Part 12 (2/2)

On the supply side, the menu of international reserve a.s.sets should be expanded beyond the U.S. dollar and a few other currencies: over time the SDR can and should play a greater role. Likewise, in the coming years, central banks and sovereign wealth funds may start to hold currencies of emerging-market economies as part of their reserves. In the short term, this won't threaten the role of the dollar as the major reserve currency; the U.S. dollar has no clear alternatives. But if the United States keeps running large twin deficits-or worse, starts to monetize its fiscal deficit-the resulting high inflation will accelerate the decline of the U.S. dollar as a major reserve currency, with unpredictable results.

Let's a.s.sume that the United States doesn't go down that road, and that the reforms we've described can bring about an orderly adjustment of global imbalances. There's one more piece of the puzzle. A substantial change in the inst.i.tutions of global economic governance is necessary and desirable within both the G-20 and the IMF. The needed changes would provide more formal and effective power to emerging-market economies and ease the transfer of economic power from one part of the globe to another.

Will the world's major economies truly cooperate for the common global good? Or will they keep on following their national interests, eventually destabilizing the global economy and the global financial system? The question remains open, but both China and the United States in particular need to contemplate it in the coming years. Neither country stands to win from a continuation of the status quo, and everyone-emerging and advanced economies alike-stands to lose.

Conclusion.

Throughout most of 2009, Goldman Sachs CEO Lloyd Blankfein repeatedly tried to quash calls for sweeping regulation of the financial system. In speeches and in testimony before Congress, he begged his listeners to keep financial innovation alive and ”resist a response that is solely designed to protect us against the 100-year storm.”

That's ridiculous. What we've just experienced wasn't some crazy once-in-a-century event. Since its founding, the United States has suffered from brutal banking crises and other financial disasters on a regular basis. Throughout the nineteenth and early twentieth centuries, crippling panics and depressions. .h.i.t the nation again and again.

Financial crises disappeared only after the Great Depression, a period that coincided with the rise of the United States as a global superpower. At the same time the U.S. government reined in financial inst.i.tutions with legislation like the Gla.s.s-Steagall Act and sh.o.r.ed them up by creating agencies like the SEC and FDIC. The dollar became the ballast of an extraordinarily stable international monetary system, and crises came to seem like things of the past. Though serious cracks started to appear in the facade after the 1970s, economists in developed nations kept the faith, wors.h.i.+pping at the altar of the Great Moderation.

The recent cataclysm marks the beginning of the end of this dangerous illusion. It also marks the end of the financial stability ushered in by the Pax Americana. As American power erodes in the coming years, crises may become more frequent and virulent, absent a strong superpower that can cooperate with other emerging powers to bring the same stability to the global economy. Far from being a once-in-a-century event, the recent financial disaster may be a taste of things to come.

A new era demands new ways of thinking. We should jettison bankrupt ideas about the inherent stability, efficiency, and resilience of unregulated markets, and we should let crises take their rightful place in economics and finance. Sadly, many otherwise intelligent people cling to the belief that the recent crisis was an unpredictable, unheralded event. No one could have seen it coming, they say, and we'll never see the likes of it again-at least not in our lifetimes.

We can wait for a new financial calamity to deal a coup de grace to this continuing complacency. Or we can embrace understanding a new economics: crisis economics.

Tragedy and Farce.

Crises, as we have seen, are as old and ubiquitous as capitalism itself. They arose hand in hand with capitalism in the early seventeenth century, and like the plays that Shakespeare first staged at this time, they have remained with us ever since, in much the same form. The staging changes, as do the audiences, but everything else-the cast of characters, the order of the acts, and even the lines-remains remarkably consistent from crisis to crisis, century to century.

Almost all crises begin the same way: modestly. Subtle developments set the stage for the real drama down the line. This scene setting can take years, even decades, as numerous forces create conditions hospitable to a boom-and-bust cycle.

The crisis that exploded in 2007 was no exception. Decades of free-market fundamentalism laid the foundation for the meltdown, as so-called reformers swept aside banking regulations established in the Great Depression, and as Wall Street firms found ways to evade the rules that remained. In the process, a vast shadow banking system grew up outside regulatory oversight.

Over the same period banks increasingly adopted compensation schemes like bonuses that encouraged high-risk, short-term leveraged betting, even though such bets would undercut a financial firm's long-term stability. They effectively s.h.i.+fted negative consequences away from traders and bankers and onto the backs of the firm's shareholders and other creditors. Such problems, part of a larger epidemic of moral hazard, had been percolating throughout the U.S. financial system long before the crisis finally broke. The Federal Reserve played an instrumental role, rescuing the financial system in its time of need and giving rise to the famed ”Greenspan put.”

