I want to say “thanks” to Statsguy for first-rate work. What this piece does is try to seperate different diagnoses & accompanying policy perscriptions, and tie them to underlying evidence. It also (although rather briefly) explains to what extent the diagnoses are consistent.

Most of the pieces I read on this topic have their own favoured narrative and then (and I don’t want this to sound unfair although it in fact will) they tend to cherry pick data in order to support their narrative. That has some value, but the kind of structured overview that Statsguy has given us is an invaluable complement to these other pieces.

Thanks, Statsguy.

Their failure to exercise their authority is directly related to the regulatory capture that Simon (and others) have been pointing out.

Why would anyone invest in the Enronesque entities that dominate and plague the financial services sector? We need publicly traded firms with truly independent boards and financial accountants willing to provide useful, honest, complete and necessary investment information. Returning power to owners of publicly traded companies will probably address the destruction of the middle class and possibly TBTF narratives.

Anyone with a bank account should see this film

Most of us don’t know, where their money is. One thing is for certain. It ‘s is not in the bank, to which we entrusted it. The bank and our money is already part of the cycle of the global money market.
The financial crisis is sending shock waves across the world. More than ever before, it’s become clear that the markets affect us all. The film “Let’s Make Money” by Austrian director Erwin Wagenhofer follows the tracks of money through the worldwide finance system. For example in the Costa del Sol region of Spain. Despite a million homes standing empty, the building frenzy is still going strong after 18 years, spurred by the belief that real estate is a lucrative investment.
Wagenhofer has done it again following up on the success of the “We Feed the World” documentary about our food industry. This one combines interviews with key people directly involved in strong-arming governments, hiding the owners of trusts and supporting laws that allow financial institutions (in London, for example) to operate unregulated in order to maximize profits for the few as they they destroy the lives of many,This is one better than Michael Moore’s films because it leaves the audience feeling informed, but not manipulated. The prevailing thought after seeing this film is “what can I do to make it better?”.

But the ability to make future changes is better if the economy is worse. Them’s the political facts as far as the evidence shows. So it’s crucial to fix TBTF before fixing the economy, or very soon after, before everyone goes “oh, the economy’s better, we don’t need to fix that any more”

That being said, other issues in your post stand out.

There was not one word about Fannie and Freddie as a major cause of the collapse. Yes the big Wall Street banks aided and abetted in the collapse, but without the trillions in loans to people who long term could not afford them, this crisis would be significantly smaller in scope.

The Wall Street oligarchy formed a tacit alliance with the political left oligarchy and used the financial system for their own ends. Bush is also to blame because he let Wall Street and the Left get away with it.

Another one of your choices of causes is the decline in middle class effective incomes. I believe that decline in buying power forced many people to get in way over their ahead, just to maintain their lifestyle. The cause was the Nanny State, not trade.

As an example, here in Los Angeles, the business environment went from the most dynamic in the world as late as the early 70′s to a city in great decline with two thirds of the city now qualifying as distressed enterprise zones . This happened because of overwrought socialist regulatory restrictions and taxes that drove out business, ruined the educational system, abetted a huge influx in illegals and drove housing prices through the roof. The ratio of average housing prices to income went from roughly 2 1/2 to one in 1970 to over 10 to one at the time of the collapse. LA went from the most educated among America’s big cities to one where over 50% of the population by some polls are functionally illiterate. And according to Calculated Risk, LA County leads the nation in total job loses since 2007 at 285,000.

This is what happens to socialist economies: poverty and ruin.
And it’s what Obama and friends have in mind for the US.

Unregulated leveraging! If I borrow excessively exposing myself to increasing risk and crash, I have to lose my shirt. Bankers can borrow excessively, fail at the risk hurdle and be TBTF? No better reason for changing banks to NTBTF (not)? Individuals hiding behind corporate identities should also be accountable and risk imprisonment.

The situation could be seen as analogous to our highway system:

We have vehicle roadworthiness regulation (dimensions, load restrictions etc), operating regulation (keep right, obey road signs etc)

We have confidence to use roads because all must operate so as to not injure others. Large trucks cannot bully other drivers and operators of large vehicles are individually responsible (just like small business operators).

