Monday, December 03, 2007

Some Easy-Peasy Economics on a Nasty Topic

Paul Krugman has written a very good column which explains why we just might be heading towards a bad recession, especially with the free-market-whee! guys at the helm. Here is the main reason:

How did things get so opaque? The answer is "financial innovation" — two words that should, from now on, strike fear into investors' hearts.

O.K., to be fair, some kinds of financial innovation are good. I don't want to go back to the days when checking accounts didn't pay interest and you couldn't withdraw cash on weekends.

But the innovations of recent years — the alphabet soup of C.D.O.'s and S.I.V.'s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn't have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.

Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, a member of the Federal Reserve Board, about a potential subprime crisis.

And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted to Fortune magazine that financial innovation got ahead of regulation — but added, "I don't think we'd want it the other way around." Is that your final answer, Mr. Secretary?

This is a good time to remind all of you, my sweet and intelligent readers, that it was another financial innovation: leveraging, which made the 1929 stock market crash so vicious. The markets need oversight and the Bush administration has not been willing to provide that. Neither did the Clinton administration, really.

And the reason for that reluctance is probably that presidents can exploit the bubbles the markets create for their own purposes. The bubbles serve as the engine of the economy, until they burst. If you figure the timing out you can be out of office before the bubble bursts. But someone always must bear the consequences. Too often it is those who are least able to do so.