Washington was in a flurry last week about causes of the banking crisis of 2007-2008.  Unfortunately, politicians are too eager to propose solutions without fully understanding all the dimensions of the problem.  The process has just begun, a bit late some might say, and already the inquiry is infused with proposals that are designed to make people feel good rather than protecting them from future crises.

A commission headed by Phil Angelides, former treasurer of California, aims to write the definitive history and analysis of the financial crisis, much as the 9/11 Commission has done.¹  As a first step, they deposed CEOs of four top banks in an exchange that was at times contentious: “people were throwing themselves out of windows on Wall Street [during the Depression, but now] they’re lining up for bonuses” observed Angelides.  When Lloyd “we-do-God’s-work” Blankfein, Chairman of Goldman Sachs, described the practice of selling mortgage backed securities to clients while contemporaneously betting against those securities, Angelides thought it looked more like the work of the devil: “It sounds to me a little bit like selling a car with faulty brakes, and then buying an insurance policy on the buyer of those cars.”²  These types of financial institutions are expected to hedge bets for their clients, albeit an ethical dilemma is created when they bet against their clients, or when they move markets artificially to create paper profits.  An example of the latter case is the practice of buying insurance against corporate default (credit default swap) while selling the company’s stock short to drive up the price of that insurance: another way to buy insurance and kill the insured for profit.

As the commission was just beginning its work, the President felt obliged to proffer punitive solutions: “We want our money back and we’re going to get it,” he chanted, perhaps in anticipation of the decision of the Massachusetts voters to turn Ted Kennedy’s seat back to the people.  All Obama needed was a hand sign as the populist-in-chief floated the notion of a “Financial Crisis Responsibility Fee” presumably to “recover” funds given banks under TARP.  But … wasn’t TARP supposed to include its own mechanism for taxpayer funds to be paid back?  What is pernicious about this new tax is that it will be assessed not on profits but on uninsured liabilities—in effect on deposits and loans to the bank.  It should be obvious that these fees will land on depositors’ statements.  On the one hand the administration wants banks to lend more, while on the other they seek to tax their sources of capital.  

It is a “teachable moment”—to use one of the President’s preferred ways of benefitting from aberrations in human interaction—to examine why the “responsibility” fee passes over the most irresponsible of corporations that contributed to the crisis: General Motors and Chrysler, which also received government aid, and the two most sanguinary companies responsible for the mortgage market failures, Freddie and Fannie.  This kind of selective punishment and reward is simply favoritism characteristic of centralized industrial management, the supporting postulate of which is “government knows best”.

Paul Volcker, former Fed chairman and current advisor to the President, provides a more sober approach.³  He argues against “unmanageable conflicts” within banks between consumer lending and high-risk trading and believes the functions should be separate, much as they were when the Glass-Steagall of 1933 was enacted to separate commercial and investment banking.  There may be merit to the idea of ending the admixture of bank businesses with dissonant objectives and interests, but reversing deregulation sets precedence for government management in other industries and may introduce higher transaction costs for consumers.  Improved regulation that fosters efficiency in capital markets while imposing the necessary consumer and investor protections is better than striking grand new economic policy or imposing obligatory corporate structures.  Good banking helps businesses manage risk, not take unnecessary risk solely for trading gains.

Another dimension is the role the Fed played in the crisis.  Chairman Bernanke insists that the loose monetary policies of his predecessor, Alan Greenspan, did not cause the housing bubble.⁴  Most economists and FDIC head Sheila Bair disagree: free and easy money encourage risk taking and artificially inflate prices.  Even bankers admitted to the commission that they wrote mortgages with high loan-to-value ratios or without properly documenting a borrower’s income to cover a loan, and that they allowed these practices even for second and third homes.  Ignoring the role of easy money might lead one to believe that today’s cheap money is not causing another bubble.  Yet most financial papers from Barron’s to The Economist⁵ are warning the Fed to tighten money before it is too late.  It might be teachable to recall similar prognostications before the current crisis.

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[1] Inquiry Panel’s Head Is Known as a Scrapper.” The Wall Street Journal, 14 Jan. 2010, http://online.wsj.com/article/SB10001424052748704675104575001324187741494.html

[2] “Panel Rips Wall Street Titans.” The Wall Street Journal, 14 Jan. 2010, http://online.wsj.com/article/SB10001424052748704362004575000752756113586.html

[3] “Volcker Voices His Views in a Vacuum.” The Wall Street Journal, 15 Jan. 2010, http://online.wsj.com/article/SB10001424052748704363504575003510035624020.html

[4] “Bernanke’s Puzzling Bubble Logic.” The Wall Street Journal, 14 Jan. 2010, http://online.wsj.com/article/SB10001424052748704675104575000862637148440.html

[5] “Once again, cheap money is driving up asset prices.” The Economist, 7 Jan. 2010, http://www.economist.com/businessfinance/displaystory.cfm?story_id=15211520