Shaking the Invisible Hand

Shaking the Invisible Hand

Mini Teaser: The chances of another cycle of optimism, overconfidence, hubris, panic and a long period of pessimism are high.

by Author(s): Liaquat Ahamed

Once Washington finally saw what was happening, did it do a reasonable job of resolving the crisis? Posner believes it did. Stiglitz thinks it didn't. The odd thing is that they reach these conclusions on the basis of very similar analyses. They both agree, for example, that the financial rescue package failed to jump-start lending by banks. Stiglitz argues that it should, as a consequence, be judged a failure. Here, I fear, he is being naive. In September 2008, the financial system was unraveling by the hour-even General Electric was shut out of credit markets, and its ability to meet its payroll was seriously in doubt. The goal at that point was simply to prevent a complete meltdown and collapse in credit. Central bankers in fact do know how to stop a bank run. What they do not know is how to get bank credit flowing again. They are like doctors who know how to arrest a heart attack, but have neither the knowledge nor the tools to reopen arteries so as to keep the blood supply flowing. Posner, on the other hand, is more realistic, willing to accept that there was little the government could do to forestall the credit crunch.

Stiglitz and Posner are in agreement that the bailouts were a giveaway. The finance industry and its creditors received an enormous gift from the rest of us. Every large bank-whether it took the government's money or not, whether it needed the cash or not, whether it has paid the money back or not-is still in business only because of the intervention. The extent to which firms across the industry are beneficiaries of government action cannot be measured simply by how much government money they took. Rather, the real benefit of having a lender of last resort is it allows big banks to borrow at exceptionally attractive terms that do not accurately reflect the costs of default. One study has calculated that this implicit subsidy from the taxpayer lowers the cost of borrowing for the major banks by about $35 billion a year, almost half of their 2009 profits. Stiglitz is so incensed by what happened that he forgets to tell us what we should now do about it. Posner seems to be willing to accept the outcome as just an unfortunate side effect of saving the financial system.

The Obama administration has in fact tried to grapple with the issue of Main Street bailing out Wall Street. Its proposal to levy the wonderfully named Financial Crisis Responsibility Fee on the debts of all large banks is an attempt to recoup, at least partially, some of this backdoor subsidy. Unveiled after the Stiglitz and Posner books went to press, it is the sort of concrete proposal that, based on their analyses, both economists should be championing.


THEN THERE are the recommendations to prevent a recurrence of another banking crisis in the future. In June, the administration outlined its plan. Treasury officials believe that banks got into trouble essentially because of too much leverage and too much short-term borrowing. The central thrust of the administration's proposal is thus to impose a mandate on liquidity and reduce leverage by raising capital requirements-especially on large banks because they pose a bigger risk to the system.

The efficacy of these measures will obviously depend on their precise parameters. Currently, banks must have capital totaling 4 percent of their assets on hand; that amount needs to be raised to 8-10 percent. How tightly these requirements are enforced-whether banks are prevented from channeling their risky activities into off-balance-sheet affiliates in order to evade capital requirements-also matters. And whether regulators allow the system to be gamed the way it was before (for example, by allowing goodwill to be included in the definition of capital) will have an impact on the plan's effectiveness as well. As long as the Treasury proposals are given some real bite, they would seem to be moving in the right direction. Stiglitz criticizes them as inadequate and not far-reaching enough. Posner calls them "premature and overambitious." Neither, it seems, believes that increases in capital and liquidity requirements will suffice to rein in the risks that banks take, although each economist's reasoning is unclear.

Strangely, both advocate a return to some variant of the New Deal-era Glass-Steagall Act, in which investment banking is separated from commercial banking. Again, the Obama administration has unveiled its version of this very proposal since the Stiglitz and Posner books went to press.

All this talk of returning to Glass-Steagall is perplexing. There is no evidence that it was the investment-banking activities of commercial banks that either got them into trouble or that threatened the stability of the system. Commercial banks like Washington Mutual and Wachovia in the United States, and Royal Bank of Scotland, Northern Rock and Fortis in Europe, had no trouble losing vast amounts of money without having any investment-banking activities to speak of. Similarly, pure investment banks like Bear Stearns and Lehman Brothers brought the whole system to the edge of collapse without being deposit-taking institutions. The biggest culprit in the whole mess, AIG, was neither an investment nor a commercial bank.

Moreover, the notion that loans made by commercial banks are safe, while securities held by investment banks are risky, is surely wrong. Banks lost as much on the mortgage loans they made as they did on the mortgage securities they held. In fact, in a world where technology now allows us to securitize loans, the distinction is meaningless.

Over the last twenty years, the world of finance has been irrevocably transformed. Forget for the moment about complicated securities. Concentrate instead on the fact that money has migrated out of commercial banks. Individuals now hold their liquid savings in money-market funds. Big institutional investors hold their cash in the "repo," or repurchase-agreement market, which allows them to use financial securities as collateral for cash loans at a fixed interest rate and is the primary mechanism by which investment banks raise money. The combined total of money-market funds and "repos" is now almost as large as commercial-bank deposits. As a result, before the crisis, half the credit provided in the United States was being channeled outside the traditional commercial-banking system through what has come to be known as the "shadow banking system." That new artery has been ruptured and we need to repair it.

With so much credit provided through capital markets rather than old-fashioned commercial banks, the whole concept of banking has changed. Rather than hark back nostalgically to a regulatory system that was designed in 1934, we need to design one that ensures the smooth functioning of modern twenty-first-century credit markets so that they do not break down in the way they did last year. I am not sure that the Treasury knows quite how to do this. But it is also clear that neither does Stiglitz nor Posner. It really does turn out to be harder to figure out what to do as we move forward.

A theme that runs through both Freefall and The Crisis of Capitalist Democracy is the notion that the finance industry has become overblown, that it accounts for far too much of the GDP and that it is unproductive to devote so much of the nation's resources to moving money around rather than making things. This carries a certain resonance after the massive injections of public money in to the banking system and the subsequent rebound in the fortunes of Wall Street. My own intuition is that the financial sector is too large, and I have never quite grasped why bankers get paid so much more than other professionals. Yet again, however, I found myself wishing that Stiglitz and Posner had used their analytic firepower to give me a more solid basis for my views rather than simply echoing and reinforcing my own prejudices.


[amazon 0465018769 full] PAST ECONOMIC cataclysms have led to dramatic changes in international financial arrangements. The Great Depression knocked the world off the gold standard. The economic turmoil of the late 1960s and early 1970s led to the collapse of Bretton Woods. Will the current crisis bring about similar changes? Berkeley professors Stephen S. Cohen and Brad DeLong argue in The End of Influence: What Happens When Other Countries Have the Money, that since the end of the Second World War, it has been the locomotive of the United States that has propelled the global economy and kept it on its tracks.

The basic pact was that America would act as the underwriter of world prosperity, allowing other countries to keep their currencies undervalued and thus promote economic development through export-led growth. Foreign countries were not only granted access to the enormous U.S. market, they were provided with liquid markets and a reasonably stable currency in which to invest their excess savings. The United States used its financial muscle to push free-market policies like open trade on the rest of the world. It was this economic Pax Americana that enabled Europe to rebuild after World War II, Japan and the countries of East Asia to industrialize, and China to take off.

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