Storm-Proofing the Economy

Written by Nicole Gelinas

October 20, 2008
Nicole Gelinas
City Journal
We can't prevent Wall Street turmoil, but we can make it less destructive.
This year, after a quarter-century of relatively free-market governance of the economy, the only thing protecting Americans from the complete vaporization of the financial industry has been the United States government.
Treasury secretary Hank Paulson has spent the past six months using the trillions of dollars in promises and loans that only the government is powerful enough to make to avert the immediate collapse of the insurance giant AIG and those two mortgage behemoths, Fannie Mae and Freddie Mac. Government officials had hoped that their actions would persuade the financial world's private lenders, trading partners, and customers to stop fleeing financial institutions in a Depression-style terror. The efforts failed. As the private credit markets collapsed in September and early October, the government stepped in to guarantee new lending to banks and to provide new investment capital to financial firms so that the industry wouldn't fail utterly and drag the rest of the economy down with it.

Contrast these extraordinary actions with the government's calm response to another recent financial implosion that could have provoked a crisis of confidence. In mid-July, President Bush reassured a nation rattled by the sight of Californians lining up to withdraw money from the failing commercial bank IndyMac. "If you have a deposit in a commercial bank in America, your deposit is insured by the federal government up to $100,000," he said. "My hope is that people take a deep breath and realize that their deposits are protected by our government." Franklin Delano Roosevelt must have looked down from Campobello in the sky and smiled. Facing a potential panic, Bush had turned the public's attention to the Federal Deposit Insurance Corporation (FDIC), a collective insurance program and a hallmark of FDR's New Deal. In late September, an even bigger commercial bank, Washington Mutual, failed in a similarly orderly fashion.

The FDIC's success in controlling a modest part of the financial crisis shows that market regulation matters. But what kind of regulations work best? Each presidential candidate promises to sign legislation overhauling the financial regulatory system, but a President McCain or a President Obama will have a thicket of questions to get through. What's broken about the existing regulatory system? Are our existing regulations, most of them seven decades old, still relevant? In financial risk-taking, who should be protected and from what? Do we want to protect big companies from the risk of failure-or do we want to protect the overall financial system? And what can't regulations do? Until we ask these questions and get the right answers, the financial firms still standing can't know what their future world will look like.

Important people who ride around in black cars would like you to think that the credit crisis is complicated. But all the acronyms-CDO, ABS, RMBS, CMBS, CMO, SIV-are just distractions. The reason for the crisis is simple: when you lend money to people who can't pay it back, they won't.

All right, it isn't that simple. But it isn't inexplicable, either. For the half-decade or so that ended in mid-2006, financial firms and investors, lulled by low inflation and interest rates, thought that there was no risk in increasing their lending exponentially to consumers and speculators seeking to buy houses, office buildings, and other assets. After all, mortgage lending over the past decade had seemed a sure thing, with ever-rising prices and few defaults. Plus, lenders had "securitized" mortgages and other types of loans-that is, transformed them into easily tradable securities. So if banks and other investors wanted their money back, they weren't stuck for 30 years waiting for borrowers to pay them; instead, they could sell the loans to other eager investors, and then use the cash to make yet more loans. And even if a borrower couldn't repay his loan, the collateral behind it-the house, in the case of mortgages-was a fail-safe. CONTINUE

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