What happened to the global economy and what we can do about it
with 132 comments
By Simon Johnson, co-author, “13 Bankers: The Wall Street Takeover and The Next Financial Meltdown“
Update: link to Senator Kaufman's speech yesterday
Senator Ted Kaufman (D, DE) is best known these days for arguing that, as part of comprehensive financial reform efforts, our biggest banks need to be made smaller. His advocacy on this issue helped build support around the country and forced a Senate floor vote on the Brown-Kaufman amendment, which was defeated 33-61 last Thursday.
Senator Kaufman has also pushed strongly the idea that in recent years there was a pervasive “arc of fraud” within the mortgage-securitization-derivatives complex. This thesis also seems to be gaining traction – according to the WSJ today, the criminal probe into this part of the financial sector continues to develop.
But the Senator’s biggest home run has been on a different issue: his warnings about the dangers of high-speed trading, involving “dark pools” of money, appear to have been completely vindicated – ironically enough, also last Thursday.
Think about it this way. The US stock trading system, long-established and widely thought to be robust, crashed on Thursday afternoon. Widely held stocks, traded with consistent liquidity, do not fall in value from $40 to 1 cent and then bounce back again – even in emerging markets, let alone in the United States. It is true that complex systems crash, but given the infrastructure and back-up systems involved here, this is much closer to east coast air traffic control shutting down for 15 minutes than it is to your local cable company having a problem.
And here’s the most remarkable point – after 6 full working days (and top people do sweat this kind of issue on the weekend), we are still no closer to really understanding what happened. To be sure, there are plenty of theories – and no shortage of proposals for avoiding a recurrence. But, despite the evident resources thrown at this problem, we do not know what went wrong.
As Senator Kaufman points out, the SEC does not even routinely collect the data it needs to understand the actions and impact of large traders.
The Merkley-Levin amendment would also likely be a step in the right direction, in terms of reducing the socially dangerous casino nature of our financial markets. But it is far from enough.
The rationale for organizing our financial system as we do is that this leads to a reasonable allocation of capital across the economy. We can argue the merits of this proposition at various levels – but no one would suggest that the extreme volatility and breakdown of trading last week was anything other than completely dysfunctional.
The SEC is, without question, beginning to get its act together under Mary Shapiro. But there is also no doubt that it needs to lift its game to a much higher level, if regulation is even to catch up with how markets have developed over the past decade – just look at this timeline of problem identification and policy response.
Senator Kaufman has flagged mortgage-related fraud, high-speed/dark-pool trading, and bank size as pressing issues to address. He was completely right on trading and, based on what we know so far, also right on fraud.
How long before he is completely proved right on the dangers posed by excessive bank size?
Written by Simon Johnson
May 13, 2010 at 5:54 am
Posted in Commentary
Tagged with high-speed trading
Senator Kaufman is spot on but the “black box” high speed melt down happened before as well,in August 2007. The MIT magazine Technology Review wrote about in the Nov/Dec 2007 issue. The article written by Bryant Urstadt is titled The Blow-Up !! In 3 years nothing has changed.
Mark Forziati
May 13, 2010 at 7:51 am
Can you get that online for free?? I would be very curious to read that. Sounds insightful.
Ted K
May 13, 2010 at 8:53 am
Ted K—You can purchase it for 1.99 or subscribe to the magazine from their website
Mark Forziati
May 13, 2010 at 10:14 am
Free repro is here:
http://www.chesler.us/resources/links/blow-up.pdf
erichwwk
May 13, 2010 at 11:57 am
Thanks for the answer Mark. And erichwwk, you’re my new hero. I sincerely appreciate it, both of you. Here’s a terrific Op-Ed by Nouriel Roubini. It’s a relatively quick read and very insightful. Like scarily insightful. http://www.nytimes.com/2009/05/14/opinion/14Roubini.html?_r=3
Ted K
May 13, 2010 at 12:15 pm
Ted,
Roubini here sounds like a typical dollar hawk, lamenting how bad it would be for everyone for the dollar to lose value. This point of view is particularly dubious when the comparison currency is the Renminbi, which China depends on being less valued than the Dollar in order to maintain a strong export sector to the American market. So on the one hand, a gradual decline of the Dollar vs the Renminbi would help with trade imbalances and the relentless downward pressure on US wage levels; on the other hand, the loss of “prestige” that would accompany the transfer of reserve currency status from US Dollar to Renminbi is contingent on two major things happening in China, only one of which does Roubini even mention. The first is eliminating capital controls and making the Renminbi fully convertible (mentioned in the article). The second is reworking major sectors of the Chinese economy to be less dependent on exports. Both of those things are going to be very painful and unpopular in certain powerful sectors of the Chinese polity, and are likely to take some time to enact. There is certainly time to deal with long-term structural problems with government finances, and it can be done so long as there is a commitment to leaving budget surpluses rather than “giving them back to the taxpayers.”
(Although, there are those who have a pretty good case that the structural problems are not really there, either: See Here.
engineer27
May 13, 2010 at 1:23 pm
I agree with Roubini when he writes "Now that the dollar's position is no longer so secure, we need to shift our priorities. This will entail investing in our crumbling infrastructure, alternative and renewable resources and productive human capital "” rather than in unnecessary housing and toxic financial innovation."
And that means not subsidizing risk aversion the way it is done with capital requirements for banks that are lower for what is perceived as having lower default risks, and therefore already pays lower interest rates.
But I absolutely disagree with Roubini on that nonsense of China taking over in ten year a role as a reserve currency, when it cannot even afford that the dollar loses that status. Yes there are very serious troubles awaiting the US and the dollar but, first, China at their current level of development, would not last one day suffering the "reserve currency curse" which would immediately halt their exports, and second, even if the US would default and their current dollar sink, the world would, the morning after, be willing to accept its New Dollars.
Per Kurowski
May 13, 2010 at 10:34 pm
Could it be Far-fetched… “Austerity Measures” coming soon to America with All These Market Rumblings…
Otherwise, other name for this could be called,”Coase Oppression Theorem Conundrum Problems”.
What a story, which is the real story and no one knows what is right.
Bail out TARP and all who hold or are in debt and pretend and make it all go away might read the headlines…
The headlines could read what has been Greece’s Demise or CUT THE LEGS OUT OF THE SOCIAL SPIRIT of EVERY MAN AND WOMAN and CHILD of your Country to pay back your debts.
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