Flog the Pols

N.B. Zach asked that I comment and, based on some of our conversations, will not be surprised that I take a somewhat different view. Here it is:

I’m afraid our fearless blogmeister is flogging misdirected fear when he likens our situation to a house of cards in the below entry. He raises many valid concerns about the $700 billion sweetheart deal, but may be getting some of the fundamentals wrong. First off, to liken the entire world of financial risk evaluation as a shell game is to misinterpret finance’s fundamental role in a healthy economy – which is the efficient allocation of capital. In an open, capitalist economy there are surely excesses which we can all agree about, but to call them indicative could well turn into a disastrous own-goal. Yes, during a crisis we all tend to look for scapegoats, but is it really helpful to throw the proverbial baby out with the bath water?

It is an old canard, and even somewhat retro, to lament the flight of US manufacturing to foreign shores. Before then, we probably lamented the loss of farm jobs to manufacturing ones. The competitive advantages of nations, as suggested in Adam Smith’s ground-breaking The Wealth of Nations and elucidated in Michael Porter’s The Competitive Advantage of Nations (1990) is just as valid as it was in the 18th century: as we become more innovative and creative, we as a nation are marching irreversibly into service jobs. Think of the technology sector: would we really want to still be manufacturing computer boxes instead of dreaming up the software, games, uses and frustrations that go in them? Or physically make the internet switchers instead of having brought forth the world wide web itself? Whether it is Bear Stearns or, for that matter, Disney or Dreamworks, does it matter that there are few physical assets when you turn out the lights? No, because in a country which most unleashes human initiative and creativity, the primary ‘assets’ are us, the people. (And speaking of Lehman’s 22,000 employees, let’s not cry crocodile-shoe tears for them: Nomura is in the process of buying Lehman’s Asian operations and most of Lehman’s ‘assets’, its people, will quickly find work in other financial firms – perhaps at slightly less elevated salaries, amen.)

This gets to the fallacy that Wall Street doesn’t create real value. Of course it does! By taking companies public, creating innovative debt instruments, financing bold new ideas, and myriad other activities, Wall Street, arguably, is the most important creator of value after entrepreneurs and employees themselves. An efficient distribution of capital is what turbo charges our robust economy, still the envy of the world. That financial services represent a fifth of our economy is not a red flag at all: broaden your parameters and it is a fraction of the word’s economy that is driven by the US’s enviable leadership of such an all-important sector.

Yet, sadly but inevitably, even Masters of the Universe are fallible. Even worse, add to the very human attributes of greed, avarice and lemming tendencies the vanity and power hunger of politicians, now THAT’s a real crisis. While I couldn’t agree more that reform is needed, I couldn’t disagree more with the understandable if erroneous reaction that more and ‘stricter’ regulation is needed. (Sarbane-Oxley and ‘mark-to-market’ accounting rules are two examples of counterproductive, perhaps disastrous ‘stricter’ regulations.) By my view, it was the nexus of political patronage with the politically mandated do-goodsim (i.e. mortgages to people who couldn’t afford them) of Fanny and Freddie – a truly rampaging elephant created by politicians for the ultimate benefit of politicians and therefore given a semi- (and now total) government guarantee – that was truly innovative.

The $700-1000 billion bailout (including this summer’s $300 b mortgage stop gap bill) is scary not because it is fueling another house of cards. (Technically speaking, it is to buy up the ‘bad’ mortgage paper of house loans that should never have been made in the first place.) What is scary is that our political class has no interest in getting to the root of the crisis, their own power-hungry patronage plays. Even today, Barney Frank (D-MA, Chair House Financial Services Committee), the congressman with the dubious record of having blocked most meaningful reform of his favorite, pet semi-governmental companies in recent years, has no interest in scaling back Fannie and Freddie’s future activities. The most meaningful reform bill, which from the Senate in 2005 was set to rein in Freddie and Fannie via bank regulator-like powers, was opposed by all Finance Committee Democrats and never allowed to come to a full vote. Yet the blame can easily be spread around: the Fed’s dangerously low (real negative) interest rates fueled the bubble real estate market, and the Administration’s weak dollar policy fueled inflation in that and all markets. In the end, once again, we, the duped taxpayers, are being called in to clean up after the consequences of the political class’s malfeasance – which shows no capacity for self-correction or -policing.

Who’s to blame then? We, after all, elect the politicians who legislate the incentives that Wall Street responds to. Despite the ‘greed is good’ caricature of Wall Street, it is the woeful ignorance of most of the DC political class when it comes to how our wildly successful economy works that most scares me. The Depression was not caused by the stock market crash, but by the entirely ill-advised policy reactions of our political savior saints. Let’s hope we avoid a repeat, not of the Depression (which I believe unlikely), but of the 14 years of lost growth in the Japanese economy, once believed (as China is now) to be the dragon breathing down our door. The dragon, it so happens, is already inside.

We are in perilous times and I would put politicians, not bankers, at the center of it.