There are two major problems with securitization.

First, in modern securitization markets, nobody is really responsible for the credit risk. Instead of taking loans onto their own balance sheet, and losing money if they default, mortgage companies merely sell the loans they originate to Wall Street, pocketing a fee for doing so. Wall Street, in turn, retains very little of the resultant mortgage packages: It sells them on to investors, who can hardly expect Wall Street to be responsible for each individual mortgage.

Thus, all the parties involved in originating the transaction became salesmen. Since it was no longer necessary to have a balance sheet to originate mortgages, mortgage brokers became pure sales operations.  The sales business being what it is, the more unscrupulous and aggressive the sales operation, the more business it did.

That’s how we ended up with so-called “Liar Loans.”

In newly unveiled draft legislation, the U.S. Treasury Department has proposed to reduce this problem by making securitization originators keep 5% of the resultant credit risk. This seems a sensible move, and should help matters considerably, even if it does reduce the attraction of the more-exotic securitizations.

A second problem with securitization, highlighted by the Massachusetts court decision, is that of documentation.  As I can testify from experience, securitizations are by far the most tiresome of all Street transactions to document, with a non-standard securitization creating incalculable costs while taking 18-24 months to complete.

You can see why the more complex transactions were complicated: Hundreds – or even thousands – of mortgages were being bundled and sold as a bundle to maybe tens of thousands of investors.

Read the full article here

The bottom line is: in every trade there is a buyer and a seller. What needs to happen is the risk skew has to be eliminated and everyone has to be on equal footing. If an AIG or Goldman is aware that they can sell CDS in a company X all the way to zero because if the bet goes against them, they will be “rescued” by a moral hazard encouraging Federal Reserve. In doing so they will squeeze the natural market to a point where enough opposite bets emerge in order to arrive at some imbalanced equilibrium. The imbalance would disappear if Goldman were to realize that it has the same risk/return profile as a Carl Icahn or any other CDS player. If you want to have an efficient CDS market, remove the government backstops of its core players: AIG some years ago, which was more an implicit understanding of their TBTF status, and Goldman Sachs and all the TBTF banks currently, courtesy of explicit guarantees by the government. That is the first and critical step to making CDS trading sensible.

Even with a myriad of cons, CDS has its pros. Credit Default Swaps provide the most liquid and effective mechanism to express a directional bias. With equity volumes ransacked courtesy of HFT systems and various algos that have taken the equity market to unsustainable valuations all with the administration-backstopped desire to provide the “image” to the retail public (and their 401(k) holdings) that things are ok, it is next to impossible to hedge positions for the downside, as every equity short gets run over (courtesy of the Fed), and purchased puts expire worthless: in essence the equity market is broken from a hedging perspective. This only leaves fixed income as some semblance of providing a hedging opportunity. This of course excludes cash bonds (good luck finding borrow to offset long bonds anywhere even close to 1:1), thus leaving asset managers with only CDS as a natural hedge to any and every risk imaginable: from corporate, to duration, to interest rate, to counterparty.

All those who would see CDS extinguished, should consider that without this most liquid product, there will practically be no way to express bearish opinions on the most critical part of the  capital structure. And as we live in a valuation vacuum and true enterprise values are well below the equity tranche for the bulk of corporations (yet above 0, we hope), CDS is precisely the principal and only way to express a valuation bias for such time as the Fed decides to stop fighting the market and tightens (which may or may not happen in our lifetimes). Absent CDS, we will revert to the day when the mutual funds could only go directionally long, and when selling begins, look out below with no natural bids on the way down. A CDS ban is to the fixed income market, as a shorting ban is to equities…

Read the full post here

Bedlam Asset Management takes a look at exchange traded funds in its latest market commentary. Specifically, at how — largely because of greed — a sound concept has once again potentially been bastardised by the financial industry.

As Bedlam notes, ETFs started off as a simple and good idea. They were convenient for investors, easy to understand, affordable, the natural successor of earlier market structures  like futures.

