First Bank of the Living Dead

First Bank of the Living Dead

Mini Teaser: As the Great Recession gnaws at our very belief in the ability of capitalism to raise us to ever-escalating levels of wealth and prosperity, Keynes's no-longer-viable financial prescriptions are being resurrected.

by Author(s): Daniel W. Drezner

Sebastian Mallaby, More Money Than God: Hedge Funds and the Making of a New Elite (New York: Penguin Press, 2010), 496 pp., $29.95.

John Quiggin, Zombie Economics: How Dead Ideas Still Walk Among Us (Princeton, NJ: Princeton University Press, 2010), 216 pp., $24.95.

Robert B. Reich, Aftershock: The Next Economy and America’s Future (New York: Alfred A. Knopf, 2010), 192 pp., $25.00.

Nouriel Roubini and Stephen Mihm, Crisis Economics: A Crash Course in the Future of Finance (New York: Penguin Press, 2010), 368 pp., $27.95.

EARLIER THIS year, Goldman Sachs CEO Lloyd Blankfein attempted to justify his professional existence, proclaiming, “We’re very important. We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. . . . We have a social purpose.” This all sounds good enough, except that finance went from being responsible for 2.5 percent of GDP in 1947 to 7.7 percent in 2005. And at the peak of the housing bubble, the financial sector comprised 40 percent of all the earnings in the Standard & Poor’s 500. The incomes of the country’s top-twenty-five hedge-fund managers exceeded the total income of all the CEOs in that index. And by 2007, just about half of all Harvard graduates headed into finance jobs. If capital markets merely serve as conduits from savers to entrepreneurs, then why does such a large slice of them get siphoned off to compensate people like Lloyd Blankfein? To put it more broadly, what is the role of finance in a good and just society?

These are not merely theoretical questions. They come at the end of an era when Big Finance played an outsize role in the American political economy. Furthermore, the political system is now responding to these perceived ills. I write this sentence on the day that President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law, completing the most sweeping overhaul of financial regulation since the 1933 Glass-Steagall Act (which segmented commercial from investment banks in a sweeping reformation). Now the G-20, IMF, Financial Stability Board and the Basel Committee on Banking Supervision are hashing out new financial standards that are ostensibly supposed to prevent a sequel to the Great Recession. Meanwhile, concerns over mounting sovereign-debt loads in the developed world are causing ripples in capital markets and potentially triggering a double-dip recession. The quicker that finance’s role in the world economy is well defined, the better for everyone.

The trouble is that finance now permeates not only the economic but also the political and social fabric of our world. No one can talk about Big Finance without talking about the power of capital in politics. At the same time, Goldman Sachs now possesses all the cultural cachet of a tobacco company. And no matter how Washington attempts to curb the excesses of an industry whose core purpose is the making and reallocation of money, the future of global financial regulation remains unclear.

Even economists are still unsettled about banking’s place in the economy. Paul Volcker, chairman of the President’s Economic Recovery Advisory Board, argues that the value-added of financial innovation is limited to the ATM. Yet, when New York Times columnist Paul Krugman argues that the big banks shouldn’t be broken up, perhaps it means that the world is a bit more complicated than Volcker’s blunt assessment.

Socially, the rise of hedge funds and investment houses has triggered nostalgia for the days when America built things, as if goods are somehow magically different from services. Still, it is not necessarily the best of all worlds when finance drains the brains of physicists, mathematicians and economists from other pursuits. There is a nugget of truth in Blankfein’s plea for the utility of finance—but it’s a much smaller nugget than he realizes.

[amazon 1594202559 full] THE WHYS and wherefores of economic calamities as yet unsolved, four new books attempt to tackle Big Finance from different angles. Robert Reich, Bill Clinton’s first secretary of labor and now a public policy professor at the University of California, Berkeley, focuses on the rise in political and economic inequality over the past few decades, and how that inequality abetted the recent crisis. John Quiggin, an economist at the University of Queensland in Australia, performs a clinical autopsy on the cluster of market-friendly ideas that emerged from the ashes of Keynesianism, asserting that the Great Recession should have exposed market fundamentalism (faith in the power of markets to correct themselves) as a fraud. Quiggin argues that still these ideas continue to lurch around like the undead, moaning “maaaaaaarkets” rather than “braaaaaiiins” because we are intellectually unable to adapt to these changing times. Washington Post columnist Sebastian Mallaby addresses the problem from a different angle entirely by drafting the first history of the hedge-fund industry. New York University economist Nouriel Roubini—who deserves pride of place for warning about the financial meltdown before it happened—has coauthored a book with University of Georgia historian Stephen Mihm that looks at the crisis, the policy response and what to do now.

