NYT/Krugman: Innovating Our Way to Financial Crisis



New York Times
Op-Ed Columnist

Innovating Our Way to Financial Crisis

Published: December 3, 2007

The financial crisis that began late last summer, then took a brief vacation
in September and October, is back with a vengeance.

How bad is it? Well, I¹ve never seen financial insiders this spooked ‹ not
even during the Asian crisis of 1997-98, when economic dominoes seemed to be
falling all around the world.

This time, market players seem truly horrified ‹ because they¹ve suddenly
realized that they don¹t understand the complex financial system they

Before I get to that, however, let¹s talk about what¹s happening right now.

Credit ‹ lending between market players ‹ is to the financial markets what
motor oil is to car engines. The ability to raise cash on short notice,
which is what people mean when they talk about ³liquidity,² is an essential
lubricant for the markets, and for the economy as a whole.

But liquidity has been drying up. Some credit markets have effectively
closed up shop. Interest rates in other markets ‹ like the London market, in
which banks lend to each other ‹ have risen even as interest rates on U.S.
government debt, which is still considered safe, have plunged.

³What we are witnessing,² says Bill Gross of the bond manager Pimco, ³is
essentially the breakdown of our modern-day banking system, a complex of
leveraged lending so hard to understand that Federal Reserve Chairman Ben
Bernanke required a face-to-face refresher course from hedge fund managers
in mid-August.²

The freezing up of the financial markets will, if it goes on much longer,
lead to a severe reduction in overall lending, causing business investment
to go the way of home construction ‹ and that will mean a recession,
possibly a nasty one.

Behind the disappearance of liquidity lies a collapse of trust: market
players don¹t want to lend to each other, because they¹re not sure they¹ll
be repaid.

In a direct sense, this collapse of trust has been caused by the bursting of
the housing bubble. The run-up of home prices made even less sense than the
dot-com bubble ‹ I mean, there wasn¹t even a glamorous new technology to
justify claims that old rules no longer applied ‹ but somehow financial
markets accepted crazy home prices as the new normal. And when the bubble
burst, a lot of investments that were labeled AAA turned out to be junk.

Thus, ³super-senior² claims against subprime mortgages ‹ that is,
investments that have first dibs on whatever mortgage payments borrowers
make, and were therefore supposed to pay off in full even if a sizable
fraction of these borrowers defaulted on their debts ‹ have lost a third of
their market value since July.

But what has really undermined trust is the fact that nobody knows where the
financial toxic waste is buried. Citigroup wasn¹t supposed to have tens of
billions of dollars in subprime exposure; it did. Florida¹s Local Government
Investment Pool, which acts as a bank for the state¹s school districts, was
supposed to be risk-free; it wasn¹t (and now schools don¹t have the money to
pay teachers).

How did things get so opaque? The answer is ³financial innovation² ‹ two
words that should, from now on, strike fear into investors¹ hearts.

O.K., to be fair, some kinds of financial innovation are good. I don¹t want
to go back to the days when checking accounts didn¹t pay interest and you
couldn¹t withdraw cash on weekends.

But the innovations of recent years ‹ the alphabet soup of C.D.O.¹s and
S.I.V.¹s, R.M.B.S. and A.B.C.P. ‹ were sold on false pretenses. They were
promoted as ways to spread risk, making investment safer. What they did
instead ‹ aside from making their creators a lot of money, which they didn¹t
have to repay when it all went bust ‹ was to spread confusion, luring
investors into taking on more risk than they realized.

Why was this allowed to happen? At a deep level, I believe that the problem
was ideological: policy makers, committed to the view that the market is
always right, simply ignored the warning signs. We know, in particular, that
Alan Greenspan brushed aside warnings from Edward Gramlich, who was a member
of the Federal Reserve Board, about a potential subprime crisis.

And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the
Treasury secretary, admitted to Fortune magazine that financial innovation
got ahead of regulation ‹ but added, ³I don¹t think we¹d want it the other
way around.² Is that your final answer, Mr. Secretary?

Now, Mr. Paulson¹s new proposal to help borrowers renegotiate their mortgage
payments and avoid foreclosure sounds in principle like a good idea
(although we have yet to hear any details). Realistically, however, it won¹t
make more than a small dent in the subprime problem.

The bottom line is that policy makers left the financial industry free to
innovate ‹ and what it did was to innovate itself, and the rest of us, into
a big, nasty mess.



Ask a Question

Want to reply to this thread or ask your own question?

You'll need to choose a username for the site, which only take a couple of moments. After that, you can post your question and our members will help you out.

Ask a Question