But then — unhappy with the ETFs’ solid but low returns — the industry turned to financial rocket scientists to try and beef up the ETF game. Or as Bedlam observes:

Like alcoholics, investment bankers can never have enough, but in the ETF markets they had made a mistake. For the annual management charges and the dealing commissions were set at a low, thus fair, price to make them attractive.

Having established these precedents, it proved hard to raise the profitability for their managers and thus skin the investor. Banks really dislike steady, recurrent low fee income from low-risk products as they can never cover their bloated overheads; so they consulted their rocket scientists.

They invented the ‘Almost as Safe ETF’, but with a much higher fee base. Some started using derivatives and other opaque financial instruments to offer an increase in value twice that of the price gain of the underlying gold or other commodity. These attracted more trading and higher fees too.

The next phase, as Bedlam notes, was similar to the development of asset-backed mortgage securities. The industry thinking appeared to be:

Why not have gold ETFs not backed by gold at all but say by gold shares, with price differences smoothed out through ever-liquid derivatives and hedges?

And the risk (and fees) just kept getting greater:

The ability to play around globally in multiple types of listed paper generated even more commissions; and because these vehicles were far more complex — but still very safe — management fees charged could be higher for enhancing the rise or fall relative to the underlying commodity. The die was cast. As it worked so well, and profitably, for bullion and then hard commodities why not apply it to others such as sugar, cocoa or coffee? Why not to anything not nailed down? So ETFs spread like a virus; the market went fissile. Having dredged most commodities — yes, there are even lean hog ETFs over which you can buy an OTC put — investment bankers took the final leap of taking it back into actual listed companies.

Read the full post here

The problem is that financial breakdowns come with low frequency. Since flaws in the financial system may appear decades apart, it is hard to figure out how some new financial device will behave. Moreover, because of the low frequency of crises, people who use financial instruments often have little or no personal experience with the crises and so trust is harder to establish.

When people invest for their children’s education or their retirement, they are concerned about risks that will not become visible for years. They may not be able to rebound from mistaken purchases of faulty financial devices and they may suffer if circumstances develop that create risks that could have been protected against.

Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. They must work towards clearing the way to widespread use of better products, concerning themselves with both safety and creative ideas. They must not simply be law enforcers against the shenanigans of cynical promoters, but also be open to making complex ideas work that have the potential to improve public welfare. Unfortunately, the crisis has sharply reduced trust in our financial system.

…Unfortunately, people do not trust some good innovations that could protect them better. The innovations in mortgages in recent years (involving such things as option-adjustable rate mortgages) are not products of sophisticated financial theory. I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future.

Another example of a potentially useful innovation is the target-date fund (also called life-cycle fund) that invests money for people’s retirement in a way that is specifically tailored for people their age. Such a fund plans for young people to take greater risks and for older people to invest more conservatively. Target-date funds, first introduced by Wells Fargo and BGI in the 1990s, are growing in importance, but few people commit the bulk of their portfolio to such funds, or make use of target-date funds that might make adjustments for their other investments. It appears that people do not fully trust that these funds are designed correctly, or would protect them from crises.

…It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. Despite the apparent improvement in the economy, the crisis is not over and so the public continues to support government-led interventions. Doing this means encouraging better dialogue between private-sector innovators and regulators. My experience with regulators suggests that they are intelligent and well-meaning but often bogged down in bureaucracy. Regulatory agencies need to be given a stronger mission of encouraging innovation. They must hire enough qualified staff to understand the complexity of the innovative process and talk to innovators with less of a disapprove-by-the-rules stance and more that of a contributor to a complex creative process.

Read the full article here

Leave it to Wall Street to give innovation a bad name. Americans prize out-of-the-box thinking in technology and culture, but they fear it in finance—understandably, thanks to innovative disasters like credit default swaps, collateralized debt obligations, and “negatively amortizing” mortgages whose principal grows instead of shrinking.

In spite of the public’s mistrust, entrepreneurs and academics are plunging ahead. They’re working on ideas they hope will help the consumer borrow more safely and build wealth more reliably. Some are ambitious, like reducing homeowners’ exposure to declines in local housing prices. Others are fanciful, like an electronically rigged wallet that becomes harder to open when your bank account is low, an idea from the Massachusetts Institute of Technology.