Some of these books address some of the big questions some of the time. Most of the authors, however, focus on the retrospective at the expense of the prospective. With the partial exception of Roubini and Mihm’s Crisis Economics, these authors seem more concerned with looking back at the halcyon days of the postwar era than looking forward to the twenty-first century. Unfortunately, none of these books recognizes two important facts of life. First, at present, no economic model perfectly captures the interrelationship between the financial sector and the global economy. Second, no matter what regulatory arrangements are put in place, the next global financial order will last no longer than a generation—because whatever ideas replace the current ones will also prove fallible over time.

There were four interrelated factors that led the global economy to the precipice in the fall of 2008. And the truth is, how well any given expert grapples with these conundrums is a pretty good indicator of how seriously we should take their advice as the financial marketplace seemingly sets itself up for yet another economic disaster down the road.

[amazon 0691145822 full] THE EARLIEST and most controversial catalyst to our recent demise finds itself in the aftermath of the Asian financial crisis, which started all the way back in Thailand in July 1997 and rocked much of the developing world. After the budgetary- and monetary-policy strictures placed on those seeking protection from the IMF, governments across the Pacific Rim cried “never again.” To shield themselves, these economies consciously began to amass sizable foreign-exchange reserves to avoid having to turn to international financial institutions in the event of a future crisis. In pursuing this course of action, capital from these countries flooded into asset markets of the Anglosphere. This jump-started what Federal Reserve Chairman Benjamin Bernanke labeled a “global savings glut”—a.k.a., “Bretton Woods II.”

The macroeconomic effects were reinforcing and significant. The capital inflows kept interest rates low and asset prices high in the American, British and Irish economies. This encouraged a decline in American savings and an explosion in the current-account deficit. Surging American consumption, in turn, fueled the export-led growth of the Pacific Rim and energy-exporting economies. Official creditors from these countries—central banks, sovereign-wealth funds and other government investment vehicles—purchased more dollars and more dollar-denominated assets. Foreign purchases of U.S. Treasury bills, Fannie Mae and Freddie Mac mortgage-backed securities, real estate and equities increased. All of this accelerated the boom in asset prices, which further fueled American consumption, widening the trade deficit and reinforcing the cycle.

[amazon 0307592812 full] This growth in imbalances led a few sage economists—most notably, of course, Nouriel Roubini—to predict a major financial crisis in the making. How this disaster would manifest itself, however, was a whole other matter entirely. Here even the few wise nay-saying outliers got it woefully wrong, predicting that official creditors would grow increasingly reluctant to hold even more greenbacks and a crash in the dollar’s value would thus bring down the global economy. That did not happen—and these same economists acknowledge that these imbalances did not in the end directly cause the crisis. Indirectly, certainly, the rush of capital into the United States facilitated lax monetary policy and contributed to the asset-market bubble that, in turn, triggered the meltdown. But though Quiggin notes that having money from the capital-starved developing world rush into the capital-rich developed world does not seem like the most efficient allocation of resources, growing trade imbalances were a backdrop to a much larger story.

Roubini and Mihm do the best job of integrating this part of the story into their analysis and putting its role in the proper perspective. Crisis Economics attributes the proper role to the rise in macroeconomic imbalances, arguing that China and other surplus countries acted as “enablers” for the asset bubble in the Anglo-Saxon economies rather than as the inherent cause of the crash. This is a fair assessment—while capital was sloshing around in the U.S. system, it was the peculiarities of the American financial sector which translated that capital into a housing bubble. Indeed, Crisis Economics outclasses the other books in highlighting both the global origins of and the global fallout from the Great Recession.

MAKING MATTERS worse, while all the foreign money was flowing onto our shores, a wave of financial deregulation and innovation was transforming capital markets. A host of changes allowed the financial sector to run rampant. Each innovation triggered a slew of unintended consequences.

[amazon 1594202508 full]In the decades prior to the Great Recession, the fixed commissions on stock trading in the United States were eliminated, leading investment banks to engage in more aggressive activity to maintain profitability. The 1933 Glass-Steagall Act was revoked. Banks shifted their capital-adequacy standards from a simple reserve ratio to more questionable complex models of risk and diversification (models that valued assets according to their theoretical value rather than past market prices, which meant that these asset valuations were only as accurate as the underlying model—and we know how that turned out). On top of this, key parts of the financial sector were left essentially unregulated. Despite efforts by the Securities and Exchange Commission, Congress expressly forbade it from regulating derivatives markets. Both private-equity firms and hedge funds were also left to go about their business unimpeded. This was somewhat surprising, given that Long-Term Capital Management’s assumption that a global financial crisis couldn’t really happen brought the financial system to the brink of destruction in the late 1990s.

