The most pivotal moment of the ongoing global financial crisis thus far was the decision to let Lehman Brothers sink on September 15, 2008. The decision which now looks like a monumental blunder?the crisis took a decisive turn for the worse in the weeks and months after Lehman?s demise?had its fair share of supporters, particularly from the ruling Republican Right. It was believed that free market capitalism must allow bad firms to be destroyed, and not be rescued by the state. The ten months after that have been spent repairing the damage caused by the complete loss of confidence in the financial system in the aftermath of Lehman?s death. But in the fast moving world of global finance, that?s history.
Now, in July 2009, the worst of the crisis in the financial sector seems to be over, at least if the latest quarterly results declared by major US financial institutions are an indicator?Goldman and JP Morgan in particular have reported handsome profits in the April-June quarter. Ironically enough, this story of turnaround forms the backdrop for the next pivotal moment in US (and by corollary global) finance.
The announcement of record profits and the payout of large bonuses, at Goldman in particular, have prompted a surge of outrage among a section of influential economists and the media in the US and elsewhere. The potent political argument is simple: in an economy still weighed down by a recession (unemployment still rising towards the10% mark) brought on by the excesses of financial institutions, how can select bankers be earning such ?obscene? bonuses? Add to that the fact that almost all financial institutions, including Goldman and JP Morgan had received almost costless government aid, which helped them tide over the worst of the crisis, in the last ten months.
The more technical argument against the profits and bonuses is different: Paul Krugman, for example, argued in a New York Times op-ed that the profits are the result of the same risky practices that sank Wall Street in the first place and that the bonuses are part of the incentive problems which led to reckless behaviour by bankers in the first instance. If this is allowed to continue, another crisis will erupt, goes this line of argument.
Now, the ball is in the court of the US government and regulatory authorities?how seriously are they going to take what the critics say and how will that play in the process of reform of the entire financial system?
It is to the credit of the Democratic administration that they have intervened intelligently in the rescue process so far, and not succumbed to their instinctively anti-Wall Street core constituency. An example of intelligent intervention was the move to nudge all major financial institutions to take government funding to shore up their capital base without any outright nationalisation except those of Freddie Mac and Fannie Mae, which in any case sat on a flimsy fence on the border of government and private control. There have been no knee-jerk moves to over-regulate the financial system and many proposals are still being debated. The US would not like its dynamic capitalism to change character. To their credit, some banks including Goldman and JP Morgan have already paid the government back in full, which should leave them completely free to take decisions on how to run their business and how to pay their employees.
In any case, simply focusing on the issue of executive pay is diverting attention from the real epicentre of the crisis. Sure, there is an argument for bankers to operate over longer time horizons than they sometimes do. But the real centre of this crisis lay in the opaque securitised assets and derivative instruments that pervaded through the entire financial system, without any control over their quality, or indeed adequate supervision of the loans mortgages that lay behind them. The real villains of the crisis were in fact credit rating agencies which more often than not, with multiple conflicts of interests, over-rated many of these securitised assets?securitisation therefore increased the risk in the system rather than reducing it. The real policy debate, if a recurrence of a crisis of this scale is to be prevented, should therefore be about the future of securitisation and the role of credit rating agencies, and not executive pay. So far, credit rating agencies have largely got away despite their considerable errors of judgment. And there is insufficient discussion of how to make securitised assets more transparent?this has to perhaps go beyond trading them in exchanges rather than over the counter.
No one can argue that Wall Street got everything right and that there is no need for reform. Of course, there is. But, by barking up the wrong tree of populist politics, the critics risk letting the real culprits go scot-free.
?dhiraj.nayyar@expressindia.com