The big problem: It’s hard to tell the beneficial ideas from the ones that are self-serving or dangerous. Many top economists, including former Federal Reserve Chairman Alan Greenspan, once lauded subprime mortgages as a fantastic innovation. With this fresh in mind, there’s a risk that government will overreact and suppress good ideas along with bad ones.

Read the full article here

Hat tip to Washington’s Blog for bringing this story to my attention. Morningstar Advisor posted a great piece back in June when they held a conversation with Ed Kane, Martin Mayer, and Walker Todd–three people who have great depth and experience in understanding the plumbing, history, and effects of the regulatory infrastructure of our financial markets. Below are some highlights:

[Finance professor Ed] Kane: One has to remember that these are profit-making institutions. Issuers will would pay more money for a good rating than a bad one, and issuers are very clear what kind of ratings they want. This is a straight-forward way to pay bribes without ever violating the law, it appears, and the credit rating organizations do not take formal responsibility for their incompetence or negligence.

[Prolific financial journalist, Brookings Institution scholar, and the author of more than 30 books on financial market issues Martin] Mayer: One of the untold scandals of this country is that our museums are stuffed with fake old masters because the people who authenticated paintings for the Mellons and Morgans of this world were paid a percentage of the price for the authentication. If they said it was no good, they got a few hundred bucks. If they said it was great, they got $100,000. Same story in the credit-rating organizations.

[Former Federal Reserve attorney and economist Walker] Todd: Right. They also drop the ball. I’ve been around failing banks and financial crises since 1974, and the rating agencies have dropped the ball almost every time. They were always at best late to the party.

Mayer: John Heimann [former comptroller of the currency] used to say that the function of the ratings agency is to go on the battlefield after the battle is over and shoot the wounded.

Read the whole Morningstar discussion after the jump…

How the Fed Contributes to Crises
by Bill Bergman | 06-03-09

If your clients had a bad year last year, it might seem easy to conclude that you shouldn’t take it personally, because your clients were far from alone. After all, market prices for individual investments are driven by macro-economic factors as well as factors specific to the investments at hand. And the financial crisis significantly undermined economic and investment confidence in many corners of the markets.

On the other hand, there could be a good reason to take the meltdown personally. Our crisis has had important regulatory underpinnings. Those institutions we’ve created to help “stabilize” banking markets and to “protect investors” may not have done what they advertise heading into the crisis, as well as when dealing with it.

On April 27, we held a conversation with Ed Kane, Martin Mayer, and Walker Todd–three people who have great depth and experience in understanding the plumbing, history, and effects of the regulatory infrastructure of our financial markets. Kane is professor of finance at Boston College, past president of the American Finance Association, and co-founder of the Shadow Financial Regulatory Committee. Martin Mayer is a prolific financial journalist, a scholar at the Brookings Institution, and the author of more than 30 books on financial market issues. Todd worked in the Federal Reserve System as an attorney and economist and is now affiliated with the American Institute for Economic Research. The conversation has been edited for clarity and length.

Bill Bergman: Where does this financial crisis rank historically?

Ed Kane: I call it the Great Recession. It hasn’t become a depression by any means, but it is the worst recession we’ve had since Keynesian economics led to a more active government acceptance of the responsibility to ameliorate business cycles.

Martin Mayer: We were always going to have a bad patch. A lot of very dumb things had been done, particularly at the federal banks, but also, a lot of people’s worst instincts were pandered to, and they were inviting what is now fashionable to call the Minsky moment, when actually it looks as though it’s a Goldilocks moment–the economy was suddenly eaten by bears.

Walker Todd: I would note that Martin’s book, The Fed (Plume, 2002), should be required reading for everybody to gain a view of the run-up to this crisis. You can easily see how we got here. This financial situation is the worst since the end of World War II. We looked at the charts at AIER last Friday, and virtually all the economic-performance charts were at unheard-of or post-war lows. This really is the big one.

