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Banks Gone Wild
By Paul Krugman
11/24/07 "New
York Times " -- -- “What were they
smoking?” asks the cover of the current issue of Fortune
magazine. Underneath the headline are photos of recently deposed
Wall Street titans, captioned with the staggering sums they
managed to lose.
The answer, of course, is that they were high on the usual drug
— greed. And they were encouraged to make socially destructive
decisions by a system of executive compensation that should have
been reformed after the Enron and WorldCom scandals, but wasn’t.
In a direct sense, the carnage on Wall Street is all about the
great housing slump.
This slump was both predictable and predicted. “These days,” I
wrote in August 2005, “Americans make a living selling each
other houses, paid for with money borrowed from the Chinese.
Somehow, that doesn’t seem like a sustainable lifestyle.” It
wasn’t.
But even as the danger signs multiplied, Wall Street piled into
bonds backed by dubious home mortgages. Most of the bad
investments now shaking the financial world seem to have been
made in the final frenzy of the housing bubble, or even after
the bubble began to deflate.
In fact, according to Fortune, Merrill Lynch made its biggest
purchases of bad debt in the first half of this year — after the
subprime crisis had already become public knowledge.
Now the bill is coming due, and almost everyone — that is,
almost everyone except the people responsible — is having to
pay.
The losses suffered by shareholders in Merrill, Citigroup, Bear
Stearns and so on are the least of it. Far more important in
human terms are the hundreds of thousands if not millions of
American families lured into mortgage deals they didn’t
understand, who now face sharp increases in their payments —
and, in many cases, the loss of their houses — as their interest
rates reset.
And then there’s the collateral damage to the economy.
You still hear occasional claims that the subprime fiasco is no
big deal. Even though the numbers keep getting bigger — some
observers are now talking about $400 billion in losses — these
losses are small compared with the total value of financial
assets.
But bad housing investments are crippling financial institutions
that play a crucial role in providing credit, by wiping out much
of their capital. In a recent report, Goldman Sachs suggested
that housing-related losses could force banks and other players
to cut lending by as much as $2 trillion — enough to trigger a
nasty recession, if it happens quickly.
Beyond that, there’s a pervasive loss of trust, which is like
sand thrown in the gears of the financial system. The crisis of
confidence is plainly visible in the market data: there’s an
almost unprecedented spread between the very low interest rates
investors are willing to accept on U.S. government debt — which
is still considered safe — and the much higher interest rates at
which banks are willing to lend to each other.
How did things go so wrong?
Part of the answer is that people who should have been alert to
the dangers, and taken precautionary measures, instead blithely
assured Americans that everything was fine, and even encouraged
them to take out risky mortgages. Yes, Alan Greenspan, that
means you.
But another part of the answer lies in what hasn’t happened to
the men on that Fortune cover — namely, they haven’t been forced
to give back any of the huge paychecks they received before the
folly of their decisions became apparent.
Around 25 years ago, American business — and the American
political system — bought into the idea that greed is good.
Executives are lavishly rewarded if the companies they run seem
successful: last year the chief executives of Merrill and
Citigroup were paid $48 million and $25.6 million, respectively.
But if the success turns out to have been an illusion — well,
they still get to keep the money. Heads they win, tails we lose.
Not only is this grossly unfair, it encourages bad risk-taking,
and sometimes fraud. If an executive can create the appearance
of success, even for a couple of years, he will walk away
immensely wealthy. Meanwhile, the subsequent revelation that
appearances were deceiving is someone else’s problem.
If all this sounds familiar, it should. The huge rewards
executives receive if they can fake success are what led to the
great corporate scandals of a few years back. There’s no
indication that any laws were broken this time — but the
public’s trust was nonetheless betrayed, once again.
The point is that the subprime crisis and the credit crunch are,
in an important sense, the result of our failure to effectively
reform corporate governance after the last set of scandals.
John Edwards recently came out with a corporate reform plan, but
it didn’t receive a lot of attention. Corporate governance still
isn’t regarded as a major political issue. But it should be.
Paul Krugman is Professor of Economics at Princeton University
and a regular New York Times columnist. His most recent book is
The Conscience of a Liberal.
© 2007 The New York Times
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