Our system of borrowing, lending, and financing investments by both businesses and households is a national treasure, one which we have squandered in recent years.
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Bubble, bust, repeat...bubble, bust, repeat...bubble, bust, repeat...

For the last few decades, that's been the American growth recipe. The damage done by these cycles is evident in both the current downturn and the daily headlines featuring systemic failures large and small. But what may be unique about today's climate is that this dysfunctional process is clear to anyone willing to take close look at it. This should be especially notable to that group whose approval rating just hit record lows: the US Congress.

One reason for those in the tank ratings is that we're looking for smart, aggressive action on these issues that get policy makers ahead of the economic curve, instead of where they've been: reacting to every bit of bad news like deer in the headlights, pulling a new bailout plan out of their antlers (I was actually thinking of a different part of the deer's anatomy, but this is a family post).

What are "these issues?" What are the processes that generate the shampoo economy?

As is often the case, there's no single smoking gun. Instead, there's a bunch of bloody knives.

It starts with ideology (doesn't it always?). YOYO economics -- the "you're on your own" market fundamentalism that has a) dominated policy makers thinking and b) is impermeable to empirical facts revealing its failures -- convinces policy makers that deregulation of key markets is necessary to promote growth. They've even got the matrix algebra to prove it.

Next, investment begins to flow into some corner of these markets -- usually either financial markets, housing markets, or some exotic new product market (could be tulip bulbs, could be fiber optic cable) -- where returns have been above average. Next, as George Soros explains very compellingly in his new book, the process feeds on itself as turbo-charged investment flows lead to higher prices, which lead to more investment, higher prices, and the bubble is underway.

In this last episode, add a new dimension: a level of financial "innovation" that added growth hormones to the process. Some of these ideas, like shadow accounts that investment banks could legally keep off their balance sheets were just chicanery, but others were legitimately designed to diversify, and thus reduce, investment risk.

Take, for example, the process of bundling mortgage debt into "mortgage-backed securities," a debt instrument comprised of different parts with varying quality. The idea was to spread the riskier debt around so that its downsides would be diminished and offset by the higher quality stuff. But it clearly had the opposite effect, such that the bad debt infected the rest in ways that eluded both rating agencies and investors.

Part of the problem stemmed from the greater distance between the original lender and the ultimate debt holder, a development that requires stricter lending standards -- the exact opposite of what we got -- because market discipline is unlikely to punish careless lenders when they're not holding the loan. It's a good example of how the ideology and the market innovation fed off of each other in precisely the wrong way.

Note a key point above. The YOYOs will always argue "market discipline" is the ultimate regulator. That is, they'll do so until the weekend when the bank actually fails. Then it's handout time.

In this manner, the last two, and arguably last three recessions have been self-inflicted. They've been brought to us by exploding bubbles, in housing (today), IT (2001), and banking/housing again (1990-91).

The thing is, this tendency of financial markets to go off the rails is well known. Since Adam (Smith), it has been recognized that self-interest and greed must be checked with regulation. Of course, regulators always walk a fine line, particularly in financial markets, where innovation and leverage have long played important and useful roles. It is also the case that when disaster strikes, the tendency among policy makers can be to become too zealous and overcompensate, imposing regulations that go too far in restricting necessary freedoms.

Yet few would disagree that the pendulum has swung much too far in the direction of unregulated markets, and the results have been costly. They can be measured in macro, micro, and financial terms. Lending institutions are in the process of writing off hundreds of billions of dollars in failing debt. Millions of homeowners face foreclosure, and tens of millions face "underwater" debt burdens. The spillovers from the bursting housing bubble helped pave the way for what is surely a recession waiting to be officially labeled as such, one for which working families are uniquely unprepared, given their failure to benefit from much of the growth over the 2000s business cycle.

To not make some version of these changes would pose a greater threat to financial markets than those posed by the recommendations themselves. Investment analyst Michael Lewitt puts it well (pdf):

"[One] often hears the argument that too much regulation will force business offshore and render the U.S. financial industry less competitive. Our response to that argument is that institutions and fiduciaries in the end will gravitate to the system with the strongest and wisest regulatory protections. Moreover, we should be pushing the most reckless practices out of our markets and into other markets. We should be creating global competition over best regulatory practices, not worst ones."

Our system of borrowing, lending, and financing investments by both businesses and households is a national treasure, one which we have squandered in recent years. Excessive deregulation has thwarted the transparency that is integral to creating appropriate price signals. Risk has been consistently underpriced, contributing to bad underwriting, negligent risk management, and deeply damaging bubbles. When policy makers ignore these dynamics, as they have in recent years, our economy is put at great risk.

The time has come to re-regulate these markets. I've got some ideas which I'm planning to present in testimony to the Joint Economic Committee this Wednesday, and I'll be sure to post it on the EPI website as well. Nothing fancy, just obvious stuff regarding mortgage underwriting (actually, we've got decent rules already in this area; we've just been ignoring them), capital reserves (the faster and looser you play it, the more dough you need around when the deal goes bad), and transparency (if you're too big too fail, then Congress must oversee your market exposure).

Our worst enemy here is not over-reacting. It's doing nothing. Stay tuned.

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