the ‘time to start preventing the next crisis is now‘ yesterday…

Posted on Saturday 29 November 2008

Lest We Forget
November 27, 2008

A few months ago I found myself at a meeting of economists and finance officials, discussing — what else? — the crisis. There was a lot of soul-searching going on. One senior policy maker asked, “Why didn’t we see this coming?” There was, of course, only one thing to say in reply, so I said it: “What do you mean ‘we,’ white man?”

Seriously, though, the official had a point. Some people say that the current crisis is unprecedented, but the truth is that there were plenty of precedents, some of them of very recent vintage. Yet these precedents were ignored. And the story of how “we” failed to see this coming has a clear policy implication — namely, that financial market reform should be pressed quickly, that it shouldn’t wait until the crisis is resolved.

About those precedents: Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories? Why did so many people insist that our financial system was “resilient,” as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world? Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

Paul Krugman has joined the ranks of the columnists I look forward to reading: Dan Froomkin, [Washington Post], Charlie Savage [Boston Globe], now Paul Krugman [New York Times]. Frankly, these last eight years have been such a nightmare that most of us howling at the moon about the Bush Administration have been so tied up in the noisy business of the Niger forgeries, the War in Iraq, the C.I.A. Leak Scandal, the U.S. Attorney firings, the N.S.A. Domestic Spying Program, the Torture Memos, etc. etc. that the economy has occuppied a [too] small place our the radar screen. Krugman has talked and talked about it, written books about it, and won a Nobel Prize in the process. So, when Paul Krugman speaks, we ought to listen. Actually, we should’ve listened more carefully all along:
One answer to these questions is that nobody likes a party pooper. While the housing bubble was still inflating, lenders were making lots of money issuing mortgages to anyone who walked in the door; investment banks were making even more money repackaging those mortgages into shiny new securities; and money managers who booked big paper profits by buying those securities with borrowed funds looked like geniuses, and were paid accordingly. Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?
Aside: "A Ponzi scheme is a fraudulent investment operation that involves promising or paying abnormally high returns ("profits") to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. It is named after Charles Ponzi. A Ponzi scheme has similarities with a pyramid scheme though the two types of fraud are different."
"nobody likes a party pooper" just shouldn’t matter. In reviewing the Great Depression and the Republican driven Deregulation beginning with Reagan, one thing I’ve learned is that a Booming Market is a sign of coming trouble. Something is wrong. So, forget "nobody likes a party pooper." We need more party poopers before we poop ourselves out of existence. People like Paul Krugman and Robert Shiller, if anything, haven’t been loud enough [to be fair to them, haven’t been listened to enough].
There’s also another reason the economic policy establishment failed to see the current crisis coming. The crises of the 1990s and the early years of this decade should have been seen as dire omens, as intimations of still worse troubles to come. But everyone was too busy celebrating our success in getting through those crises to notice.

Consider, in particular, what happened after the crisis of 1997-98. This crisis showed that the modern financial system, with its deregulated markets, highly leveraged players and global capital flows, was becoming dangerously fragile. But when the crisis abated, the order of the day was triumphalism, not soul-searching.

Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers “The Committee to Save the World” — the “Three Marketeers” who “prevented a global meltdown.” In effect, everyone declared a victory party over our pullback from the brink, while forgetting to ask how we got so close to the brink in the first place.

In fact, both the crisis of 1997-98 and the bursting of the dot-com bubble probably had the perverse effect of making both investors and public officials more, not less, complacent. Because neither crisis quite lived up to our worst fears, because neither brought about another Great Depression, investors came to believe that Mr. Greenspan had the magical power to solve all problems — and so, one suspects, did Mr. Greenspan himself, who opposed all proposals for prudential regulation of the financial system.
This is another whole story – the story of Alan Greenspan. Here’s my current take on Mr. Greenspan. It’s similar to Krugman’s. Greenspan was a pretty good wizard, one who genuinely believed in what he was doing. His early years as an Ayn Rand devotee either gave him or reinforced his own sense of grandiosity and evangelical capitalism. Using his tool. he was able to keep things steady [like during the dot com bubble], by playing with interest rates. I don’t think he knew that by holding the ship on course, he was steering us into the treacherous shoals of the current crisis – but he was. Greenspan massively multiplied the problem as surely as the Keating Five with the S&L Crisis. I think he quit because he had an inkling of what he had done, but it was too late to do anything about it.
Paul Krugman 2003Now we’re in the midst of another crisis, the worst since the 1930s. For the moment, all eyes are on the immediate response to that crisis. Will the Fed’s ever more aggressive efforts to unfreeze the credit markets finally start getting somewhere? Will the Obama administration’s fiscal stimulus turn output and employment around? (I’m still not sure, by the way, whether the economic team is thinking big enough.)

And because we’re all so worried about the current crisis, it’s hard to focus on the longer-term issues — on reining in our out-of-control financial system, so as to prevent or at least limit the next crisis. Yet the experience of the last decade suggests that we should be worrying about financial reform, above all regulating the “shadow banking system” at the heart of the current mess, sooner rather than later.

For once the economy is on the road to recovery, the wheeler-dealers will be making easy money again — and will lobby hard against anyone who tries to limit their bottom lines. Moreover, the success of recovery efforts will come to seem preordained, even though it wasn’t, and the urgency of action will be lost. So here’s my plea: even though the incoming administration’s agenda is already very full, it should not put off financial reform. The time to start preventing the next crisis is now.
Krugman has said elsewhere that he does not want to be in the Administration. That’s understandable. But there are a number of Economists, Krugman among them, who have had their finger on the pulse of this thing for a long time.They’ve spent the past years warning us, as in this article. What we need now is a change of direction from them. We know we need to do something. What we now need help with is the whatwhat, exactly, do we need to do? To be honest, the most encouraging thing in this article is that Krugman seems to think that we’ll even survive to have another crisis. "Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?" Maybe we should name that thing I was inventing I called the Economic Oversight Agency in my last deregulation post the Dismal Economists Warning Agency [D.E.W.A.]. It has a nice ring to it…
    November 29, 2008 | 7:21 PM

    […] 1 Boring Old Man « the ‘time to start preventing the next crisis is now‘ yesterday… […]

    November 30, 2008 | 9:44 PM

    […] on Sunday 30 November 2008 Last night, in response to Paul Krugman’s NYT op-ed, Lest We Forget, I wrote: … But there are a […]

Sorry, the comment form is closed at this time.