Why Financial Crises Will Keep Happening

gold watch by Rhys400D

The financial crisis unfolding in slow-motion before our eyes was inevitable and predictable.

I say this because this financial crisis was predicted by numbers of people. It was obvious: anyone with sense (which apparently includes very few people) knew a financial crisis was coming, and despite the fact that we’ve known for years it was going to happen, it happened anyway.

The same was true of the dot-com bubble. It was obvious, at least as far back as ’96/’97. Everyone who wasn’t paid not to know it, knew it, and it happened anyway and burst anyway.

Now part of that is a question of deliberate government policy–both bubbles were fostered and grown from tiny soap-suds with the aid of Alan Greenspan’s Fed and various other government and private and semi-private actors (like Fannie Mae and Freddie Mac.) But creating the bubble took the cooperation and encouragement of a lot of people beyond the government, people who benefited a great deal from it.

For example, take Chuck Prince, the ex-CEO of Citigroup, who walked away from his near-destruction of Citigroup with about 41.5 million, including a 12 million dollar bonus for his performance. Drive the place into the ground, get paid well. Then there’s Merrill Lynch’s Stan O’Neal who walked away with 160 million. Nice work if you can get it.

But if the rot was limited to the top, it wouldn’t be nearly as big a problem.

Mortgage brokers were paid to sell what everyone knew were mortgages that probably couldn’t be repaid. Why? Because the banks knew that they were going to slice-and-dice the mortgages into Collateralized Debt Obligations (CDOs) and sell them to suckers investors. When the loans went bad they wouldn’t be on the bank’s books. It didn’t (and isn’t) quite working out like that for the banks.

Then again, in a more real sense it is working out that way.

  • The mortgage brokers still got their commissions.
  • The real-estate agents got their commissions. In many cases they made enough money to live on for the rest of their lives.
  • The executives in the banks and in the Wall Street firms like Morgan Stanley, who created these CDOs also got rich. They made millions. If they were smart and saved some of it, they will never ever have to work again.

The system did what it was supposed to do: it made the people who run the system stinking filthy rich.

If you’re reading this, odds are you expect to work to 65 or so and pray that when you retire you’ll have enough money to support yourself in a style that doesn’t require you to eat cat food. You’ll work forty or forty-five years to get that retirement.

What would you do, or rather, what wouldn’t you do, if you knew that by working hard for five years you’d have enough money that you need never, ever, work again for the rest of your life? Not just that, but for most executives, you would be rich. Want a house on the Riviera? Want to spend the rest of you life travelling? Have a hobby? Whatever your whim, you’ll be able to indulge it, because you’ll be rich and money is freedom.

So even if in the end Merrill Lynch was going to be stuck with a bunch of bad debt, or Citigroup was going to have problems, why should you give a damn? Making record profits for a few years allows you pay yourself, or to be awarded commissions and bonuses, that add up to more money than a normal person earns in 45 years.

From the perspective of self-interest you’d have to be a fool not to do it. And for most people, even some CEOs, even if you don’t like it you’d still be a fool not to do it, because if you opt out, someone else will just take your place, run the scams and reap the windfall of ill-gotten gains.

What is good for the economy, the country and for the long term health of your company is not what’s good for you. A set-up like that is a recipe for disaster for everyone, possibly even for you, if you aren’t real smart. (Money is only worth what the country behind it is worth, after all. Trash your country, or your world, and you trash your own wealth.)

As a result of this incentive system, if it is possible to have another financial bubble after this one crashes out, there will be one. Guaranteed. There is no way to avoid it unless the economic circumstances are so bad it can’t get off the ground (which is possible, if the monetary base starts collapsing).

The answer is fairly simple, mind you. These sorts of bubbles didn’t happen in the post-war period. They didn’t happen because you couldn’t pay enough people enough money to make it worth their while. After a certain amount of income, in most western countries, you got taxed at a marginal rate of over 90%. A few CEOs might be able to make it, but most of the executive suite was going to need more than 5 years–they were going to need an entire career.

At this point to wring the excesses out of the system and to stop the systemic incentives to keep blowing bubbles is going to require making it so that reaping a fast fortune at the expense everyone else doesn’t pay. There are two parts to any solution:

  1. The first and simplest way is to put a very progressive tax on all income no matter how or where earned that probably comes in at over 95% of all income over, say, $500,000 or a million at the most. Suddenly, needing to actually keep the companies sound, and knowing that in 7 years when the loans go bad, they’ll still be there taking the heat for it, will tend to concentrate the mind not on “can I make enough money to be in a yacht in 3 years” but into “does this deal make sense over the longrun”.
  2. The second thing to do is to stop allowing people to sell risk.

For years Greenspan argued that risk markets (the ability to take on, say, default risk in credit or for that matter to sell loans in CDOs) made the system stronger and actually reduced systemic risk by spreading risk around. What it did instead is take the risk away from the people who were able to manage it because they were close enough to the ground to know whether a loan was risky and give it to people who really had no clue and had to rely on bond rating agencies to tell them if the risk was acceptable. Without a loan officer in the actual district, without actual inspections of houses and businesses and without the loan officers knowing that 10 years from now if the loan goes bad some manager is going to call them into the room and ask them to justify the decisions they made, the people taking on the loans had no ability to know if they could, or would, be repaid. And the banks, since they thought they were selling the risk, mostly didn’t bother with old style vetting and indeed banks like Citigroup have gutted the departments which used to do that sort of work.

