Part 8 (1/2)

This time around, instead of letting things spiral out of control, the U.S. government unleashed a shock-and-awe campaign against the crisis. The directors of this campaign had cut their teeth studying the Great Depression, and the failures of their predecessors shaped their aggressive response. They threw everything they had at the problem, borrowing ideas from the past as well as tactics that had never seen the light of day.

They began with conventional monetary and fiscal policy, tossing all the usual weapons into the fight, from tax cuts to interest rate cuts. When those didn't work and deflation and depression became real possibilities, the Fed embraced its historic role as a lender of last resort, throwing lifelines of liquidity to one kind of financial inst.i.tution after another, as well as to ordinary corporations that needed to roll over their commercial paper obligations. Other central banks followed suit, interpreting their statutory powers in expansive, even radical ways.

The scale of the rescue effort was without precedent. It transcended national boundaries, as the IMF stepped into the fray, and the Fed lent to other central banks, directing much-needed dollars to struggling banks and corporations around the world. It was the biggest financial rescue effort of modern times, if not all times.

And it was only the beginning. The government became a shareholder in a host of businesses, buying shares and injecting capital in exchange for an equity stake. The government also guaranteed deposits, money market funds, and even the bondholders of banks. As if that weren't enough, in several high-profile cases it covered prospective losses to investors, then inst.i.tuted outright bailouts of individual banks, homeowners, and others. It even offered to subsidize the purchase of toxic a.s.sets, hoping this might restore faith.

Yet even that was not enough. To lend, to guarantee, and to absorb the losses were one thing; to restore faith to the markets was another. The Fed and other central banks eventually became investors of last resort, wading into government debt markets to inject still more liquidity into the system via quant.i.tative easing. In their most radical interventions of all, central banks attempted to provide demand where demand had all but disappeared, purchasing mortgage-backed securities and other structured financial products backed by everything from auto loans to student loans.

Lawmakers in the United States and other countries did their part too, freeing up funds to underwrite these actions, offering help to distressed homeowners, and most important of all, approving trillions of dollars' worth of deficit spending to underwrite the cla.s.sic strategy of a targeted fiscal stimulus aimed at infrastructure improvements and aid aimed at anyone floundering in the face of the crisis, from local governments to the unemployed.

All these monetary and fiscal measures fell into place over the course of over two years-unevenly, imperfectly, and accompanied by enormous controversy and skepticism. The response to the financial crisis had all the grace and beauty of a battlefield retreat, but in the end it seemed to work: capitalism did not collapse; the fate of particularly hard-hit Iceland was not the fate of the world at large. The measures adopted by central banks, governments, and legislatures effectively brought the crisis to a near end. Some semblance of calm returned to the financial markets, and many nations' economies, while wounded, managed to eke out better-than-expected performances as 2009 came to a close. What had seemed like the end of the world a year earlier now seemed like a very close call.

That's the good news. The bad news is that this stability has been purchased at tremendous cost. Thanks to all the bailouts, guarantees, stimulus plans, and other costs of managing the crisis, the public debt of the United States will effectively double as a share of the nation's gross domestic product, as deficits in the coming decade are expected to hit $9 trillion or more. Economists of a Keynesian bent tend to minimize these risks, pointing out that the United States ran enormous deficits during the New Deal and World War II and managed to pay them off without a problem. The total value of the public debt hit an all-time high in 1946, when it was equivalent to 122 percent of the nation's GDP. By contrast, current projections point to debt reaching 90 percent of the GDP in the near future, though it may certainly go higher.

That's a somewhat comforting comparison, but it's highly misleading. In 1946 the United States was at the peak of its power. Its manufacturing base, unscathed by the war, was the envy of the world, and its future compet.i.tors-j.a.pan and Germany-were in ruins. The United States was the world's biggest creditor and net lender by running current account surpluses, and the dollar had just become the global reserve currency. Little wonder it was able to pay down its debt with ease. Whether the same can happen today is another question. Much of the country's manufacturing base is weak, and the United States has become the world's biggest debtor and net borrower as it runs large current account deficits, thanks in no small part to loans made by China, its apparent rival in the twenty-first century. The United States of today is not the country of 1946, and it's naive to believe that it will be able to escape the shadow of the crisis by deficit spending alone.

The fiscal burden of the response is but the beginning of our problems. At many critical junctures in the crisis, governments opted for forbearance and bailouts over a more aggressive resolution of the problem. The United States did not nationalize problem banks; it gave them easy money, covered their losses, and otherwise kept them alive. Many of these banks were and remain insolvent, but the rescue efforts did not differentiate between the good and the bad. Stabilizing the financial system was the order of the day.

