The signs are subtle, but it seems many have already forgotten the lessons of the Great Recession. These signs lie on both sides of the political aisle, in different branches of government, and in all parts of the country. Why exactly this has happened requires a much more extensive analysis, but one thing seems certain: good intentions based on flawed rationalizations are leading us once again astray.
The 2008 Recession showed us that financial interconnectedness coupled with risky bets creates a potential for systemic failure. Everyone saw this first-hand in the mortgage industry, where lenders hinged their profits on financially unreliable individuals. These individuals became homeowners, housing prices rose, and an economic expansion ensued. Even though at first glance everything seemed picture-perfect, an asset bubble was forming. Among others, Janet Yellen warned about this in a Salt Lake City community gathering back in 2005, saying, “analyses do indicate that house prices are abnormally high—that there is a ‘bubble’ element, even accounting for factors that would support high house prices, such as low mortgage interest rates. So a reversal is certainly a possibility.”
Within a few years, that fear became a reality, and our economy came crashing down. Some blame the banking industry for establishing a many-tiered edifice of profits and portfolios on a brittle layer of shoddy lending and shareholder’s interests. Others blame regulators for negligence in an era of prosperity. But at the heart of the crisis was the unwillingness to compromise long-term stability for short-term gain.
Today, remnants of that unwillingness pervade far too many leaders’ decision-making. Just last May, a front-page story on the Wall Street Journal read, “The Obama administration and federal regulators are reversing course on some of the biggest postcrisis efforts to tighten mortgage-lending standards,” which marked “a sharp shift from just a few years ago, when Washington, scarred by the 2008 crisis, pushed to restrict the flow of easy money that fueled the housing bubble and its subsequent bust.” The loosened lending standards were the result of leaders who “have expressed worries that the housing sector, traditionally a key engine of an economic recovery, is struggling to shift into higher gear as mortgage-dependent borrowers remain on the sidelines.”
Admittedly, the 2001 recession following the dot-com bubble was quickly ended by, among other factors, the flourishing housing sector. Nonetheless, is the solution of one asset bubble to create another? If fixing the mortgage industry entails slightly dampening the recovery, then so be it. Intuitively, a recovery is as much about making sure that the same mistakes are not repeated as it is about helping those in trouble.
Although not necessarily reversing course to the extent of the White House, the Federal Reserve has shown signs of delaying important post-crisis measures to contain excessive financial leveraging. Reuters’ Douwe Miedema reported last April, “The U.S. Federal Reserve will give banks two more years to divest collateralized loan obligations (CLOs) that fall under the Volcker rule, a part of the Dodd-Frank financial law that bans banks from making a range of risky investments.” Since the Volcker rule will result in significant losses for the banking industry, given its growing dependence on trading, it is no wonder that reluctance to accept the new regulation has persisted since the rule’s passage in 2010, more than four years ago.
A worrisome trend documented extensively by former banker Steven G. Mandis in his book What Happened to Goldman Sachs, the continued focus on proprietary trading by large financial institutions is emblematic of the culture of excess we ought to be combating. Mandis writes, “it is a particular challenge to reconcile the goals of proprietary trading with putting clients’ interests first.” When banks begin building their own investment portfolios and their own capital is on the line, market success becomes a top priority. When all that stood between banks and double-digit returns in the stock market was passing off securities backed by risky debt obligations to an unknowing business or investor, they decided the latter option was necessary.
The Volcker Rule seeks to prevent decisions like these from being made by limiting commercial banks’ involvement in proprietary trading, in effect pressuring those banks to consider the interests of their clients to a greater extent than they previously had. The recession, after all, should have taught everyone that misaligned interests could lead people to take risks that put others in danger. Leaders, by now, should be working to restrict the recklessness of many financial institutions. Moreover, it should be acknowledged that delaying tough changes only furthers irresponsibility. The more we allow banks to concentrate on trading, the more rooted that focus becomes in their behavior.
As important as it may be to identify what has been done, knowing what has not been done is even more worrisome. Anyone remotely involved with political headlines is well aware of the Congressional gridlock that, among other things, brought us last year’s unneeded government shutdown and stalled immigration reform. But one subject that has received relatively little media coverage is that of the bipartisan bill to wind down Fannie Mae and Freddie Mac. Reuters’ Margaret Chadbourn reported last May, “A Senate panel on Thursday approved legislation to wind down Fannie Mae and Freddie Mac and redesign the U.S. mortgage finance system, but sparse support among Democrats means the measure is unlikely to make it into law.” Chadbourn continued, “Even if the full Senate were to approve it, it was never likely the Republican-led House of Representatives would sign off on the measure.”
While the proposal contains some concerning implications, it had the potential to be deliberated, revised, and improved. Hardly anyone in Congress has argued that the current set-up of Fannie Mae and Freddie Mac will remain effective for the decades to come. This inaction reveals the most important sign that Congress failed to learn an important lesson from the recession. The answer to hardship is not procrastination, obstinacy, or petty rivalries.
At the same time, certain compromises ought to be avoided. In the face of hardship, leaders ought to promptly enact reforms that assure anyone suffering that the same mistakes will not be repeated. In the years leading up to 2008, Republicans maintained a strictly pro-business stance, while Democrats championed the interests of financially troubled borrowers. Both parties successfully scored political points, but the false compromise that ensued essentially created a highly profitable banking industry with loose lending standards for all. Instead of fixing the problematic financial system we now have, Republicans and Democrats have decided to maintain the same near-sighted priorities and dwell on issues like IRS overreach or the delay of judicial and executive nominations. Since the recession affected all constituents, from the most liberal to the most conservative, the response of Congressional leaders should be to act fast and not only gain electoral favorability from their enterprising efforts but also, finally, make good policy.
Granted, the fix-all solution is not to double down on every form of regulation, because some measures are indeed unnecessary. Alan Greenspan, a former Federal Reserve Chair, noted several times in his book The Map and the Territory that examining the entirety of our complex financial system “would require an examination force many multiples larger than those now in place in any of our banking regulatory agencies” and would impede “sound bank lending and its necessary risk taking.” Even so, Greenspan acknowledges that it is “not wholly accurate” to suggest “that people behave in their rational long-term self-interest.”
As such, the point of contention in political debates regarding economic policy should not be whether or not any financial regulation is necessary, but instead which financial regulations are necessary. The time to start deciding which are needed began in 2008, and the time for implementation is now. The result of the false compromise before 2008, no doubt, benefited bankers, shareholders, borrowers, and even public servants themselves. But if sacrificing those benefits in the name of long-term financial stability prevents a future recession, the scars from 2008 should lead us to definitively believe it is worth it.