Wednesday, February 18, 2009

Government Incompetence and the Creation of the Crisis

The vast majority of severe economic crises start with an unexpected bursting of a speculative bubble. These speculative bubbles are usually very complex, and are made more potent by complex financial instruments that only the people who created them can understand. This is also the idea behind these complex instruments; it will make them seem worth more than they are because people don’t realize what they are made up of.

During crises in the past, governments have always been unable, or in the case of the U.S., unwilling, to keep up with the ever increasing complexity of the financial instruments. In the end, that leads to a situation where nobody knows what anything is worth, so prices can only go down.

In the panic of 1873, which led to the “Long Depression”, speculation in complex bonds relating to railroad construction was a large contributing factor. Before the “Great Depression”, traders were mailing complex trades across state borders in order to evade any financial regulation (which only existed as local law at the time).

In the crises in Sweden and Japan in the 90s, complex financial products related to real estate speculation were almost fully responsible for the crisis, as they are in the crisis in The United States today.

As I mentioned above, governments are usually unable to keep up with financial markets when complex financial products are being created. This is mainly a result of the lack of competence within the government, and a lack of understanding of the financial markets on behalf of its staff. George W. Bush was famous for having repeatedly mixed up inflation and deflation. More importantly, however, the SEC has been largely absent in recent years.

Many traders that I have talked to here in New York, as well as traders in the media, say that they have never once been contacted by the SEC in any capacity over the last decade. This is especially true for the most complex trading, including trading with mortgage-backed securities and CDOs “squared” (don’t ask). Similarly, the ratings agencies were left alone to prosper as they saw fit.

The long-term commitment to self-regulation has obviously contributed a lot to the current situation. And U.S. politicians have failed the country in more ways than one in the creation of this crisis. Self-regulation becomes a vicious cycle in the following way: when the government does not engage in regulating, it loses the capacity and competence to do so.

Hence, after two decades of self-regulation, the U.S. government has no idea what’s going on in the financial markets because they haven’t touched them, studied them or regulated them. The SEC has under 4,000 employees, which I’m guessing is less than the amount of shoe shiners in New York City. Needless to say, this lack of competence is very problematic in trying to deal with this crisis.

An unfortunate “solution” to the problem of not being able to deal with a complex financial crisis has been to bring in the people who created the crisis in order to solve it. Of course, these people have their own agendas, and are easily able to enrich themselves as taxpayers pay money to resolve the crisis. This is the “solution” currently being pursued by Obama and Geithner, which has already turned out to be very detrimental, as taxpayer money has been thrown into a black hole, only to enrich individuals on Wall Street.

The much talked about Swedish solution to the crisis also dealt with this problem. In Sweden, executives were fired, and representatives from the financial industry were not made a part of the team that would clean up the mess, or at least they were included to the smallest extent possible. The Swedish government had to create competence within its agencies in order to deal with the problem and get the best deal for taxpayers. It did so mainly with the help of academia.

The belief that the government can never be competent enough to engage in issues such as these is misguided. When it comes to the IRS, the U.S. government is very competent. The IRS has vast, in-depth knowledge of anything that pertains to taxes, domestically and abroad, and in immensely complex arrangements. I’m not saying that the IRS is perfect, but that the SEC MUST become more like it. The IRS has over 86,000 employees, which is more than 20 times as many as the SEC.

The SEC is, at present, completely incompetent. The people that are advising Obama and Geithner are nothing but self-serving Wall Street insiders, as the people who advised Bush and Paulson also were. The Obama administration and the Treasury need to turn to international and domestic academia (except for those who used to work on Wall Street) and to Sweden, Japan, The IMF and The World Bank for help in resolving this crisis. By gradually building competence, the U.S. can hope to avoid some of these problems in the future.

Moreover, I advise that the winner-takes-all voting system should be destroyed.


Anonymous said...

I think larry summers is really going to screw obama up.

I just read an article in the nyt where he encouraged harvard to take advantage of the low interest rates as an investment vehichle. now that rates are practically down to zero, harvard is feeling the pinch.

is larry summers overrated?

Jacob said...

Well, I wouldn't put too much trust in economists that worked for Reagan, as they are perhaps the biggest contributors to this crisis. I'm not sure Harvard is listening much to him now after his resignation for bashing women as academics (even though his own mother is an economist too...)