By Yinan Hu
With the U.S. trade deficit reaching the highest levels in three years, the unemployment rate hovering at 9.1 percent, and President Barack Obama announcing the second stimulus plan in two years, Americans are terrified of their country’s fiscal future. It should be no surprise that young protesters have camped out on Wall Street, venting their anger at the financial system. Against this backdrop of widespread discontent, the same financial institutions continue the same risky strategies that led to the crisis in the first place. If this continues, say World Policy Institute senior fellow Jeff Madrick and former Assistant Secretary of the Treasury for Financial Stability Herb Allison, these firms will keep finding ways to fail. For the U.S. to recover and avoid further financial disaster, the government needs to find a way to re-regulate Wall Street.
As the country struggles to get back on its feet, hostility and blame fall on Wall Street as the root cause of the banking crisis. Now, many Americans are demanding reregulation and the removal of Wall Street’s lobbyists’ hold on Congress. Madrick and Allison echoed these sentiments in a The Century Foundation and World Policy Institute talk on Sept. 16 where they discussed what the role of Wall Street really is, and what can be done to fix its dangerous shortcomings. Madrick, who wrote The Age of Greed: The Triumph of Finance and the Decline of America, 1920 to the Present, raises an important question in his book and in the discussion: What good is Wall Street? It’s a question “we should ask, and we were being afraid to ask,” Madrick says.
As the size of the financial industry grows, the original purpose of banking to allocate capital to its most productive uses has been forgotten not only by the bankers but by the public as well. According to Madrick, the current system that pushes the socially beneficial goals of the industry to the periphery only encourages greed. Now, banking shifts money around while rarely increase market efficiency.
Allison, who wrote The Megabank Mess on financial reregulation, takes a bolder step, claiming, “Trading has never made money on Wall Street.” Allison points to proprietary trading, where banks bet their own capital on movements in the markets, as a financial activity with no economic benefits. The profits, he claims, are illusory since they always will disappear, usually all at once in downturn. It can take months or years to find out whether the profit is real or the temporary result of excessive risk.
Before directing the Troubled Asset Relief Program (TARP), the government’s $700 billion financial bailout program, Allisonworked as President and CFO of Merrill Lynch. At the financial firm in the 1990s, he once saw a trading desk lose more money in a day than the company had made in more than 100 years. Allison says the payment structure is partly to blame. “Traders are getting paid on a basis of carrying risks,” he says.
As Wall Street continues to evaluate profits and losses every afternoon based on the closing prices, traders are motivated to think in the short-term, ignoring uncertain or pessimistic long-term growth predictions. Defending their activity as an obligation to make profits for shareholders, banks actually fail shareholders when the market collapses. Traders are left with huge personal bank accounts, while shareholders and taxpayers pick up the losses.
Though the Dodd-Frank financial reform bill came out to prevent banks from taking too many risks, its effect is limited, according to Madrick and Allison. Some banks now issue bonuses in the form of restricted stock that can’t be sold immediately or cash that cannot be used for a certain number of years. Still, with continued loose regulation, the previous model focused on short-term profits is too lucrative for traders to stop.
[slideshow courtesy of Ahmet Sibdial Sau]
On Wall Street, there is a widely held belief that “Greed is Good.” Allison says, “These banks had one goal, and they still do. Their goal is measured in profitability. If there is only one goal, there are no limits.” The pressure to generate profits immediately while ignoring long-term outcomes will continue to drive excessive risk taking.
Deregulation of Wall Street was once necessary for growth, Madrick says, but that need is long gone. Now that firms have consolidated into just a few players—many arguably too big to fail—the government needs to return to Wall Street with real regulations so they can’t ignore their social role of allocating resources efficiently.
But before the government can do this, Allison argues, officials will need to break free of Wall Street’s grip on the government. Major investment firms turn their money into power when their lobbyists go to Congress, preventing any government attempt at regulation. Only after the conflict of interest is resolved can there be any hope for the reregulation of Wall Street.
Yinan Hu is currently an intern at the World Policy Institute
[Photo courtesy of flickr user jhandelman]