Kane: Officials panicked in September 2008, and the public lost confidence in their ability to manage. It is striking how in these different agencies, a small inner circle of people have closed themselves off to ideas from even the rest of their staff. I understand that in a lot of agencies everybody goes home on time, but this inner circle has been working itself to death. Along with panic, I think there is exhaustion and some loss of judgment, because they’ve been under pressure for so long.

Mayer: What happened right after Lehman was that the commercial paper market closed down, and quite a lot of the extension of credit in the U.S. economy ran through the commercial paper market. I got a peculiar insight on the situation. I was giving a talk to the fixed-income division of Fidelity. It was the week after the Lehman collapse. There was a $600 billion money market fund that Fidelity ran, and the Fidelity folks said that all of their institutional clientele were calling up and saying, “Get us out of commercial paper. Get us out of anything that’s private. We want nothing but government guaranteed paper. Cleanse that money market fund of yours!”

The whole crisis accelerated over the course of that week, while the Treasury and the Fed, which had not anticipated any of this, didn’t understand well enough how their own system worked. They thought that all that mattered was the banks. Meanwhile, all the informal sources of credit in the economy, which are bigger than bank loans in the commercial economy, faded away to nothing. These guys sat there and wrung their hands and wondered what was going on.

Todd: The panic then spread into the general public after September and October because of the meltdown of 401(k) plan values. There, too, it’s not entirely clear who’s to blame. One wants to point the finger at the sell-side distributors of securities, but the typical 401(k) plan does not offer a vehicle with a proper hedge for the consumer in moments like these. I, like other investors, was confronted with the question of: Do I go all to cash, risking the devaluation by the Fed of the value of that cash in the future? Where were the commodities? Where were the gold funds offered in 401(k)s that would both offer investors some protection and upside against future Fed inflation?

Bergman: Martin, you had an interesting story in The Bankers (Plume, 1998) about the origins of AIG’s financial products unit. To what extent was AIG and its involvement in the credit default swap market at the center of the storm?

Mayer: Certainly, it was the center of the panic. That the Federal Reserve system would support, on very dubious legal authority, an insurance company with $180 billion of advances so that this insurance company could get away with the fact that they wrote policies and never put aside any reserve to be able to pay them–it’s a disgrace.

Incidentally, this problem is by no means gone, because one of the reasons you can’t price assets is that nobody knows whether they’re really insured. Nobody wants to release a loan that may in fact be insured, but no one knows whether it’s insured or not.

Kane: Another point is that these so-called “hard-to-price assets” have much more value to “zombie banks” than to anyone else, which is why there is no liquidity in that market. The deeply insolvent institutions want what everyone else calls “toxic assets” because it gives them a chance to climb back if the economy recovers well into solvency.

Bergman: Ed, you coined the term “zombie banks” in the S&L crisis. What inspired you?

Kane: It was just an attempt to make clear to people the dangers of keeping an institution that was deeply insolvent alive, or at least walking. The notion of the zombie is that it would be put in its grave by its creditors if it weren’t for the black magic of government credit support guarantees and loans. These institutions have very distorted incentives, just as the zombies do in the horror movies. They’re looking for things that even might have negative present value but have a possibility of producing good results. It’s a long shot bet to plug a hole in their balance sheet.

The trouble with the zombies is that they ruin the market for everyone else. They’re not looking for solid investments but something that has a chance of a big payoff. They’re willing to pay more for deposits or funding generally than other institutions, so they spread “zombieness.” They make other institutions have trouble earning a living.

Todd: It is the dead feeding on the living.

Bergman: Martin, you used the words “dubious legal authority” for the Federal Reserve’s lending. Walker’s done a lot of work in that area and Section 13(3) of the Federal Reserve Act. Walker, could you describe the origin of Section 13(3) and its relevance to this crisis?

Todd: Most of the actions the Fed has taken since the spring of 2008 have been said to be under the authority of Section 13(3) of the Federal Reserve Act. That’s an emergency powers section that was plugged in first around 1932. It gave the Federal Reserve Board of Governors the power in “unusual and exigent circumstances” to make loans directly to individuals, partnerships, and corporations–not just to banks or other financial institutions. It required a positive vote of five members of the board to invoke this authority. It was rarely used during the 1930s because the Reconstruction Finance Corporation was created and made the great bulk of all the loans that this statute was originally contemplated to do. That Section 13(3) authority, in fact, was not used after 1936.

