Stop the Presses

Whatever the backlog of subjects I had in mind for this issue, they have been blown away by events that have overwhelmed even what is shaping up as a watershed presidential campaign.  In fact, aside from their respective economic policy strategies if elected, the two presidential nominees are pretty irrelevant to the urgency of the crisis, and both of them illustrated why this is so in their second debate.

We are certainly living through the most significant financial crisis of the past twenty years, and it will no doubt ultimately rank among the most significant in U. S. history, for several reasons:  (1) since the beginning of the worldwide securitization of financial assets and  the derivative segmentation of risk made possible by the warp speed development of computing technology over the past 25 years, this is the first true stress test of the management of this revolutionary risk segmentation and diffusion; (2) it comes at a time when the globalization of trade and employment and the challenges to the long-held principle of comparative advantage have given rise to worldwide anxiety about employment security and the related economic security of nation-states; and (3) because of the convergence of these forces with the current political trends, particularly in the U. S., there is the very real threat that the political response to the present crisis will result in regulatory overreach in the financial markets and other measures that will be destructive to capital formation, enterprise, and economic growth.

Many observers have blamed the financial market deregulation of the 1980s and 1990s and the failure of regulation for the crisis in the first place, but I believe that there is much more to the real story.  In fact, the market, which always leads and never lags public policy, had already run circles around the antiquated 1930s financial markets regulatory system by the time the Glass-Steagall Act (which prohibited the combination of commercial and investment banking) was repealed in 1999.  This was a fait accompli on the ground in the market for at least 20 years before it was ratified.

Not that I am exonerating the investment bankers or the regulators.  In fact, as I wrote in the wake of the Enron meltdown in early 2002, the investment banking industry has been headed in the wrong direction since the major firms began offering their shares publicly a couple of decades ago. The concept of privately owned, self-regulated, general partnership governance of these firms served us well.   As unlikely as this may be, we would probably greatly benefit by a return to the days when investment banking, accounting, and commercial banking were conducted based on the concept of the “trustee” by partners with full liability and a significant personal financial stake in their stewardship.

The late Walter Wriston, former Citicorp Chairman, had the new realities pegged in his book, Twilight of Sovereignty, in 1991 when he noted that the days when nation-states can control economic events are numbered and that technology has produced a new “gold standard” in the form of the then 200,000 computers (now many multiples of that number) run by money managers worldwide who never sleep and who “vote” on public policy and discount its implications often before the policy pronouncements by politicians.  And this was before the explosion of the Internet!  Of course, the key is full and complete transparency of information, and that is what has obviously been left behind in the blinding speed of the effect of Moore’s Law on computer capabilities to drive market innovation.  And despite the diminished ability of governments to control events, they continue to have a way of pursuing micromanagement with unintended consequences.

The over-indulgence in the subprime mortgage market of the past several years shouldn’t have been much of a surprise after 30 years of misguided social policies in pursuit of “affordable housing”, manifest in the Community Reinvestment Act and its mandated affirmative action lending practices in low socio-economic markets, compounded by the well-documented explosive growth of Freddie Mac and Fannie Mae that was directly tied to cronyism in the various Congressional relationships, the financing of which was made possible by Federal Reserve monetary policy that produced significant misallocations of resources to this high risk market.  This crisis has many parents, but the real culpability should not be difficult to identify.

This too shall pass.  We won’t know where the bottom is until private capital begins to move back into the markets in critical mass.  Sooner or later, this will happen.  But with the change of political regimes in January 2009, I worry less about where the market bottom might be than about the movement toward the socialization of risk indicated by the tendency to cure the problem with massive asset acquisitions by the government and the resulting increase in moral hazard , along with regulatory overreach, the combination of which would have serious long-term detrimental consequences for capital formation and our competitive position in the world.  We already have a Sarbanes-Oxley bill, courtesy of Enron, that is a severe overreaction and has already significantly damaged the competitiveness of U. S. capital markets; we don’t need a Sarbox II for the financial institutions, nor do we need government ownership of these institutions without a definitive exit strategy and unemployment for those CEOs whose firms accept the infusions.  The “too big to fail” policy should also be revisited.  Someone recently said that if an institution is too big to fail, then it’s too big, and I agree.  We could also use some fiscal policy response, and I don’t have in mind a so-called stimulus package of tax rebates, but rather a significant cut in the tax rates on capital formation, i. e., capital gains tax and the onerous corporate income tax.  Good luck on that with a Democratic Congress.

So get ready in January–at a minimum, we are certainly in for much more government oversight and intrusion , at least until the governance and self-regulatory functions catch up with the markets, and right now they are not even closing the gap.