This past weekend I’ve been reading Roubini and Mihm’s Crisis Economics, a worthwhile read if you’d like to understand what went wrong.
I’m “just an ordinary guy” when it comes to international-scale economics; and like most people probably — I’ve been baffled by what the financial crisis that peaked in the fall of 2008 was really about. This book is a great and neutral exposition of what really happened and what we should do about it.
The first two thirds of the book is a history lesson on what happened, a parallel tale of 1929 and 2008. The last part talks about what we should do about it, and how the concequences of the US’s enoumous current trade deficit may unfold.
The latter part is the more interesting of course. The authors make it very clear that the crisis is not directly the fault of the individual actors in the financial system; it’s the system itself that is fundamentally broken.
One central principle that was broken in the recent crisis was that central banks bailed out (a) financial institutions that were not just illiquid but they were also insolvent, and (b) they also bailed out non-banks. Both represent moral hazards, as it may cause people to expect such bail outs in the future; even in non-bank financial institutions, which is likely to make them take risks they would not otherwise undertake.
What should be done?
The crisis is an eminent opportunity to change legislation. Generally, the legislation need to guide system actor’s motivations and increase transparency.
- Compensation in the financial sector should be restructured so as to value long-time gains rather than quick wins. The authors make it an explicit point to say that it is not necessarily the size of compensation which is the problem; it’s the structure. There needs to be more skin in the game.
- The fact that rating are payed for by the very institutions that are selling financial products, is fundamentally broken. IMO, ratings should be provided to the public free of charge by truly independent bodies — national or supernational, and the more the merrier. Until then, never trust an AAA rating again.
- Derivatives need to be controlled. It’s absurd that the system alows anyone to buy CDS’s “bankrupcy insurance” for a any 3rd party; even without having an equity interest in that party. It’s like buying fire insurance for your neighbours house ... which might motivate me to play around with some matches ...
- Too-big-to-fail oriented legislation is bullshit; rules should apply to everyone. If anything, corporations that are too large to fail should be split up.
The book contains many more suggestions for what could be done, the above are some of the more important ones it seems.
According to the authors it is inevitable that soon, the US’s status as the world’s primary economy will fade, and likely be replaced with a century with Chinese dominance. The US Dollar cannot continue to be the reference currency. Hopefully this shift will happen in an orderly fashion, but if the US tries to devaluate the dollar by inducing too much inflation (reducing the value of treasury bonds) we might see a “run on the bank” out of the ordinary.
Great book. There’s a lot of “doom day” books out there, this is not one of them. It provides a solemn and trustworthy account of what happend and argues what we need to do.