Some Clear Thinking on the Financial Mess from Norris and Krugman

I read both of these columns in last Friday’s edition of the New York Times.  It’s the end of a historic year for the U.S. economy.  We may look back in a few years and say that 2008 was the beginning of the end for supply-side economics (trickle down) and a nearly wholly unregulated financial services system.  2008 will hopefully become known as the time when ordinary people got concerned enough about the price they were paying for the excesses of banks which traded stocks, brokerages which sold insurance and insurance companies which did both.  2008 was a year when ordinary folks began to understand mortgage backed securities and credit default swaps – and what the failure of those derivatives meant for their local widget makers’ line of credit.

If you don’t read anything else today, read these two columns:

• Op-Ed, Floyd Norris: A year of financial contradictions and chaos - New York Times
• Op-Ed, Paul Krugman: The Madoff Economy – The New York Times

Krugman’s column shows the Bernard Madoff Affair as a microcosm – if you can use “micro” to describe a $50 billion bilking – of the entire state of the financial services system.  An excerpt:

So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. And while Mr. Madoff was apparently a self-conscious fraud, many people on Wall Street believed their own hype. Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

Norris does an overview of just how profoundly out of balance the credit system was in 2008.  Things we thought were sure bets got turned on their heads.

In 2007, the people who ran Wall Street, and the ones who regulated it, did not understand how serious the financial crisis was becoming. They saw the primary problem as one of a housing slowdown caused by a subprime mortgage crisis, and assumed the securitization machine — which had come to finance everything from corporate loans to credit cards to student loans — would keep on ticking even if its mortgage factory could keep operating only with the government guaranteeing almost everything.

In 2008, the government effectively nationalized Fannie Mae, Freddie Mac and the American International Group, and it bailed out those who had lent to Bear Stearns. It let Lehman Brothers fail, briefly reassuring market ideologues but terrifying many market participants, and the rout was on.

The securitization machine ground to a halt, and the banking industry was in no position to assume its historical role as a lender that patiently waited for loans to be repaid. To the contrary, banks trusted neither their own balance sheets nor those of other banks. For a significant part of the economy, the government became the lender of first and only resort.

For most of 2008, the Federal Reserve and the Treasury failed to realize that the banking system faced a solvency crisis rather than a liquidity crisis. Liquidity-providing moves proved ineffectual because no one had confidence in the values of enormous amounts of derivatives and securitizations that the banks owned.

“No financial market can function normally when basic information about the solvency of market participants is lacking,” wrote Michael D. Bordo, a Rutgers economist.

Trust and transparency – these are primary factors in any long-term, healthy relationship among people.  They also help people who aren’t so inter-personally involved exist in healthy business relationships.  Norris and Krugman nail the importance of these two principles to our financial system.  Barack Obama has a big job ahead of him to restore trust and transparency to finance and politics.  I can hardly wait for 2009.