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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

By Ezra Klein
Sunday, July 18, 2010; G01

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.

"One or 2 percent would be more sustainable," he says.

-- The indebted American. The fact that money is available to borrow doesn't explain why Americans borrowed so much of it. Household debt (mortgages, credit card balances, etc.) as a percentage of GDP soared from a bit less than 60 percent in the early 1990s to a bit less than 100 percent in 2006.

"This is where I come to income inequality," says Raghuram Rajan, an economist at the University of Chicago. "A large part of the population saw relatively stagnant incomes over the '80s and '90s. Credit was so welcome because it kept people who were falling behind reasonably happy. You were keeping up, even if your income wasn't."

Incomes, of course, are even more stagnant now that unemployment is bumping up against 10 percent (and underemployment is nearer to 15 percent). And that pain isn't being shared equally. Inequality has actually grown since before the recession -- joblessness is proving sticky among the poor, but recovery has been swift for the rich. Household borrowing is still above 90 percent of GDP, and the conditions that drove it up there are, if anything, worse.

-- The shadow banking market. The Great Depression was visually arresting: long lines of desperate families trying to get their money in hand before the bank collapsed. The financial crisis started out similarly severe, but aside from some despondent-looking traders, there was little to look at. That's because this bank run wasn't started by families. It was started by banks.

Regular folks didn't pull their money out of the banks, because our deposits are insured. But large investors -- pension funds, banks, corporations and others -- aren't insured. They use the "repo market," a short-term lending market in which they park their money with other big institutions in exchange for collateral, such as mortgage-backed securities. This is the "shadow banking system" -- it's a real banking system, but it's young, and until now largely unregulated. As such, it's been vulnerable to the sort of problems we ironed out of the traditional banking system decades ago.

When institutional investors hear that their deposits are endangered, they run to get their money back. And when everyone panics at once, it's like an old-fashioned bank run: The banks can't pay off everyone immediately, so they unload all their assets to get capital. The assets become worthless because everyone is trying to sell them at the same time, and the banks collapse.

"This is an inherent problem of privately created money," says Gary Gorton, an economist at Princeton University. "It is vulnerable to these kinds of runs. It took us from 1857, which was the first panic really about deposits, to 1934 to come up with deposit insurance."

This year, we're bringing this shadow banking system under the control of regulators and giving them all sorts of information on it and power over it, but we're not creating anything like deposit insurance, where we simply made the deposits safe so that runs became a thing of the past.

-- The "It's so little money!" problem. In the 1980s, the financial sector's share of total corporate profit ranged from 10 to 20 percent. By 2004, it was about 35 percent. That's a lot of money in a few hands.

Simon Johnson, an economist at MIT, recalls a conversation he had with a hedge fund manager. "The guy said to me, 'Simon, it's so little money! You can sway senators for $10 million?' " Johnson laughs ruefully. "These guys don't even think in millions. They think in billions."

This financial crisis will stick in our minds for a while, but not forever. When it fades, the finance guys will begin nudging. They'll hold fundraisers for politicians, make friends, explain how the regulations they're under are onerous and unfair. And slowly, surely, those regulations will come undone.

And they'll have plenty of money with which to do it. After briefly dropping to less than 15 percent of corporate profits, the financial sector has rebounded to more than 30 percent.

-- Can regulation fix, well, regulation? The most troubling prospect is the chance that this bill, if it had passed in 2000, would not have prevented this financial crisis. That's not to undersell it: It would've given regulators more information with which to predict the crisis. It would have created a consumer financial protection agency that might have intercepted the subprime boom. But plenty of regulators had enough information, and they did not act.

Bubbles always fool the regulators with the powers to pop them; otherwise they would have been popped.

In 2005, with housing prices running far, far ahead of the historical trend, Bernanke said a housing bubble was "a pretty unlikely possibility." In 2007, he said Fed officials "do not expect significant spillovers from the subprime market to the rest of the economy."

Alan Greenspan, looking back at the financial crisis, admitted that regulators "have had a woeful record of chronic failure. History tells us they cannot identify the timing of a crisis, or anticipate exactly where it will be located or how large the losses and spillovers will be."

But this bill leans heavily on regulators: According to the U.S. Chamber of Commerce, the bill includes 533 rules and calls for 60 studies and 94 reports. Regulators will be in charge of all of them.

Greenspan, in that same speech, expressed a preference for rules that "kick in automatically, without relying on the ability of a fallible human regulator to predict a coming crisis." The bill contains precious few of those, at least for now.

"In history," Princeton's Gorton says, "it always takes us a long time to get financial regulation right, and I expect it will this time, too. Maybe we're done for this year, or the next couple. But we can't possibly be done."

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