The same can be said of all the bailouts aimed at homeowners, automakers, and other beneficiaries of the government's largesse. So far the recent crisis has produced precious little of the creative destruction that Schumpeter saw as essential for capitalism's long-term health. Preventing this necessary adjustment via tax cuts, cash-for-clunkers incentives, and programs designed to prop up the housing market will only delay an inevitable reckoning. That's not to suggest that the middle of the financial crisis would have been the best time to stage that shakeout; doing so would only have fueled the crisis. But it will have to take place. Debt will have to be forgiven, banks will have to go under, automakers will have to shutter factories, and homeowners will have to leave homes they can no longer afford.

In a way, our response to the recent crisis has only been partly different from that of Herbert Hoover. True, we have been infinitely more effective in preventing the crisis from spinning out of control via aggressive fiscal stimulus, but we are still trying to reconcile the irreconcilable. We cannot have our cake and eat it too; we cannot rescue everyone who made bad decisions in advance of the crisis while simultaneously restoring our capitalist economy to its former vitality. That's an unpleasant truth, but one that has so far been avoided in the rush to save anyone and everyone from the effects of the crisis.

Nor will this indiscriminate approach solve the growing problem of moral hazard. In the past few decades, central bankers have moved aggressively to contain potential crises. Alan Greenspan led the way, intervening in markets after the crash of 1987, the savings and loan crisis, and September 11. The recent crisis occasionally tested this belief in the Greenspan (or Bernanke) ”put”-most notably with the decision to let Lehman Brothers fail-but for the most part, faith in the omnipotence of central banks and governments was upheld. If anything, it seemed that there was nothing that governments wouldn't do to save the financial system.

That said, the cloud has a few silver linings. For example, many of the countries that sustained heavy hits to their balance sheets while managing the crisis began with relatively low levels of debt by historical standards, giving them some leeway to ”break the bank” in allocating funds to combat the crisis. Moreover, had they not committed those funds-particularly the various stimulus packages enacted around the world-the long-term cost would arguably have been greater, thanks to a collapse in tax revenues and a need to cover huge portions of the population with unemployment benefits and other aid. While recent fiscal policies may weigh many countries down in the coming years, debt burdens are not yet at a breaking point for many of the advanced industrial nations, even if issues of public debt sustainability and risks of refinancing crises-if not outright default-are becoming sources of serious concerns for financial markets.

The larger problem of bailouts and moral hazard is a bit more complicated. Bailouts of reckless lenders and borrowers can easily lead to even more reckless behavior in the future. That in turn can lead to more bubbles and more crises. But it's important to keep things in perspective: holding the line on moral hazard in the midst of a crisis can inflict tremendous collateral damage. Why? Imagine that someone living in a huge apartment building has done something extraordinarily reckless and stupid, like smoking in bed. His apartment catches fire. Should he be bailed out? In other words, should the fire department come to rescue him? If the fire department doesn't, the entire building may go up in flames, taking the lives not only of the person who started the blaze but of hundreds of innocent people.

That's basically the predicament faced by central banks and governments in the midst of this crisis. Does some investment bank or insurance company that set fire to the global economy deserve to go under? Absolutely. But if the resulting conflagration devours the entire financial system, never mind destroys the lives of ordinary workers around the world, the lesson tends to be lost in the ensuing mayhem. While some fiscal actions were wasteful and some bailouts not warranted, the fiscal stimulus and the backstopping of the financial system prevented the Great Recession from turning into another Great Depression at a time when private demand was in free fall.

The time to address issues of moral hazard, and all the other weaknesses of the financial system, comes after the immediate crisis has pa.s.sed. A financial crisis is a terrible thing to waste: it opens, however fleetingly, the possibility of real, enduring reforms of the global financial system. Just as the Great Depression swept away the contradictions embodied by Hoover and replaced them with the consistencies of Keynes, the Great Recession promises to usher in a new way of understanding and, above all, preventing crises. It is to that pressing matter that we turn next.

Chapter 8.

First Steps.

It's a truism that crises go hand in hand with regulation and reform of the financial system. The near-death experience of a financial crisis pushes many people to contemplate what government can and should do to prevent another disaster. As Harvard economist Jeffrey Frankel wryly observed at the onset of the recent crisis: ”They say there are no atheists in foxholes. Perhaps, then, there are also no libertarians in [financial] crises.”

Like so much else in crisis economics, this theme is recurrent. In 1826, the year after a speculative bubble collapsed in Britain, leaving behind scores of broken banks, Parliament pa.s.sed legislation that overhauled the entire banking system. In the United States, the panic of 1907 left many lawmakers concerned about the nation's lack of a central bank, and prompted the formation of the Federal Reserve a few years later.

