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The economic, political, and financial problems behind the financial crisis

PH2010071602735.gifI didn't want to run over my article on the five places to watch for the next financial crisis with secondary commentary, as then, none of you would've read the underlying piece. But now that it's been up for a while, a few more thoughts.

The basic point of the article is that there are structural problems, both inside and outside the financial system, that we're not fixing.

Outside the system, global capital flows are still wildly imbalanced, with developing economies pushing torrents of money to developed countries; inequality is increasing and ordinary Americans are seeing their incomes stall and slip, which is creating more pressure for easy credit and other illusory fixes to wage stagnation; and Congress remains a cheap investment over the long term, making it hard to imagine reforms in a sector as complex as the financial industry sticking over the long run.

Inside the financial system, the shadow banking market, which is where the run that began this whole crisis happened, is being brought under the regulatory umbrella and its actions are being made visible, but we're not doing anything on the scale of deposit insurance, which is what finally ended systemic runs in the consumer market; and regulators, who, by definition, run financial regulation, will still be vulnerable to intellectual capture and inattention and overconfidence.

Some of these problems have solutions and some of them don't. But the solutions, in all cases, are difficult and structural -- much more so than anything we've done in financial reform. Take wages. Extending false wage increases in the form of easy credit, Raghuram Rajan says, was attractive because the actual solutions are tough and slow. "The real fix would be to deal with the problem at its source," he explains, "which is that too many Americans don't have the qualifications for the jobs being produced in this new economy. That means far more time and attention to education, retraining, and skills. But it will take time." How do you tell someone whose incomes are declining now that we might have this solved in 10 or 20 years?

Or global imbalances. We really don't have the capacity to fix this on our own. We can do a bit, by making our investment markets less attractive to outside investors, but we're not going to do that. The real answer is currency changes on the part of developing countries like China and a rapid maturation of their homegrown capital markets, so their investors see homegrown opportunities for their money. "Asian bond markets are incredibly small and underdeveloped," says Kenneth Rogoff. "That’s one of the reasons people who want to hold bonds look to Europe and the United States."

When we think about fixing what went wrong, we tend to date what went wrong to late 2007, or maybe a few years before. But if you go back further, you find a shaky economy that wasn't working for enough people but that was being hidden by cheap foreign money and easy domestic credit. A weak political system wasn't able to anything about it, and nor was it able to keep up with the financial system when it started rapidly transforming itself in response to these new economic realities. We've made progress on some of these problems, but not enough of them. In fact, some of them aren't in the discussion at all.

By Ezra Klein  |  July 16, 2010; 2:16 PM ET
Categories:  Articles , Financial Crisis , Financial Regulation  
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I'm not convinced by Rajan's explanation of why incomes are mal-distributed or by what caused the crisis. There are plenty of problems with education, but we still send a zillion folks, more than ever before, to college, and heaps of highly trained chemists, engineers, etc., struggle to find work. Many wind up in the financial sector because they cannot work in their disciplines. That the govt through Fannie/Freddie have carried the mortgage mkt is undeniable, but that that fact caused the subsequent panic I find hard to believe. Fannie/Freddie bonds haven't defaulted, & they're broke because they bought so many CDOs. I have to think that Stiglitz's explanation is better than Rajan's: lack of regulation, including the failure of the FRB to act on the housing bubble, caused the panic, Fannie/Freddie are victims of the panic, & the real cause was a naive belief in the efficiency of unregulated mkts which permeated both political parties, all regulators, & most of all the banking industry, whose managers didn't understand the risks they were running.

Posted by: davidpancost | July 16, 2010 2:35 PM | Report abuse

Ezra, I would appreciate if at some time you would expand your discussion on household debt, and exactly how this trend, if not reversed, will eventually play out.

Posted by: Patrick_M | July 16, 2010 2:40 PM | Report abuse

Finally sounding like Martin Wolf of FT, but not like Dr. Doom - Roubini.

Your job Ezra is to help figure us out, or so to speak 'clean the intellectual space' in order collectively us to know how politics of this is going to resolve.

Does it mean, lost decades like Japan? Or equivalent of French Revolution in 2010s?

