I am pleased to be able to bring you another wonderful piece of writing by Uwe Reinhardt. In some ways it is a a sequel to his earlier piece on this blog “I hate mom (and the government too)”, but it also stands very well on its own. This article was first published in The Daily Princetonian, on Tuesday, April 29th, 2008. The marine referred to in the column is Uwe’s youngest son, Mark (aka Hsiao Hoo or Little Tiger). I knew him as a tiny tot, when he used to hang around the pool and fountain next to the Woodrow Wilson School at Princeton University.
As the Fed and the Treasury once again staff the shovel brigade behind one of Wall
Street’s periodic asset-bubble parades – lest the foul economic odor in its wake seep too
deeply into the rest of the economy – my mind wanders back to spring 2002, when the
previous asset bubble had burst. At the end of the financial accounting course I then
taught, I projected onto the screen the picture of a Princeton graduate who had just
joined the Marines. “Take a good look at your classmate,” I told the 300 or so students
in the class. “He is likely to be ordered abroad soon, there to lead a platoon of enlisted
Marines into possibly lethal combat, for the sake of you and me, he is told. When he and
his men come home – if they do come home – what will you have made of their country?
Will you have used the accounting tools I taught you to make the country better and
stronger, or will you have used them to engage in the shenanigans that drove our recent
asset bubble and begot the current recession – just to make money, country be
America is a nation at war. Our sailors, soldiers and Marines fight with great honor at
high risk to life and limb, and at very low pay, for what they believe to be our nation’s
best interest. They often take added personal risks to avoid visiting collateral damage on
innocent bystanders of a foreign land. Against that backdrop and the financial crisis and
consequent recession now besetting our country, it is pertinent to ask: Do the leaders of
our financial markets ever stop to think what their reckless recent conduct has done to
the country these brave warriors fight to protect?
At their best, our financial markets play a pivotal role in enhancing human welfare.
They then channel the savings of households, business firms and governments
anywhere in the world efficiently to their most productive uses anywhere else in the
world and allocate financial risk from those unable or unwilling to bear it to those who
can tolerate it. Many of the recent innovations in these markets such as structured
securities, currency- and interest-rate swaps, credit default swaps, and so on, have
made these important functions ever more efficient.
But when investment banks seek profits by recklessly concocting hundreds of billions
of mortgage-backed securities that are anchored in shaky mortgages whose quality no
one has bothered to check, sell these dodgy derivatives to others, and even risk their
own institution’s equity cushions by borrowing billions of dollars to invest in junk
securities themselves, they are not making their country stronger. Instead, they act like
reckless laboratory scientists who concoct toxic substances that can infect not only
them, but also millions of innocent bystanders.
When investment banks sell multiple credit default swaps to buyers who do not own
the underlying bond, but merely want to bet on its default, the banks stray into pure Las
Vegas-style gambling. Productive risk taking is the central driver of efficient capitalism,
but how does helping person A gamble on the default of a bond held by person B
strengthen the American economy? Why not sell bets on the weather as well? No one
seems to have a clear idea of the net financial exposure our banks have to the $45
trillion or so of notional credit-default swaps currently reported to be outstanding. In an
era of widespread credit defaults, such multiple credit-insurance contracts on given
bonds could confront some banks with huge claims that their equity cushions might not
be able to absorb, forcing the Fed and the Treasury yet again to mobilize their shovel
brigade, at taxpayers’ expense.
Finally, when, for handsome fees, smooth-talking investment bankers persuade
unsophisticated treasurers of local school districts or small endowments to enter into
highly risky and opaque interest-rate swaps, or into investing their limited funds in the
so-called “toxic waste” tranches of complex structured securities, they are not making
America stronger. They risk driving important local institutions to the brink of bankruptcy.
An innate professional ethic deters the overwhelming fraction of our physicians from
exploiting their patients’ clinical ignorance as no set of explicit regulations ever could.
Does an analogous ethical anchor – a financial Primum Non Nocere – constrain Wall
Street as well?
This is not an idle question. American leaders of finance now promise to practice
self-discipline guided merely by regulatory principles rather than by explicit rules. That
would be a sensible approach, but only in markets whose agents are ethically principled
and, yes, patriotic – like, say, 18-year old sailors, soldiers and Marines.
Uwe E. Reinhardt is the James Madison Professor of Political Economy and a
professor in the Woodrow Wilson School of Princeton University. He can be reached at firstname.lastname@example.org.