The clamor about JPMorgan’s losses in credit default swap speculation is dying away. That is unfortunate, because it is the tip of the greatest economic policy challenge we face today.
The questions should be clear: Why did a housing and mortgage bubble, admittedly severe, lead to the near-meltdown of global finance in 2008? To what extent did policy and institutional changes in finance contribute to the crisis? And what is the best way to avoid this happening again in the future, probably with even worse results?
As I noted in an earlier column, contributing factors for the ongoing global financial debacle were myriad. But whatever the reasons, by September 2008, we stood on the edge of a financial abyss. Lehman Brothers, a second-tier investment bank, was failing; AIG, the world’s largest insurance company, was insolvent and several of the rest of the nation’s large financial institutions teetered on the edge.
The Federal Reserve and Treasury let Lehman go — wisely, in my view. But they then stepped in with unprecedented direct loans from the Fed and with the Bush administration’s Troubled Asset Relief Program to keep AIG and other large firms from collapse. TARP passed Congress only after its initial failure threw world markets into an uproar. Markets stabilized and history eventually will be clear that, at least so far, we got past that crisis in much better shape than other nations.
The crucial question is how we got to where we were by mid-August 2007, when seized-up European money markets told us we were in deep trouble. What we did in response over the next two years is secondary. Yet that is not how the public policy debate is playing out.
Much good economic theory explains how overly large financial firms can take on too much risk and then fail spectacularly, taking down entire economies with them. Economic history gives even stronger proof of that. But politicians in both parties are unwilling to face this.
There are different ways to deal with the problem. One is to regulate the activities of financial firms to limit their risk-taking. A second is to try to separate firms by financial function, keeping commercial banking (deposits and loans) separate from investment banking (issuing stocks and bonds), from insurance and from speculative investing. A third is to allow firms to combine such functions, but to keep any of them from getting large enough so that their individual failure would trigger an economic deluge.
The Dodd-Frank Bill represents the first approach. It clearly has many flaws, and many Republican presidential and congressional candidates have called for its repeal. The Glass-Steagall Act of 1933 represents the second approach. Large financial firms, aided by a fifth column within the Fed, were able to riddle this with loopholes by the 1980s and secure its repeal in 1999.
The apparent default for many is to pretend that the problem does not exist, that the current structure of financial institutions is a socially optimal outcome of market forces with no dangerous externalities.
The flaw in this argument is that the advantages conferred by U.S. financial firms come from the strong base of venture capital and private equity firms, from competing stock markets — NASDAQ as well as the New York Stock Exchange — and from a broad set of independent and community banks that are far more responsive than the big boys to small business.
But the concentration of power in a few large firms and the development of increasingly esoteric financial instruments have not conferred any edge.
Think back three decades to a time when there still was greater separation between commercial and investment banking, when the credit default swap and “structured investment vehicles” and “flash trading” had not yet been invented, when investment banks were partnerships rather than publicly traded corporations and did little speculation for their own accounts, and when there was much less concentration of market shares in virtually all areas of financial services.
Have all these subsequent innovations lowered the cost of capital for U.S. firms? Have savings and new capital formation burgeoned? Has GDP growth spurted? Are the financial system and the overall economy more stable? Are we really better off now?
Much evidence shows the answer to these questions is “clearly not.” And fostering megafirms makes the whole system much less stable. Perhaps it will take a cataclysm to make that clear to voters and politicians.
Write Ed Lotterman at ed@edlotterman.com.
