An apocalyptic end to the Greenspan era. On bailing out, regulating, or simply stopping taking risks

April 3, 2008


The Credit Crunch has reached unprecedented proportions, not least with the last bail-out of Bear Stearns. More losses are announced. When’s the next bail-out?

Until recently hailed the big guru of the financial world, former Fed chief Alan Greenspan, is now seen as at least partly responsible. He is also the author of a book I haven’t yet come round to read with a telling title: “The Age of Turbulence” (here a few comments on it). In the meantime the cacophonia on “what to do now” has started…..

Even “The Unthinkable” is being thought about, so we are told. To bail out or not to bail out failing banks, that is one of the most recurrent questions asked everywhere for the short term. For the long term, we hear it is on how to impose even higher capital adequacy ratios (Basel II’s 8%, a result of the Asian crisis, haven’t done the job, or isn’t it rather the problem of off balance-sheet accounting?), how to foster better transparency, and the like. Back to the short term. The risk of bailouts, as usual is moral hazard. And the fact that taxpayers will ultimately have to foot the bill for the reckless acts of a few reckless people. An almost too “super-mega-systemic” analysis of the latter problem was given by Economics Pope, Martin Wolf in yesterday’s FT. After describing the apocalyptic mechanic of the financial crisis thus:

There are “three ways in which [financial] markets have malfunctioned: via the originate-to-distribute model, with its weak incentives to assess loan quality and wide diffusion of assets of unknown quality; via the vicious spiral in credit default swaps, with rising prices forcing a higher cost of funds on banks, so worse credit standing and so forth; and, finally, via tumbling market valuation of assets, with distressed sales in thin markets lowering solvency and forcing further sales.”

he concludes thus:

“However much one may loathe the idea, a private-sector financial mania will finish up as public-sector pain.”

Greed leads to sin leads to pain. Amen.

A few proposals for action are irrelevant to the current crisis. Rodrik and Subramanian’ recently made a call to cut cross-border capital flows, for example. This completely misses the point, but it does show that the crisis is likely to fuel even more detestation of capitalism. The problem is not cross-border capital flows, but a very domestic US mortgage mania that ran foul (Northern Rock in the UK being a consequence of a UK domestic policy choice to follow a similar real estate frenzy). A few European investors who took risky exposures across the Atlantic (such as the German IKB and Sachsen LB) were hit as well. Or other globally operating banks with high exposure to the US market (such as UBS). But it looks like the rest of the world is relatively resilient. It is affected by the crisis, but rather indirectly, due to the consequence of a slowdown/recession in the US economy, or because overripe asset bubbles in some countries such as Spain or Ireland have found the right time to finally start unwinding.

Hank Paulson, the US Treasury Secretary announced a radical overhaul of the US’ regulatory system. The former head of the now embattled UK Financial Service’s Authority, and now Dean of the London School of Economics, Howard Davies, gave us an entertaining and very well-written lecture on what these regulatory challenges are all about, providing the bigger picture. But it gives no precise idea on how this precisely relates to the mortgage crisis.

In a more classic monetarist “libertarian” tradition – it is interesting to read these days Chapter III on “The Control of Money” in Milton Friedman’s “Capitalism and Freedom“, which I am incidentally currently doing – the Wall Street Journal protests against Paulson’s proposals. To the WSJ, the problem is not regulation. The Fed should not become a regulatory “supercop”; the problem is the reckless monetary policy pursued in the last years, which fuelled cheap lending and therefore the subprime mortgage boom:

“The mortgage mania and panic weren’t caused by a failure of the regulatory structure or a dearth of rules. They were caused by a failure of the men and women who ran those financial and regulatory institutions”.

Yes, but in such a complex and sophisticated financial world, failure is inevitable. The problem of knowledge and information is acute. High-falutin’ and increasingly sophisticated mathematical models to measure risk are regularly accused of not delivering. These are old dilemmas…. Greenspan just said it himself:

“We will never have a perfect model for risk.”

This crisis, however, really, in some sense, makes “the unthinkable” happen. Indeed, the trigger for this post was a comment by the Icon of Global Financial Capitalism, George Soros, in today’s FT . To Soros, the culprit is the “false ideology” of “market fundamentalism” in financial services…. He attacks the idea that markets will regulate themselves, which stands behind most of the Fed’s action, or lack thereof, before the crisis. This was mainly under Alan Greenspan. However, Soros does make interesting proposals, that do not miss the point, even if people much more competent than this modest blogger will be able to judge on their ultimate soundness:

• For the outstanding CDOs and credit default swaps: “establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted.”

• And to put an end to the housing crisis: “cut foreclosures”.

Given that finance and its related capitalism are all so complicated, that risk is lurking around every corner, that we will all at some point lose our money to awful reckless money-making sharks, and that even safe havens such as gold or a bricks-and-mortar house are never safe enough, I would suggest considering, like The Economist, “a return to the agrarian past”.


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