[This book review article was published in the Fall 2009 issue of The Journal of Social, Political and Economic Studies, pp. 356-373.]
Book Review Article
The Future Will Marvel:
The Follies Leading to the “Great Credit Crunch of 2007-2009”
Dwight D. Murphey
, retired Wichita State University
The current age prides itself on its technical sophistication. It is likely, however, that future generations will look back on the “follies of global finance” that led to the “Great Credit Crunch of 2007-2009” with the same incredulity with which later generations have so long perceived the “tulip mania” in seventeenth century
. This article will explore some of the substantial economic commentary that has recently described in detail the “perfect storm” that came to be present in global finance in the early twenty-first century. The literature detailing how the table was set for economic catastrophe will be a fascinating subject of study for as long as people seek to understand the vagaries of human behavior in general and in finance. Holland
Key Words: Global finance, global credit crisis of 2007-2009, recent financial literature, financial architecture, business failings, financial regulatory deficiencies, ideological over-extension, proposed financial crisis preventatives.
A visit to the “Business and Economics” section of any major bookstore in the
makes it clear that a vast literature is coming into being that describes in detail the multitude of factors that led to “The Great Credit Crunch of 2007-2009.” We reviewed three of the books – David Smick’s The World is Curved: Hidden Dangers to the Global Economy, and John Bogle’s twosome, Enough and The Battle for the Soul of Capitalism – in the Summer 2009 issue of this journal. United States
The growing pool of writings is authored almost entirely by people who have worked in global finance for several years and hence are highly knowledgeable about it. Somewhat at random, we have as the basis for this article dipped into that pool to include:
. Charles R. Morris’ The Two Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash. Morris, a lawyer and one-time banker, has written prolifically on economic issues for several major outlets, as well as authored ten books.
. Daniel Gross’ Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation. Gross is a senior editor at Newsweek and is aptly described as “one of the most widely read economic/financial writers working today.”
. Robert J. Barbera’s The Cost of Capitalism: Understanding Market Mayhem and Stabilizing Our Economic Future. Barbera is Chief Economist at the Investment Technology Group.
The tone of these critiques is evident from their titles. They affirm that the “credit crunch” was preceded by years of folly. The review of that folly in this article will reveal that there was a conjunction of (1) ubiquitous self-regarding behavior, unconstrained because very few were concerned about the systemic risks that that behavior was creating, with (2) an ideology that encouraged that behavior and that saw much philosophical virtue in placing no limits upon it. If we seek an overall understanding of what happened, we see that this brought together two social pathologies, each of which reflects developments long in the making: the “do your own thing” narcissism and essential elitism of a “gimme” mentality that has come to pervade much of American life; and the transformation of free-market thinking into an over-extended caricature of itself. The analysis of these developments is a vast subject that would take us well beyond the scope of this article, which is intended to look at the immediate preconditions of the economic collapse...
There were voices that warned of the impending dangers. Barbera, one of our authors here, says that “an impressive number of papers were published from 2004 through 2006 that warned of the extraordinary risks building in the world’s financial system.” The Economist tells us that “some warned of trouble. The likes of Robert Shiller of Yale, Nouriel Roubini of
and the team at the Bank for International Settlements are now famous for their prescience.” New York University
These observers deserve recognition, but it seems odd that some are given such credit when others sounded the alarm considerably earlier. (Perhaps the selectivity reflects a certain pecking order in the intellectual world.) Richard Barnet and John Cavanagh wrote in a 1996 book that “in a globalized economy, wired together by technologies capable of moving unimaginable funds instantaneously around the globe at the behest of speculators and immune to any ability to regulate or control this movement, we are in for more frequent catastrophes… This is a condition the world will not be able to tolerate for long… It puts the entire international economic apparatus into a most precarious situation.”
And in 1997, William Greider wrote that “if my analysis is right, the global system of finance and commerce is in a reckless footrace with history, plunging toward some sort of dreadful reckoning with its own contradictions.” He predicted it was “leading toward an unbearable chaos,” but admonished that “this outcome is avoidable, I believe, if nations will put aside theory and confront what is actually occurring, if they have the courage to impose remedial changes before it is too late.” A decade then passed without his admonition being heeded, while the world rushed toward crisis.
