Part 8 (1/2)

This tis spiral out of control, the US governainst the crisis The directors of this ca the Great Depression, and the failures of their predecessors shaped their aggressive response They threw everything they had at the proble ideas froht of day

They began with conventionalall 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 e lifelines of liquidity to one kind of financial institution after another, as well as to ordinary corporations that needed to roll over their coations Other central banks followed suit, interpreting their statutory powers in expansive, even radical ways

The scale of the rescue effort ithout precedent It transcended national boundaries, as the IMF stepped into the fray, and the Fed lent to other central banks, directingbanks and corporations around the world It was the biggest financial rescue effort of inning The govern shares and injecting capital in exchange for an equity stake The governuaranteed 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 instituted outright bailouts of individual banks, homeowners, and others It even offered to subsidize the purchase of toxic assets, hoping this h 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 becaovernment debt markets to inject stillIn their most radical interventions of all, central banks attempted to provide dee-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 ho trillions of dollars' worth of deficit spending to underwrite the classic strategy of a targeted fiscal stimulus aimed at infrastructure i in the face of the crisis, froovernments 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 skepticisrace 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 islatures effectively brought the crisis to a near end Some semblance of calm returned to the financial ed 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 seeood news The bad news is that this stability has been purchased at treuarantees, sti the crisis, the public debt of the United States will effectively double as a share of the nation's gross do decade are expected to hit 9 trillion or more Economists of a Keynesian bent tend toout that the United States ran enored to pay them off without a probleh 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 itco In 1946 the United States was at the peak of its power Itsbase, unscathed by the as the envy of the world, and its future competitors-japan and Gerest creditor and net lender by running current account surpluses, and the dollar had just becolobal 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'sbase is weak, and the United States has becoe 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 probleovernressive resolution of the probleave 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 hoovernesse So far the recent crisis has produced precious little of the creative destruction that Schu-ter this necessary adjustraThat's not to suggest that the middle of the financial crisis would have been the best ti 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 hoer afford

In a way, our response to the recent crisis has only been partly different from that of Herbert Hoover True, we have been infinitelyout of control via aggressive fiscal sti 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 si 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 indiscri problem of moral hazard In the past few decades, central bankers have ressively to contain potential crises Alan Greenspan led the way, intervening in s 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 overn, it seeovernments wouldn't do to save the financial systes For example, many of the countries that sustained heavy hits to their balance sheets while an with relatively low levels of debt by historical standards, giving the funds to combat the crisis Moreover, had they not coes enacted around the world-the long-terreater, 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 policiesyears, 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 beco sources of serious concerns for financial er 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 s in perspective: holding the line on moral hazard in the e Why? I has done so in bed His apartment catches fire Should he be bailed out? In other words, should the fire department come to rescue hio up in fla the lives not only of the person who started the blaze but of hundreds of innocent people

That's basically the predicaovernments in the midst of this crisis Does solobal econo 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 asteful and some bailouts not warranted, the fiscal sti of the financial syste 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 passed A financial crisis is a terrible thing to waste: it opens, however fleetingly, the possibility of real, enduring reforlobal 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 pro and, above all, preventing crises It is to that pressing matter that we turn next

Chapter 8

First Steps

It's a truisulation and reform of the financial system The near-death experience of a financial crisis pushes overnment 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, Parlia 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 systeall Act of 1933 created federal deposit insurance and established a firewall between coave the Federal Reserve the power to regulate bank reserves The governht 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 cri state year saw the creation of the Securities and Exchange Co the buying and selling of securities Though many other countries adopted similar measures, the United States implemented one of the ht of this history, we ain to take the lead in refor the financial system The financial turmoil revealed fundamental weaknesses in the operation of US and European financialsysteulation But over the course of 2010, the urgent calls for reforulation 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 policythe Depression, the calls for refor like ubiquitous breadlines and 25 percent uneislators But because the disaster was handled more deftly this time, the impetus for deep, structural reforms of the financial syste out record bonuses, despite the fact that they owe their lives to governesse

This absence of reforerous time, when the structural problems that created the crisis remain, even as aftershocks continue to rattle countries and economies around the world Massive 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 fro

What refor on the table, from institutions at home and around the world: from the US 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 acade the merits of each proposal, it makes more sense to pinpoint the fundaue the world's financial systematic solutions We stress the word funda 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 require to the botto 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 coer toward the bankers tends to overwhel problem Put differently, while torches and pitchforks may seem appropriate under the circumstances, it's wiser to step back and dispassionately evaluate the options

First, contrary to conventional wisdoest 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 environent problem, which we discussed in chapter 3 That is, modern corporations are run not by the shareholders (the principals) but by roups don't see eye to eye: the shareholders want to -run returns froers want to maximize their short-term income, bonuses, and other forms of compensation

As we have seen, if shareholders could ers, all would be well But it's difficult in any corporation and next to impossible in the financial institutions at the heart of the recent crisis Why? Sioing on than the shareholders to whoet, and their own strategies formoney in the market It's difficult for outside shareholders or a board of directors to knohat's going on in one of these little cells; it's utterly i on in several thousand of thee bank or financial firovernance circles as the ”asymmetric information problem,” also discussed in chapter 3 Translation: one side knows more than the other

Add to this probleency conflict” In many financial firms, the shareholders (the principals) are theent problee institutional investors, such as pension funds The ents, and just as it's hard for shareholders to , it's equally difficult for shareholders to monitor the actions of their proxies Worse, these institutional investors, not the ulti 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 reroup delegates responsibility to another, which in turn delegates it to another group Little wonder that no one knew-or cared-as 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 thatup a bunch of toxic CDOs and leaving the 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 suuide, 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 co on too n their interests with those of the existing shareholders and -term interest of the bank One incentive-compatible solution would be for firms to compensate the traders ork for them with restricted shares in the firm (Restricted shares have to be held a certain amount of ti-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 firies that led to their eventual destruction This fact raises the unsettling possibility that the proble the will of shareholders In fact, it points to a grim reality: there are tin to destructive effect

Sometimes shareholders are e and risk They're willing to let theame 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 shi+rts, they're fine turning a blind eye when traders roll the dice In fact,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 overnment Shareholders take only a ood times and bad When a booed returns so as to ers, and others who give theers and shareholders both think the trading strategies are risky, they know that if they don't pursue theher returns Forroup CEO Chuck Prince su as the et up and dance”

When things go south, traders and shareholders don't necessarily retreat froness to double down and bet the far parlance, this strategy is known as ”ga for rede to curtail the culture of risk taking This sort of behavior is fueled even further by the presuovernh occasionally tested in the recent crisis, has been affirain

At this point, the readerto put the entire financial system to the torch On the one hand, if the shareholders of financial fir-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 haveoversize returns), they're not going to do anything to stop the traders-which, as the principal-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 so with this mess could tackle the problem at its core: the issue of coinates, 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 theer period of ti periods are limited to a few years; they should be extended E the stock until their retirement, or at the very least, for well over a decade

That's a good first step, but a ser 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 firenerates oversize ”alpha” returns in the short ter-term consequences