Howto: Create a Financial Crisis

Mar 17th, 2008 | By | Category: Economics

Kenneth Rogoff, the former chief economist at the IMF and now a professor at Harvard University, said the greenback may drop another 12 percent on a trade-weighted basis.“This recession will be long and deep and when we get out of it, we’ll have inflation,”

How did this happen? This stick-figure cartoons sorts it out for you. The short of it? “Really smart guys” at financial services companies figured out a legal (but ethically dubious) means of recycling crappy mortgages into something resembling actual investments. How did they get it past the audits, the financial controls, the rating agencies? Well, it’s easier when they’re all the same few companies, each profiting from the bigger lie.

Why is this legal? It didn’t use to be. In the aftermath of the Great Depression, regulations were written into law specifically to prevent this sort of Ponzi scheme from occurring again, like the Glass-Steagall Act of 1933. It worked, until the laws were written out of existence in the late 90′s. In a great triumph of conservative economic theory, the laws, protections and regulations were evaporated, leading to an orgy of mergers resulting in the flailing financial service monsters of today.

Not every economist was happy about this turn of events.

Twenty-five years ago, when most economists were extolling the virtues of financial deregulation and innovation, a maverick named Hyman P. Minsky maintained a more negative view of Wall Street; in fact, he noted that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles. The only way to break this pattern was for the government to step in and regulate the moneymen.

You might think that the best solution is to prevent manias from developing at all, but that requires vigilance. Since the nineteen-eighties, Congress and the executive branch have been conspiring to weaken federal supervision of Wall Street. Perhaps the most fateful step came when, during the Clinton Administration, Greenspan and Robert Rubin, then the Treasury Secretary, championed the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the Depression.

As pleasant as it would be to lay the current financial crisis entirely at Bush’s feet, a significant amount of the blame should go to Rubin and Clinton. Signing the (now clearly disastrous) Gramm-Leach-Bliley Act in November of 1999–dismantling most of the Depression-era protections–was a classic bit of Clintonian triangularization, a gigantic sop to Wall street firms at the expense of Bill’s base of liberal and working class supporters. What could they do? Who could the people hurt by this act vote for? Nader? Let the checks from the financial services industry roll in!

Some might call this experience that matters.

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  1. [...] since the start of the mortgage crisis–whose origins and effects can be revisited at this post, or on this podcast–I’ve been waiting for the great taxpayer-fueled bailout to [...]

  2. [...] say 1 ends up being false–say because banks invested in a bunch of secured debt that ends up having no verifiable assets securing the debt. All of your money the bank lent out is gone. [...]

  3. [...] say #1 ends up being false–say because banks invested in a bunch of secured debt that ends up having no verifiable assets securing the debt. All of your money the bank lent out is gone. [...]

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