Until 1991. In the dark of night during the Senate markup of the FDIC Improvements Act, lobbyists for the investment banks saw to it that Sen. Christopher Dodd introduced an amendment that would waive the statute’s technical collateral requirements, because the statute required collateral of the type eligible for discount at the Federal Reserve–which was short-term trade-related obligations and certain government securities. By and large, investment banks did not hold that kind of collateral, but they had lots of stocks and bonds and other things that were not eligible for discount.

So the collateral requirement was changed to any collateral satisfactory to the Federal Reserve Bank, and that meant that investment banks could borrow at the Fed for a change. Now, I opposed that change, and I identified it in an article that was published by the Cleveland Federal Reserve Bank in its Economic Review in the third quarter of 1993. The publication of the article created an internal firestorm. The Board of Governors really came down on me hard for having published it. Years later, we find out why. They wanted to use that power if they had a big enough emergency–as they thought they did once Bear Stearns went down–to make a bailout loan to an investment bank.

This stands the entire Federal Reserve Act on its head. The exceptional rule–the emergency power–has now become the regular way of doing things and the quantitatively dominant method of extending credit for the Fed. It’s very bad from a number of perspectives, not the least of which is institutional structure, because it means that the narrow and insular views of the Board of Governors together with the New York Federal Reserve Bank, the entity that’s making these loans, are the only views listened to in deciding when and how an emergency loan is being made. Basically, the credit gets booked and then the other Reserve Banks are required to eat a pro-rata share of these loans through loss-sharing agreements and the like.

It’s a process that needs to be stopped. They need to channel all of this out into something like a newly created RFC. The only other alternative would be to just explicitly require the Treasury to take these loans off the books of the Fed, to recapitalize them and refund them with Treasury debt issues.

Kane: What do you think is going to be the long-term effect on the Federal Reserve as an institution? It has exercised discretion it was never given. The independence of monetary policy was always the central principle underlying its responsibilities and discretion. By putting bankers and brokers first in the line out of all other members of society, do you think that the Federal Reserve can retain its independence going forward?

Todd: Martin, do you want to respond to that?

Mayer: I have been very disturbed about the way this thing has worked in terms of body language. [Fed chairman from 1951 to 1970] Bill Martin was very reluctant to go to the White House for lunch with Lyndon Johnson because he thought that he was not part of the executive branch, which indeed the Fed is not, remember? The Constitution gives Congress the power to coin money and regulate the value thereof. [House Banking Committee chairman from 1965 to 1975] Wright Patman used to say, “We farmed it out to the open market committee of the Federal Reserve.” The basic source of the Fed’s real authority is in the Congress, not the executive branch.

It was always Bill Martin’s feeling–and it was certainly the feeling of [Fed chairman from 1979 to 1987] Paul Volcker–that they were not part of the executive branch. They didn’t take dictation from the president of the United States, and indeed, Lyndon Johnson blew his stack about Martin once raising interest rates, but Johnson couldn’t do a thing about it.

I think all of this has been lost. The Fed has sacrificed under Ben Bernanke, as it had under [Fed chairman from 1970 to 1978] Arthur Burns, quite a lot of its independence. There should be a law that prevents academics from becoming chairmen of the Fed.

Kane: Do you think that there’s something just inherently weak in the experience of these people–that they haven’t had enough tussles to be able to stand up to authority?

Mayer: I think so. The experience of being an academic is not good for the sort of self-assertion that Bill Martin was good at.

Todd: The main problem with these guys is that they never examined a bank and they never made a loan before they got these jobs. Tom Hoenig of the Kansas City Fed wrote a very interesting speech, essentially dissenting from current Fed policy and advocating explicitly that the new lending activities be channeled off into a newly constituted RFC. He does have a Ph.D. in economics and he is a Keynesian, but he came up through the bank examination channel and served as the discount window officer at the Kansas City Fed. As he used to put it, unlike all his other colleagues at the Federal Open Market Committee meetings, he had in fact examined a bank or made a loan, and nobody else sitting at the table had ever done that.

