Wednesday, July 29, 2009
The New York Federal Reserve has just published a new report entitled "The Shadow Banking System: Implications for Financial Regulation".
One of the main conclusions of the report is that leverage undermines financial instability:
Securitization was intended as a way to transfer credit risk to those better able to absorb losses, but instead it increased the fragility of the entire financial system by allowing banks and other intermediaries to “leverage up” by buying one another’s securities. In the new, post-crisis financial system, the role of securitization will likely be held in check by more stringent financial regulation and by the recognition that it is important to prevent excessive leverage and maturity mismatch, both of which can undermine financial stability.
That is true.
In fact, every independent economist has said that too much leverage was one of the main causes of the current economic crisis.
However, notwithstanding the NY Fed's recommendations, the Federal Reserve and Treasury have, in fact, been encouraging massive leveraging.
As I pointed out in October, in an article entitled "In Trying to Stop the Inevitable Deleveraging Process, the Government is Only Making It Worse":
The government is reducing [banks'] cash reserve requirements so they can increase their leverage to loan money they don't have through fractional reserve banking. See also this. And - even after Greenspan confessed that derivatives were dangerous (and see this) - the government refuses to rescind them or take any other real actions to contain the nuclear fallout from such "weapons of mass destruction". Instead, the government is trying to prop up the derivatives market by various means.
By trying to put out the raging deleveraging forest fire, the government is actually fanning its flames and making it more dangerous. And even in those areas where the government appeared to put out the fire, there are hot coals just beneath the surface that are already erupting back into flame.
Unfortunately, as I've repeatedly pointed out, Summers, Bernanke, and Geithner are too wedded to an overly-leveraged, highly-securitized, derivatives-based, bubble-blown financial system. They are some of the main boosters of speculative finance. Indeed, Summers was one of the people most responsible for allowing the big financial institutions to speculate and gamble using insane amounts of leverage, and insisting that toxic derivatives be left completely unregulated.
But the blame does not solely rest with Summers, Bernanke and Geithner.
In other words, economists and financial advisors - in academia, government and elsewhere - have been subservient to the financial elites, and have trumpeted the safeness and soundness of cdos, credit default swaps, and all of the rest of the shadow economy which allowed leverage to get so out of hand that it brought the world economy to its knees.
This is no different from the promotion of sports doctors to become team doctor when they are willing to inject various painkillers and feel-good drugs into an injured football star so he can finish the game. If he is willing to justify the treatment as being safe, he is promoted. If not, he's out.
Economists have acted like team docs for the financial giants. When the football team doctor who gives the injured patient steroids and stimulants and tells him to get back in the game, it might be good for the team in the short-run, but the patient may end up severely injured for decades.
When economists have prescribed more leverage and told the banks to go trade like crazy to get the economy going again, it might be good for the banks in the short-run. But the consumer may end up being hurt for many years.