Booms and busts are inevitable in a capitalist system. Right now, the Federal Reserve and, belatedly, the U.S. Treasury, are out to avoid facing the terrifying prospect that the credit crunch currently bedeviling Wall Street could morph into a sharp and sickening economic downturn—or even a full-fledged depression.
Think about what the Fed has done in recent months: cut its benchmark interest rate by 3 percentage points (including a 75-basis-point easing on Mar. 18), injected massive amounts of liquidity into the financial system, set up an alphabet soup of funding mechanisms for big U.S. banks (a Term Auction Facility, or TAF; a Term Security Lending Facility, or TSLF; and a Primary Dealer Credit Facility, or PDCF), and wielded extraordinary powers to engineer the rescue of investment bank Bear Stearns (BSC).
The Fed's unusual burst of activity has a clear, specific purpose. In the jargon of Wall Street rocket scientists, the Fed wants to avoid a "fat tail" catastrophe event or "regime shift." In simpler, terms, it's trying to stop a financial-system meltdown. The Fed's urgent efforts to shore up the financial system are understandable, when depression fears have shifted from society's "crackpot fringe" to the power centers of Washington and New York. For Ben Bernanke & Co., there was no real alternative.
While Fed officials scramble to contain the damage, financial markets reel, and taxpayers get ready to foot the bill for the rescue efforts, a nagging question remains: What about the Wall Street titans who got us into this mess?
"The Federal Reserve continues to bail out major financial institutions without imposing meaningful conditions to improve their conduct and performance," complains Peter Morici, professor at the Smith Business School at the University of Maryland.
Here's a staggering figure to contemplate: New York City securities industry firms paid out a total of $137 billion in employee bonuses from 2002 to 2007, according to figures compiled by the New York State Office of the Comptroller. Let's break that down: Wall Street honchos earned a bonus of $9.8 billion in 2002, $15.8 billion in 2003, $18.6 billion in 2004, $25.7 billion in 2005, $33.9 billion in 2006, and $33.2 billion in 2007.
Those years were the heyday of the hedge fund pirate, the private equity buccaneer, the 9- and 10-figure-salary quant jock, and other financial creatures who created all kinds of complex securities and highly leveraged transactions, many of which are now coming a cropper, from LBOs to CDOs.
Paying for "Free" Markets
What a deal. Financiers preached the free-market gospel and pocketed unheard-of sums of money—yet when times got tough, they called for a government bailout. "Markets work if participants are at risk to both positive and negative consequences," says Raghuram Rajan, an economist at the University of Chicago Graduate School of Business and a former chief economist at the International Monetary Fund. "But on the upside, [financial firms] said, 'Hands off, don't upset the party,' and 'Don't even think of regulating us,' yet when things go the other way they say, 'We need help.'"
To be sure, not everyone has escaped unscathed. Nine months ago, Bear Stearns stock sold for $150 share. JPMorgan Chase (JPM) bought the beleaguered investment bank for $2 a share over the weekend, wiping out much of the wealth of the firm's employees.
So far that financial hit seems to be more the exception than the rule. After all, when Stanley O'Neal lost his job as head of Merrill Lynch (MER), he retired with more than $160 million in benefits and stock while Charles Prince, former CEO of Citigroup (C), left with a walk-away package worth almost $70 million.
Regulation Is Necessary
In our system it's impossible to insist that Wall Street cough up the vast sums earned during the go-go years. That said, when the turmoil calms down regulators should sharply step up their scrutiny of the industry, demand more transparency, and require greater accountability among financiers. The pendulum had swung too far toward "anything goes."
The President's Working Group on Financial Markets—the heads of the Federal Reserve Board, the New York Federal Reserve Bank, the Securities & Exchange Commission, and other financial policymakers and regulators—recently issued recommendations for overhauling mortgage finance (BusinessWeek.com, 3/13/08). The recommendations are certainly a good start. But much more needs to be done. For instance, "if the regulators now say that investment banks have a line to the Fed in bad times, then the Fed has to have monetary authority over the investment banks in good times, too," says Rajan.
Economist John Maynard Keynes described the essential dynamic of a capitalist economy as a struggle between the lure of financial safety, or "hoarding," and the entrepreneurial instinct, or "animal spirits." As in many other areas of life, a sense of balance is essential. We've all learned that too much deregulation unleashes an abundance of animal spirits that can be dangerous to our economic health. The trick for the men and women that guide the nation's financial affairs will be to create a regulatory regime that encourages innovation while discouraging bailouts. In that regard, a little moral hazard can go a long way.