my thoughts on the financial crisis, second edition
A couple of days ago, I wrote a long post in which I tried to explain what had actually happened with the mortgage mess in the financial market. I took it down for a bunch of reasons, but mostly because I realized that, although I know more about how it worked than most of my friends, I didn't know enough.
Fortunately for me, the NPR show This American Life did an hour-long broadcast where they explain it in depth, and they did a pretty good job. Even more fortunately, there is now a transcript available, so you don't have to spend an hour listening. I think it was well done, and it does a very good job of showing the natural market motivations that arose to cause a lot of people to make a lot of bad decisions, without having to postulate any criminal conspiracies.
So, what to do about it? I find it hard to know what to advocate. The Paulson Plan looks at the moment like it is going to go through. I think it could work, if it is managed intelligently, and I think that Paulson has the skills to manage it intelligently, but a) he could make a mistake, and b) he could find his hands tied by the fact that he is working for the US government now, and not for the board of Goldman Sachs, and he must therefore show that he can be persuasive to a set of people that thinks along completely different lines. One major advantage that could come of the Paulson Plan is that, suddenly, the zillions of mortgages that have no clear owner will have a clear owner, and it will be possible to re-negotiate the terms of those mortgages. One downside to that, of course, is that you'd be hard-pressed to find an American who wants to be in debt to the government (and to their primary financial interface to the US taxpayer: the IRS.) And I haven't even begun to touch the ideological arguments over whether the government should be in the business of mortgage administration, or of buying commercial securities on the open (albeit distressed) market.
I find that I am not all that concerned with "punishing the guilty". There was clear fraud, at the very least on the part of the mortgage brokers who put down fictitious salary numbers on behalf of their clients. Those would not be hard to prosecute, if the clients who were sold the mortgages have held onto their documents. That would be far more satisfying to me than arbitrary caps on executive pay, which have no economic basis and, as far as I can tell, have only been proposed in order to make the "have-nots" feel like the "haves" are being punished at least a little.
What I do care about is the systemic problem. (Of course I do; I'm an engineer.) I'd love to get my hands on the design of a proper regulatory system for the US. Over the last twenty or thirty years, the financial markets have become an amazing ground for creative engineering. This has a lot of parallel with the computer technology world, and probably for a lot of the same reasons. The only way to devise appropriate regulation for such financial innovation is to innovate. The Fed needs a well-paid team of financial strategists to go over new products as they come out, and as they go to market; the job of these strategists is to look for things like asset bubbles—sudden inflations in house prices, or sudden explosions in the number of mortgages approved; that is, precisely the sort of thing that people were spotting four or five years ago—and dig around for the causes. You can't regulate effectively until you have seen the consequences, both expected and unexpected, of a new activity.
I still think Hank Paulson is a smart guy, and I still hope that his plan works. I wish I had some more effective way than "a blog with a small readership" to debate these ideas with policymakers though.
