Some more thoughts on the Credit Crisis

Over the last several days the weltschmerzing on the problems in the credit crisis has increased to a fever pitch. As I have thought about it there are three points that have not been made clearly enough.

#1 -Wall Street/Wall Streeters are not the only source of the problem. We've heard both liberal democrats and conservative republicans argue that the problem was caused by "greed" or "Wall Street" or some derivative of those terms (pun intended). That is nonsense. Obviously, part of it was caused by the markets moving too riskily into financial instruments that they should have thought about more carefully.

On my recent trip east I read a biography of Anthony Drexel who was a major financier of the Nineteenth Century. Drexel lived through several financial panics in his life - and each time they were caused by a bit more optimism or pessimism than was warranted.

Some of these problems came from Wall Street pushing the envelope and from compensation schemes that rewarded even mediocre performance. (That is not limited to Wall Street firms.) We should introduce not new regulations to discourage such rent seeking but more transparency so that investors will be able to know all about compensation schemes. Perhaps some careful review of the way we set tax laws on compensation could be considered, if we had confidence that our elected officials had the care to think about this issue with some caution (I do not have that confidence).

The new financial instruments which securitized mortgages are not the problem by themselves. The credit agencies did seem to drop the ball on doing their diligence. But the fundamental basis for these issues came from a number of sources.

#2 -Political inteventions in the marketplace have exacerbated the problem. Perhaps one of the wisest things that anyone could have said about our current crisis was said by Richard Epstein "The moral of this story is that bad regulation metastasizes."

A good part of this problem also came from the desire of some in Congress to increase the number of homeowners. They pushed the Government Sponsored Enterprises (Fannie and Freddie) to loosen their standards. That helped to create such novel ideas as "stated interest loans" and "teaser rates." As Adam Smith pointed out mercantilist systems tend to have odd results, even odder than market based systems. If government sets up the wrong incentives be sure that the business community will follow them anyway.

Another part of the problem came from the Community Reinvestment Act, which was passed to require financial institutions to invest "across the community" but whose real effects was to authorize loans to more risky entities. CRA worked in concert with the GSEs to broaden credit opportunities to borrowers. My concern with these types of things is the looseness in how they are defined. Supporters of the Act saw it as a way to increase housing ownership, but I think it was not that simple.

Part of my concern about the Paulsen plan is it seems to have been thought out on the back of an envelope. The concerns of the American people about the "bailout" are justified. I was less bothered by the rejection by the House yesterday than I was by the bitter partisan rhetoric about the package. I flew back from Washington with my congressman last night (a republican who voted for the package) and he described yesterday as "one of the worst days in my life." I understand why. I believe the tax proposals offered by the GOP are probably not appropriate to this act but Congress should have done more in thinking about the entire range of governmental efforts which brought us to this. That should have included tightening or privatizing the GSEs and limiting the scope of CRA. While I am not sure that I would have voted for the package, I am pretty sure he did what good public officials do - think about the best possible solution.

#3 - Be careful of listening to popular sages. Part of this problem came about as a result of excess liquidity in the financial system - money chasing yield. For all of the hype that Alan Greenspan created, his tenure at the Fed was not a magical mystery tour. Loose money came in part from a fairly loose money policy of the fed at times during this decade but it also came about because of foreign investors looking to stable investment markets. But there is hope, all this uncertainty might encourage a lot of investors to look to other markets as possible venues for their dough. That may make the loose money of the early part of this decade a bit less common but it may bring about some higher levels of stability in the markets. Fareed Zakaria is sound on the diversity of the world's political realm, the same should be said of the financial markets.

I would be a lot more comfortable about any package if I were sure that someone who was competent on financial issues were going to run the government's efforts. But there is precious little evidence that our policy makers have thought of that.