The books that form the basis for this article do not themselves (except the two by John Bogle) explore the broader social preconditions of the meltdown, but they do cite “chapter and verse” about problems in four closely related areas which we will explore: the global financial architecture; failings in the business, professional and financial communities; deficiencies in regulation; and warpings of ideology (which will by the time we reach it hardly need separate mention).
The global financial architecture. The world financial scene has several facets that make up what is called its “architecture”:
1. Perhaps the most striking feature of recent global finance is the immensity of its capital flows. Bogle gives us the incredible statistic that “the notional principal value of all derivatives is… some $600 trillion, nearly 10 times the…
GDPof the entire world” (emphasis added). Gross says “the volume of mortgage-backed securities packaged and sold increased from $482.4 billion in 2000 to $2.14 trillion in 2003.” He adds that “the amount of debt insured through CDS [“credit default swaps,” which are contracts for credit insurance and are one of the types of “derivatives”] rose from $100 billion in 2000 to $6.4 trillion in 2004,… rising to $62 trillion by 2007” (emphasis added). Greider speaks of “the gargantuan daily inflows and outflows of capital across national borders,” commenting descriptively that “liquidity sloshes about in the global financial system, seeking the highest returns.”
This lends itself to a potentially catastrophic herd-effect that is far beyond anything central banks and government fiscal policy can handle. Smick warned that “the global financial system… is vulnerable to a psychological herd effect that could wreak havoc with the industrialized world economics.” Greider says “a nation may find itself inundated with ‘hot money’ from abroad that can ignite a giddy boom – or abruptly starved for credit when the foreign money decides, for whatever reason, to leave.” Barbera tells how at the time of the U.S. stock market crash in October 1987 “thousands of institutional investors watched their automatic sell orders kick in on the same day… delivering a one day 25 percent decline in the Dow.” The Economist reports about the herd-effect in the money-market fund industry that in September 2008 there was “a run on money funds… forcing the American government to guarantee the industry’s almost $4 trillion of assets – and confirming fears that it had become a big source of systemic risk.”
The danger comes from the acts of a few and of the many. As to the few, David Smick tells us that “the industrialized world has surrendered control of its financial system to a tiny group of five thousand or so technical market specialists spread through investment banks, hedge funds, and other financial institutions.” As to the many, Smick gives the example of the Japanese housewives, who taken together control the enormous pool of household savings in Japan (some $11 trillion), invest through the Internet, and may well react spontaneously in tandem with one another to any given economic shock.
2. The ingenuity of a good many bright people has been brought to bear to create an extensive array of complicated financial instruments involved in the “securitization” of debt of all kinds. This was a process pioneered, Gross tells us, by the
mortgage agencies Fannie Mae and Freddie Mac. The result is an opaqueness to the securities that belies the normal expectation that sophisticated purchasers will only buy a security if they can understand it. The opaqueness and an essential lack of “due diligence” run together. [The “due diligence” that was shown consisted largely of investors’ relying on the credit rating agencies, which proved scandalously unreliable, and on unbelievably over-committed credit insurance.] Gross speaks of “huge quantities of CDOs, CMBS, U.S. RMBS, CLOs, and other securities that… CEOs, CFOs, and CIOs could neither understand nor value.”
Likewise, Morris says “the complexity of the instruments spiraled into absurdity.” Many of the securities divided the underlying loans into segments known as “tranches,” and Morris mentions “phantasmagorical 125-tranche instruments that no one could possibly understand.”
3. Smick mentions how the precarious the currency markets are. “If the financial market perception developed that [an] economy was about to weaken, the traders across the board would dump [the currency], sending it into free fall.” We saw in our Summer 2009 review of his book that he added that there is “a highly leveraged, globalized ocean of skeptical currency traders.”
4. “Sovereign wealth funds” – huge investment pools created by various governments, mostly nondemocratic such as those of China, Russia and Saudi Arabia – have become prominent actors in the global financial architecture, dwarfing the International Monetary Fund. Smick points to the danger that in a crisis the
and United States Europemay need these funds’ assistance as “our only hope.”
