Eichengreen’s May Day Conjecture
This bit from Barry Eichengreen (ht Mark Thoma) is getting a lot of attention. (See, for example, Dani Rodrik.) Describing the “roots” of the current financial mess, he writes…
In the United States, there were two key decisions. The first, in the 1970’s, deregulated commissions paid to stockbrokers… In response, investment banks branched into new businesses like originating and distributing complex derivative securities. They borrowed money and put it to work to sustain their profitability. This gave rise to the first causes of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage.
I want to push back on this a bit. I find it hard to believe that on Wall Street, there were these lucrative side businesses just waiting to be exploited, but investment bankers would have been content to ignore them if they had retained their thick commissions on stock trades. As a historical matter, I’m sure Eichengreen is right that May Day was a spur. But it’s a huge stretch to say that derivatives and originate-to-distribute wouldn’t have been discovered, grown, and grown massively, if only there hadn’t been a competitive squeeze on stockbroker profits.
Eichengreen’s story, taken naively, might lead to the suggestion that we give financial intermediaries cushy sinecures, because, if we don’t, we will have forced the poor dears to get creative and deploy financial weapons of mass destruction that destroy the world!
Financiers will destroy the world however much money you give them (it is never enough), if they have a profitable scheme for doing so and if they are not held back by regulation.
Financiers may also improve the world, in large and important ways, when they find profitable schemes for doing so. We want the financial community to innovate, we just don’t want them to innovate crappily. That means that, yes, we want regulators to have some veto power over their innovations. But a bad response to this crisis would be to suggest that today’s big names be given monopolistic cash cows so they can make lots of money running a museum of Wall Street, circa 1970.
Today’s big names deserve to be ripped apart. They should not be granted plush monopolies. Tomorrow’s big names deserve competition just as much as the next business. More so, actually. Finance should be rife with creative destruction to keep that market discipline vibe going… the “masters of the universe” must always be kept meek and terrified.
Finally, not all “financial innovation” is created alike. Collateralized, cleared, exchange-traded derivatives were a marvelous innovation. Letting poorly collateralized, opaque, nonstandard, eclectically-offset swaps grow into a large-scale financial instrument was idiotic, and was recognizably idiotic (which is why ISDA has had to work so hard and diligently to patch all the idiocies as they showed through the cracks). We desperately need good innovation, tools for intermediation that increase investor discrimination and decrease aggregate credit and counterparty risk. Sure, that’s precisely the opposite of what this decade’s signal innovations were all about. But developing a poison and developing the antidote are both innovation.
Eichengren is an idiot!
September 22nd, 2008 at 7:37 pm PDT
link
Agreed. And even the now unthinkably toxic innovations of recent years like “Pay Option” ARM mortgages and ABS CDOs had good reasons to exist, albeit probably in much smaller size.
And I think you’re right to give a shout-out to ISDA. The existence of a healthy CDS market is an unequivocally good thing, and thanks to the idiocy-patching you mention, it seems to have shaken off the failure of a huge swap counterparty (though I’m holding my breath to see if it will survive the coming wave of new regulation).
September 22nd, 2008 at 7:44 pm PDT
link
Greed, greed, greed. It took the Republicans to turn a blind eye to–to encourage, even–the inequality-bloating excess of the Wealth Thieves of Wall Street in the name of a bastard capitalism that Adam Smith himself would have disparaged for its lack of moral sympathies.
And this is the ideological blood that flows through the veins of McCain and Palin–their party will extinguish any “maverick reformer’s zeal” they may have misbegotten.
Let’s call a spade a spade, and stop all the high-falutin’ financial obfuscation.
Paulsen doesn’t want any restrictions on executive compensation of the firms that are being bailed out…. People are going to get angry pretty soon, I’d guess… and I hope they have the smarts to ignore the War Card when the Israelis hit Iran and McCain says we need a “wartime leader”….
September 22nd, 2008 at 10:33 pm PDT
link
Just like we divorce speech from political control, let’s divorce monetary policy from political control. Free speech and market money. I don’t get it –The Federal Reserve system is a group of banks able to privatize gains and socialize losses. That’s the real issue here. Whatever regulations are put in place can be changed with hanging chad. I’d like to see the crux of the world financial system a bit more solid … and that means choices as to what money to use.
September 23rd, 2008 at 11:44 am PDT
link
Don’t mean to hijack the blog, but “The Crisis” seems fair game.
Alan Meltzer was just on PBS with Paul Krugman arguing that the Fed should *loan* capital to the ailing banks to recapitalize them (apparently this solution was used by Chile in the 1980s quite successfully). The loans had to be repaid with interest, and no dividends or bonuses could be paid until they were paid off.
Why can’t Congress agree to do this before going home? Krugman witheld agreement with Meltzer on this shamefully, IMHO. The more anyone influential waffles in this situation, the more likely Paulsen is to get his way.
BTW, Bernanke’s threat that the economy will “go into recession” if the Paulsen plan isn’t adopted is a cowardly bluff. The economy has *never* gone into recession within a year with the yield curve as steeply sloped as it is now, and any yield curve based recession forecasting model is now showing the slump to be *over* in first half 2009. (Documentation available upon request.)
We are at generational lows of *confidence* in the USA now, but let’s try not to do anything stupid just because we’re a little depressed at the outlook.
My “lower capital requirements” was idea incomplete, but Meltzer’s plan completes it.
September 23rd, 2008 at 8:07 pm PDT
link
you took that entirely out of context, the second part was referring to glass-steagall
September 24th, 2008 at 8:26 pm PDT
link
observant — I wasn’t interested in commenting on the Glass-Steagall part, but I don’t think I took out of context or misrepresented Eichengreen’s comments on deregulating commissions.
September 25th, 2008 at 12:09 am PDT
link