The bond agencies got paid by the people they issued ratings to. I’m sure you understand what that means for their objectivity. Nor could they, even if they had made an honest effort, duplicate the sort of vetting and checking which banks used to do routinely. They don’t check every mortgage and simply can’t.

So the rule going forward has to be that if you make the loan you keep the risk on your books. You cannot load it off on other people. There are mathematical reasons why in theory it ought to reduce systemic risk to do so, but in the real world they generally don’t actually occur because of the problem of incentives:

  • the people with the necessary information to manage the risk have no incentive to do so;
  • the people who wind up with the debt do not have the ability to manage the risk;
  • and the third parties like bond agencies have neither the incentives nor the ability to manage the risk either.

Such a world will be a world with a much smaller less flamboyant financial sector with much lower returns.

But the idea that the financial sector could somehow make far greater returns than GDP growth and do it for decades was always insane and simply could not work. The only way to do it, the only way it has in fact been done, was to cheat and to ignore systemic risk, use massive leverage, print money and shove it into asset bubbles and so on.

The end result has been two financial bubbles and thirty years in which the average American hasn’t had a raise and has taken on debt. A lot of people have gotten rich, mind you, and for them these last thirty years have been great, which is why there’s a bipartisan consensus amongst the people who matter in both parties to keep going what has been, for them, the best of all possible times. Given a choice, they will keep it going.

There’ll be a lot more rich in America, but odds that you’ll be one of them are near zero. And when it all comes crashing down, somehow ordinary Americans, despite having never been invited to the party, will be stuck with cleanup duty and the bill.

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Ian Welsh

17 CommentsLeave a comment

  • Reinstate the death tax at its old rates. American society is becoming an aristocracy. Stocks, bonds, and other assets like art that appreciate over time are passed on to the children with no tax consequence whatever – the classic means by which aristocracies arise and democracies wither away. It’s so insidious and pervasive that Americans don’t see it. They just happily accept that the sons and daughters of politicians, businessmen, musicians (see Miley Cyrus), actors (I wouldn’t know where to stop when it comes to detailing the nepotism of Hollywood), lawyers, doctors, and any other professional or well-paid sector of society are entitled to the same wealthy positions as their parents. This doesn’t even count the natural advantages wealthy parents can pass on to children who don’t have to worry about college tuition. The U.S. is a celebrity-obsessed society, which allows all this nepotism to fester and appear natural. The chance for advancement for everybody else is diminished.

  • For one, the fat lady is warming up in the background.

    Obama takes lead in New Hampshire polls

    A USA Today /Gallup poll said Mr Obama had opened up a 13-point lead over Ms Clinton in New Hampshire, 41 per cent to 28 per cent, to 19 per cent for former North Carolina Senator John Edwards.

    Another poll showed Mr Obama leading Ms Clinton by 39 per cent to 29 per cent. Earlier polls had shown the race to be a heat between the two.

    Bottom line, people want to hear a positive message of hope and are well tuned to detecting insincerity. Only someone that truly believes they can save this mess can win the election. And only someone sadly uniformed (or misinformed), like bush in 2000 and Obama in 2008 can stand and deliver a positive message in today’s climate. Hail the new chief.

    I did inhale.

  • As does bush. Believe hard enough and it will happen.

    Unfortunately reality gets in the way. You open a school for young girls thinking throwing money at something cures an ill. Next thing you know, the teacher you hire is fucking the young girls.

    You wave your magic wand, print a bunch of cash, send it to New Orleans…

    By the way, Ron Paul is another uninformed true believer. He thinks the free market fixes everything.

    It’s damn hard to sincerely deliver a postive message when you know the way things really work (like a McCain or a Clinton or a Biden or a Gore).

    I did inhale.

  • is related:

    NYT – …The November election will take place against that background of economic distress, which ought to be good news for candidates running on a platform of change.

    But the opponents of change, those who want to keep the Bush legacy intact, are not without resources. In fact, they’ve already made their standard pivot when things turn bad — the pivot from hype to fear. And in case you haven’t noticed, they’re very, very good at the fear thing. much more at link

    1.”George Washington did not cross the Delaware for Capitalism,” -Shmuley Boteach.
    2.The Dems haven’t punished the GOP enough, so you’re going to reward the Republicans?

  • The whole rationale of the contemporary paper economy is I Be Gone You Be Gone, after a stop by the bank on the way out to deposit the loot. Something wrong here called, “No accountability.” According to the Street, Prince and O’Neal were ultimately accountable. Not.

    We need an overhaul of the paper economy. And some people need to be go directly to jail, and others heavily fined, over the present debacle. I’m surprised that there aren’t more civil suits for fiduciary irresponsibility and malfeasance.

