Wall Street is working its way through the cycle of grief that starts with shock and denial, progresses to accepting responsibility and eventually gets to the stage of learning from mistakes. In contrast, Washington remains stuck in the denial phase, with political leaders refusing to admit that their actions have any responsibility for the credit panic. This matters because regulatory denial is suppressing confidence in markets, especially now that the country’s financial capital is in Washington, not in New York.
Last week’s congressional hearings included important mea culpas. Former US Federal Reserve chairman Alan Greenspan focused on the information gap in the banking industry that he, and others, failed to see. “The best insights of mathematicians and finance experts, supported by major advances in computer and communications technology”, had a fatal flaw. “The whole intellectual edifice”, he admitted, “collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria”.
On Wall Street, it pays to admit mistakes, then at least try to make different mistakes the next time. The best news last week was the little-noticed success in settling the credit default swaps relating to Lehman Brothers’ debt. Traders called this bellwether for the opaque, $62 trillion market a “non-event”. Having learnt the hard way that opaque markets are risky markets, the private sector is trying to bring transparency to credit derivatives, either by creating a clearing house to centralize information, or through an exchange with disclosure of prices and conditions. Derivatives would again reduce risk, not heighten it.
But Washington’s culture is fundamentally different from Wall Street’s. Politicians of all parties thrive by avoiding responsibility and shifting blame. Congress has not even held hearings yet in the area where it is most clearly responsible: social engineering through banking by pumping mortgages to unqualified borrowers via Fannie Mae, Freddie Mac and laws that required banks to make bad loans. Hearings are promised after the election.
Markets expect even more politicized lending now that the government has direct stakes in banks. US treasury secretary Henry Paulson offers assurances that banks will operate without political influence, but just last week a group of Democratic senators agitated for lending rules aimed at supporting their social goals. We’ve learnt that complex modern banking can barely cope with its core function of allocating capital efficiently, much less politically. Denial of this basic point is undermining the beginnings of a return to confidence.
Indeed, a relevant lesson from the Great Depression is that economic recovery was postponed for years by what economist Robert Higgs calls the “regime of uncertainty”. Higgs traces the uncertainties caused by extreme government economic intervention in the 1930s through laws, regulations and confiscatory tax rates. Or, as Amity Shlaes, author of the best-seller on the causes of the Great Depression, The Forgotten Man, puts it, our current economy is in a “recession of uncertainty”. Until Washington accepts responsibility for its role in politicizing banking over the past several years, markets will not be confident about the rules of the road.
The lesson from both the Great Depression and Greenspan’s apology is that reforms should address the underlying problem of missing information. Over the past few years, markets didn’t have the information needed to price bad mortgages or overly complex securities. The securities laws of the 1930s are a model for today’s solution. They required transparency about stocks and the other investment vehicles of the time. These reforms played perhaps the central role in restoring trust in financial markets.
The rules for disclosure need to be updated for modern financial instruments. More transparent information would restore trust. If Washington can catch up with the private sector in admitting its mistakes, we can move forward to restore stability, with an end in sight to the current cycle of grief.
The Wall Street Journal
L Gordon Crovitz is a columnist for ‘The Wall Street Journal’ and writes the Information Age column.
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