Beneath the credit crisis that now threatens economies all over the world is a deeper crisis of credibility. People no longer trust financial markets to correct themselves, and for good reason. What was supposed to be unbreakable has been broken.
Until very recently we were told, by economists and Wall Street insiders, that American-style capitalism was the envy of the world—the solution not only to every economic problem, but to many political ones as well. Millennial rhapsodies for globalization promised ever-greater growth, ever-greater affluence and, yes, even world peace, as people would be too busy getting rich to have time for violent nationalism or religious zealotry. This glorious flat-world future was in any case inevitable, the experts said. Any effort to resist or restrain it was self-destructive and, in the end, doomed.
So much for all that. Neither capitalism nor globalization is going away any time soon, but absolute confidence in the power of free markets to police themselves—and a corresponding contempt for government regulation—is now seen to be what it always was: not science or the verdict of history, but an ideology, and a flimsy one.
Even the flimsiest ideology can breed fundamentalism, however, and fundamentalists are unbothered by evidence of failure. Predictably, some last-ditch fanatics insist that the whole problem was that a few outrageously greedy rogues took advantage of an otherwise solid system. It would be truer to say that the whole system took advantage of normal human greed, while punishing caution and skepticism. As long as the housing bubble continued to expand, there was no incentive for investors or bankers to stay clear of it, even though many of them knew that, like any other bubble, it would sooner or later burst. They could have guessed that after it did, a credit freeze would affect everyone indiscriminately, including anyone who had refused to participate in the reckless speculation. So, while the bubble lasted, why not get rich? Greed, along with a vicious improvidence, became the rule in a market where prudence was unprofitable.
Fat compensation packages for the Wall Street executives who helped get the economy into this mess now strike many as obscene, but these, too, were a predictable feature of an underregulated financial system: executives were paid enormous fees to maximize short-term profits by gaming an unsustainable market. This was the job investors asked them to do, and they did it well, with the tacit encouragement of federal regulators.
Until the markets collapsed, the now-disgraced fund manager Bernard L. Madoff also did what his clients expected him to do, producing mysteriously high returns on their investments. Neither his investors nor the Securities and Exchange Commission seemed to care very much how he did it. In this sense, Madoff is to Wall Street as Governor Rod Blagojevich (apparently) is to Illinois machine politics: an egregious emblem rather than a mere anomaly. Just as it is hard to imagine how a politician so mediocre and unscrupulous could have flourished in a healthy political environment, it seems unlikely that Madoff’s scam could have gone undetected for so long in a healthy—and properly regulated—financial industry. (Of course, most investment managers did not commit fraud, and some of them were no doubt as surprised as their clients by the market’s precipitous decline; there has been incompetence to rival the corruption.)
The credit crisis was caused partly by a lack of due caution, both on Wall Street and in Washington. Paradoxically, it is now excessive caution that may keep us from adequately addressing it. The problem is too big to be solved by minor adjustments or executive temporizing. The Obama administration will need to undertake several large-scale reforms, which are bound to be unpopular with the banking industry and devotees of laissez-faire economics. Credit-rating agencies, for example, must no longer be allowed to work for the companies whose bonds they rate. Credit-default swaps, which were originally designed as a kind of insurance but later turned into an instrument for high-stakes gambling, need to be regulated. Investment firms and banks with financial divisions should be required to hold more capital, so that when things go bad they can cover their own losses instead of cadging a government bailout.
Above all, Congress and the new administration should steer Wall Street back toward its principal function, which is to direct capital to the productive part of the economy, not to peddle complex derivatives or place high-risk bets with other people’s money.