My friend and former colleague, Uwe E. Reinhardt, James Madison Professor of Political Economy at the Woodrow Wilson School of Public and International Affairs and the Economics Department of Princeton University, has written the following lovely reflection on the role of the government in the US economy. Its applicability to current discourse in the financial markets throughout the North Atlantic area should be obvious.
Start of Uwe Reinhardt’s guest blog
To provide a proper backdrop for my lecture on “The Government’s Role in the Economy” in Econ 100, I always preface it with the question: “Who in this class has a mother?” In a good year, as many as 25% of the students raise their hand. The rest won’t admit it, because regulating mothers, like regulating government, are the ultimate buzz kills in the human experience.
If enterprising children are out in the yard, researching how hard a snowball can be before breaking a window, who usually kills that experiment? Mom, of course. When, after attending a rock concert, a fully mature 15-year old wants to stay overnight at the Waldorf Astoria with her boyfriend or his girlfriend, who usually kills that enterprising initiative? Mom, of course. Why evolution has not done away with these enterprise-stifling-and-human-development-arresting Moms is an intriguing question. Perhaps they have survived because, when teenagers get into trouble, mothers usually are the source of instant succor. Click on http://www.youtube.com/watch?v=x1fVfcv3vHc, there to see a rugged, All-American teenager accidentally breaking his fish tank with his bar bells and promptly emitting the universal, primeval teenage scream “Mom! Mom!” That is typical for teenagers.
What mothers are to teenagers, government is to the adults who run the private sector of our economy. While teenagers chafe under Mom’s regulations, these free enterprisers sit in their offices, clubs or golf carts, wringing their hands over the mindless regulations issued by politicians and government bureaucrats who “cannot walk and chew gum at the same time.” Yet, like troubled teenagers seeking succor from Mom, when the going gets tough, these same free enterprisers frequently run to the government for instant succor.
Watch, for example, as our investment bankers on Wall Street, a.k.a. Masters of the Universe, now run to our government for help, after the mess they have made of their companies, of our economy and, indeed of global finance. One can cloak what they did in technical jargon such as “under-pricing risk.” One can even write sycophantic apologias on their behalf, as did New York Times columnist David Brooks when he opined that the current calamity on Wall Street is just a byproduct of “financial innovation.” The fact is that what happened on Wall Street was much less innovative than reckless and ill advised (in the vernacular, “stupid.”)
The bankers’ new, new thing was persuading investors around the world (and ultimately themselves) that if dodgy mortgages –technically known as sub prime mortgages –were packaged and repacked several times over, the risk inherent in them would somehow miraculously evaporate. By skillfully marketing that belief, it was possible to suck sheiks in Dubai and town governments as far away as Narvik, Norway into financing millions of dodgy home mortgages in the U.S., extended to borrowers unlikely to make the mortgage payments on them over the longer run.
The foundation of this game was a set of incentives that would have been judged misaligned by any freshman in economics. The dodgy loans were originated by brokers who did not care about the borrowers’ credit worthiness because they were paid commissions simply on bringing the deals to local banks, which then made the loans. The local banks did not care about the borrowers’ credit worthiness either, because they immediately sold the right to the monthly mortgage payments at a profit to the big banks on Wall Street. The latter bought these receivables sight unseen, usually without checking the credit standing of the original mortgagees, because they made their profits by bundling tens of thousands of these dodgy mortgages to resell them the world over as “collateralized debt obligations” (CDOs),” which are rights to the giant but inherently uncertain cash flows from the dodgy mortgages.
In the end, the banks even booked huge profits on repackaging their original CDOs into yet other bundles of CDOs, which were then peddled around the world as well. Evidently believing themselves that thus manure could be made to smell like roses, so to speak, the big banks invested hundreds of billions of their own shareholders’ dollars in these miracle bundles, usually with borrowed funds.
Eventually news penetrated even Wall Street that millions of the dodgy mom-and-pop mortgages would be likely to default unless government came to the rescue. Once that became obvious, the CDOs directly or indirectly based on these mortgages plummeted in value, driving many heavily indebted investors in them to the brink of bankruptcy, among them some of the big banks. And thus we now hear from Wall Street the primeval scream “Mom! Mom!” – with ”Mom” being dutifully played by former Princeton colleague Ben Bernanke of the Fed and, ultimately, the U.S. taxpayer.
Alas, it is a safe bet that a year or so after the federal “Mom” will have brought succor to these swash-buckling free-enterprisers, they once again will sit in their offices, clubs and golf carts, cursing the government and its “mindless regulation.” And therein lies the essential difference between teenagers and the adults on Wall Street. Eventually teenagers learn to appreciate their Moms.
© Uwe E. Reinhardt 2008