Unrestrained capitalism leads to reckless behavior for the benefit of the few at the expense of the many. That is what we are witnessing now. Capital standards only go so far. What is needed is more daylight in the system. Skyrocketing oil prices can be traced to exemptions in the CFTC rules for oil trading, for example. Hidden manipulation of markets is threatening world stability. We need to move quickly to circumscribe these excesses
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JUDGMENT CALLS
Robert J. Samuelson
High Finance Laid Low
It has a split personality: what is productive most of the time can also lead to destructive spasms of greed and herd behavior.
From the magazine issue dated Apr 14, 2008
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Except for oil executives, no group of business leaders is now more resented than the titans of finance—the heads of banks, securities dealers, hedge funds. It is these folks who are blamed for causing or aggravating the housing crisis that in turn has plunged global financial markets into turmoil and has brought the U.S. economy to the edge of recession or perhaps beyond. The sweeping indictment may seem overdrawn. It isn't. Yet it is only half the story of modern finance, whose basic job is to allocate Americans' nearly $2 trillion of annual savings into the most productive uses for individuals and society.
The paradox of finance is that its advantages and disadvantages are tightly commingled. What we call "financial services"—insurance and real estate, as well as banking and securities trading—has been a growth sector. In 1976, it was 15 percent of gross domestic product; now it's 21 percent. The expansion has produced many benefits: more and often cheaper credit for families and businesses; more investment choices for people saving for retirement and anything else; more investment capital for start-ups and smaller firms. Unfortunately, financial advances have also created periodic episodes of massive waste that threaten to destabilize the entire economy.
The subprime-mortgage debacle is not a rare exception. Before that, there was the tech bubble of the late 1990s when stock valuations floated into La-la Land and anyone with a business plan ending with .com could get money from venture capitalists. (From 1997 to 2000, the annual amount of American venture capital raised jumped from $18 billion to $107 billion.) Earlier, the junk-bond mania of the late 1980s ended badly. According to finance professor Josh Lerner of the Harvard Business School, there seems to be a regular cycle of financial innovation (good), imitation (good up to a point, because it provides competition) and finally suicidal excess. Herd psychology reigns: investors assume that whatever made money yesterday will make money today.
The idea that enlightened government regulation can outlaw this cycle is at best an optimistic exaggeration. Just last week, in a major report, Treasury Secretary Henry Paulson proposed a new framework of government oversight for the financial system. Some ideas are worth adopting: merging the Securities and Exchange Commission and the Commodity Futures Trading Commission; expanding the Federal Reserve's powers. But the basic problem is that as long as people are benefiting from innovation and investors are making money, it's hard to impose restraints on the excesses. Only a crackup brings clarity.
In 2005, foreclosures on subprime mortgages totaled a modest 3.4 percent. Warnings about abusive and reckless lending practices went unheeded, as overpaid Wall Street investment bankers stuffed the mortgages into ever more complicated securities. In the disastrous aftermath—the foreclosure rate is now nearly 9 percent and rising—it's easy to forget the brighter side of financial innovation.
Consider mortgages. In 1980, they came in one flavor: 30-year fixed-rate loans. Because fees and closing costs were so high, it was hard to refinance into a cheaper loan even if interest rates fell. The rule of thumb was that rates had to drop 2 percentage points before refinancing made sense. Now homeowners can chose from many mortgages with different maturities, as well as fixed and floating rates. Lower fees and transaction costs (from automated underwriting, among other things) make refinancing attractive if interest rates drop 0.5 percentage points or even less.
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