5. Smick also perceives considerable risk in the West’s growing interdependence with
. He sees China ’s rapid economic expansion as a form of “bubble” that is bound to burst, bringing with it an enormous deflationary impact. This is accompanied by the risk of China and other foreign countries pulling out of their vast holdings of U.S. Treasury bonds (if at some time they find that their own interests will not be substantially hurt by doing so). He also points to a large volume of pie-in-the-sky investments in the underdeveloped world, and sees this, too, as a form of systemic risk, since the investments are seriously undependable.  China
6. The Federal Reserve in the
has gone away from the earlier monetarist concern about the “quantity of money” and its velocity. In doing so, it seems oblivious to the almost unthinkable quantity of money that is at work in the global financial system. “Hundreds of trillions of dollars” – where did all of that come from? Smick speaks of “the raging ocean of capital, through the use of leverage.” We find “leverage” with as much as a 100-to-one ratio between indebtedness and capital. This marks a credit expansion of historically unprecedented size. It must certainly have been matched by an almost unfathomable credit contraction when the system fell in upon itself. Morris speaks to this: “Since hedge funds and investment banks now provide about half of all market credit, their accelerated deleveraging would make the total credit contraction far worse than in previous commercial-bank-driven cycles.” The books we are discussing tell of the conditions that preceded the collapse. The books describing in detail the actual implosion and how the various bailouts and stimuli interacted with the chaos have yet to be written, but should be of great interest when they appear. United States
7. The global financial architecture was built in part on misdirected computer modeling. Morris calls “the increased dominance of investment decisions by mathematical constructs” a “dangerous trend.” We see an important part of global financial architecture in the detailed description he gives: “A root cause of the credit crisis was the shift over the early 2000s to the new ‘Basel II’ system of calculating leverage through model-based ‘value-at-risk’ (
VAR) analysis.” He recalls that “’ I,’ established by global agreement, … imposed a fairly simple-minded, but effective, risk-adjusted 8:1 leverage limit on all depository banks.” He says “the failure of Basel VARhas been cataclysmic.” World finance paid “a big price” for “model-based regulation.”
The Economist reveals a built-in conceptual vacuum affecting the models: “Few financial economists thought much about illiquidity or counterparty risk… because their standard models ignore it… Macroeconomists also had a blind spot: their standard models assumed that capital markets work perfectly… By assuming [this], macroeconomists were largely able to ignore the economy’s financial plumbing.”  We all know that computers work wonders, but the lesson is being taught time and time again that their results are no better than the assumptions built into their models.
Failings of the business and financial communities. Although we are listing this as a separate category, it is in many ways indistinguishable from the issue of “financial architecture” that we have been discussing.
1. Systemic brinksmanship lay at the heart of the crisis. Barbera has high praise for the economist Hyman Minsky, who considered it a principle never to be forgotten that “a long period of healthy growth convinces people to take bigger and bigger risks.” In the years immediately preceding the crisis, there was a well-nigh universal drive to take borrowing and lending to the point of extreme risk-taking. The quest for fees, commissions and other profit by economic actors of many types (from local mortgage brokers on up the chain) was accompanied by an insouciance toward the dangers, not just to oneself but to the society as a whole, arising from growing systemic risk. Certain mental features were essential to this: the elan of a profit-engendering atmosphere (which critics aren’t necessarily off the mark in calling “greed”); the readiness to believe that prices and values would go up forever; an abandonment of fiduciary responsibility by those in charge of large institutions; and an implicit understanding by smaller actors that their own actions were of little importance so far as “the bigger picture” was concerned.
Daniel Gross says Fannie Mae and Freddie Mac “had thin layers of capital underlying… [the] trillions of dollars in debt” that they issued and insured. It is Charles Morris who tells of hedge fund partners’ being “leveraged… 100:1.” At this level of borrowing, he says, “a loss of 1 percent on the
CDO[the securities purchased by the fund] wipes out all hedge fund partner equity.” It is worth noting that Morris explains that “the availability of credit insurance let investors climb higher and higher up the risk curve.” Part of the dynamics involved is explained by Smick when he tells us that “the bankers who engage in lending are no longer tied to the risk of the borrower… because the risk, when cut up into pieces, is quickly shoved out the lender’s door to be packaged with pieces of other risk and to be sold as investment to the unknowing global financial community.”
