Grading our policymakers: how effectively have they dealt with the root causes of the Great Financial Crisis?

• Position: A SYMPOSIUM OF VIEWS

Blame for the Great Financial Crisis can be laid on many causes. Some argue that the crisis stemmed from severe global savings imbalances that led to the under-pricing of financial risk. The United States consumed too much and saved too little, while large parts of the world became dangerously export-dependent.

Others attribute the crisis to a lack of transparency in the asset-backed securities markets. Observers have cited the bank regulators and credit rating agencies for being asleep at the switch, along with the banks 'inability to value the sophisticated assets on their balance sheets even as they increased their use of financial leverage to dangerous levels. Then there was the alleged politicizing in the United States of Fannie Mae and Freddie Mac.

Some attribute the crisis to an overly accommodative monetary policy. The breakdown of Glass-Steagall and the growth of "too big to fail" institutions, which were able to engage in reckless financial risk-taking using taxpayers as their safety net, is also faulted.

To what extent have our policy leaders addressed these and other causes to prevent future crises?

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An Incomplete.

BARRY EICHENGREEN

Professor of Economics and Political Science, University of California, Berkeley

My own diagnosis of the crisis sees it as fundamentally the result of lax supervision and regulation of financial institutions and flawed incentives in financial markets. It was inadequate regulation that sparked the flames: the Fed's exceptionally low interest rates in 2003-04 and the capital inflows into the United States associated with reserve accumulation abroad then poured additional fuel on the fire.

So in asking whether our policymakers have effectively dealt with the root causes of the crisis, I would look first and foremost at the steps they have taken to strengthen the application of existing regulations, promulgate constructive new regulations (Basel III), and correct the flawed incentives flowing from perverse executive compensation practices in the financial services industry. Here, I would give them a grade of Incomplete. I'm not so pessimistic as to believe that the window of opportunity has closed, but I've learned from years of teaching that the longer a grade of Incomplete remains on the books, the less likely the student is to complete the course requirements.

To date they deserve an A.

JAGDISH BHAGWATI

University Professor, Economics and law, Columbia

University, and Senior Fellow, Council on Foreign Relations

Remedies must reflect, and readily follow from, diagnosis. Let me therefore concentrate on the many causes of the Great Financial Crisis.

Ideology played a role. The extraordinary belief, despite over a century of experience with panics, bubbles, and manias, that financial markets needed only notional regulation can be laid mainly at the door of former Fed chair Alan Greenspan. But there was also an unwarranted extrapolation to the financial markets of the successes we had in non-financial postwar liberalization of international trade and direct foreign investments.

Another important cause was also what I called, in my 1998 Foreign Affairs article, the Wall Street-Treasury Complex. With continual back-and-forth movement from Washington to Wall Street, commonalities of viewpoint followed, as did suspension of worries about the occasional downside in the financial sector. MIT professor Simon Johnson has picked up this theme, calling the Complex a "Corridor" instead and vulgarizing my idea by turning it into a "capture" proposition which makes little sense.

An equally important factor was the failure to recognize that financial innovation was not the same as non-financial innovation. The latter raised problems which Schumpeter described as those of "creative destruction," as old technologies and products had to be eased out, whereas the former had a potential downside with huge adverse effects so that we were dealing with what I have called the problem of "destructive creation." This required a comprehension of the downside of the new instruments, along with vigilance and monitoring which were absent.

But this governmental regulatory error was also compounded by the contributions made by the U.S. Congress. Congress aided the formation of the housing bubble through low-quality mortgages from Freddie Mac and Fannie Mae. Congress also fueled, instead of halted, the race to the bottom, such as when Senator Charles Schumer (D-NY) sided with the big investment banks when they successfully lobbied the Securities and Exchange Commission for absence of capital and reserve requirements.

The proposed reforms are many-sided. Capital and reserve requirements will be introduced for investment banking activity. The "destructive creation" point and the consequences of the Wall Street-Treasury Complex have been grasped and should inform the new regulators. Some key international coordination has been achieved. I do not agree with many details, but the policy leaders deserve an A to date.

