[For a brief comment on the future of securitization, click here.]
It pays to listen carefully to really smart people.
Our huge, diverse land has many of them. For the last eight years they’ve kept their heads down, as hurricanes of mindless bombast roared by. Now that we have a really smart president, they seem to be popping up all over.
One of them is Eric Schmidt, Google’s CEO and an early Obama supporter. He strutted his stuff on Charlie Rose recently. He uses simple language—rarely a polysyllabic word. Yet his thoughts are uncannily precise and insightful. He speaks the way the best of us write after four or five drafts.
You could tell right away something special was going on. Uncharacteristically, Rose interviewed Schmidt before an audience of educated professionals, who reacted appreciatively. If you missed the show, you can watch it on line.
Toward the end of the interview, Schmidt said something simple but profound. If you have to survive a depression like the one now beginning, you’d rather be in America than anywhere else. Why? Because it’ll be “more painful, [but] you’ll get out faster.”
I didn’t fully appreciate Schmid’s sagacity until the next day, when I read a New York Times article headlined: “Job Losses Hint at Vast Remaking of Economy.”
Industrial economist Joseph Schumpeter was another really smart man. He described capitalist innovation as “a perennial gale of creative destruction[.]”
Many people have quoted that marvelous phrase, but few understand it fully. It means there are two sides to the coin: creation and destruction. You can’t have one without the other. Old industries and ways of life must die so that new ones can be born and thrive. Destruction and dying are painful but necessary companions to creation. They are the pain to which Schmidt referred.
Schmidt’s optimistic prediction—that the pain will be severe but brief—depends on us heeding Schumpeter’s warning. Unfortunately, we Americans have become soft: we wince at pain. As a result, vital sectors of our economy have put their creative destruction off far too long. So now they need a much bigger dose of it, and the result will be more painful.
Although we invented nuclear power, over half our electricity still comes from burning coal—a nineteenth-century technology that is destroying our biosphere. For transportation we depend almost totally on oil, an early twentieth-century fuel that (in economic terms) is rapidly becoming scarce. For health care, we rely on outmoded and failing private markets that all our trading partners have abandoned.
Not only that. Our private markets in health care leave 47 million “customers” unserved. Aren’t shortages and rationing supposed to be consequences of socialism and central command, not capitalism and free markets? We’ve turned capitalist economic theory on its head, and no one even noticed.
Our auto industry is another example, if one were needed. While the Japanese introduced the Wankel engine and hybrid technology, our car industry has introduced no basic advance in propulsion technology in over fifty years. Now we wonder why it’s going under.
Why have we let these failing industries linger so long? The reason has nothing to do with capitalism. They’ve entrenched themselves far beyond their technological or market merit by subverting government to their own ends.
For most of a century these three basic industries (fossil fuels, autos, and health care) have enjoyed massive direct and indirect governmental subsidies. Not only have they been mostly free from reasonable regulation; their rivals have often been more heavily regulated. What was the taxpayer-built Interstate Highway System but a massive subsidy to the automobile and fossil-fuel industries? As for regulation, these industries paid few, if any, of the costs they impose on society through pollution, climate change, economic waste and (in the case of health care) lack of prevention, belated treatment, needless suffering and death. They all have been favored children of government, maintaining their predominance not through free markets, but though lobbying, political contributions and other forms of special influence.
Since government has always been part of the problem, it has to be part of the solution. For decades it has favored these industries in ways big and small. It has postponed their inevitable destruction without regard to Schumpeter’s capitalist credo. It’s past time for them to exchange the government-rocked cradle for the coffin.
Our banking meltdown and collapsing general economy leave no alternative. Government must help jump-start creative new industries to replace the ones we’re losing because, in an imploding economy, no one else can. Only government can help young industries give us electric cars, rapid transit and the windmills, solar energy and safe nuclear energy to run them, as well as smaller, denser planned communities (with well-staffed local health clinics) that use them more efficiently, so as to preserve our clean air and our biosphere.
One of my favorite stories of resistance to change comes from the steam-engine era. After watching a steam locomotive reach the unheard-of speed of twelve miles an hour, a newspaperman was inconsolable. Such vicious velocity, he wailed, would destroy our way of life by frightening the horses.
