We Need to Guard Against Destructive Creation

It seems clear that the current financial crisis, terrifying though it is in its dimensions, will not be allowed to turn into the Great Crash of 2008. However, the larger lessons of the crisis, and its commonalities with previous calamities, must still be learnt if a new financial architecture is to be designed that can reduce the prospect of something similar happening again.

We can be optimistic about the effective handling of this crisis based on several factors. The Great Crash of 1929 has taught everyone lessons in what to do and, more importantly, in what not to do. Monetary policy is being loosened, not tightened: we can thank Milton Friedman’s influential analyses for that. Fiscal policy will be expansionary, not deflationary: we all live in the age of John Maynard Keynes, whose fiscal prescriptions were unavailable in 1929 and grew out of the mistaken doctrines and policies of that time. The Smoot-Hawley tariff of 1930, which led to “competitive” increases in protectionism by all, accentuated the Crash. No one is willing to repeat that error.

Neither Ben Bernanke, the Federal Reserve chairman, nor Hank Paulson, the Treasury secretary – nor for that matter, President George W. Bush, who must take ultimate responsibility – wants to go down in history as another President Herbert Hoover, who presided over the Great Crash.

Besides, the ideology of the US is a lack of ideology. Where Nicolas Sarkozy, the French president, could not resist being photographed reading Marx’s Das Kapital and announcing the death of “capitalism”, the Americans settled down to fix the problem. They will do everything required to stem the crisis: for evidence of this, witness the shift of the $700bn (€515bn, £401bn) bail-out fund from buying toxic assets to recapitalizing banks.

When the dust has settled, we must ask the question: why did this crisis occur? There are specifics that are not applicable everywhere. The crisis was, for example, kicked off by highly leveraged lending for uncreditworthy mortgages by the quasi-governmental Freddie Mac and Fannie Mae. But the problems became huge because “policy innovations” had been racing ahead of comprehension. The securitization of mortgages was an innovation that led unwittingly to what Wall Street calls “betting the company”. Creditdefault swaps allowed AIG to bring in huge returns but at high risk if things went wrong, which they did.

The Long Term Capital Management crisis had a similar problem. At its heart were derivatives that no one quite understood. The Asian financial crisis was a result of a different innovation: the spread of capital account convertibility to economies that had registered miraculous growth for three decades, based on trade, but which were felled by their shift to financial convertibility. The downside had not been anticipated.

In each case, the assumption was that financial innovation was like non-financial innovation. When the personal computer was invented, the economy profited without upheaval. The typewriter became obsolete – an example of what Joseph Schumpeter famously called “creative destruction”. But with financial innovation, the downside can be lethal – it is “destructive creation”. We have to work hard at defining the downside scenarios.

The failure to think about the downside results from what I call the “Wall Street-Treasury Complex”. Robert Rubin went from Goldman Sachs to the Treasury and back to Citigroup. Hank Paulson went from Goldman Sachs to the Treasury and will doubtless return also to Wall Street. This network shares the optimistic scenarios that Wall Street spins. Mr. Rubin was in charge of the Treasury during the Asian financial crisis, whereas Mr. Paulson was among the five major investment banking chief executives who persuaded the Securities and Exchange Commission not to extend prudential reserve requirements to their companies.

We therefore need a truly independent commission of experts to look closely at each financial innovation and work out its potential downside. Keynes once wrote that the inevitable never happens, it is always the unexpected. This commission would be charged with trying to narrow the range of the unexpected. We do not have to be blindsided by downsides just because we lazily surrender to the euphoria of the Complex. [End...