Friday, March 21, 2008

The Failure of the New Financial System and the Need for Wide-Ranging Reform

Our financial system is very different from what it was twenty years ago. Regulated banks no longer have as big a role in the financial system, and even banks have made end-runs on regulations. The whole system has accepted more risk and abandoned much of its safety net in pursuit of ever higher short-term profits.

So when the US Federal Reserve Board steps in, as it did last week, to prop up an investment institution (Bear Stearns), it has ventured into the Wild West. The Fed isn't equipped to accumulate risky assets of a failing investment company. The fact that it has done so has added another vulnerability to our shaky economic situation. And now the Fed has extended its bailout to the rest of the investment industry.

The reason that the Fed had to be the one to step in and rescue Bear Stearns is that the institutions designed to deal with crisis in the real estate sector, Fannie Mae and Freddie Mac, had leveraged themselves so highly that they didn't have the capacity. Why were they leveraged? I'm assuming it was to make a profit. That wasn't their mandate, but in the current political climate everyone has to make a buck.

Bear Stearns had to be bailed out because its failure could have triggered the investment industry equivalent of a run on the banks. Even with the bailout the market is in turmoil. There have been hundreds of thousands of failed contracts in the repo market, leading today to negative interest rates on T-bills.

Some economists are saying (here and here) that short term interest rates are now virtually zero, meaning that the Federal Reserve Board is unable to lower interest rates - and so rendering toothless its main tool, monetary policy.

Paul Krugman describes the new world of banking: "In the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages... The shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned."

Former Federal Reserve Board chair Paul Volcker recently said that the current financial crisis is a test of the new financial system. I think it's safe to say that the system is failing. The crisis boils down to a crisis in confidence in the US financial system, and that lack of confidence seems to be rational and well-founded.

It is the current state of federal mismanagement and ineptitude that led to this day: to a largely unregulated economic giant, the investment industry, that is threatening to bring us down to what some have called a civilization-threatening depression. What we need is massive and effective reform. The investment industry must be much better regulated; the mandate of the Fed must be tightened; and we must ensure that institutions like Fannie Mae are ready to do their jobs.

Will it happen? I don't know. I was at a dinner the other night in New York with a bunch of people in the investment industry, and when I suggested the need for more regulation in their sector they thought I was joking. The current political climate is all about less regulation and lower taxes. We need a giant paradigm shift in politics, and it needs to be about realism and public responsibility over personal greed.


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