The mother of all financial crises-the chain of disasters known as the Great Depression-sparked radical reforms of financial systems internationally. In the United States, the Gla.s.s-Steagall Act of 1933 created federal deposit insurance and established a firewall between commercial and investment banking; subsequent legislation gave the Federal Reserve the power to regulate bank reserves. The government brought the stock market to heel as well: the Securities Act of 1933 required issuers of securities to register them and to publish a prospectus, and it made the investment banks that underwrote the sale criminally liable for any errors or misleading statements in the prospectus. The following year saw the creation of the Securities and Exchange Commission, which remains the agency charged with regulating the buying and selling of securities. Though many other countries adopted similar measures, the United States implemented one of the most comprehensive series of reforms.

In light of this history, we might reasonably expect the United States once again to take the lead in reforming the financial system. The financial turmoil revealed fundamental weaknesses in the operation of U.S. and European financial markets and serious flaws in the existing system of supervision and regulation. But over the course of 2010, the urgent calls for reform faded, and legislation that would radically overhaul regulation and supervision had yet to see the light of day. Just like soldiers in foxholes abandoning their pledges to lead a better life as soon as the firing stops, lawmakers and policy makers now seem happy with the status quo.

There's a perverse irony in all of this. Had policy makers failed to arrest the crisis, as they failed during the Depression, the calls for reform today would be deafening: there's nothing like ubiquitous breadlines and 25 percent unemployment to focus the minds of legislators. But because the disaster was handled more deftly this time, the impetus for deep, structural reforms of the financial system has faltered. Instead, the surviving banks are paying out record bonuses, despite the fact that they owe their lives to government largesse.

This absence of reform is profoundly unfortunate. We live at a dangerous time, when the structural problems that created the crisis remain, even as aftershocks continue to rattle countries and economies around the world. Ma.s.sive intervention in the financial system has restored some confidence in the financial system, but we have yet to undertake the necessary reforms to preserve that confidence and prevent a crisis from recurring.

What reforms make the most sense? Many proposals are now lying on the table, from inst.i.tutions at home and around the world: from the U.S. Treasury and the Federal Reserve; but also from the Financial Stability Board, the Financial Services Authority, and other policy bodies in the United Kingdom; and from the G-7, the Bank for International Settlements, and the IMF. Innumerable further proposals have emanated from think tanks, policy workshops, and academia.

Rather than a.s.sessing the merits of each proposal, it makes more sense to pinpoint the fundamental weaknesses and distortions that plague the world's financial systems, then pose some pragmatic solutions. We stress the word fundamental. There is plenty wrong with the financial system, but not all its problems are essential; many are merely superficial manifestations of a deeper rot.

Unfortunately, fundamental is not always synonymous with simple. Some of the subjects that follow-derivatives, capital requirements-may seem rather recondite. That's true, but getting to the bottom of this mess requires that we deal with such daunting concepts. As the crisis has amply shown, the devil lies in these details, and the discussion that follows should give the reader a genuine appreciation-as well as a clear comprehension-of the complex but core issues that need to be addressed to prevent future crises.

Curing Compensation.

Whenever the question of compensation on Wall Street comes up, visceral anger toward the bankers tends to overwhelm more careful considerations of the underlying problem. Put differently, while torches and pitchforks may seem appropriate under the circ.u.mstances, it's wiser to step back and dispa.s.sionately evaluate the options.

First, contrary to conventional wisdom, the biggest problem with compensation is not the amount of money involved; it's the way this compensation is structured and delivered. Much research on corporate governance suggests that any corporate environment is apt to suffer from the princ.i.p.al-agent problem, which we discussed in chapter 3. That is, modern corporations are run not by the shareholders (the princ.i.p.als) but by managers (the agents). These two groups don't see eye to eye: the shareholders want to maximize their long-run returns from owners.h.i.+p of the company, but the managers want to maximize their short-term income, bonuses, and other forms of compensation.

As we have seen, if shareholders could monitor managers, all would be well. But it's difficult in any corporation and next to impossible in the financial inst.i.tutions at the heart of the recent crisis. Why? Simply put, traders and bankers know much more about what's going on than the shareholders to whom they answer. All traders have their own profit-and-loss budget, and their own strategies for making money in the market. It's difficult for outside shareholders or a board of directors to know what's going on in one of these little cells; it's utterly impossible to know what's going on in several thousand of them, as in a large bank or financial firm. This predicament is known in corporate governance circles as the ”asymmetric information problem,” also discussed in chapter 3. Translation: one side knows more than the other.

Add to this problem what could be called ”double agency conflict.” In many financial firms, the shareholders (the princ.i.p.als) are themselves enmeshed in a princ.i.p.al-agent problem: they own shares via large inst.i.tutional investors, such as pension funds. The managers of these funds are their agents, and just as it's hard for shareholders to monitor what traders are doing, it's equally difficult for shareholders to monitor the actions of their proxies. Worse, these inst.i.tutional investors, not the ultimate shareholders, are often the ones who end up sitting on a firm's board of directors.