2. The “credit rating agencies” were of pivotal importance, depended upon to perform with great integrity a function that was vital to the market. Barbera tells how poorly they performed: “Rating agencies, mesmerized by the math and oblivious to the need for ever higher home prices, gave triple A ratings to highly dubious mortgages.” Gross explains that the real risk of the securitized debt instruments was masked: “The ratings agencies – Standard & Poor’s, Moody’s, or Fitch – happily slapped ratings on them in exchange for the mother’s milk of Wall Street: fees.” To Morris, “it seems clear that the agencies slanted their ratings to please their clients.”
3. Bogle has rightly described a market economy as depending upon “a virtuous cycle of trusting and being trusted.” It is a systemic flaw of the first order when such an ethos no longer exists, which now seems to be the case. Bogle speaks of “how rotten our investment banking system had become.” Similarly, he mentions “the over-reaching by the sell-side of the powerful marketing machine that is Wall Street. Puffery is its stock in trade….” More generally, he says that “not knowing what enough is… makes salespersons of those who should be fiduciaries… It turns a system that should be built on trust into one with counting as its foundation.” He refers to this as “a ‘bottom line’ society.” (This reminds us of Thomas Carlyle’s complaint more than a century and a half ago about things centering on a “cash nexus.” So the recent exacerbation would seem just a heightening of a long-standing problem.)
Our other authors share in this perception of the loss of trustworthiness. Morris writes about “the consistent failure of profit-making entities as statutory fiduciaries,” and says that “the securities laws assume that lawyers, accountants, and credit raters will not allow monetary incentives to override their professional ethics – an assumption that draws little support from the abysmal recent record.” He mentions that the appraisers who were important to property lending were corrupted: “Tracking appraiser performance pressured appraisers to conform their values to a bank’s mortgage targets.” We should notice that what he has been doing is to name various of the economy’s “gatekeepers” as among those who have defaulted. Bogle adds to the list when he tells of the “62,000 who hold the designation ‘chartered financial analyst’” and says that “these independent analysts apparently succumbed to the mania as well… As money poured into the funds they managed, they were well compensated….” As to American politicians, he says “too many of our elected officials abdicated their public duty,” blocking reforms in response to political contributions and to “the fierce lobbying efforts of corporate
.” And he faults corporate directors, saying that they were actually “primarily to blame.” America
This matter of trust raises a question that goes to the heart of free-market theory. Adam Smith argued that if economic actors pursued their own self-interest, an invisible hand would lead them, in doing so, to serve the public good. This has long seemed to be a major advantage of a capitalistic system over a socialist one: self-interest is a much more effective motivator than a collectivist system’s continuing exhortations to individuals to serve whatever public purposes the particular system considers valuable. People seem to be obdurately resistant to exhortation, a human quality that frustrates idealists of all sorts. But one of the reminders from recent experience is that for everyone to be at all times to the fullest extent self-regarding, in the many ways we have described in this article, leads to disaster. What we see is that the pursuit of gain needs to be tempered by an inbred, acculturated sense of values. These values must include respect for others and adherence to a set of obligations: honesty, a conscientious regard by each actor about whether he is rendering genuine value (referred to in the labor context as “an honest day’s pay for an honest day’s work”) – what Bogle calls “trustworthiness” and “stewardship.” It is often forgotten that Adam Smith was fully conscious of this, as we see from his book The Theory of Moral Sentiments. The need to temper self-interest takes away the pure black-and-white polarity, and means that a free society must be informed by much that idealists value.
There are even further implications. Free-market advocates have felt strongly that private companies, competing against each other to attract customers, are something solid to rely upon – much more reliable than most government operations with their bureaucracy and politics. That faith in the private sector is an essential part of a “free society” as Americans have known it. But it is now under a cloud. We see this nowhere better than in the health field, where it becomes difficult to have implicit confidence that the private health insurance companies will by themselves be faithful servants of the public good. Only through a renewal of Bogle’s “trustworthiness” can the confidence in the private sector be restored.
