Mar 132010
 
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Financial markets have stabilized – people believe that the US and West European governments will not allow big financial institutions to fail.  We have effectively nationalized any banking system losses, but we’ll let bank executives enjoy the full benefits of the upside.  How much shareholders participate remains to be seen; there will be no effective reining in of insider compensation (my version; Joe Nocera’s view).  Small and medium-sized banks, however, will continue to fail as problems in commercial real estate continue to mount.

The economic recovery, in the short-term, may be surprisingly strong in terms of headline numbers; this is a standard feature of emerging markets after a crisis (e.g., Russia from 1998 or Argentina after 2002).  Official short-term forecasts are probably now too low, as the IMF and other organizations make the case for continued fiscal stimulus and very loose monetary policy.

However, a two-track economy appears to be developing: one part will do well (e.g., around big banks on Wall Street), and another part will struggle (many consumers and firms around the world want to reduce their debt; the same thing happened in Japan’s “lost decade”).  During the 1990s, Japan had some years with good growth, but overall the decade was a disappointing deceleration of growth; the same could be true now at the global level.

Longer term U.S. growth prospects remain particularly uncertain – has consumer behavior really changed; if finance doesn’t drive growth, what will; is the budget deficit under control or not (note: most of the guarantees extended to banks and other financial institutions are not scored in the budget)?   The implication, presumably, is higher taxes on the productive nonfinancial part of the economy – to pay for the implicit subsidies and ongoing rents of the financial sector.  While many entrepreneurs understand and resent this math, they are strikingly unwilling to do anything about – or even speak out on – reining in the power of the biggest banks.  Even the smaller banks – who have really been hammered by the actions of larger banks – are only just now figuring this out and beginning to express resentment; sadly, this is too late to make much difference.

There has been a great deal of attention recently on income distribution (WSJ; NYT), with the argument being that the long financial boom made some people richer and the bust is bringing them back down.  But this misses the point that (a) some of the mega-rich will do very well; think about how Carlos Slim took over large parts of the Mexican economy after 1995, and watch Wilbur Ross acquiring assets in the US today, (b) billionaires becoming millionaires is hardly something to get worked up about.

The real damage is for 10-15 percent of American society, mostly without college education, who lost jobs, houses, and education opportunities.  The First Great Depression was a decade of effective poverty and other terrible outcomes for around 25-30 percent of American society.  We have avoided a Second Great Depression but the social costs are still huge.  Think through the political implications of that.

The collapse of Lehman Brothers in particular and the ensuing financial crisis in particular exposed serious weaknesses in our banks, insurance companies, and financial structures more generally.  We were “saved” by radical central bank action and additional government spending.  Over the past 20 years, crises have become more severe and more expensive to counteract.  We are on a dangerous and slippery slope.

Yet there is no real reform underway or on the table on any issue central to (a) how the banking system operates, or (b) more broadly, how hubris in finance led us into this crisis.  The financial sector lobbies appear stronger than ever.  The administration ducked the early fights that set the tone (credit cards, bankruptcy, even cap and trade); it’s hard to see them making much progress on anything – with the possible exception of healthcare (and even there, the final achievement looks likely to be limited).

The latest New York Times assessment of financial sector reforms is bleak.  The Washington Post is running an excellent series on exactly how and why the banks have become stronger (part one; part two).  Big banks have risen greatly in power over the past 20 years and were already strong enough this winter to ensure there was no serious attempt to rein them in.

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