Global Policy Forum

From Credit Mess, Lessons About Government


By David Wessel

Wall Street Journal
November 8, 2007

As redwoods topple in the Wall Street forest -- Chuck Prince of Citigroup, Stan O'Neal of Merrill Lynch -- we're learning a lot about the business of modern finance. Or, more precisely, we're relearning a lot of old lessons: If you don't understand it, don't buy it. Trust, but verify. What are we learning about the role of government?

Ditch the cliché that government should be run more like a business.

It's too flattering to business. It would be great if government were as efficient and agile as the most nimble companies. Heck, it would be great if most businesses were as efficient and agile as the best companies. But the past few weeks are a reminder that a big title at a big-name company is no guarantee of smart, savvy management. Government doesn't have a monopoly on incompetence, imprudence or short-sightedness.

Only government can protect the most vulnerable consumer.

A lot of sophisticated lenders and borrowers gambled and lost. Government can't and probably shouldn't protect them from themselves. But, as late U.S. Federal Reserve governor Edward Gramlich argued, the Fed didn't use all the power it had to expand consumer-protection rules to mortgage lenders outside traditional banks. Some mortgages shouldn't be made. Some people are better off renting, not owning houses. Mortgage brokers should have at least some responsibility -- stockbrokers do -- to assess whether a loan is suitable for a customer's circumstances.

The Fed is neither irrelevant nor impotent.

It has become fashionable to argue that the Fed has lost its mojo and has been overwhelmed by the growth of global financial markets and the rise of economies outside the U.S. But the Fed is blamed for (a) keeping credit too easy for too long and causing an unsustainable borrowing and housing boom (and there's some merit to that case); (b) not acting quickly enough to respond to the housing bust; and (c) moving too swiftly to rescue beleaguered banks. The fact is that central banks still do matter, and the Fed matters more than any other. At times of financial panic, the value of having a wise central bank becomes clear. It just did, again.

Allowing the financial engineers to disperse risks has downsides as well as upsides.

For years, Alan Greenspan and the like-minded argued that allowing Wall Street to slice and dice loans and sell the pieces as securities was an innovation that dispersed risks widely and made the financial system and economy more stable. There's a lot to that. But as loans leave the books of those who make them and are sold off in parts to different investors, no one can be sure who holds the risk. If everyone fears that the other guy has a portfolio of toxic waste, markets freeze and the rest of the economy can be hurt. That, in large part, explains the behavior of big banks in the U.S. and Europe since early August.

At some point the risks that greater opacity and complexity pose to financial stability offset the benefits of widely dispersing risks. Because what is in the clear interest of each individual player may not be in the interest of the global financial system as a whole, market players aren't likely to get this balance right without at least prodding from government.

Market discipline isn't all it was cracked up to be.

The U.S. savings-and-loan crisis of the late 1980s was made in Washington. The Tax Reform Act of 1986 whacked the real estate on which they lent. Changing rules on interest rates unhinged their business model. And more generous federal deposit insurance amounted to a government offer of heads-we-lose-tails-you-win to S&L operators. (If risky loans paid off, the operators made huge profits; if they didn't, government made the depositors whole.) Duh, the S&L crowd took the bet.

This crisis was made on Wall Street. That's not to say government doesn't share the blame. But all this occurred at a time when government regulators were in retreat. The complex financial instruments were designed and sold by Wall Street. And they were purchased by huge institutional investors that now say they blindly relied on credit-rating agencies -- which are staffed by analysts whom the big investment houses didn't consider smart enough to hire for their own staffs.

But ... regulation isn't all it's cracked up to be, either.

For months, the oft-heard worry was that hedge funds, the big, largely unregulated pools of money, would either cause or amplify the next financial crisis. But when the crisis hit, it turned out that commercial banks -- the most regulated, supervised institutions in the entire financial system -- were at the epicenter.

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