Saturday, June 12, 2010

Banking Reform: A Personal Comment

The Senate and House are now about to hold a conference committee to reconcile their respective versions of the banking reform bill. I want to post on the subject before it is too late.

But first, let me be clear. I do not understand finance. I have never understood finance. Since the 2008 crash, I have been struggling mightily to wrap my head around the subject, making progress, but only beginning to understand how little I know. In college, I took some basic undergraduate courses in economics and attempted a paper on the IMF, but whenever our economics courses made the most elementary discussion of finance, my mind went blank. Yet finance is a very important subject. Most of our economic disturbances, and certainly the major ones, are the result of something going wrong in the finance system.

2008 was both the year our financial system went off a cliff and the year I started law school. In 2005-2006 I started learning the joys of net surfing on the job. Occasionally an article would pop up warning that we were in a huge real estate bubble and no one knew what would happen when it burst. I didn't understand the stories and mostly ignored them. In 2007, I came into some money and asked a realtor about buying a house. She said better buy now, because housing prices were about to crash. In my innocence, I thought good, I'll wait till housing prices crash and then buy cheap. (Besided, I was about to start law school and not have an income, which made buying a house just then seem like a really bad idea. Which means I know more about finance than a lot of mortgage originators, apparently).

Over the summer of 2008, gas prices soared to $4.00 at the pump, food prices went up, and bad news rained in from all sides. At that time I commented that we seemed to be facing stagflation for the first time since the 1970's and that the accepted remedy was for the Federal Reserve to tighten the money supply, raise interest rates, and induce a recession to squeeze inflation out of the system. But the finance system was healthy last time and could withstand the strain. In 2008 I had my doubts. It was a foolish concern. What I should have remembered is that if your goal is to induce a recession to squeeze out inflation, an unhealthy finance sector is more than capable of doing the job without any help from the Fed.

In August, 2008, I started law school. In September, all hell broke loose in the financial system. Everywhere, articles popped up trying to explain what was happening that I couldn't make heads or tails of. People were talking about asset-backed securities, LIBOR spreads and the relative merits of mark-to-market and mark-to-model accounting. I didn't know a hedge fund from a line of credit at a garden store or the LIBOR spread from an exotic brand of mustard. Articles attempting to explain what was going on mostly confused. (Someone who worked in the finance industry was quoted as saying that the problem with most articles in the popular press was that they needed to be about four times as long to even begin to explain what was happening).

So I went to Borders to look for a book explaining it. Most of what they had were either investment books on how to make money in the crash (which assumed much greater financial sophistication than I had), books with detailed explanations of some sub-part (which also assumed greater sophistication than I had and left large areas unexplained) or books advocating a certain course of action (all of which had some sort of ideological axe to grind). What I wanted was something entitled Sub-Prime Crisis for Dummies or The Complete Idiot's Guide to the Financial Crisis. There was no such book. The best alternative I could find was Financial Shock by Mark Zandi. Zandi is an economist for Moody's ratings who served (as it would turn out) as a financial advisor for the McCain campaign and for the Obama Administration. His book had blurbs from everyone from Lawrence Kudlow to Barney Frank. So it did not look like the work of anyone with an ideological agenda. It described the sub-prime crisis and the workings of the finance system as an insider, explaining the system to outsiders. It made what was going on comprehensible (though still rather dry and technical). It had two major shortcomings. First, it focused too much on the financial crisis as a crisis of sub-prime mortgages, rather than a general crisis in the financial system (although it moved more toward that later on). Second, and more seriously, it was written in summer of 2008, at which time the author could say that the worst seemed to be over. Little did he know everything up till then was just a preview for coming attractions! (He has since corrected that shortcoming with an updated edition).

I spent Christmas Break of 2008-2009 visiting my parents and reading Financial Shock. My mother commented that it looked dull and technical and bought me Paul Krugman's The Return of Depression Economics. Depression Economics has less depth than Financial Shock, but more breadth. It does not have much description of the inner workings of high finance, or much technical explanation of all the complex financial instruments that brought the system down. But it has a longer-term and more international focus, looking in particular at international currency crises in 1990. In this (as in some other things), the books reinforce each other. Zandi has a chart of the LIBOR spread, which is not an exotic mustard, but the spread in interest rates between US Treasury bonds and loans between major banks. The spread goes up in financial crises, when banks become nervous about lending to each other. Both books demonstrate that the 1990's, which Americans think of as a golden age of prosperity, was in fact a time rocked by constant financial crises, all of which should have warned us that our finance system was running badly out of control. I also read the mid 1990's book, When Corporations Rule the World, particuarly its section on finance, warning about the dangers of an out-of-control finance system, citing many of the same incidents that Krugman mentions and that show up on the LIBOR chart.

Finally, as the Senate debated financial reform, I read up on it on internet sites, from Wikipedia, to serious geek sites, trying to drive these complex and technical concepts into my head. It got so bad that I would read the sites late into the night and go to bed with financial information whirling in my head. In the morning I would be wakened by my cat, crying to be fed, and mistake him for a bank, crying to be deregulated! (Upon waking up further, I would realize that a cat just wants food and doesn't know about banks at all. Lucky cat!)

So, despite still not understanding finance, despite knowing no more about it than an Enlightened Layperson who has done some desparate cramming, I will, nonetheless, presume to do a series of posts on finance and banking reform. I hope to follow (and be influenced by) Krugman, taking a historical approach through past financial crises, up to the Great Depression, the 1990's, the present, and a mighty attempt to understand what Congress is debating.

Wish me luck!



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