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By Floyd Norris
Published on Sunday, Apr 13, 2008
NEW YORK: As the credit crisis has slowly expanded and worsened, there has been a flurry of activity in Washington to reduce the damage from it. There are bailouts and tax breaks, and even checks to parents of school-age children.
But there is remarkably little action aimed at getting the credit system functioning again.
In part, that is because there is a scarcity of ideas. Paul Volcker, the former Federal Reserve chairman whose legacy has not crumbled since he left office, was right last week when he said the financial engineers had created ''a demonstrably fragile financial system that has produced unimaginable wealth for some, while repeatedly risking a cascading breakdown of the system as a whole.''
But it is far from clear what should replace it, or if it can somehow be mended.
To be sure, we had a system that worked for generations, based on commercial banks constrained by regulation. But that system is not coming back, as Volcker noted in his extraordinary speech to the Economic Club of New York last week.
''Any return to heavily regulated, bank-dominated, nationally insulated markets is pure nostalgia, not possible in this world of sophisticated financial techniques made possible by the wonders of electronic technology,'' he said.
In any case, the banks are not all that healthy anyway, thanks to their losses from the strange securities created under the new system.
For the time being, the solutions being pushed would not seem unreasonable to an old-fashioned socialist. Most new mortgages are now guaranteed by the government or by government-sponsored enterprises, whose ability to lend is being expanded.
The Bear Stearns precedent seems to assure that investment banks have joined commercial banks in the Fed's safety net, and the Fed has now taken control over what Volcker calls ''mortgage-backed securities of questionable pedigree.''
Some ideas are obvious, but so far not widely accepted. The Basel II capital rules for commercial and investment banks clearly need to be strengthened, and regulators need to develop the ability to do their own risk assessments, rather than leaving the task to the banks and the credit rating agencies. That will take time and cost a lot of money, and it will require the derivative markets to be much more transparent.
Regulation needs to be strengthened, particularly for investment banks. Providing a safety net brings, in Volcker's words, ''a direct responsibility for oversight and regulation.'' He forecast that ''investment banks are going to end up with a leverage ratio imposed upon them.'' And one lesson of this disaster is that having parallel financial institutions — one regulated and one not — simply drives activity to the unregulated area, at least until something blows up.
But while reducing leverage is crucial, it makes a difference, as Lawrence H. Summers, the former Treasury secretary, said this week, how that is accomplished. If the banks decrease leverage by selling assets or cutting back on lending, there could be a prolonged drought of available loans to fuel the economy. It is far better for them to raise capital and keep lending, but there is little evidence now that the institutions have much willingness to do that.
Summers believes that the government-sponsored enterprises, Fannie Mae and Freddie Mac, should have been forced to raise capital quickly — rather than simply promise to do something someday — and that ways should be found to push other institutions to do so.
It is also clear that the efforts being made to cut back American regulation, in the name of making our markets more competitive, are attempts to deal with the wrong issue. To quote Volcker again, ''For financial regulation in general, competition in regulatory laxity cannot be a tolerable approach.''
At the same time, there is a limit to the usefulness of finger-pointing. Most of the critics — myself included — did not anticipate the severity of the credit collapse, and we should not act as if the executives and regulators who failed to prevent it were blind or stupid. Rather than go into self-defensive crouches, those people need to use hindsight to ameliorate the mess.
There is a real risk that the ad hoc efforts now being made to deal with this crisis will create other problems. Volcker, who knows how inflation can get out of hand, said the current situation reminds him of the early 1970's, when inflation began to accelerate. The Fed's moves to slash short-term interest rates and bail out Wall Street, however necessary they may be, could easily raise inflation and cause more damage to the weak dollar.
It is striking to realize that while Volcker has been gone from the Fed for two decades, he is, at 80, two years younger than his successor, Alan Greenspan. Had Volcker somehow kept the job, he almost certainly would have been more skeptical about the new financial architecture — and less popular on Wall Street — than Greenspan was when times were good. But the bad times we are now entering might not have become nearly so large a threat.
Norris is a New York Times business columnist.
NEW YORK: As the credit crisis has slowly expanded and worsened, there has been a flurry of activity in Washington to reduce the damage from it. There are bailouts and tax breaks, and even checks to parents of school-age children.
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