Tuesday, March 24, 2009

The Failure No One Talks About

[This was originally submitted to the NY Times as an op-ed piece, but rejected.]

Yes, it's true that Madoff ran a ponzi scheme estimated at sixty billion dollars.  Yes, the rating agencies rated complex mortgage derivative securities like CDOs and CDO-squareds, even as they were engaged in a clear conflict of interest with the issuers of those securities.  Yes, corporate governance was notable only by its absence during the various scandals that hit the US - Worldcom, Enron and AIG.  And finally, yes, greed not only on the part of Wall Street executives, but also the consumers of their inventions - asset managers, insurers, pension funds and their ilk - led to the dot-com bubble and more recently the credit crisis.

Mr. Madoff was excoriated in numerous articles, as he should well have been.  The rating agencies were blamed for not performing their primary function, namely, accurately representing the risks inherent in the rated securities to investors.  Most recently, we were rightly outraged by AIG using in excess of two hundred billion dollars of the bailout monies to grant retention bonuses to the very executives that broke the global financial system, some of whom left the company after collecting their paychecks.  It is easy to rail about these failures, because, in each case, there is an easily identifiable villain, and we love to hate these villains.

However, these individual failures are, at their core, the result of a breakdown in the enactment and enforcement of comprehensive legislation.  They represent a failure, not of capitalism, but of the government.  Government appears too diffuse to be an effective target of our anger.  Members of the government, such as congresspersons and senators, have rushed to express outrage in populist terms, seeking to effectively redirect our anger at such villains.  Their portrayal of the crisis so far relies on stereotypical divisions such as Wall Street versus Main Street and oxymorons like corporate greed.  A bit of clear thinking is in order here.

The global financial crisis was many years in the making.  It was precisely because the US economy was so large relative to other world economies, that the crisis took so long to come to a head.  Several market commentators saw this coming many years in advance.  William Bonner and Addison Wiggin outlined why America would have to deleverage as far back as 2003 in their book "Financial Reckoning Day: Surviving the Soft Depression of the 21st Century."  While the imbalances were building, the government failed to stay ahead of them and took no action to prevent this global crisis.

We had a star culture at the Federal Reserve.  Chairman Alan Greenspan was beyond criticism.  Members of congress and the senate, and indeed, the market itself, hung on his every word.  Investor protection fell to diverse, frequently under-resourced entities such as the SEC, the CFTC, and the rating agencies, instead of being the mandate of a single powerful entity with jurisdiction over markets in all types of securities.  Investment banks operated under a self-regulatory regime, even as their traders were repeatedly found to have defrauded investors through front-running, hyping worthless startups.  State attorneys general won out-of-court cash settlements, while the banks accepted no culpability for their infractions.  Financial laissez-faire reigned and no regulations were created to organize the market for derivatives.  Capitalism without regulation produced the financial anarchy we are now witnessing.

Why did the government fail to enact legislation to keep the financial system whole by addressing the problem of systemic risk?  Why did it fail to protect investors adequately?  It failed because corporations can legally influence whether legislation gets passed at all, and if so, shape any such passed legislation to their advantage, through lobbying.  Lest we forget, individuals may be excused for acting in their self-interest; corporations even more so, since they are designed for the express purpose of benefiting equity holders alone.  Indeed, Adam Smith fully expected them to do just that, albeit legally.  Government, on the other hand, is supposed to moderate their influence and act in the common interest of the governed.  But government has presided over this slow-motion train wreck for the last thirty years, and blaming corporations and individuals for errors of commission is far easier than blaming the government for errors of omission.  When congresspersons and senators express outrage at corporations and individuals, we need to remind them that they have only themselves to blame.

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