Time to tame the reckless crew running Wall Street
Posted on 14 January, 2010 | 62 Comments
Have we learned anything from the financial crisis?
A year ago, investors were panicking. Now the MSCI world index of global share prices is more than 70 per cent higher than its low in March 2009. “The effect of free money is remarkable,” the Economist says. “Today, the prices of many assets are being held up by unsustainable fiscal and monetary stimulus. “Something has to give.”
John Cassidy, a New Yorker economics writer, has written dozens of articles about the crisis. Among them is a piece in the Jan. 11 issue on the rise and fall of the University of Chicago school of laissez-faire economists. Now he’s written a book, How Markets Fail: The Logic of Economic Calamities (Viking, $35), that has received excellent reviews since coming out last month.
Instead of getting into the heads of Wall Street executives, he analyzes 230 years of economic theories, from Adam Smith to Alan Greenspan. He also credits the contributions of lesser-known economists, such as Hyman Minsky, who taught at Washington University in St. Louis, Mo.
Minsky advanced the view that free market capitalism is inherently unstable because of the irresponsible actions of bankers, traders and other financial types. During times of prosperity, Cassidy explains, banks have an increased appetite for risk-taking and businesses seek more money to finance expansion. As competition between lenders increases, their sense of caution decreases. They start lending to borrowers who can pay only interest.
Eventually, they extend credit to people and firms that can’t even afford to make regular interest payments. The longer the loans last, the more borrowers end up owing because of negative amortization – or what Minsky calls “Ponzi finance.” Lenders are repaid only if the borrower somehow gets access to a new source of income.
If such a source doesn’t materialize, borrowers are forced to default and sell off whatever assets they can liquidate. This can lead to a collapse of asset values – which, in turn, can lead to a spiral of declining investment and profits and, if not checked, a depression. Minsky’s thesis that capitalist economies inevitably progress from conservative finance to reckless speculation is close to Cassidy’s heart.
He has a similar theory he calls “rational irrationality” (also the name of his blog), which means that in finance, actions can be both individually prudent and collectively disastrous. Born in England and a graduate of Oxford University, Cassidy has a master’s degree in economics from New York University and has read Adam Smith’s great opus, The Wealth of Nations, from cover to cover.
Few journalists have. “Alan Greenspan and other self-proclaimed descendants of Smith rarely mention his skeptical views on the banking system,” he says. “The notion of financial markets as rational and self-correcting is an invention of the last 40 years.
“It was based, at least partially, on a misreading of the theory of the invisible hand, which Smith had never intended to be applied to finance.” Cassidy ends with a call to arms. He wants a new system of economic regulation that recognizes the usefulness of markets, but also their tendency to break down.
Perhaps the biggest lesson learned from the crisis is one Hyman Minsky taught as far back as the 1980s, he says: “Wall Street needs taming.”
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