4. The atmosphere has lent itself to a number of abuses beyond those we have mentioned. Bogle, who has long championed “index” mutual funds for their low fees and superior performance (in comparison to the many funds that would seem to be exercising professional judgment in picking stocks but rarely even do as well as the stock market index they’ve selected as a benchmark), describes in detail how most of the mutual fund industry skims returns from the millions of investors who entrust as much as $8 trillion to them. He speaks of “the huge returns earned by fund management companies regardless of whether fund shareholders are making any money,” and adds that “I have seen no defense of the inadequate returns delivered by mutual funds to investors.” He quotes with favor a statement by U.S. Sen. Peter G. Fitzgerald (R-Ill.) in 2003: “The mutual fund industry is now the world’s largest skimming operation – a $7 trillion [now $8 trillion, according to Bogle] trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation’s… savings.”
None of our authors (who are by no means anti-capitalist) embraces the commonly-heard ideological rationalization that “any amount of profit is acceptable in a capitalistic system.” They all condemn what they see as “obscene compensation.” Bogle tells of “the billion-dollar-plus annual paychecks that top hedge fund managers draw” and refers to “the obscene (there is no other word for it) compensation paid to the chief executive officers of our nation’s publicly held corporations – including failed CEOs, often even as they are being pushed out the door.” He mentions a startling fact: that “it’s hard to see that the CEOs of our great corporations, as a group, have added much value to the natural growth of our economy,” pointing out that over the preceding 25 years “CEO compensation rose at a rate of 8.5 percent annually” while “in real terms, aggregate corporate profits grew at an annual rate of just 2.9 percent, compared to 3.1 percent for our nation’s economy.”
Morris cites an example: “Stan Oneal, ousted as CEO of Merrill, was paid more than $200 million from 2006 through the fall of 2007.” He adds this about the compensation received by financiers: “Nine-figure compensation packages for bankers – and billion-dollar paydays for takeover artists and hedge fund managers – became routine in the 2000s.” Daniel Gross tells of private equity funds that “take control of a company, have it issue $500 million in bonds, and use the cash to pay the new owners a $500 million dividend.” He points to a mentality that has infuriated the public (the members of which, however, as with so many things, seem impotent to do much about it): that during the bailout, “Wall Street firms, which had literally become wards of the state, were unable to understand why they should reduce bonuses.”
Another abuse was the decline in lending standards. I lectured to real estate brokers for a number of years, and was later dumbfounded when I learned that the standards that had so long been conventional had been abandoned. The Community Reinvestment Act was passed during the Carter administration, and “required banks to lend to the poor communities in which they took deposits.” There was much “civil rights” pressure against the ostensible abuse called “redlining,” which referred to lenders’ (and insurance companies’) blocking off of certain parts of a city that they would not do business in. Anti-discrimination law made such companies vulnerable to punishing litigation if they didn’t comply. This meant that stern realities (such as I once saw in a burnt-out, post-riot section of St. Louis when I went there to interview a basketball player’s mother as part of a university investigation of possible NCAA violations) had to be overridden. One way to think of it is that there was an unfunded mandate for the companies to take extraordinary risks that they would not otherwise have taken.
Because of this, the frantic push for commissions, and the absence of regulatory oversight, the home-lending industry moved into an era of “collapsed borrowing standards, leaving the housing financing market with absolutely no margin of safety,” according to Barbera. The phenomenon was by no means limited to subprime mortgage lending in the housing market. We see it, too, in the broader area of finance when Gross tells us that “as private equity firms started to do larger deals [buying up businesses], banks competed for their business by lowering standards.”
Anti-regulatory ideology (to which anti-discrimination laws remained an exception) prevailed and was basic to the thinking of the chairman of the U.S. Federal Reserve, Alan Greenspan. Morris speaks of “Greenspan’s resolute insistence on focusing only on consumer price inflation, while ignoring signs of rampant inflation in the price of assets, especially houses and bonds of all kinds.” This lack of concern for “bubbles” and, every bit as importantly, for systemic risk carried with it an indifference to the abandonment of lending standards. It meant, too, a failure to pay attention to the financial architecture with its opaque securities and far-over-extended leverage.