If this seems like a hall of mirrors, that's not far from the truth. The entire financial system was-and remains-riddled with these kinds of problems, in which one group delegates responsibility to another, which in turn delegates it to another group. Little wonder that no one knew-or cared-what was going on at all the trading desks.

Here's the upshot: absent any direct or indirect oversight from shareholders, traders and bankers have every incentive to do crazy things that maximize their short-term profits and bonuses (like rustling up a bunch of toxic CDOs and leaving them hanging on the bank's balance sheet). By the time the bank blows up, the traders and bankers have already spent the money on fast cars and that summer place in the Hamptons. And if recent history is any guide, it's easier to get money back from Bernie Madoff than it is to claw back a trader's bonus.

In an ideal world, shareholders and their representatives would be aware of this problem and create a system of compensation that's ”incentive compatible,” one that stops traders from taking on too much leverage and risk. In theory, this system would align their interests with those of the existing shareholders and make everyone work for the long-term interest of the bank. One incentive-compatible solution would be for firms to compensate the traders who work for them with restricted shares in the firm. (Restricted shares have to be held a certain amount of time before they vest.) That way, everyone would have the long-term health of the firm in mind.

If only it were so simple. In fact, at both Bear Stearns and Lehman Brothers, employees held upwards of 30 percent of the firm's shares. Yet both firms pursued suicidal trading strategies that led to their eventual destruction. This fact raises the unsettling possibility that the problem goes beyond a bunch of rogue traders subverting the will of shareholders. In fact, it points to a grim reality: there are times when the interests of shareholders and traders align to destructive effect.

Sometimes shareholders are more than happy to see traders take on leverage and risk. They're willing to let them do so because they don't actually have much skin in the game. They've put up some of the bank's capital, but not a whole lot of it, and while they don't want to lose their s.h.i.+rts, they're fine turning a blind eye when traders roll the dice. In fact, most of the money that the traders are playing with is borrowed; it belongs to someone else. If the traders win at the roulette table, the shareholders win too. If the traders lose, the burden falls on the fools who loaned the bank money-and, if the recent crisis is any indication, the government. Shareholders take only a minor hit.

This principle is true in good times and bad. When a boom is under way, banks are under pressure to deliver supercharged returns so as to maintain the loyalty of the pension funds, endowment managers, and others who give them money to invest. Even if managers and shareholders both think the trading strategies are risky, they know that if they don't pursue them, their investors will walk to other banks that promise higher returns. Former Citigroup CEO Chuck Prince summarized it best in 2007 when he observed, ”As long as the music is playing, you've got to get up and dance.”

When things go south, traders and shareholders don't necessarily retreat from risk. Instead, they may share a willingness to double down and bet the farm in the hopes of righting the sinking s.h.i.+p. In banking parlance, this strategy is known as ”gambling for redemption,” and while it's sometimes successful, it does nothing to curtail the culture of risk taking. This sort of behavior is fueled even further by the presumption that if things blow up, government will ride to the rescue-a belief that, though occasionally tested in the recent crisis, has been affirmed again and again.

At this point, the reader may be forgiven for wanting to put the entire financial system to the torch. On the one hand, if the shareholders of financial firms are virtuous and actually have the long-term interests of the firm at heart, they lack the ability to control the traders. And if they aren't virtuous (because they don't have much skin in the game or are simply seeking oversize returns), they're not going to do anything to stop the traders-which, as the princ.i.p.al-agent problem makes clear, would be impossible anyway. Either way, financial firms are apt to unleash behavior that is ruinous to the stability of the global financial system.

So what to do? This complex problem clearly has no easy solutions. But some very basic, commonsense approaches to dealing with this mess could tackle the problem at its core: the issue of compensation. That is where the problem originates, and it's where the solution should be focused.

For starters, when employees of financial firms are compensated with restricted stock, provisions should be in place that force them to hold these shares for an even longer period of time than is now customary. Currently, many vesting periods are limited to a few years; they should be extended. Employees should be restricted from selling the stock until their retirement, or at the very least, for well over a decade.

That's a good first step, but a small one. The bigger issue is the bonus culture of Wall Street, in which employees are compensated when their bets pay off, but are not penalized when those bets cost the firm money. This system encourages risk taking that generates oversize ”alpha” returns in the short term, with little consideration of long-term consequences.

One way to fix this mess would be to create bonus pools that aren't calculated on short-term returns but are based on a longer time horizon-say, three years or so. Instead of rewarding its employees for making their particular canny bets, a firm averages their performance over the course of several years. Let's say a trader's risky bets yield outsize returns one year and equally outsize losses the next. Under the current system, that trader will get a nice bonus the first year and nothing the second. By contrast, under a longer time horizon, the losses would cancel out the profits, and the trader would get nothing at all.