Financial innovations also increased the complex interdependence of global capital markets. The growth of private equity and hedge funds allowed large pools of capital to act free of any regulatory oversight. The expansion of prime-brokerage firms and the “re-hypothecation” of money-market funds deposited with those firms created new profit opportunities. The “carry trade” allowed money-market-fund managers to take assets from one country and make overnight deposits into other countries with higher interest rates, turning places like Iceland into temporary financial powerhouses. The securitization of subprime mortgages into collateralized debt obligations allowed banks to pass on the risk of default to others. The growth of credit-default swaps expanded this market even further, creating the illusion that financial actors were hedging against downside risk, all the while building up systemic risk to unsustainable levels.

For consumers, the effect was equally pernicious. The explosion of financial innovations translated into more and more aggressive lending practices. Worse, the explosion in subprime mortgages meant that soon-to-be-new homeowners least familiar with finance were the ones agreeing to interest-only adjustable-rate mortgages in inflated property markets. This of course was fine, as long as property values continued to rise. The moment they leveled off, the market seized up and crashed.

Several of these books cover this dimension of the crisis with gusto. Reich focuses on the ways in which consumers had no choice but to borrow in order to sustain living standards. More than anything else, Reich blames rising inequality for the financial crisis. In his interpretation of recent economic history, so many lower- and middle-class individuals had to borrow in order to keep up their lifestyles that an unsustainable debt cycle emerged. Politically, rising inequality further empowered the rich at the expense of the poor, ensuring that the Goldman Sachses of the world could keep the regulatory game rigged in their favor. This echoes the crude, deterministic model that MIT’s Simon Johnson and other economists have been articulating since they miraculously discovered the significance of politics.

How persuasive is Reich’s argument? Not very. Reich is correct to note the rise in U.S. income inequality—indeed, Quiggin’s book does Reich one better, highlighting the fact that income mobility in the United States is among the lowest of the advanced industrialized states. As Roubini has pointed out repeatedly in the past (and does so again with his coauthor), however, the United States was hardly the only country to experience an unsustainable debt cycle—Great Britain, Spain and the Netherlands possessed all of the social safety nets that make Reich salivate, and yet they suffered as much as we did. Other countries, such as China, experienced even-greater spikes in inequality, while avoiding the worst of the financial crisis (though with China’s property bubble, just you wait). Rising inequality might warrant greater intrinsic concern, but Reich’s attempts to connect those concerns to the Great Recession are unpersuasive.

Mallaby is the most market friendly of these authors, and tries to use his history of the hedge-fund industry to point out that sometimes minimal regulation can be a good thing. The heroes of More Money Than God spot pricing inefficiencies in a single bound, pouring their own money into mispriced assets in an attempt to make the market work more efficiently. Unlike commercial or investment banks, hedge funds still operate as partnerships, which means that the investors are playing with their own money along with everyone else’s. This gives them powerful incentives to avoid excessive risk, unlike their financial brethren. He notes, “The case for believing in the industry is not that it is populated with saints but that its incentives and culture are ultimately less flawed than those of other financial companies.” It is certainly noteworthy that despite feeling the crisis just as severely as banks, hedge funds received no bailout money from the federal government.

Does this mean hedge funds should stay unregulated? Not even Mallaby agrees with such a laissez-faire sentiment. Instead he argues that if a hedge fund becomes sufficiently large (say, more than $120 billion in assets), sufficiently leveraged or trades heavily in illiquid markets, then greater government scrutiny is warranted.

THE TOTAL lack of regulation was bolstered by a common misperception among economic-policy makers: the efficient-market hypothesis. The argument was that it was impossible for individual investors to beat the market over sustained periods of time because it was self-regulating. By the turn of the century, this belief had hardened further: the market price of an asset reflected all available information about that asset; and, because of efficient markets, most forms of financial regulation were unnecessary. There were simply so few market imperfections to correct, who needed big government? A large number of Nobel Prize–winning economists held intellectual and financial stakes in this hypothesis, making it difficult to challenge.

In an intellectual version of trickle-down economics, regulators at the Securities and Exchange Commission and the Federal Reserve imbibed these ideas, and placed greater faith in private codes and standards than public regulation. As a result, private ratings agencies were trusted to objectively assess the riskiness of complex collateralized debt obligations, even though they were paid by those issuing the debt. The shadow banking system of structured investments was allowed to explode with minimal monitoring and regulatory oversight.