But setting the stage is not the same thing as creating a bubble. A bubble requires a catalyst. In previous financial crises the catalyst was a shortage of some coveted commodity or the opening of a new market overseas. Or a technological innovation stirred investors to believe that the old rules of valuation no longer applied. Fresh ways of doing things could originate in the financial system itself: a new way to package investments, or a new way of managing risk.

Unfortunately, the recent financial crisis fell into this final category, as financial inst.i.tutions embraced securitization on a ma.s.sive scale, giving us an alphabet soup of increasingly complex structured financial products. While securitization had been around for many years, it exploded in importance in the years immediately preceding the bubble. ”Originate and distribute” became a vehicle for originating junk mortgages, slicing, dicing, and recombining them into toxic mortgage-backed securities, and then selling them as if they were AAA gold.

Another axiom of crisis economics is the straightforward observation that a bubble can grow only if investors have a source of easy credit. It might come courtesy of a central bank, or from private lenders-or from both, especially if unwary regulators allow the credit bubble to grow and fester. Easy credit might even come from an unexpected source of surplus cash slos.h.i.+ng around the global economy in search of an investment.

Here too the recent crisis followed a predictable plot. Greenspan slashed interest rates after September 11 and kept them too low for too long. Banks and shadow banks leveraged themselves to the hilt, loaning out money as if risk had been banished. Regulators and supervisors, captivated by industry and by an ideology of laissez-faire self-regulation, failed to do their jobs. And plenty of savings flowed into the United States, courtesy of savers in emerging economies around the world.

At a certain point bubbles become self-sustaining. Banks and other financial inst.i.tutions eager to cash in on rising prices make even more credit available. Every a.s.set that investors purchase can then become collateral for yet more borrowing and more investing. Using the magic of leverage, growing numbers of investors build soaring towers of debt-a sure sign that a bubble is brewing. And that's precisely what happened in the bubble that reached remarkable proportions by 2005. Vaulting ambition and utter greed kept pus.h.i.+ng this process forward, as developers built innumerable tract homes, speculators snapped them up, and bankers packaged the resulting mortgages into increasingly fragile financial instruments.

In every such drama, a new character arrives onstage around this time: the self-proclaimed visionaries who spring up to explain why this boom will continue to yield perpetual profits-why ”this time is different” or why the old economic rules no longer apply. The appearance of these boosters and their empty claims are a sure sign that things have started to spin out of control.

The recent housing bubble attracted hordes of such charlatans, all of whom disregarded history and common sense to claim that housing was a safe investment whose value would only increase. Their numbers included everyone from s.h.i.+lls for the real estate industry to investment bankers who packaged dubious mortgages into AAA securities labeled as no riskier than supersafe government bonds.

These mountebanks may dominate the drama, but they do not go unchallenged. Inevitably, a handful of people who can see through the bogus claims speak up. Hardheaded realists, they point to acc.u.mulating weaknesses, but their warnings often go unheeded. One of the authors of this book played that role in the recent crisis, warning early on of a coming crash with remarkable specificity. Other prominent economists and a.n.a.lysts also pointed to the writing on the wall, but to no avail.

Like all bubbles, this one eventually stopped growing. And as in most bubbles, the end began with a whimper, not with a bang. Prices moved sideways; a strange sort of stasis came over the markets. The bubble boosters insisted this lapse was momentary; prices would rise again soon. But they did not. At this point in the drama, they rarely collapse overnight. They simply stall.

Then they collapse, a few inst.i.tutions at first, then many. The effects reverberate throughout the financial system. Fear and uncertainty grip the markets, and while the price of the bubbly a.s.set crumbles, the real action lies in the financial inst.i.tutions that provided the credit behind the bubble. Deleveraging begins, and faced with overwhelming uncertainty, investors flee toward safer, more liquid a.s.sets.

The recent crisis stuck to this script. At first a few big mortgage lenders went under, stirring anxiety. Then came a series of higher-profile collapses, each one bigger than the last. Some big hedge funds failed. Eventually, other leading parts of the shadow banking system crumbled too. While many of these inst.i.tutions didn't look like banks, their death throes would have been instantly recognizable to anyone familiar with financial crises from the seventeenth century onward. Like countless financial inst.i.tutions before them, these twenty-first-century shadow banks swiftly succ.u.mbed to a crisis of liquidity and, in many cases, insolvency.

Rarely do the banks collapse all at once. In fact, one dramatic bank collapse may be succeeded by an interlude of relative peace, as a superficial calm returns to the markets, inducing a sucker's rally. But things continue to deteriorate beneath the surface, setting the stage for even more dramatic failures, and panic grows. The recent crisis displayed precisely these sorts of fluctuations, worsening, as in previous disasters, with each high-profile failure. The biggest crises have another defining characteristic: they rarely respect national boundaries. They can begin anywhere in the world, but they have a habit of going global, as problems in one country surface elsewhere, or problems in one country spread via channels-commodities, currencies, investments, derivatives, and trade-to other countries. When it comes to financial crises, all the world's a stage.