Kane: I think it’s wrong to suggest that it is a matter of individuals. I do think there’s a terrible problem in how we recruit top officials in government, but I suspect that whoever would have been Fed chairman at this time, whether he was an academic or not, would have been subject to intense pressure to do what the Treasury wanted, what Wall Street wanted, to keep from having these losses go to counterparties who are politically very powerful. A person would have to be extraordinarily tough to survive this pressure.

Mayer: Volcker.

Kane: Volcker was a unique person, and we were lucky to have him at the time.

Todd: He would have been the best choice for chairman, but I have seen him cave on occasions when he shouldn’t have.

Kane: You’ve worked in government, so you know how intense these pressures are, and it’s always hard to do the right thing. Someone who does the right thing 90% of the time is a hero in Washington.

Todd: In Washington, 70% is good.

Mayer: The thing that shocked me the last few days is the fact that the Fed is now insisting that on the Term Asset-Backed Securities Loan Facility, it all has to be rated by the same stupid rating agencies that got us into trouble to begin with. What’s wrong with these people?

Kane: It’s plain avoidance is what it is. It has been very convenient to let these credit rating organizations call themselves “agencies,” even though they aren’t. I’ve been objecting to that term for decades.

Bergman: It’s also the way the government incorporates credit ratings into their own regulations, thereby downloading the regulatory responsibility on the rating agency. Was that part of the problem?

Kane: Absolutely. One has to remember that these are profit-making institutions. Issuers will would pay more money for a good rating than a bad one, and issuers are very clear what kind of ratings they want. This is a straight-forward way to pay bribes without ever violating the law, it appears, and the credit rating organizations do not take formal responsibility for their incompetence or negligence.

Mayer: One of the untold scandals of this country is that our museums are stuffed with fake old masters because the people who authenticated paintings for the Mellons and Morgans of this world were paid a percentage of the price for the authentication. If they said it was no good, they got a few hundred bucks. If they said it was great, they got $100,000. Same story in the credit-rating organizations.

Todd: Right. They also drop the ball. I’ve been around failing banks and financial crises since 1974, and the rating agencies have dropped the ball almost every time. They were always at best late to the party.

Mayer: John Heimann [former comptroller of the currency] used to say that the function of the ratings agency is to go on the battlefield after the battle is over and shoot the wounded.

Bergman: Maybe we’ll learn something from that and pass some legislation.

Kane: Oh, I don’t think so. All kinds of regulations are reasserting the role of the credit agencies. You know what is really disturbing? If you take something like a money market fund, it isn’t a matter of rating the portfolio’s individual securities. Rather, the focus should be on how the portfolio as a whole rates. The current focus says it’s okay to take a lot of things that are investment grade, as if that could keep people from taking a lot of credit risk. Many firms, as we know, were concentrated in their real estate risk exposure, most of which was rated as being investment-grade.

Todd: In historical time, this credit-rating mess was created only the day before yesterday. Before the 1990s, I don’t think you’d find any explicit incorporation of ratings into federal bank supervisory regulations. So it’s something that could be undone. For those who say that we’re stuck in the world we’ve created, I think it’s easy enough to do: Just rewrite the regulations to take the rating agencies out of it.

Bergman: One other thing historically we’ve learned to be concerned about is rapid growth in banks. One of the fastest-growing banks out there is the Federal Reserve Bank in New York. Should we be leery about this?

Kane: We’ve been leery of this throughout our entire discussion! The assertion of the right to make all kinds of risky loans in the context of a staff that lacks experience in lending goes back to what Walker was saying. We know that the trick is to get the money back, and there doesn’t seem to have been enough effort to be sure they can get the money back. It’s just this belief that somehow if you kept putting money into these zombies, the tide will turn and everything will get well.

Mayer: The notion that the nation’s currency is backed by a bunch of junk bonds and CDOs and such things on the books of the Federal Reserve District Banks is pretty scary.