Both John Quiggin’s book as well as Crisis Economics take economists and regulators to task for being in the thrall of the efficient-market hypothesis. They prefer a heretofore-neglected strain of economic thinking, espoused by John Maynard Keynes, Charles Kindleberger and Hyman Minsky, which posits that financial markets are inherently prone to crisis and occasional collapse. Quiggin’s book is the best on this front, as he traces how the weak—and likely correct—version of the efficient-market hypothesis morphed into the caricature that guided policy makers during the housing boom. Roubini and Mihm’s efforts are perfectly fine on this score, but in an important way Crisis Economics disappoints by not meeting its own expectations. They clearly want their book to push forward the idea of economic logic built on the permanent instability of asset markets, but Crisis Economics in the end fails to deliver on that front. Instead, the book closes with a series of technocratic policy proposals, many of which are sensible, but none of which deepen our economic understanding all that much.

Intriguingly, More Money Than God also rebuts the efficient-market hypothesis, but Mallaby disproves the theory by example, pointing out that some hedge-fund managers have in fact consistently outperformed the market by recognizing when and where governments and markets have erred. Mallaby’s implicit argument is that this value-added, or “alpha” to use the financial argot, helps to correct markets and justifies the outsize incomes earned by the savviest players. In making this case, More Money Than God epitomizes a genre that Michael Lewis unintentionally midwifed with Liar’s Poker: the financier-as-capitalist-role-model. Books in this vein glorify the financial entrepreneur who spots the imperfections in the market and then figures out a way to make money from it. The best of these books captures the raw energy that comes with the good and the bad of financial innovation.

Because Mallaby is so meticulous in his financial history, however, he undercuts his own case for the virtuousness of hedge funds. The most successful players in More Money Than God make the bulk of their profits in one of two ways: exploiting regulatory loopholes and betting against unsustainable exchange-rate policies. The former does not appear to generate much social welfare, and the latter causes at least as much harm as good. Mallaby then contradicts himself by noting that hedge funds are too small to create any systemic risk in capital markets. He is likely correct in this conclusion, but this also means that hedge funds are too small to reduce volatility. In chapter after chapter, Mallaby’s heroes nearly lose their shirts by prematurely betting against bubbles. To paraphrase Keynes, the market can stay irrational longer than hedge funds can stay solvent. In the end, Mallaby fights the pervasive anti–Wall Street hysteria to a standstill. One walks away from More Money Than God convinced that hedge funds did not play a crucial role in the Great Recession. At the same time, however, the notion of hedge-fund-manager-as-hero does not really fly either.

BUT THE folks who really come out worst in all of this are the politicians, economists and financial actors that had faith in the idea of the Great Moderation; the observation that nimble monetary and exchange-rate policies could diminish any severe economic downturns should our ever-so-efficient markets momentarily fail us. This faith was most religiously held in the United States, and with some justification. Over the twenty-five years prior to the Great Recession, each American slump had been milder in its effects on GDP than the one before. Faith in the Federal Reserve’s ability to cushion the force of downward shocks was often referred to as the “Greenspan put.”

With unmitigated glee, Reich argues that the boom of the Great Moderation masked the underlying fragilities of asset bubble piled upon asset bubble. Both Crisis Economics and Zombie Economics go further on this front, detailing the ways in which Fed Chairmen Alan Greenspan and Ben Bernanke made the asset bubbles worse through easy monetary policies. Indeed, Greenspan is cuffed around for twin failures: though his infamous 1996 “irrational exuberance” speech popped one asset bubble before it expanded, he failed to heed his own warning by keeping interest rates after 9/11 so low for so long. We should not be surprised by the outcome. Bernanke gets it on the chin for maintaining that the subprime-mortgage crisis was containable.

Considering that by 2005 many economists were cognizant that housing prices were rising at an unsustainable rate, why wasn’t preventive action taken sooner? The first rule for policy makers in an asset bubble is that they can’t talk about the existence of an asset bubble. The reason for this is simple: pricking an asset bubble requires pursuing policies that, in one way or another, tell people that the good times have come to an end. Any effort by the Fed or the SEC to contain the housing bubble would have met fierce congressional and executive-branch resistance. So long as asset prices continued to rise, it was difficult to expose the flaws in the financial system.

While these books occasionally discuss these politics of bubbles, they tend to elide all that is political. For them, it’s strictly about the power of the financial lobby, which is not an entirely fair assessment. In this narrative, interest groups with a powerful stake in maintaining the status quo blocked any serious efforts at reforming the financial system. Domestically, this came in the form of lobbying by Big Finance, whether one refers to Fannie Mae, Freddie Mac or Wall Street more generally. Globally, it was the princelings who dominated China’s export sector, the sheikhs who set up sovereign-wealth funds in the Gulf emirates and the hedge funds ensconced in America that all bitterly resisted any effort to prick the bubble.

