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Sunday, October 12, 2008

Rodrik: Who Killed Wall Street?

What caused the financial crisis and can we stop it from happening again?:

Who Killed Wall Street?, by Dani Rodrik, Project Syndicate: ...[L]et's remind ourselves how compelling the logic of the financial innovation that led us to our current predicament seemed not too long ago.

Who wouldn't want credit markets to serve the cause of home ownership? So we start by introducing some real competition into ... mortgage lending... We allow non-banks to make home loans and let them offer creative, more affordable mortgages to prospective homeowners not well served by conventional lenders.

Then we enable these loans to be pooled and packaged into securities that can be sold to investors, reducing risk in the process. ... We then call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in. In case anyone is still nervous, we create derivatives that allow investors to purchase insurance against default by issuers of those securities.

If you wanted to showcase the benefits of financial innovation, you could not have come up with better arrangements. Thanks to them, millions of ... hitherto excluded families became homeowners, investors made high returns, and financial intermediaries pocketed the fees and commissions.

It might have worked like a dream ― and until about a year and a half ago, many financiers, economists, and policymakers thought that it did. Then it all came crashing down. ...

But where did it all go wrong? If our remedies do not target the true underlying sources of the crisis, our newfound regulatory zeal might end up killing useful sorts of financial innovation, along with the toxic kind.

The trouble is that there is no shortage of suspects. Was the problem unscrupulous mortgage lenders who ... led unsuspecting borrowers into a debt trap? ... [M]aybe the culprit is the housing bubble that developed in the late 1990s, and the reluctance of Alan Greenspan's Federal Reserve to deflate it. ... [Would] the crisis ... have reached the scale that it did without financial institutions of all types leveraging themselves to the hilt... But what, then, were the credit rating agencies doing? ... Isn't this the crux of the matter?

Or perhaps the true culprits ...[are] Asian households and dollar-hoarding foreign central banks produced a global savings "glut," ... stoking the U.S. housing bubble while sending financiers on ever-riskier ventures with borrowed money.

Macroeconomic policymakers could have gotten their act together and acted in time to unwind those large and unsustainable current-account imbalances. Then there would not have been so much liquidity sloshing around waiting for an accident to happen.

But perhaps what really got us into the mess is that the U.S. Treasury played its hand poorly as the crisis unfolded. ...[W]hat caused credit markets to seize up was Treasury Secretary Henry Paulson's refusal to bail out Lehman Brothers. Immediately after that decision, ... the entire financial system simply became dysfunctional. ...

Perhaps it is futile to look for the single cause... A comforting thought ― if you still want to believe in financial sanity ― is that this was a case of a "perfect storm," a rare failure that required a large number of stars to be in alignment simultaneously.

So what will the post-mortem on Wall Street show? That it was a case of suicide? Murder? Accidental death? Or was it a rare instance of generalized organ failure? We will likely never know. The regulations and precautions that lawmakers will enact to prevent its recurrence will therefore necessarily remain blunt and of uncertain effectiveness.

That is why you can be sure that we will have another major financial crisis sometime in the future, once this one has disappeared into the recesses of our memory. You can bet your life savings on it. In fact, you probably will.

    Posted by on Sunday, October 12, 2008 at 12:15 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (36)

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