Nonbank lenders and off-balance-sheet entities came to the fore. Gross speaks of “a new class of Cheap Money businesses: lightly regulated nonbank lenders who could borrow money in the capital markets, rather than from depositors, lend to whomever they saw fit, and then sell the mortgages as bonds.” Morris follows up on this by pointing out that “since loans are held only long enough to repackage and sell them… the pressure is to increase volumes by increasing leverage.”
Morris gives us a description of the off-balance sheet entities: “Big banks, especially Citigroup,… held hundreds of billions of long-term loans in mysterious off-balance sheet entities called SIVs [“structured investment vehicles”] that they financed in the short-term commercial paper market.” He says they were “run within – but legally separate from – the major money center banks.” The entities were “typically
limited partnerships.”  Cayman Island
Absence of appropriate and effective regulation. Each of the dangers and abuses recounted by our authors testifies, in effect, to a lack of suitable regulation to establish “rules of the game” that would assure a sound system.
Partly this was caused by ideational deficiencies:
Anti-regulatory ideology became the conventional wisdom. Morris says “the watershed presidential election of 1980 brought free-market ‘
’ ideology to Chicago School ” (although we should recall that the movements toward privatization and deregulation had started well before the election of Reagan, even though that election brought them to a crescendo). Washington
He points out that in 1995, Greenspan “argued against margin – or minimum capital – rules on derivative positions.” In Greenspan’s thinking, markets would police themselves. The Fed chairman argued that “market pricing and counterparty surveillance can be expected to do most of the job of sustaining safety and soundness.” This reminds us that the animus against regulation was part of a larger body of thought. This placed abiding faith in the self-automating ability of markets. Beyond that, it accepted an over-simplified free-market philosophy that was not fully adequate to meet a free society’s needs – in that it failed to appreciate that a market economy requires an elaborate skeleton of laws, ethics and institutions.
thinking had long been hostile to anti-trust laws, including limits on the size of business entities. It should come as no surprise that some entities became “too large [to be permitted] to fail.” They had grown to such size that their failure would bring down not just themselves, but the economy as a whole. Chicago School
We have seen how the collapse of lending standards arose out of a combination of anti-regulatory and Civil Rights ideology.
The use of essentially naïve computer models has to be attributed to conceptual deficiencies of a different sort. There is a tendency for much modern thought to proceed in lock-step, with reductionist over-simplification and a hubris that insists that the over-simplified models tell the whole story.
Another ideational factor was the change in thinking by monetary authorities away from a concern about the volume and velocity of money. This lent itself to “easy money” policies in national economies, leading to “bubbles” – and, perhaps much more significantly, created the bland acceptance of international credit expansion to the point at which, as we have seen, “hundreds of trillions of dollars” came into existence.
It is a mistake, however, to think that misdirected ideas have been alone in causing the catastrophe. The ideological factors behind the collapse of lending standards, for example, were accompanied by the cupidity that drove both borrowers and lenders to take advantage of the standards’ removal with an attitude of “damn the torpedoes, full speed ahead.”. No one’s philosophy dictated the washing-away of ethical and professional standards among the many “gatekeepers” – corporate directors, accountants, lawyers, financial consultants, credit rating agencies, and the like. Nor did philosophy drive the clever sophisticates of the financial world to create and then indulge in the drive toward ever-more elaborate securities and derivatives.
The marriage of the American political and governmental system with lobbyists from Big Money and a raft of other pressure groups militates strongly against a disinterested, rationalized system of controls. When legislators and administrators move from their positions into lobbying, where they receive extraordinary compensation, and then back again into government in a perpetual game of musical chairs, personal gain rather than principled thinking takes center stage. Policy, even ideas, are driven by the contending interests. This is not to say that a democratic system, even at its best, will not need to hear from and work out compromises among existing interests; but there is a necessary line between a process in which “public servants” are stewards of the public good, and one driven by each individual’s pursuit of maximum personal gain. Thus, the problems of character that pervade so much of American life, including but not limited to the business and political worlds, are central to the crisis and are not themselves due to inappropriate ideas.