Yet beyond interest-group politics, no politician likes to hear that contractionary policies are on the horizon, regardless of their ties to Wall Street. Plenty of incumbent Democrats were plenty comfortable with Greenspan’s easy-money policies when the alternative seemed like a more severe recession. The asserted power of Wall Street also does not square with the events of the past few months. Despite fierce lobbying by the financial sector, Dodd-Frank regulates derivative markets, toughens consumer finance, enhances the Fed’s oversight powers and creates an authority to wind down big financial firms. The SEC’s lawsuit and settlement with Goldman Sachs eroded that firm’s share price considerably. Yes, financial firms still possess political clout—but the attempt in these books to stoke populist resentment does not work all that well.

IN THE end, the big question that these books wrestle with is how to reintegrate John Maynard Keynes’s ideas about finance into a world of instantaneous, complex and globalized capital markets. Keynes distrusted the financial sector, seeing it as an arena combining greed with bouts of irrationality. Thus he wanted it heavily segmented, subordinated to full employment policies and embedded in a tight web of regulation. But though market fundamentalism might be mortally wounded, it’s not clear how much room there is for Keynesian macroeconomic policies. And if one is looking for answers they aren’t to be found with Sebastian Mallaby. His hedge-fund-formed recommendations of a light regulatory touch make some sense but extrapolation to larger prescriptions is difficult; as he notes, hedge funds are only a small sliver of the financial sector, and More Money Than God is mum on big-think policies.

And if Mallaby’s focus is too narrow, Reich’s is too inchoate. Aftershock tries to scare moderates into redistribution policies, arguing that otherwise a political revolution will take place that makes the Tea Party activists look like a sewing circle. Yet he does not persuade. At one point he allows that “opulence has provoked more ambition than hostility” and that “economic resentments have not yet propelled anyone into the White House.” Reich clearly yearns for a return to the policies of the Bretton Woods era. But he never wrestles with the ways in which the world has changed since the 1950s. Nor does he even mention the reasons why the Keynesian policies failed during the 1970s.

Unlike Reich, Quiggin is clear-eyed about Keynesianism’s failures as well as its successes, but he believes that:

The failures of the 1970s were the result of mistakes that could have been avoided with a better understanding of the economy and stronger social institutions. If so, the current crisis may mark a return to successful Keynesian policies that take account of the errors of the past.

He might be right, but if so it would contradict everything else contained in Zombie Economics. Quiggin thinks he’s only writing about the failure of free-market ideas, but he’s actually describing the intellectual life cycle of most ideas in political economy. All intellectual movements start with trenchant ways of understanding the world. As these ideas gain currency, they are used to explain more and more disparate phenomena, until the explanation starts to lose its predictive power. As time passes, the original ideas become obscured by ideology, caricature and ad hoc efforts to explain away emerging anomalies. Finally, enough contradictions build up to crash the paradigm, although current adherents often continue to advance the ideas in zombielike form. Quiggin demonstrates with great clarity how this happened to the Chicago school of economics. How he can think it won’t happen with whatever neo-Keynesian model emerges is truly puzzling.

In the end the best Keynesian-like proposals come from Roubini and Mihm, even if they do not develop a grand theoretical paradigm. Instead, Roubini and Mihm outline a plan for reform with ideas like “Glass-Steagall on steroids,” and countercyclical rules on capital adequacy for banks (holding more capital on reserve during boom times but relaxing those rules during downturns). Some of these ideas make a great deal of sense. Others, such as transitioning away from the dollar toward multiple reserve currencies, are unlikely to take place. Certainly parts of their conclusions read less like a summing-up and more like an investment newsletter. Still, as the book that does the best job of explaining where we have been, it would behoove policy makers to read Roubini and Mihm’s thoughts on where we should be going.

In 1933, Keynes wrote:

The decadent international but individualistic capitalism, in the hands of which we found ourselves after the [First World W]ar, is not a success. It is not intelligent, it is not beautiful, it is not just, it is not virtuous—and it doesn’t deliver the goods. In short we dislike it, and we are beginning to despise it. But when we wonder what to put in its place, we are extremely perplexed.

Regretfully, eight decades later, there is not much more to offer in the way of clarity.

Daniel W. Drezner is a professor of international politics at the Fletcher School of Law and Diplomacy at Tufts University and a senior editor at The National Interest.

Pullquote: The trouble is that finance now permeates not only the economic but also the political and social fabric of our world. No one can talk about Big Finance without talking about the power of capital in politics.Image: Essay Types: Book Review