If unacceptable activity occurs (speeding, wrecks etc) assigned people address the problem and fix. Each operator is not responsible for recovery action or its cost.

Now contrast this with our banking scene. Banks and their personal income incented apparatchiks have operated with no limits. Bigger size, more profit is required each year. Will bank share of everything increase infinitely?

Enough said about the problem scene. Now what is the description of the ‘fixed’ scene? Seems to me there is plenty of emoting about the problem or the mechanisms but no one has proposed/defined the solution scene? Back to BAU is hardly the answer.

Please Simon tell us what is the fixed financial highway system we need and can have which will not crash. We want to have at least the same level of confidence as when we take to the road.

May I say I have yet to see the fixed system goal description targeted by the President’s fixit team. Why is this? Maybe they don’t have a vision of success? Are they fixated on restoring BAU for TBTF outfits?

Something just does not compute and our money is handed to either villains or incompetents (take your pick).

Can someone please describe the vision splendid we seek and compare this to the fixit team goal?

Right-on-the-money!

Very true. If you look at the graph on US economic growth over time, the cycles grow more intense as we approach 1940 (as industrialization progresses). This looks very much like an (undampened) oscillating system with positive feedback.

This is consistent with arguments that the economy has grown more endogenous over time. That is, more of the value we create in the economy is manmade (therefore part of the endogenous system), rather than extracted from natural resources (and thus exogenous).

One of the positive things that seems to be emerging out of this crisis is that we have some economic institutions – like the IMF – suddenly thinking like engineers rather than like physicists. Systems dynamics is not a scientific problem, it’s an engineering problem.

Economic dampeners were removed because they caused local inefficiencies. They were _supposed_ to cause local inefficiencies. And frankly, some smart economists (e.g. Tobin) knew this, but got ignored. Who’s going to listen to the guy who says “we’re intentionally creating inefficiencies to make the system more robust, because otherwise it’s going to blow up in 10 years”?

James Kwak, I’ve replied to your other comment on relative importance of comments. Hope you enjoy my reply as much as I enjoy writing it. Hahah!

Statsguy, thank you for the excellent write up.

Some brief comments:

StatsGuy: “TBTF may have been the trigger,”

“Too big to fail” is not only a description, it is a policy, one that has been explicit in regard to banks since 1984, when the government called Continetal Illinois “too big to fail”. It is a policy of both Republican and Democratic administrations. The politicians have not talked much about this policy, because it is their policy, and they like to pretend that we do not have welfare capitalism. Given the obvious moral hazard, why economists have not been jumping up and down and holding their breath until they turned blue is another question. This policy is inherent in the other mentioned aspects of our current crisis.

Systemic Risk: Having banks that are too big to fail is one kind of systemic risk. Aside from that, the massive growth of the financial system occurred since 1980, and the policy of too big to fail has been part and parcel of that growth. Being too big to fail endowed those financial institutions with political clout, which played no small part in changing the system to enable them to become even bigger, richer and more powerful.

Destruction of the Middle Class: (That is an overstatement, of course, but we know what you mean. :)) Welfare capitalism tends to increase the stratification of society. (Much more can be said, of course. But these are brief comments. :)) Boom and bust cycles are hardly healthy homeostasis. However, crashes can be great levelers. That will not be the case if the rich and powerful are protected and put back on their pedestals.

Irrational Exuberance: The capacity for irrational exuberance does seem to be innate in humans. (However, there is evidence that people can be trained to manage risk rationally.) Irrational exuberance can lead to crashes, but crashes do not necessarily bring the system down. For that to happen you have to have systemic vulnerabilities, such as having institutions that are too big to fail. For those institutions, the exuberance may not be irrational. After all, they are protected on the downside. Bubble we win, bust they lose. Institutions that are too big to fail feed off of the irrational exuberance of others. They may even whip it up, or at least do nothing to rein it in.

What to do now?

I agree that it would be counterproductive to do a hatchet job on too big to fail institutions, at least for now. But the government seems intent upon making them whole. The theory seems to be that if they are made whole, then they will start lending again. Perhaps we should leave them weakened and instead throw our support to other, smaller banks that had little to do with bringing about the current crisis, and let them do the lending. :)