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Financial Threat-Over and Out?

September 12, 2009

Lessons Learned and Soon Forgotten

Posted: 10 Sep 2009 06:45 PM PDT

One year after the collapse of Lehman, the controversial “rescue” of AIG, and the ensuing collapse of world financial markets there are two questions: what have we learned, and what good will it do us?

The second question is essential, because we have learned so much about the functioning of our financial system – and the three main lessons are all rather scary.

First, our financial system has become dangerous on a massive scale.  We knew that the banks were playing games, e.g., with their so-called off-balance sheet activities, but we previously had no idea that these huge corporations were so badly run or so close to potential collapse.

Second, we also learned the hard way – after many revelations – that pervasive mismanagement in our financial system was not a series of random accidents.  Rather it was the result of perverse incentives – bank executives felt competitive pressure to behave as they did and they were well-compensated on the basis of short-term performance.  No one in the financial sector worries too much, if at all, about risks they create for society as a whole – despite the fact that these now prove to be enormous (i.e., jobs lost, incomes lowered, and fiscal subsidies provided).

Third, weak government regulation undoubtedly made financial mismanagement possible.  But poorly designed regulations and weak enforcement of even the sensible rules were in turn not a “mistake”.  This was the outcome of a political process through which regulators – and their superiors in the legislative and executive branches – were captured intellectually by the financial system.  People with power really believed that what was good for Wall Street was great for the country.

But how much good does all this new knowledge now do for us?  There is very little real reform underway or on the table.  We can argue about whether this is due to lack of intestinal fortitude on the part of the administration or the continued overweening power of the financial system, but the facts on the ground are simple: our banks and their “financial innovation” have not been defanged.

In fact, they are becoming more dangerous.  The “Greenspan put” has morphed into the “Bernanke put”, to use the jargon of financial markets, where “put” means the option to sell something at a fixed price (and therefore to limit your losses).  The Greenspan version was always a bit vague, involving lower interest rates when a speculative bubble ran into trouble; the Bernanke version is huge, involving massive cheap credits of many kinds (as well as interest rates set essentially at zero).

Bernanke’s Federal Reserve has shown that, when the chips are down, it can save the financial system even in the face of unprecedented global panic.  But this will now just encourage more reckless risk-taking going forward.  In the absence of full re-regulation of the financial system, the Fed’s policies are asking for trouble.

Lou Jiwei, the chairman of China’s large sovereign wealth fund, summed up the view of big international financial players last week, “It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that.  So we can’t lose.”

We have lived through a massive crisis – and learned how close we came to a Second Great Depression – yet nothing is now happening to prevent a repeat of something similar in the near future.

 By Simon Johnson

This is a slightly edited version of a post that appeared first on the NYT’s Economix blog.  It is reproduced here with permission.

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