book review
May 7 (Bloomberg) -- Nouriel Roubini has a modest proposal for deflating Wall Street’s bubble-prone bankers.
Break up Goldman Sachs Group Inc., he says. Consider banning collateralized debt obligations. And why not compensate traders with slices of their own exotic securities instead of with cash or shares?
These prescriptions crop up in “Crisis Economics,” a rigorous yet highly readable look at why booms and busts occur and how to keep them from wreaking havoc on the real economy.
Roubini is usually remembered as “Dr. Doom.” He’s the New York University professor who predicted in 2006 that the U.S. would soon suffer a once-in-a-lifetime housing bust and deep recession. What’s less appreciated is that he based his forecast on years of studying booms and busts. His conclusion: Financial crises are hardwired into capitalism.
“Far from being the exception, crises are the norm,” he says in this book, written with journalist Stephen Mihm. To prove the point, they open with a brisk history of crises, from currency debasements in 12th-century Europe to the collapse of Lehman Brothers Holdings Inc.
By the 18th century, asset bubbles had become a common feature of capitalism: Witness John Law’s Mississippi Company and the South Sea Bubble. Panics punctuated the 19th century, and the crisis of 1907 famously prompted J. Pierpont Morgan Sr. to lock bankers up in his private library until they agreed to rescue the Trust Company of America.
(Hank Paulson attempted to replicate that act of brinkmanship one weekend 101 years later, when he leaned on Wall Street’s elite to arrange a private rescue of Lehman.)
‘The Same Script’
Crises tend to “follow the same script over and over again,” the authors say. A bubble swells the price of some asset well above its underlying value, and speculators borrow to buy into the boom. As the heap of credit rises, anyone who utters the word “bubble” is shouted down with the usual taunt, “This time is different.” It never is.
Ever since Adam Smith, economists have tended to focus on how markets succeed, not why they fail. So the book recalls the work of “crisis economists,” a rare breed of outliers such as John Maynard Keynes, Hyman Minsky and Joseph Schumpeter.
As this list suggests, Roubini and Mihm aren’t adherents of any particular economic school. They find merit in Schumpeter’s vision of “creative destruction,” waves of innovation and winnowing, yet they also credit Karl Marx for recognizing that capitalism is inherently unstable and prone to crises.
Walter Bagehot
Much of the book focuses on the mechanics of how the U.S. housing market bubbled and popped. The pathology -- and the chosen cure -- would have been familiar to Walter Bagehot, the 19th-century editor of the Economist, who argued that it takes a lender of last resort to halt a plunge into financial terror. He never foresaw the “deeply flawed version of his prescription” that emerged in 2007 and 2008, Roubini and Mihm say.
Bagehot opposed indiscriminate bailouts and argued that only solvent institutions should get access to loans, they write. Federal Reserve Chairman Ben Bernanke, by contrast, rescued illiquid and insolvent institutions alike.
His unprecedented actions probably helped avert another Great Depression, the authors say. His rush to prop up the system also set a dangerous precedent and may “sow the seeds of bigger bubbles and even more destructive crises.” They incurred massive costs -- U.S. deficits are forecast to reach some $9 trillion over the coming decade -- and dulled the appetite of lawmakers for a deep regulatory overhaul. They euthanized the forces of “creative destruction.”
Too Big
So what should be done? Like Simon Johnson, the former chief economist for the International Monetary Fund, Roubini and Mihm want to break up too-big-to-fail institutions. Their hit list includes JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc. and Goldman, to name a few.
The authors also want to change how bankers get paid, to force them to put more of their own skin in the game. Creating bonus pools calculated on average performance over several years might help. So might putting their bonuses for high returns into escrow for several years, with future losses subtracted from the total.
The Fed, for its part, should use its power to impede bubbles by removing the punchbowl, the authors say. And it’s time for a 21st-century version of the Glass-Steagall Act, to create extensive firewalls.
As for CDOs -- a.k.a. “Chernobyl Death Obligations” -- they must be heavily regulated if not banned. CDOs resemble dodgy sausages, they say: Someone needs to scrutinize the loans that go into them to make sure they don’t include “rat meat and trichinosis-laced pig parts.”
“Crisis Economics: A Crash Course in the Future of Finance” is from Penguin Press in the U.S. and from Allen Lane in the U.K. (353 pages, $27.95, 25 pounds).
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