Let’s hear it for the Senate’s Permanent Subcommittee on Investigations. Its work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation. In the past few days scandalous Wall Street e-mail messages released by the subcommittee have made headlines.He is right about the out-and-out whoredom of the agencies and I also agree that Financial Reform as is being touted right now would not solve the problem.
That’s the good news. The bad news is that most of the headlines were about the wrong e-mails. When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn’t amount to wrongdoing.
No, the e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars’ worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.
What those e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.
The issue, however, is why the once-staid and sober Moody's and Standard & Poors turned into a bunch of financial drunkards in a relatively short period of time. That is where Krugman and I differ.
As an economist, when I see something perverse like what happened, I look for the underlying reasons, and especially the structure of incentives that helped bring about this whole regime change in how the agencies went about their business. While I am sure Krugman gives lip service to incentives, he prefers the Keynesian line about "deregulation," which tends to be the ideological umbrella under which he works.
A friend of mine who is a first-rate accountant said that mortgage bankers told her that what seemed absolutely silly and reckless after the bust made perfect sense when the easy money regime was ruling. This is vital to understanding the boom-and-bust, as Austrian Economists point to the actions of the Federal Reserve System holding down interest rates and flooding the markets with credit.
Now, Krugman at the end does give lip service to incentives, but he still misses the bigger picture. Had the Fed not been reckless with interest rates and dumping credit everywhere, the incentives for the ratings industries would have been different, period. As Peter Schiff said last year, "The whole country was drunk." The real question, he asks, is who brought the booze.
This is where Krugman and the Austrians differ. We believe that if the Fed is not playing the credit sugar daddy, the incentives that run with an easy money financial regime will not be there. (This is not excusing Moody's and S&P for not doing their jobs, but rather giving a reason as to why they took flight from sound finance.)
Krugman, on the other hand, believes that the Fed should continue providing the liquor, but the regulators will tell Wall Street when, where, and how much to drink. This is a recipe for later problems that will be worse than what we are facing now.