Still further, the existence of sensible controls doesn’t prevent economic actors and their lawyers from engaging in a perpetual quest to find ways around them. Daniel Gross is perceptive when he says: “Define a practice as regulated or proscribed, and a lawyer will craft a new practice that allows companies to do essentially the same thing.” He cites the example that “after Congress struck a blow against excessive executive pay in the early 1990s by limiting the [tax] deductibility of salaries greater than $1 million, companies dispensed stock options by the gazillions.”
Looming large as a non-ideational factor is the enormous growth in scale of the global financial system. The scale is beyond the capacity of central banks to manage. It is also combined with a breaking-free from national constraints. In a globalized market, many actors have transcended national ties and loyalties. The world community has been far short of having a system of international controls, although it is working toward one in the aftermath of the present credit crisis. Even remedial measures, once calamity has struck, are lacking, as Smick tells us when he says that “the world today lacks a financial doctrine, or even much in the way of a set of informal understandings, for establishing order in a financial crisis.”
Even if such controls were agreed upon and effectively administered, the problem of a possible international “herd-effect,” with vast simultaneous tidal-waves of capital battering existing economies and currencies, would to a large extent remain a source of unfathomable systemic risk. One can well imagine the amount of resistance that any attempt to “reduce the scale” of global finance to manageable markets will run into.
Our authors have many reforms to suggest, although we can admire the candor Morris exemplifies when he, one of our experts, admits that “I don’t pretend to know how to start.” The knot is too tangled with human failings to lend itself to solutions, much less easy ones. Nevertheless, here are some of the measures the authors recommend:
1. As to improving the transparency of executive compensation, Bogle believes that “all types of stock options should be treated as corporate expense.”
2. Bogle would have large corporations adopt a practice of separating the CEO position from that of Chair of the Board. He would like to see boards much more independent, making judgments on their own. This would be enhanced, he says, if boards had staffs under their own direction. Speaking especially of mutual funds, he says “we need a board wholly independent of the manager.” Further, the nominating/governance committee “should be independent of management.”
3. As a example of what is needed to cause the economy’s “gatekeepers” to function as they should, Bogle would like to see a strengthening of the standards requiring auditors to be rotated. Much needs to be done to assure the professionalism of accountants, the independence of appraisers, the client-serving orientation of financial consultants, the proper restraint of mortgage brokers, and the mentality lawyers bring to the task of serving their clients. It is obvious that “more rules” will only partly be effective in the absence of a change in spirit.
4. Barbera wants the problem of systemic risk addressed. “The overarching theme of regulatory reform has to be about instituting rules that create safety margins for the myriad nonbank financiers….” Moreover, monetary authorities must stop ignoring financial markets and the viability of the processes within them. He calls for making finance simpler, more transparent.  Morris wants a return to the “
I” way of calculating leverage, arguing that “Basel II’s” use of “model-based ‘value at risk’ analyses” has “been cataclysmic.” He says, too, that it is just as important to make “bank balance sheets… utterly transparent,” revealing all types of retained risk. Basel
5. Since Barbera concludes that “it is not possible to regulate hedge funds and private equity funds effectively – they can be domiciled in
if they choose.” Because of this, he feels “the important object is to wall them off from the depositary banks and the payments system.” He argues that “restrictions on bank lending to [such] highly leveraged entities would close off those infection channels.” Madagascar
6. Morris argues that there is need for “limits on the size of non-regulated entities, to head off the ‘too big to fail’ syndrome.” He admonishes that “an ‘entity’ should be defined by control parties rather than legal structure.” The plan announced by the Obama administration in the United States in a “financial white paper” in June 2009 calls, according to The Economist, for making “the Fed directly responsible for the supervision of all firms deemed too big to fail.”
7. We would have liked for Morris to have written much more specifically about what he thinks should be done about the proliferation of types of securities, “collateralized debt obligations” (CDOs), “credit default swaps” (CDSs), and the like. Perhaps Daniel Gross provides the answer: he calls for the creation of a “stabilization fund” as “bubble insurance.” It would be supported by “a tax on securities trading and the creation and trading of structured financial products.” He sees such a tax as a way to cause less securitization: “As the free-market economists say: If you want less of something, tax it.” In this connection, it’s worth noting that Morris would limit the trading of “immature instruments, like credit default swaps,” to “exchange-traded, standardized, paper.”
