Correction to This Article
This article, about where the next financial crisis might arise, incorrectly described Gary Gorton as an economist at Princeton University. Gorton, who was quoted talking about the lack of the equivalent of deposit insurance for institutional investors, is a professor of finance at Yale University.

5 places to look for the next financial crisis

With financial regulatory reform passed, regulators will have tools to respond more quickly to crisis. It's fair to ask: Will it be enough?
With financial regulatory reform passed, regulators will have tools to respond more quickly to crisis. It's fair to ask: Will it be enough? (Alex Brandon/associated Press)

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By Ezra Klein
Sunday, July 18, 2010

Financial reform has passed. The sprawling legislation is meant to be an air bag protecting us from the next major crash, which of course raises the question: Will it work?

"We would have loved to have something like this for Lehman Brothers," said Hank Paulson, the Treasury secretary when the financial system melted down in 2008. "There's no doubt about it."

And he's right: The next time there's a financial crisis, regulators will say a quick prayer of thanks to Barney Frank and Chris Dodd for giving them the power and information to quickly figure out what's happened and how to respond.

The legislation ushers derivatives out of the darkness and onto exchanges and clearinghouses; gives regulators the power to oversee shadow banks and dismantle failing firms; convenes a council of super-regulators to watch the mega-firms that pose a risk to the financial system; and much more.

That's not the same, however, as averting crises in the first place. It might make them less likely, but think of the difference between public health and medicine: The bill is medicine -- it's primarily about helping the doctors who figure out when you're sick and how to make you better. It doesn't dramatically change the conditions that made you sick in the first place.

Many of the weaknesses and imbalances that led to the financial crisis escaped this regulatory response. The most glaring omission: Fannie Mae, Freddie Mac and the crazed housing market that led to the crash. That issue is slated to go before Congress next year, but here are five that aren't:

-- "The global glut of savings." "One of the leading indicators of a financial crisis is when you have a sustained surge in money flowing into the country, which makes borrowing cheaper and easier," says Harvard economist Kenneth Rogoff. This crisis was no different: Between 1987 and 1999, our current account deficit -- the measure of how much money is coming in vs. how much is going out -- fluctuated between

1 and 2 percent of the gross domestic product. By 2006, it

had hit 6 percent.

Ben Bernanke, a man not known for a vivid turn of phrase, called the hundreds of billions of dollars that emerging economies were plowing into our financial system every year "the global glut of savings." It was driven by emerging economies with lots of growth and few investment opportunities (think China) funneling their money to developed economies with less growth and lots of investment opportunities (think, well, us). The result was cheap money and fast growth that made our economy seem healthy when it really wasn't.

But we've gotten out of the crisis without fixing it. China is still roaring forward, accelerating exports and pouring money into the U.S. economy. And we're happily taking it. With our economy weak and our deficits high, we need it. So after falling to 3 percent after the crisis, our current account deficit is back to 4 percent and rising.

Rogoff thinks that's a problem.


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