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

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 The 1933 Glass-Steagall Act was revoked.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.

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