Why Financial Crises Will Keep Happening

The financial crisis currently unfolding before our eyes in slow motion was inevitable and predictable. I say this because it was predicted by numbers of people. It was obvious; anyone with sense knew it was coming (a group which apparently includes very few people); and despite the fact that we’ve known for years it was going to happen, it happened anyway.

The same was true of the dot-com bubble. The inevitability of the dot-com collapse was obvious, at least as far back as 1996/1997. Everyone knew it who wasn’t paid not to know it, and it happened anyway and burst anyway.

Both of these foreseeable collapses raises the question of deliberate government policy—both bubbles were fostered and grown from tiny soap-suds with the aid of Alan Greenspan’s Fed and various other government and private and semi-private actors (in the case of the current collapse, including Fannie Mae and Freddie Mac).

Creating the bubble behind the current financial crisis took the cooperation and encouragement of a lot of people beyond the government, people who benefited a great deal from it. Let’s take Chuck Prince, the ex-CEO of Citigroup. Prince walked away from his near-destruction of Citigroup with about $41.5 million, including a $12 million bonus for his performance. The moral of the story is: drive the place into the ground, get paid well. Then there’s Merrill Lynch’s Stan O’Neal who walked away with $160 million.

Nice work if you can get it.

But if the rot was limited to the top, it wouldn’t be nearly as big a problem.

Mortgage brokers were paid to sell what everyone knew were mortgages that probably couldn’t be repaid. Why? Because the banks knew that they were going to slice-and-dice the mortgages into Collateralized Debt Obligations (CDOs) and sell them to suckers investors. When the loans went bad they wouldn’t be on the banks’ books. It didn’t (and isn’t) quite working that way for the banks, but in a more real sense it is.

The mortgage brokers still got their commissions. The real-estate agents got their commissions. In many cases they made enough money to live on for the rest of their lives. The executives in the banks and in the Wall Street firms like Morgan Stanley, who created these CDOs, also got rich. They made millions. If they were smart and saved some of it, they will never ever have to work again.

The system did what it was supposed to do. It made the people who run the system stinking filthy rich. If you’re reading this, odds are you expect to work to 65 or so and pray that when you retire you’ll have enough money to support yourself in a style that doesn’t require you to eat cat food. You’ll work forty or forty-five years to get that retirement.

What would you do, or rather what wouldn’t you do, if you knew that by working hard for five years you’d have enough money that you need never, ever, work again for the rest of your life? Not just that, but in the case of most executives, that 5 year’s of work would make you rich. Want a house on the Riviera? Want to spend the rest of your life traveling? Have a hobby? Whatever it is, you’ll be able to indulge it, because you’ll be rich and money is freedom.

So even if, in the end, Merrill Lynch was going to be stuck with a bunch of bad debt, or Citigroup was going to have problems, why should you, the executive, give a damn? Making record profits for a few years allows you pay yourself, or to be awarded commissions and bonuses, that add up to more money than a normal person earns in 45 years.

From the perspective of self-interest you’d be a fool not to jump at the chance. And for most people, even some CEOs, even if you don’t like it, you’d still be a fool not to do it, because if you opt out, someone else will just take your place, run the scams, and reap the windfall of ill-gotten gains.

What is good for the economy, the country and for the long term health of your company is not what’s good for you. That’s a recipe for disaster for everyone, possibly even for you, if you aren’t real smart. Money is only worth what the country behind it is worth, after all. Trash your country, or your world, and you trash your own wealth.

As a result of this incentive system, if the possibility to have another financial bubble after this one crashes out is not eliminated, there will be another financial bubble. Guaranteed. There is no way to avoid it unless the economic circumstances are so bad it can’t get off the ground—which is possible, if the monetary base starts collapsing.

The answer is fairly simple, mind you. These sorts of bubbles didn’t happen in the post-war period. They didn’t happen because you couldn’t pay enough people enough to make it worth their while. After a certain amount of income, in most western countries, you got taxed at a marginal rate of over 90%. A few CEOs might be able to make it, but most of the executive suite was going to need more than 5 years–they were going to need a career.

At this point, wringing the excesses out of the system and stopping the systemic incentives to keep blowing bubbles is going to require doing something to stop it from paying. There are two parts to any solution.

The first and simplest way is to put a very progressive tax on all income no matter how or where earned that probably comes in at over 95% of all income over, say, $500,000 or a million at the most. Suddenly, needing to actually keep the companies sound, and knowing that in 7 years when the loans go bad, they’ll still be there taking the heat for it, will tend to concentrate the mind not on “can I make enough money to be in a yacht in 3 years” but into “does this deal make sense over the long run”. The second thing to do is to stop allowing people to sell risk. For years Greenspan argued that risk markets (the ability to take on, say, default risk in credit or for that matter to sell loans in CDOs) made the system stronger and actually reduced systemic risk by spreading risk around. What it did instead is take the risk away from the people who were able to manage it because they were close enough to the ground to know whether a loan was risky and give it to people who really had no clue and had to rely on bond rating agencies to tell them if the risk was acceptable. Without a loan officer in the actual district, without actual inspections of houses and businesses and without the loan officers knowing that 10 years from now if the loan goes bad some manager is going to call them into the room and ask them to justify the decisions they made, the people taking on the loans had no ability to know if they could, or would, be repaid. And the banks, since they thought they were selling the risk, mainly didn’t bother with old style vetting. Indeed banks like Citigroup have gutted the departments which used to do that sort of due diligance.The bond agencies also got paid by the people they issued ratings to. I’m sure you understand what that means for their objectivity. Nor could they, even if they had made an honest effort, duplicate the sort of vetting and checking which banks used to do routinely. They simply don’t check every mortgage and can’t.So the rule going forward has to be that if you make the loan you keep the risk on your books. You cannot load it off on other people.

There are mathematical reasons why in theory offloading risk ought to reduce systemic risk, but in the real world they generally don’t play out because of the problem of incentives:

the people with the necessary information to manage the risk have no incentive to do so;

the people who wind up with the debt do not have the ability to manage the risk;

and the third parties like bond agencies have neither the incentives nor the ability to manage the risk either.

Such a world will be a world with a much smaller, less flamboyant financial sector with much lower returns. But the idea that the financial sector could somehow make far greater returns than GDP growth and do it for decades was always insane and simply could never work. The only way to accomplish those kinds of insane returns, the only way it has in fact been done, was to cheat and to ignore system risk, use massive leverage, print money and shove it into asset bubbles and so on.

The end result has been two financial bubbles and thirty years in which the average American hasn’t had a raise and has taken on debt. A lot of people have gotten rich, mind you, and for them these last thirty years have been great, which is why there’s a bipartisan consensus amongst the people who matter in both parties to keep going what has been, for them, the best of all possible times.

Given a choice, they will keep it going. And there will be a lot more rich in America, but odds that you’ll be one of them are near zero. And when it all comes crashing down, somehow ordinary Americans, despite having never been invited to the party, will be stuck with the cleanup and the bill.

[Originally posted at FDL January 6th, 2008. Nothing has changed. More on this later.]