Reform or Regulate? A Difference of Opinion

Krugman nails it today. Here’s his column in this mornings New York Times: Op-Ed Columnist – The Market Mystique

Therein lies the rub.

Those of us who think something fundamental is wrong align with opinions like those Krugman expresses here. Clearly the Obama administration is in a different camp.

My view is that finance needs to be put back in the bottle. The financial sector has become far too large a component of our economy. It consumes too much of our physical and intellectual activity. The cost is extraordinary. Our manufacturing base has shriveled because we pour too much talent into moving rather than making money.

There is great virtue in innovating the financial sector: ATM’s; longer banking hours; internet access to deposits etc are all are beneficial to bank customers. The wonderland of securitization and derivatives are not.

The chart you can find here at the Baseline Scenario web site is telling: Pay Per Worker – Finance As Krugman points out there has been a massive shift in GDP towards the financial sector. Along with it has come a huge bias in incomes. Whereas throughout the post-war boom incomes in finance were close to the national average, since the Reagan deregulation they have diverged dramatically. The skew has been enormous. This has attracted brain power which has expended itself not in innovating the economy, but in innovating ways to accumulate personal wealth. Trading derivatives for no apparent underlying risk mitigation purpose is an example.

The kind of perverse incentives that emerged in finance since deregulation are best explained through an examination of the securitization of mortgages and the derivatives businesses.

Securitization was an innovation that severed the link between a lender, who originally made the loan, and the customer, usually a mortgagee. By making the loan and then selling it, a bank, or other lender, could relax lending standards significantly. At first this was presented as a prime example of the benefits of deregulation: it enabled borrowers with weaker finances to borrow and thus own a home. Since home ownership is viewed as socially desirable, securitization was thus seen as a ‘good thing’. When competition drove the lenders into applying even more lax standards the current economic crisis was created. Securitization laid the groundwork both for the bubble in home prices by creating an over supply of lending – banks had no limit to their ability to generate mortgages because they didn’t hold them on their own balance sheets – and the consequent bust – borrowers with weak finances were inevitably going to default if interest rates rose, which they did after the ‘teaser rates ran out. So securitization ultimately was a rotten rather than positive innovation. It needs to be limited.

The same sort of argument applies to derivatives. At first derivatives were a method of hedging risks. In limited use this is a very useful function and clearly has enduring economic value. But when traders are given huge bonuses simply for building volume of derivatives transactions risk mitigation is no longer the driver of the business, bonus creation is. At this point we enter the odd world of places like AIG whose derivatives business included some bets that were completely outrageous under all but the most optimistic of circumstances. It was inevitable that the house of cards would come down. But sober managers were constantly outvoted if they objected to the growth of a derivatives portfolio because the profits piled up and the executive bonuses were extreme.

So back to the difference of opinion:

Those of us who think things like securitization and derivatives trading need to be either eliminated or radically tamed are highly skeptical of the administration’s approach to the bailouts and future regulation. We think that the system needs not just saving, but changing. Radically. In particular we need to clean out the managers who made the wrong moves and created the mess, otherwise they will repeat their mistakes. Obama and his folks seem to think that saving is sufficient and that moderate regulation will prevent future repeats of the AIG mess.

My belief is that without radical reform of the basic business model that drives our financial system we will have a repeat of our current crisis far too soon.

Finance is inherently unstable. Its structure relies too much on obscure and now invalidated theories. It has grown far too large, and its size, coupled with it instability, can destroy economies. That can no longer be tolerated.

Hence the need for reform to augment regulation.