8. In an article about the response to the September 2008 crisis in money-market-funds, The Economist says that on
June 24, 2009, the U.S. Securities and Exchange Commission proposed rule changes whereby money-market-funds “would be required to hold up to 10% of their assets in cash or bonds that can be sold within a day so that they can more easily meet redemptions.” The average maturity of the funds’ portfolios would be shortened “to reduce interest-rate risk”; and funds would be empowered to “suspend withdrawals… to allow for more orderly liquidation.”
9. The Economist considers it a “glaring shortcoming” that the new consumer-protection agency called for by the Obama white paper will “provide little enforcement over thousands of state-regulated finance companies and loan brokers.” It says those are the companies that were mainly responsible for “a large share of toxic mortgages and abusive loans.”
and the world financial community are deeply involved in grappling with the need for reforms. The list just given is no doubt more indicative than exhaustive. United States
One point in particular remains puzzling. David Smick seems clear and emphatic when he tells us that the volume of subprime mortgages originated in the United States was not itself a vast problem, amounting “to, at worst, $200 billion in exposure in a global market worth hundreds of trillions.” The problem, he says, is that the problems of obscurantist manipulation within the financial world created a “world-wide distrust of the asset-backed securities market.” After securitization had “divided the total sum into many smaller portions, and sold these pieces to financial institutions throughout
Europeand Asia,” the critical problem was one of “information, or the lack of it.” “The issue was not the size of the subprime mess… The issue was where the toxic waste was located.” Further: “The panic unfolded precisely because suddenly nobody could say which financial institutions held the subprime toxic waste.” Morris agrees with this, saying that “what makes it [the existence of subprime mortgages] so important, and so devastating, is not its absolute size, but the way lower-quality mortgages have marbled their way through the entire world’s credit system – and they are just one of several big, and very shaky, asset classes to have done so.”
If this is so, why did then-U.S. Treasury Secretary Henry Paulson initially think in the fall of 2008 that a solution would be to “buy up the toxic assets”? Did he not understand what the financial world in general perceived, which was that the problem was precisely that the toxic assets couldn’t be identified? And why had not the segmentation of securities through the “tranching” process made it clear what tranches were sound and which ones were far riskier? After all, Morris tells us that “the top tranches had first claim on cash flows” and “qualified for the highest investment-grade ratings,” while “the bottom tranches absorbed all initial defaults but paid high yields.” Were not the lower tranches “the toxic assets”? The answer must lie in the “opaqueness” of the resulting securities, but it is puzzling why they were somehow allowed to be opaque.
Our authors cover a lot of ground despite limiting themselves to the credit crisis. Their discussion is not the same thing, though, as a comprehensive overview of the challenges faced by the American and global economies. They don’t discuss the deindustrialization of the United States; the flood of low-cost imports accompanied by unprecedented trade imbalances; the actual and potential impact of the scientific/technical revolution; the role of low-cost imports, cheap-labor immigration, and outsourcing in keeping consumer-good prices and wages down, serving as cover for a long period of “easy money” central bank policy; and a number of other facets of a complete analysis. To point this out is not to fault the books reviewed here, but simply to say that there is much more to consider.
As mentioned earlier, another wave of books is to be expected soon that will tell how the crisis unfolded and how the world managed (if it did) to swim to shore from such an ocean of defaulted-upon risk.
 . Wikipedia says the tulip mania “is generally considered the first recorded speculative bubble.” It reached its height in
in early 1637, at which time “contracts [for tulip bulbs] sold for more than 10 times the annual income of a skilled craftsman.” The bubble collapsed when people finally realized that the price of tulip bulbs would not continue to go up indefinitely. Holland
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July 18, 2009, p. 11.
 . Richard Barnet and John Cavanagh, “Electronic Money and the Casino Economy,” in The Case Against the Global Economy and For a Turn Toward the Local (San Francisco: Sierra Club Books, 1996), p. 373.
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: Free Press, 2009), pp. 31, 51. New York
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 . Charles R. Morris, The Two Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash (
: Public Affairs, 2008). New York
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for the Soul of Capitalism ( Battle : New Haven Press, 2005), pp. 77, 79. Yale University
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