A New Age Of Global Capitalism Starts Now

Indeed, the past twenty years of deregulation and financial liberalization set the stage for an era in which bank leverage ratios reached such nose-bleed heights as 33 to 1 for Morgan and 28 to 1 for Goldman Sachs and Merrill Lynch as these and other global financial giants wielded growing numbers of complex securities like mortgage-backed derivatives to boost their profits to record highs. Now, as such banks are more tightly regulated, their leverage will decrease, and with it, so will their profits. That's bad news not just for banks, but for the economy as a whole—over the past few years, financial firms have represented around a quarter of all corporate profits in the United States. Their shrinkage will take a significant chunk out of the country's national income.

Yet the riches were borne out of a system that had become so complex and opaque that many of the people doing the deals in the end had no idea about the value of the assets they were holding. "What ultimately needs to come out of this crisis is more judicious management of capital, more transparent financial instruments and institutions, and as a result, a system that is better aligned with the real economy that it was designed to serve in the first place," says Stephen Roach, chairman of Morgan Stanley Asia. "Finance has simply moved too far from its moorings in the real economy."

It didn't happen overnight. From the late 1970s onward, a slew of legal and technological changes unshackled the growth and earning potential of financial institutions—pension funds were allowed to start investing their portfolios in the stock markets, brokers were able to start offering mutual funds to individuals, different types of banks were allowed to merge and enter new areas of business, automatic teller machines and trading software created a 24/7 electronic finance network. From the 1970s to 2005, the percentage of Americans owning stock rose from 16 percent to more than 50 percent. As former Clinton labor secretary Robert Reich notes in his book "Supercapitalism," there was a profound change in the economic psychology of Americans. "Savers turned into investors, and investors turned active."

Driving it all were the investment bankers, who, in the post-Volcker era of low inflation, were looking for new ways to make double-digit returns. Financial innovation burgeoned, helped along by market-friendly politicians, mostly notably Ronald Reagan and Margaret Thatcher. There were bubbles and blips along the way—remember the S&L crisis of the 1980s? But they were quickly forgotten as growing prosperity continued to ensure that a "market knows best" philosophy reigned. Throughout the 1990s, the deregulation continued, one of the high points being the repeal of the Glass-Steagall Act that separated commercial and investment banking.

Banks took advantage of the subsequent economies of scale (and, say some, conflicts of interest) to grow even bigger, doing more and more highly profitable megamergers and underwriting ever-ballooning IPOs. The repeal of the act allowed retail banks like Citigroup and others to get into the hot new credit-derivative markets (which included products like mortgage-backed securities and CDOs, which represent the spliced and diced debt of many entities, and are at the heart of the current crisis). Investment bankers themselves became cigar-smoking, suspender-wearing Croesian archetypes immortalized in numerous books and films of the period. The rise of stock options throughout the decade further increased their wealth (along with that of the corporate executives they serviced) while at the same time making it more difficult to quantify the exact numbers. Most everyone now believes the two trends together created a toxic mix. "By allowing even commercial banks into this riskier territory, and encouraging stock options as pay, you had an increasingly short-sighted focus on immediate profits," says Nobel laureate Joseph Stiglitz. "It created a culture of gambling."

Of course, the economy had turned by 2001, making things a bit tougher at the roulette table, but thanks to lower and lower interest rates (the Federal Reserve, under Alan Greenspan, cut rates to 1 percent in 2003) easy money continued to flow. The decline in rates also had the effect of exploding the market for credit derivatives, those spliced and diced securities that are at the heart of the current crisis, as bankers looked for ways to boost returns in a low-interest environment. Between 2000 and its peak last summer, the market for credit default swaps, the main type of credit derivative, went from $100 billion to $62 trillion. While sages like Warren Buffett (who memorably called derivatives "financial weapons of mass destruction") and institutions like the Bank for International Settlements expressed concern, others like Greenspan insisted that they played an important role in spreading risk.