New York Times Op-Ed Columnist
Innovating Our Way to Financial Crisis
By PAUL KRUGMAN Published: December 3, 2007
The financial crisis that began late last summer, then took a brief vacation in September and October, is back with a vengeance.
How bad is it? Well, I¹ve never seen financial insiders this spooked ? not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world.
This time, market players seem truly horrified ? because they¹ve suddenly realized that they don¹t understand the complex financial system they created.
Before I get to that, however, let¹s talk about what¹s happening right now.
Credit ? lending between market players ? is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about ³liquidity,² is an essential lubricant for the markets, and for the economy as a whole.
But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets ? like the London market, in which banks lend to each other ? have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged.
³What we are witnessing,² says Bill Gross of the bond manager Pimco, ³is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.²The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction ? and that will mean a recession, possibly a nasty one.
Behind the disappearance of liquidity lies a collapse of trust: market players don¹t want to lend to each other, because they¹re not sure they¹ll be repaid.
In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The run-up of home prices made even less sense than the dot-com bubble ? I mean, there wasn¹t even a glamorous new technology to justify claims that old rules no longer applied ? but somehow financial markets accepted crazy home prices as the new normal. And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk.
Thus, ³super-senior² claims against subprime mortgages ? that is, investments that have first dibs on whatever mortgage payments borrowers make, and were therefore supposed to pay off in full even if a sizable fraction of these borrowers defaulted on their debts ? have lost a third of their market value since July.
But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried. Citigroup wasn¹t supposed to have tens of billions of dollars in subprime exposure; it did. Florida¹s Local Government Investment Pool, which acts as a bank for the state¹s school districts, was supposed to be risk-free; it wasn¹t (and now schools don¹t have the money to pay teachers).
How did things get so opaque? The answer is ³financial innovation² ? two words that should, from now on, strike fear into investors¹ hearts.
O.K., to be fair, some kinds of financial innovation are good. I don¹t want to go back to the days when checking accounts didn¹t pay interest and you couldn¹t withdraw cash on weekends.
But the innovations of recent years ? the alphabet soup of C.D.O.¹s and S.I.V.¹s, 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 didn¹t 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, who was 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, ³I don¹t think we¹d want it the other way around.² Is that your final answer, Mr. Secretary?
Now, Mr. Paulson¹s new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won¹t make more than a small dent in the subprime problem.
The bottom line is that policy makers left the financial industry free to innovate ? and what it did was to innovate itself, and the rest of us, into a big, nasty mess.