Thursday, November 6, 2008

Get rid of the financial sector. It serves no real purpose.

As the Fed continues to step up to do the work that a large segment of the financial sector can no longer do (as a result of terrible, failed and misguided investments), expect to see its balance sheet grow. At the same time, the balance sheet of the private financial sector will shrink and we should be happy about that. What has become plainly evident is that the financial sector contributed pretty much nothing to the real economy (the Fed is doing all the work now), but increased the risks substantially.

The financial sector went on an unbridled, giddy, nonsensical spree of malinvestment the likes of which we’ve never seen before. Most of this was conducted by unregulated, non-bank financial entities—hedge funds, financial intermediaries, mortgage brokers, etc—that at its peak provided more than 80 percent of all credit to the economy. Yet there was no support net or backstop should something fail. (By the way, commercial banks were not innocent bystanders. They were involved in this too, but since they were regulated and had lifelines to the Fed, most of them will likely survive).

Who builds a structure like this? What critical system—an airplane, a hospital’s power source, a nuclear reactor—does not have multiple backups and constant supervision? How could we have allowed a system where nearly all the credit to the economy went through, in many cases, shadowy, unregulated entities run by greedy “cowboys” whose big stakes games of dice ended by coming up craps? When they were forced to stop playing as a result of their greed and recklessness, the rest of the economy was held hostage.

After many long months the Fed has finally stepped up to act in its most important capacity, as lender of last resort. It took a while for this to happen, because all along, the Fed, Treasury, the Administration and many members of Congress were hoping, praying, that they could get the cowboys to come back to the crap table. Finally, I think they saw, reluctantly, that it’s not going to happen. Nor should it be desired. (Although they have been giving some of the players new “stakes,” which, perhaps is a little disappointing.)

The system as it existed before was inherently unstable, prone to failure and as we are now finding out, lethal. My hope is that we give up the impractical goal of trying to reconstruct it, at least in the form it was. If it comes back at all it should be a fraction of what it was and highly regulated, with many of the now familiar institutional structures like hedge funds, financial intermediaries and finance companies, done away with permanently. They contribute nothing of real value, but add a high element of risk and in many cases, siphon off brainpower that can be used elsewhere in the real economy.

The most preferable solution, I think, is to simply have the Fed continue the credit provider role that it has assumed. Maybe we’d want to keep some commercial banks around to provide the public with its credit needs (the banks can be considered, after all, as agents of the government; they have charters, come under regulatory oversight and have direct access to the Fed in times of need) although the Fed can provide that function as well. With the Fed providing the credit function there would be no risk of systemic failure. The system would be stable and fail safe. The real economy could continue to be productive and grow without the risk of being shut down.

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