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A gentleman's C.

MARSHALL I. GOLDMAN

Senior Scholar, Davis Center for Russian and Eurasian Studies, Harvard University

Most commentary on the great financial crisis of 2010 analyzes it clinically from a macro perspective. As a director of a reasonably small community bank with headquarters in a Boston suburb, I have also had the unique opportunity to observe the financial crisis from the inside or bottom up.

Our bank started forty years ago with one office operating out of a trailer. We have survived a variety of financial ups and downs and today have more than $2 billion in assets and a dozen branches, almost all created from scratch.

In other words, while we are not one of the largest--sometimes stodgy--traditional Boston banks, we are nonetheless now a solid institution. That means we have survived several financial recessions and are treated as one of the better-managed community banks in New England. We have also watched other banks that opened their doors at the same time we did disappear either through merger or financial imprudence.

We are used to hearing banking consultants tell us that we have entered a new age where recessions are a thing of the past and that if we want to survive we must take more risks. But we balance such advice with the realization that financial recessions are not unique events and that hard as the country's banking authorities might try, recessions are likely to reoccur.

If anything, when we hear such advice, we worry that it might be time to be more cautious than usual since such thinking has traditionally led to incautious lending.

We directors don't always agree about this and on occasion the bank has lost business and passed up unique opportunities. But it helps that the bank is still essentially a family bank and that the chairman of the board and CEO are its largest stockholders. As a result, they feel it is their money that is at risk. Perhaps more than anything, the dominance today of mega-banks and the pushing aside of owner-directors in other banks has brought with it an end to more cautious bank management. That can seem like an important advantage at the beginning of a business cycle but a nightmare as exuberance is transformed into regret and a search for scapegoats.

I would give our banking authorities a grade C and I would be amazed if they manage to prevent other recessions and bank failures in the future.

The real test comes in how they reduce budget deficits. The jury is still out.

OTMAR ISSING

Former Chief Economist, European Central Bank

Additional expenditure to stop the crisis from developing into a depression was appropriate. However, these decisions were the easier part. The real test comes with the need to reduce budget deficits, to set priorities for public spending, to agree on reasonable rules for the financial industry, and resist the temptation of over-regulation. Here the jury is still out.

On avoiding a second depression, an A. On fixing the causes, a gentleman's C.

GARY CLYDE HUFBAUER

Reginald Jones Senior Fellow, Peterson Institute for International Economics

In 1939, after a decade of Depression with a capital "D," gross federal debt reached 54 percent of GDP. That left ample financial room to fight the Second World War, which raised federal debt to 122 percent of GDP.

This time around, thanks to resolute action by Team Obama and Chairman Bemanke, the United States avoided a Second Great Depression. For this, they deserve an A. But gross federal debt will almost reach 100 percent of GDP in 2011, on top of unfunded liabilities that amount to another 300 percent of GDP. In other words, the United States comes out of the Great Crisis with little financial capacity to meet the next global shock. Nor is there any prospect of agreement between Liberal Democrats and Tea Party Republicans on sensible spending cuts and tax increases. Where is Alexander Hamilton when we need him?

Scoring and fixing the causes of the Great Crisis are important tasks. Team Obama and Chairman Bernanke may eventually earn a gentleman's C for correcting past failures. They are making progress on financial regulation. Still, among other question marks, we don't know what the Administration will do with Fannie and Freddie, nor whether the Fed will gently deflate the next asset bubble.

But the next financial crisis seems far more likely to arise from yawning public debt and deadlocked politics than from a repetition of prolonged easy money, sleepy regulators, Fannie and Freddie on steroids, and Wall Street follies. For the coming crisis, the most Team Obama has done so far is appoint a commission.

Policymakers must recognize there is a deeper source of economic stability.

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ROBERT SAMUELSON

Columnist, Newsweek and the Washington Post, and author, The Great Inflation and Its Aftermath: The Past and Future of American Affluence (Random House, 2010)

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