Though the recent crisis first surfaced in the United States, other countries soon exhibited the same symptoms. And no wonder: like Greenspan, central bankers around the world had adopted easy-money policies, fostering numerous housing bubbles. Banks overseas showed the same reckless appet.i.te for risk displayed by their counterparts in the United States. With a few exceptions, they took on plenty of leverage and drank from the same poisoned chalice, investing in billions of dollars of the same b.u.m a.s.sets generated by the magic of ”financial innovation.”

Crises often climax in one failure so spectacular that it overshadows all the rest. In the recent crisis, the calamitous collapse of Lehman Brothers played this role, making it seem that this one event was to blame for the tragedy that engulfed the global economy. As with earlier crises, explaining this one by a single high-profile failure is a simplistic way of looking at things that obscures more than it reveals. Lehman caused tremendous damage to the global financial system, but its failure was less a cause than a consequence.

Lehman's failure coincided with a scene commonly glimpsed in the final act: banks begging some lender of last resort-a central bank or some government ent.i.ty-to step into the breach and prop up the financial system. Such requests invariably spark a debate: Should floundering banks be saved, fostering moral hazard? Or should the market be left to its own devices, leaving ailing patients to minister to themselves?

That debate played out in stark terms in the recent crisis, and in the end Ben Bernanke threw lifeline after lifeline to the deserving and undeserving alike on an unprecedented scale. Like some colossal deus ex machina, the Federal Reserve and other central banks brought the crisis to a rather abrupt, if somewhat unsatisfying, close, leaving plenty of questions unanswered and problems unresolved.

Indeed, when the dramatic phase of a crisis comes to an end, other troubles invariably begin, as the effects of the financial meltdown echo through the rest of the economy. The damage runs deep, and the wounds take a long time to heal-not months, but years. While all manner of palliative measures can be taken-stimulus packages, for example-the road to recovery can be rough, as households, banks, other financial firms, and corporate firms need to deleverage. Countries wounded by a financial crisis may falter, weighed down by debts acc.u.mulated in better times and by the socialization of private losses during the crisis. Eventually some countries will default on their debt or wipe it out with high inflation and suffer a currency crash.

This is the point where we find ourselves now. In the aftermath of previous crises, chastened politicians have enacted sweeping reforms of the financial system. We too have that opportunity. We must seize it. If we fail to do so, we may find, as many have before us, that what's past is prologue.

The Road to Redemption.

For the past half century, academic economists, Wall Street traders, and everyone in between have been led astray by fairy tales about the wonders of unregulated markets, and the limitless benefits of financial innovation. The crisis dealt a body blow to that belief system, but nothing has yet replaced it.

That's all too evident in the timid reform proposals currently being considered in the United States and other advanced economies. Even though they have suffered the worst financial crisis in generations, many countries have shown a remarkable reluctance to inaugurate the sort of wholesale reform necessary to bring the financial system to heel. Instead, people talk of tinkering with the financial system, as if what just happened was caused by a few bad mortgages.

That's preposterous. As we've made clear throughout this book, the crisis was less a function of subprime mortgages than of a subprime financial system. Thanks to everything from warped compensation structures to corrupt ratings agencies, the global financial system rotted from the inside out. The financial crisis merely ripped the sleek and s.h.i.+ny skin off what had become, over the years, a gangrenous mess.

The road to recovery will be a long one. The first steps will entail undertaking the reforms outlined in chapters 8 and 9. For starters, traders and bankers must be compensated in ways that bring their interests into alignment with those of shareholders. That doesn't necessarily mean less compensation, even if that's desirable for other reasons; it merely means that employees of financial firms should be paid in ways that encourage them to look out for the long-term interests of the firms.

Securitization must be overhauled as well. Simplistic solutions like asking banks to retain some of the risk won't be enough; far more radical reforms will be necessary. Securitization must have far greater transparency and standardization, and the products of the securitization pipeline must be heavily regulated. Most important of all, the loans going into the securitization pipeline must be subject to far greater scrutiny. The mortgages and other loans must be high quality, or if not, they must be very clearly identified as less than prime and therefore risky.

Equally comprehensive reforms must be imposed on the kinds of deadly derivatives that blew up in the recent crisis. So-called over-the-counter derivatives-better described as under-the-table-must be hauled into the light of day, put on central clearinghouses and exchanges, and registered in databases; their use must be appropriately restricted. Moreover, the regulation of derivatives should be consolidated under a single regulator.

The rating agencies must also be collared and forced to change their business model. That they now derive their revenue from the firms they rate has created a ma.s.sive conflict of interest. Investors should be paying for ratings on debt, not the inst.i.tutions that issue the debt. Nor should the rating agencies be permitted to sell ”consulting” services on the side to issuers of debt; that creates another conflict of interest. Finally, the business of rating debt should be thrown open to far more compet.i.tion. At the present time, a handful of firms have far too much power.

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