Shiller: Against Market Fundamentalism

Far too often, debates devolve into black-and-white affairs, with strawmen on both sides taking a pummeling. Robert Shiller's latest piece in the Wall Street Journal takes on this type of Manichean thinking, as he adopts the Herculean task of convincing economic conservatives that not all financial regulation is bad. From the WSJ:

The principal long-term result of the current financial crisis should be improved financial regulation. After the immediate crisis is over, we need to restructure our fragmented system. This process will take years to complete since, if properly done, it should get at the heart of the regulatory structure.

This is not as radical as it sounds, for while many observers equate U.S.-style capitalism with unconstrained free markets, the story is more complicated. Americans have long understood that for the economy to work well, government must play an important supporting role. They've also long understood the important role that self-regulatory organizations (SROs), such as trade associations and exchanges, play in cooperation with government regulation.

An understanding of animal spirits -- the human psychology and culture at the heart of economic activity -- confirms the need for restoring the role of regulators as guiding hands in a healthy, productive free-enterprise system. History -- including recent history -- shows that without regulation, animal spirits will drive economic activity to extremes....

Such a world of animal spirits justifies the economic intervention of government. Its role is not to harness animal spirits but really to set them free, to allow them to be maximally creative. A brilliant player wants a referee, for only when the game has appropriate rules can he really show his talents. While the sports of baseball and football haven't changed much in the last century, the economy has -- and American financial regulation hasn't had an overhaul in 70 years. The challenge for the Obama administration, along with the U.S. Congress and our SROs, is to invent a new and better American version of the capitalist game.

You might think this is an uncontroversial point. Unfortunately, it is not. What was that about Dark Ages again?

Boring is the New Sexy In Banking

It's back to the future in the banking world - that is, if our policymakers are serious about reforming our financial system. The myth that financial "innovation" cannot be stifled, lest the economy stagnate, has now been laid to rest. Financial "innovation" merely allowed bankers to take and spread risks they did not understand, perform regulatory arbitrage, and justify their exorbitant salaries. Paul Krugman and Simon Johnson both make the case that we should end the era of free-for-all casino capitalism, and move back to the type of more stable, boring banking system we had during the postwar period up till 1980. From Krugman:

Before 1930, banking was an exciting industry featuring a number of larger-than-life figures, who built giant financial empires (some of which later turned out to have been based on fraud). This highflying finance sector presided over a rapid increase in debt: Household debt as a percentage of G.D.P. almost doubled between World War I and 1929.

During this first era of high finance, bankers were, on average, paid much more than their counterparts in other industries. But finance lost its glamour when the banking system collapsed during the Great Depression.

The banking industry that emerged from that collapse was tightly regulated, far less colorful than it had been before the Depression, and far less lucrative for those who ran it. Banking became boring, partly because bankers were so conservative about lending: Household debt, which had fallen sharply as a percentage of G.D.P. during the Depression and World War II, stayed far below pre-1930s levels.

Strange to say, this era of boring banking was also an era of spectacular economic progress for most Americans.

After 1980, however, as the political winds shifted, many of the regulations on banks were lifted — and banking became exciting again. Debt began rising rapidly, eventually reaching just about the same level relative to G.D.P. as in 1929. And the financial industry exploded in size. By the middle of this decade, it accounted for a third of corporate profits.

As these changes took place, finance again became a high-paying career — spectacularly high-paying for those who built new financial empires. Indeed, soaring incomes in finance played a large role in creating America’s second Gilded Age....

But my sense is that policy makers are still thinking mainly about rearranging the boxes on the bank supervisory organization chart. They’re not at all ready to do what needs to be done — which is to make banking boring again.

Part of the problem is that boring banking would mean poorer bankers, and the financial industry still has a lot of friends in high places. But it’s also a matter of ideology: Despite everything that has happened, most people in positions of power still associate fancy finance with economic progress.

Can they be persuaded otherwise? Will we find the will to pursue serious financial reform? If not, the current crisis won’t be a one-time event; it will be the shape of things to come.

Simon Johnson strikes a similar note, calling on policymakers to

make banks smaller, less powerful, and much more boring.

Using antitrust laws to break up too-big-to-fail banks into smaller parts, and re-instituting Glass Steagall and the division between commercial banking, which exists as a public utility, and investment banking, which takes on riskier enterprises underwriting securities, would be a good start. Unfortunately, Geithner and Summers seem too enamored with Wall Street to enact these reforms. We can only hope that more politicians can muster the common sense and historical humility that Senator Byron Dorgan did a decade ago, in condemning the repeal of Glass Steagall and deregulatory mania in general as an inevitable step towards a new crash.

Sanity From the Wall Street Journal?

We're not in Kansas anymore. Someone aside from a token liberal is making sense in the Wall Street Journal's opinion pages. Hedge funder Paul Singer takes to Fox News Dead Tree Version, opining that

While many of Mr. Obama's ideas warrant skepticism, conservative opposition to any expanded role for government is a mistake. There is an urgent need for a new global regulatory initiative that addresses the primary cause of the financial collapse: highly leveraged and concentrated positions.

Reform must begin with a regulatory regime focused on "behavior" instead of "systemically important institutions." Today, even small entities that trade complex instruments or are granted sufficient leverage can threaten the global financial system.

It's true that monetary policy was too lax for too long, and the government encouraged lending to people who were unlikely to repay their loans. But this crisis was primarily caused by managements and individuals throughout the financial system who exercised extremely poor judgment. The private sector, not the public sector, is where the biggest mistakes were made.

How did this get by the Journal's editors? No mention of the CRA? Or Fannie and Freddie? And an acknowledgement that crazy levels of leverage, non-existent risk management, and perverse short-term bonus incentives were the key factors in this crisis - it's so...reality-based. What's next, admitting that this is the greatest financial crisis since the Great Depression? Maybe not - but we can hope.