 2009, at 7:42 AM ETThe following was adapted From Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation by Daniel Gross, published as an e-book by Simon & Schuster. (You can buy a digital version, for the Kindle or Sony Reader, or an audio version. Readers interested in receiving a PDF of the first chapter or learning about a paper version should send an e-mail to: dumbmoneybook@gmail.com.)
PRINT
DISCUSS
E-MAIL
RSS
RECOMMEND...
Facebook
MySpace
Mixx
Digg
Reddit
del.icio.us
Furl
Ma.gnolia
Sphere
StumbleUponThe implosion of the dumb money economy—housing, insurance, real estate, the auto industry—has erased much of the economic progress of the decade. By the end of 2008, stocks had fallen back to where they were in 1997. The foreclosure epidemic took the home-ownership rate in the third quarter of 2008 back to its 2002 level. Stripped of their easy access to financing, the royalty of the Dumb Money era have been reduced to commoners.
What to do? More regulation is certainly in the offing. But Congress tends to regulate with hindsight. After a slew of accounting scandals, Congress in 2002 passed the Sarbanes-Oxley Act, which correctly forced CEOs to sign off on the accuracy of financial statements. Markets already have started doing much of the heavy lifting of retroactive regulations. Rules that prohibit houses being bought with no money down and no-documentation mortgages? All the lenders who provided such loans are out of business.
It's also impossible at some level to regulate speculation. Bubbles speak to something innate in the American psyche. They're fun. They make a lot of people feel rich. If one business idea works, 500 other people will try it. Regardless of the regulatory regime in place, somebody is always willing to fund the eighth online pet store, the 7,567th hedge fund, the 137th condo tower in Miami, and the 52nd ethanol plant.
Since we can't stop ourselves from pressing the pedal to the metal when we get excited by a hot new trend, perhaps we need some automatic brakes. In other words, we need to figure out ways to make our system and our money culture less procyclical. We need a sort of fiscal lithium, an agent that smoothes out things. It might take away some of our personality and make us a little less fun to be around, but it will also make us less destructive and easier to live with.
For example, the inadequacy of banks' capital levels—especially those of banks, like Citi, which grew too large to fail—is one of the main factors hindering a recovery. Of course, the best time to tell banks to boost their reserves is during a boom, when their balance sheets are expanding and they have easy access to capital, not during a bust, when they have effectively collapsed. To prevent a repeat, the FDIC might consider tying the level of deposit insurance premiums to a bank's size, so that, for example, Citi, or any other institution whose failure would swamp the entire system, would pay at a higher rate than a small bank with six branches.
Or what if the asset-management industry, which profited so mightily during the boom and set the stage for the debacle, effectively insured itself against meltdowns? Dean Baker, co-director of the Washington-based Economic Policy Institute, is advocating a tiny tax on trades of stocks—say one quarter of one percent of the transaction's value—and other assets. Doing so would discourage speculation for the sake of speculation, and, Baker notes, "a tax like that could easily raise $100 billion per year." We could use the funds raised from hedge funds and other manic traders to pay for the bailout.
University of Chicago economist Richard Thaler suggests that Fannie Mae and Freddie Mac, which play a larger-than-ever role in housing finance, could also become less procyclical. "One of the problems with the housing market was that as prices were going up, lending standards were going down," he says. Houses, like stocks, have price-to-earnings ratios. For homes, it's the market price of a house divided by the amount of rent it can produce. What if Fannie and Freddie were to require higher down payments as the ratio of prices to rents rose and required lower down payment as they shrank. "It would have been harder to get a mortgage at the height of the bubble, and it would be relatively easier to get one now, particularly in areas where housing prices have fallen sharply," Thaler said.
Finally, we have to be a little more willing to be stupid during Dumb Money eras, to leave money on the table, to forgo the easy returns our friends and neighbors are making. Of course, that's difficult. "When we see other people around us making money, flipping houses and tech stocks, we feel that we need to go into it as well," said Dan Ariely, author of Predictably Irrational. To minimize the regret, you join the bandwagon." To avoid this, we have to recognize the patterns of bubbles. We have to learn not to conflate a few random occurrences with a streak that can be extended into the future.
The End of Dumb Money has been like a death—of dozens of institutions, thousands of careers, millions of dreams, and billions in value. As we grapple with the aftermath, we seem to be proceeding through the five stages of grief. First came denial, which was rampant throughout the system. Next came anger at the size and manner of the bailouts. Third, bargaining: Last fall, it was common to hear arguments that taxpayers might actually make money on the bailout. And around December, the fourth stage, depression, set in. It still lingers. I hope that is where it stops. For it would be a shame if we moved on quickly to the final stage, acceptance. There is nothing acceptable about what happened. This crisis was not a random, once-in-a-lifetime thing that fell out of the sky. It was a manmade product that turned out to be immensely toxic and damaging. And we'll be paying for the cleanup for a long time. We can and should get angry. We should also get smarter.
A version of this article also appears in this week's issue of Newsweek.
When Congress Sends a Bill to the President, Do They Use E-Mail?
Gov. Haley Barbour's Strange Habit of Pardoning Murderers Who Work on His House
Slowpoke Directors Explained: Why It Took 12 Years to Make Avatar
The Surprising Reason Banks Are Suddenly Repaying Their TARP Funds
How Come You Don't Hear About the "War on Christmas" Anymore?
Jeff Bridges Gives the Performance of the Year in Crazy Heart