Some people resist inevitable change; others embrace it. In the final analysis, that may be the most salient difference between Republicans and Democrats. A few weeks ago one Daniel Henninger of the Wall Street Journal huffed:
“There isn’t much in [the President’s] plan to stir the national soul. It’s about ‘sacrifice’ now so that we can live for a future of small electric cars and windmills.”If saving our biosphere, achieving energy independence, and exchanging stinky, cantankerous cars for smoke-free ones that run more cheaply and more reliably, and that you can “fill up” from a plug in your garage, doesn’t stir the soul, I don’t know what will. As I read Henninger’s words, I mentally added “and give up our horses.”
Henninger also failed to note a few minor relevancies. First, the world is running out of the oil on which we depend utterly for transportation, so sacrifice is inevitable. Second, the economic laws of demand and supply inelasticity, which Wall Street Journal pundits ought to know, decree ever-increasing prices for oil, as soon as the global economy starts to recover. Third, he failed to mention that it takes millions of years for Nature to make oil, and we humans need all we’ve got as feedstock for chemicals, fertilizers and plastics. Finally, he failed to note that profligate burning of fossil fuels is changing our climate and destroying our way of life far more dramatically than the disappearance of horses or the decreasing popularity of SUVs and muscle cars.
As always, our youth will save us from ourselves. Is there any wonder that they favor the President and his visionary program by substantial margins? Youth understand the power of creative destruction because applying that power and achieving both destruction and renewal are their eternal role.
Resurrecting SecuritizationToday’s Paul Krugman column raises a vital question: will the resurrected system of loan securitization that Tim Geithner plans look more like Christ risen or a vampire emerging from a coffin?
As you may recall, securitization is the process of “bundling” loans and selling the bundles to get the loans off the lending institution’s books. It also has another purpose: slicing and dicing the bundles allow financial firms remote from the lender to separate various levels of risk and, by placing bets on those levels, presumably to control risk better.
You may also recall that this theory didn’t work. Instead of helping Wall Street to manage risk better, it encouraged extreme leverage and rampant gambling, which ultimately crashed the entire financial system.
Krugman is unequivocal about his conclusions. “I don’t think the Obama administration can bring securitization back to life,” he writes, “and I don’t believe it should try.”
Oddly enough, Warren Buffet said much the same thing (albeit in different words) about derivatives just a few weeks ago. In his much-awaited annual letter as CEO of Berkshire Hathway, he wrote:
“Improved ‘transparency’—a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks—won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them.”Until I read Krugman’s column today, I was deeply skeptical of securitization but still agnostic. It does leverage funds available to lend, thereby potentially loosening credit, which is tight right now. But clear and strong opposition from a Nobel Prize winning academic economist and the world’s smartest investor caused me to rethink.
To me, the crux of the matter is moral hazard. A wise lender knows her borrower. If a bad decision stands to lose her money, she will be careful. But securitization whisks the risk away from the lender to some remote office on Wall Street. Not only that: by bundling hundreds or thousands of loans together, it makes the risk of each seem negligible, even though the whole is nothing more than the sum of the parts.
Maybe this wouldn’t matter if people were dispassionate, rational computers. Then Wall Street could accurately assess the risks of each loan in a bundle and add them up.
But people are not computers, and that’s not what actually happened. Instead, people at every level—lenders, securitizers, sellers of securities, and insurers through credit-default swaps and other sophisticated instruments—had incentives to increase throughput and underestimate risks. The final link in the chain, the rating agencies, had incentives to rate high (to increase their fees) and disincentives to accuracy (because no one had ever devised a good mathematical model for a bubble popping). The results we see in shambles all around us.
Unlike computers, people need to feel a sense of personal responsibility to do the right thing. Securitization ignores that very human element. It is the financial equivalent of saying to troops in Afghanistan, “If you lose courage or screw up, your buddy next to you won’t be hurt, but some guy you once knew in high school might.” No one would run an army that way, and no one should run a financial system that way, either.
To do its work, moral hazard has to be felt and tasted. Securitization prevents that from happening. It takes the consequences of lending decisions to some remote office far away. To make that sort of system work well, you’d have to change not just regulation, but human nature.
So I add my small voice to Krugman’s and Buffet’s megaphones. Let’s make banking stodgy and boring but reliable again. Then let’s get back to the serious business of reforming our basic industries. If we put all those misdirected financial brains back to work doing something productive, who knows what we might achieve?