Hirsh: Will a Dem President Strangle Wall St.?

The British called it the "Big Bang." The deregulation revolution hit New York first in 1975, then London in 1986, creating the wild age of finance we've all grown up with. From "Barbarians at the Gate" to "Conspiracy of Fools," it was a decades-long spree of buyouts and swaps and crazy new collateralized instruments no one, in the end, could understand. Well, as we know, we finally overdosed at this seemingly endless party. Subprime mortgages were the deadly narcotic that finally did us in, and Wall Street was the drug dealer. Now, as we enter a new era of cold-turkey recession and national self-reflection, the question is: how bad will the backlash be?

Investment banking is already history. Most of the hedge-fund world is likely to follow it into oblivion, as Washington and other Western governments scurry to save their core banking sector, leaving the "nonbanks" to fend for themselves. All this reaction is, on the whole, healthy. Unchecked, Wall Street had become corrupt and profligate. But today perhaps the greatest danger is that overzealous government officials will kill the patient altogether—Wall Street, that is—by asphyxiating him with new regulations. Now that the era of Big Government seems to be back, and with the likelihood of a new Democratic president and Congress come January growing greater by the day, we need to examine whether Washington is going to overregulate and snuff the rest of the life out of American-style finance—the so-called Anglo-Saxon model—entirely.

Are we going to end up like Japan, in other words, a nether world of "zombie banks" that are not dead but not really alive either, still unable to work their way out from under all that bad debt? No one would have ever imagined this could happen in America, but conditions are ripe for just such an outcome. The Wall Street hot shots and deregulation enthusiasts in Washington who have reigned for a generation or more are thoroughly discredited, as well they should be. Consider the fate of former Federal Reserve chairman Alan Greenspan, who pleaded rather pitifully in congressional testimony Thursday morning that he had sounded some warnings about Wall Street's cavalier attitude toward risk. But "the crisis has turned out to be much broader than anything I could have imagined," Greenspan said, adding that "those of us who have looked to the self-interest of [bank] institutions" to responsibly assess risk on their own "are in state of shock and disbelief."

The onetime oracle of the Fed, whom members of Congress once treated as a holy man, has been exposed as a false prophet. And that means that Washington and the rest of the world is unlikely to heed the not-so-sage advice he and other champions of deregulation have given. Consider the rhetoric we're now hearing on both sides of the Atlantic. French President Nicolas Sarkozy, who has pronounced the "end of laissez faire," said in a speech to the European Parliament this week that "Europe must promote the idea of a radical reform of global capitalism … Can we, those of us in the rest of the world, go on financing the deficits of a leading world power without having any say? The answer is clearly no." Or recall an interesting exchange that appears in Greenspan's 2007 memoir, "The Age of Turbulence," when the then-Fed chairman lectured Japanese Finance Minister Kiichi Miyazawa in 2000 on how to work out of a bad-loan situation. "I told the story of how in the United States we'd set up the Resolution Trust Corporation to liquidate the assets of our approximately 750 failed savings-and-loans associations, and how, as soon as most of the seemingly unsellable real estate had been cleared off the shelves, the real estate market had revived and the new, smaller savings-and-loan industry had begun to prosper," Greenspan wrote. But Miyazawa responded: "That is not the Japanese way." Massive liquidation was out, he said. Japan has languished in a state of slow growth for a decade and half as its banks have kept huge amounts of bad collateral on their books in order to avoid massive defaults and bankruptcies. "They never took steps to retrench the financial system," says New York University economist Mark Gertler, a longtime collaborator of current Federal Reserve chairman Ben Bernanke's. "They kept bailing out the banks."

That approach once looked silly to us. But amazingly enough, something like it could now happen to us. As the government dithers over how to unwind massive numbers of unsellable mortgage-backed securities, the risk-averse Feds seem likely to let them fester on banks' books for years. And the repercussions from the biggest mistake Treasury and the Fed made in recent months—letting Lehman Brothers fail—is still sending shudders through Washington. What both Treasury Secretary Hank Paulson and Fed chairman Bernanke realized, belatedly, was that Lehman's issuance of commercial paper and its links to money-market funds was far more widespread and complex than anyone understood. The bank's failure touched off a global market crash few foresaw. Now Paulson and Bernanke are afraid of what else they don't understand about the world financial system. So their default position is: no one else can fail. That's not unlike the anxiety that gripped Japan's regulators in the '90s.

Among those who fear this outcome: economists Brad DeLong and Barry Eichengreen at Berkeley. Under the new Treasury plan to inject at least $250 billion into U.S. banks, the government will get preferred shares—the ones that are paid off first. This means that the government owners will in effect promote the most conservative sort of banking, including capital hoarding, creating a conflict with the holders of common stock. "This is similar to what happened in Japan in the '90s," says DeLong. "The banks weren't alive, but they weren't dead either because the government was unwilling to make any risky loans. They were zombie banks."

In truth, these worries are probably exaggerated. Unlike Japan, Bernanke points out, the U.S. government has definite plans to remove itself from U.S. bank ownership within five years. He also intends to reduce the Fed to its old narrow mission of worrying only about price stability and growth, ceding its new lending powers. And Bernanke—who is an expert not only on the Great Depression but on Japan's so-called Lost Decade, as well—is well aware of the critical differences between U.S. and Japanese banking. Japan's banks, in truth, never fully deregulated, even though Tokyo made a big deal of adopting its own "Big Bang" plan in 1998. Under the Ministry of Finance's plans back then, Japan embraced a "one country, two systems" program in which hundreds of weaker banks could "still enjoy the Japanese way of doing business," a senior ministry official told me back then. In other words, they would supply cheap capital to business and never be permitted to fail. Japanese banks, to a degree little understood in the West, have always been in effect quasi-public utilities, or social stabilizers. The cheap capital they have long supplied like so much gas or electricity allows companies to keep unproductive workers on their books—hence Japan's still strikingly low unemployment rate. The banks also own most Japanese real estate, which the government doesn't want to see sold off (in large quantities, anyway) to foreigners.

No, we're not going to become Japan. But there still remains the danger that U.S. regulators will overreach, forgetting that in the decades preceding the subprime disaster America's free-wheeling financiers provided boom after boom, underwriting the country's ravenous but growth-promoting consumption habits. In Washington, the temptation will be to reverse the Big Bang and, like its cosmic counterpart, let it crash in upon itself, turning New York into a black hole of lending inactivity. We could face an outcome analogous to what happened to the CIA after the Church commission hearings of the '70s, which exposed agency abuses but made it so risk averse that it proved fatally incapable of taking on Al Qaeda later. Let's hope that instead reason prevails this time, and the pendulum does not swing too far to the left.