    If any of a number of factors affecting the paper economy implodes in ’08, There is going to be a huge public outcry, as the world economy tanks. If the December employment figures are correct, it looks like the US (and possibly UK) consumer debt bubble is about to burst, and that will make the dot.com and housing bubbles look paltry in comparison, because it will take lots of other shaky stuff down with it. This could be “the big one.”

  • …about marginal tax rates and bubbling behavior. To me it’s always been a question of economic fairness. Nice to have an argument that doesn’t depend on such an old-fashioned concept.

  • Rather then estate taxes, make it inheritance taxes. That is, don’t tax what dead people leave, tax what their heirs receive. First, that does away with the canard that it gets taxed twice. Second, if it’s indexed, then people will keep it from being taxed at the highest rates by giving it to as many people as possible. Trickle down works better when there are more holes in the bottom of the bucket.

  • If people like Prince and O’Neil didn’t do what they did, they wouldn’t have been where they were in the first place. They were not leading, they were just at the front of the stampede for a little while.

    The fact is that modern society cannot function without various forms of virtual currency. These are no longer asset based, they are tax based. They are a public utility. Using a public utility requires responsibility in order to have the right. The problem goes to the very depths of the human desire to get ahead and now that we can just print wealth, we are all going to eventually vote for those who will run the printing presses the fastest. There is no free lunch. For anybody. Currency needs to be viewed, for better or worse, as a public utility. One that everyone has both rights to and responsibilities for. Ignore one and you lose the other. That is what is going to happen when the monetary bubble does finally burst. The economy will be like an engine that suddenly got a hole in the oil pan.


  • Just like the court system.

    People will go back to more integrated economic systems that won’t be as fluid, but will be more durable. We might actually start fixing things again and not just throw them away.

  • It’s no good unless it is spread around encouraging young things to grow. Otherwise it collects into big, stinking piles….

    “It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.”

    Charles Darwin

  • I have been reading your post for a few months and found most very informing. However, maybe I didnt read enough as I had no idea that you were a socialist!

    How can you cap everyones income at $500,000? Where is the incentive to start a business, make investments, and take other risk if you know that anything you make over $500,000 will always go to the government?

    There are many doctors, lawyers, small business owners, etc. who have work very hard and/or spent many years in school to get the success they have.

    Govt. was meant to serve the people. People shouldnt serve the govt. by giving up all their earnings over a certain amount.

  • the vast majority of doctors, lawyers and small business owners make much, much less than $500,000.

    In 2005, only 1.5% of households made $250,000 or more, and they had a median of 2 wage earners.

    By the time you get an individual making $500,000 or more, one has to suspect that additional dollars at the margin go more to ego satisfaction than real economic benefit. So let them have the ego boost, but do something useful with the money.

    Under Eisenhower, during the greatest economic expansion in our history, marginal tax rates were well over 90%.

  • income cap. If you earn over 500K, say, you pay 90% of it to the government. That’s not 100%. This is the way many countries did it after the war, including the US. Economic growth was fine. Companies could still keep cash (and had much lower tax rates) and there were still very, very rich people. Ordinary people were better off.

    500K (or a million) is still a ton of money, especially to earn in a year. Almost no one is really worth that much, including the vast majority of CEOs. Maybe I’ll write an article on that one day.

  • an effective cap. Who is going to work for xtra money if they only get 5 cents of everty dollar. Under your plan, someone would have to earn two mill to take home an xtra $100,000.

    Revenue to the government would go down!

    If you had an indivual making 3 mil a year is he suddenly going to start giving the last 2.5 to the gov’t? NO!! He is going to reduce his “official” income to $500,000 and take his compensation in another way. While trying to get 95% of that income, the gov’t would lose the 35% they get now.

    Like it or not, the idea that someone who works hard, creates jobs, or starts a business can succeed without limitations is one the reasons America was a leader for so long.

    Who is the gov’t to decide what someone is “worth”. Is Peyton Manning worth 10 mil to play football? What if he brings in an additional 30 mil in revenue for the Colts? Should Peyton only get $500,000? Should Will Smith get $500,000 for a movie that grosses half a billion? If a business owner risks his life savings, works 20 hour days for years, creates hundreds of jobs, and brings value to the public, should he be capped at $500,000?

    What someone is “worth” is what the market is willing to pay. What someone earns from work, should go to them, not the gov’t. We dont need any more bridges to nowhere or billions on needless wars. The money would be stolen from the earners and wasted. I understand that taxes are needed and the better off need to pay their fair share. That should be at most 50%(fed,state,local combined), and only during tough times (REAL wars, depressions, etc). However, 95% taxes are UNAMERICAN. I would appreciate your article on the subject. I agree with 90% of what you have written and am surprised to find out that you believe in caps on financial success.

  • Are you sure? From 1951 to 1963, the top marginal rate was over 90%. The economy was good, tax revenues were good. The Laffer curve is theoretical and has never been shown to actually exist. In fact, most people who make lots and lots of money don’t really care (in absolute terms) how much they make, as long as they make more than whoever they think they’re competing with. Since they brag about pre-tax income, they can still have their ego gratification.

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