What you are rightly doing is trying to point out the emptiness of GOP, Tea Party and Tax Cutters in addressing these problems. That is good and needs to continue happening since that has NOT become an accepted understanding or 'conventional wisdom' in that sense.

Or is the way out for Obama, as like some other comments mentioned on earlier threads, is to come forward; accept the 'pickle' in which we are, accept what things he missed and rise to the occasion and show some leadership in articulating an economic vision of what course this country should chart in coming decades? He is not doing that is a fact and on the other hand has got caught himself, as you & commenters rightly pointed, in the sinking hole of 'justifying half baked stimulus' with 'half way through on the road of recovery' result; as Warren Buffett rightly referred.

America's leader(s) has to make the call of how to address the 'crushing debt burden' on one hand and at the same time taking actions to kick start employment to deal with longer term unemployment and to bring Economy on the sustainable ground.

What we do not know is how this all going to resolve politically.

Posted by: umesh409 | July 16, 2010 3:32 PM | Report abuse

Honestly it's a little scary to be in a position in which we KNOW that there's a crisis but the President's hands are tied and Congress is, and will be, unable to act. For liberals, November will mean the end of any Keynesian stimulus. And of course, Obama can do a lot of things on his own but spending money isn't one of them.

But even for conservatives, the best they could achieve would be a solid majority in the House and a tiny majority in the Senate. To the extent that an alternative Republican deficit reducing, job creating vision exists (and I'm skeptical that it does), they're not going to get it passed in this climate. Once you spend two years saying you need 60 votes to pass anything, you can't suddenly demand majority rules.

So you end up with 10%+ unemployment and total political stasis until 2012. That's a pretty grim picture.

It's even scarier in the longer view, given the way our whole political system seems to be getting increasingly shaky since the mid-90's. Within living memory of even the YOUNGEST voters, we've seen a total government shutdown, an impeachment, a questionable Presidential election, permanent detention and torture, massive regulatory failings, and now a legislature that has totally ground to a halt and will almost certainly remain that way for another 2 years. It's hard to fathom what happens when a system this broken intersects with pathological long-term unemployment, but it won't be pretty.

Posted by: NS12345 | July 16, 2010 3:57 PM | Report abuse

We could start with re-regulating the financial sector so the banksters can't take quite so much of people's money though fees, charges and usurious interest rates on credit cards. Fin Reg started that process. Then we could reverse the Bush/Cheney tax policies that funneled more money to the rich. That will happen, either by some deal in the lame duck session that extends some of the cuts for a year or 2, or maybe by just letting them all expire, althiuygh that is painful to the folks at the bottom.

Then we could improve education, although there are going to be a substantial number of people who can't meet the needs of the new economy. We need to create more jobs here at home, which to me means investment in green tech so it doesn't all go to China, as well as infrastructure repair and buildout.

Household debt is down from its high, and it is going to get lower as people pay off debts, sell assets and retrench spending. But that is a contributor to lack of demand. That's why we need a boost like a payroll tax decrease or something.

Where do we get the money for all this? End the ruinous foreign wars and cut defense, especially hardware. The troops themselves are a good jobs program, so I wouldn't cut there, but I'd really cut contracting and fancy new weapons systems.

Posted by: Mimikatz | July 16, 2010 4:30 PM | Report abuse

It's hard to believe Ezra that you fall for this line, that the reason we have low wages is that we are not properly educated and trained for the opportunities in our economy.

If liberals fall for this, we'll have to wait for someone like Perot, and by that time, it will be too late.

One point and an anecdote:

Look at the stats of which occupations are growing. They are not trending towards high skills. They are largely low paid, low skill service jobs. That is the future.

Anecdote: I heard a former boss on the phone, chortling about how, because of China and India, he could hire a local marketing specialist with a masters degree (in computer science) and professional contacts for $20/hour.

Posted by: mminka | July 17, 2010 12:04 PM | Report abuse

Please disclose how much Obama and/or his surrogates are paying you to carry his water. Better to come clean now than wait for Bretibart.

Posted by: jplresearcher | July 23, 2010 7:44 PM | Report abuse

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