Todd: I looked at the currency tables last week, and currently it’s about 40% backed by mortgage-backed securities and the like. There’s still somewhere around a 50% to a 60% backing by full faith and credit Treasuries. Of course, you could argue that that’s nothing other than a feedback loop. How does the full faith and credit Treasury get paid off? The answer is by taxes or by borrowing. There’s no gold claim.

Mayer: The two weeks after Lehman, there was a huge rush into actual euro notes– under mattresses. The disappearance of euros was one of the things that was confusing to the European Central Bank.

Bergman: In our monetary aggregates, in the past six months the currency component of M1–the currency circulating outside of banks–has risen at the fastest rate for any six-month interval since World War II.

Mayer: They never heard of gold.

Todd: You wouldn’t want to see that continue if you were serious about containing inflation, but it’s the non-currency components that are troublesome now. For example, the banks’ free reserves at the Fed are just shy of $950 billion. This is off of a base measure of around $8 billion to $10 billion before August 2007. It’s a monster number. The Fed has created an awful lot of potential spending power. The money will show up as inflation when the banks withdraw it through the Fed and make loans, which would trigger the spending. I think the only way of avoiding it would be to pull a nationalization-style trick, not that I’m advocating it, but the Fed does think this way. They could say to the banks, “Remember that $950 billion that you had for your reserves? We’re now converting it into mandatory 10-year Treasuries, and that’s that.”

Bergman: What do you make of the government’s stress tests on banks?

Todd: Let me chime in with a little bit of background. In Washington, the party line of both parties is that we don’t want to know anything about what was done in the U.S. in the 1930s, in part because of the political perception that that would be admitting that we’re reliving the 1930s. Neither party wants to bear that onus. So whenever I talk about the Reconstruction Finance Corporation or temporary nationalization or bank holiday or some device that gets you to more or less the same point of a quick, simultaneous fair market value evaluation of the banking system, nobody wants to hear about it, because my reference point is what was done in the U.S. in the 1930s. But if a reference point is foreign, they’ll listen to it. So they talk about the Swedish model of 1993 or the Japanese bank model of 1999. But both of those models were in turn relying on what was done here in the U.S. during the bank holiday of 1933, which was led by the RFC.

Kane: I would like to underscore Walker’s point. The term zombie bank came up in some hearings, and Bernanke said that the term had been invented in Japan in the late 1990s.

Mayer: It’s yours, that term!

Kane: No question about it. He said this, I believe, because he wanted to give the notion that we didn’t have anything in our history that you could compare it to. It shows the extent to which people will go to make it seem like this is a unique time in American history and that we have to have creative responses without any guidance from the past.

Bergman: Will we see any more backbone on the part of our regulators in the next year?

Kane: I think we will only because they’re going to see that what they’re doing isn’t working and can’t work. It’s one of these instances where people eventually do the right thing, but only because there’s no choice to do anything else.

Todd: People ask me, “When will you get the RFC?” My answer is when they’ve tried everything else.

Mayer: Well, I think that the bolstering of the commercial paper market has in fact done some of the things that they had hoped it was going to do. It’s in the banks, where their proper responsibility and powers are, that they’re screwing up.

Todd: I agree with you, Martin, that the Fed has succeeded a little bit better than I thought it would in propping up the commercial paper market, which looked to be on its last legs last fall. But I think that has a short half life, and I can’t imagine that that rosy new world can last long in light of the continuing rise of unemployment, and the prospective shut down of half the automobile industry in the heartland. In agriculture, there are equally scary things happening.

I think all the chickens will begin flocking home to roost in about the middle of the third quarter. Whenever the further downturn comes, if I’m right, what will these players do then for an encore? What happens if and when the next downturn comes?

Mayer: I think one of the questions that has bewildered me is why there isn’t more work done on the question of what’s in the black box at the Fed when they put money out? How does that thing work? Where does the money go out? It seems to me that what Greenspan did was to put out money, and because it didn’t go into consumer price inflation, they could ignore the fact that it went into dotcoms and then it went into housing. But the Fed money goes somewhere, and it gets used by people eventually. In some periods of time, it goes to real estate. In some periods, it goes to real production. In some periods, it goes to inflating paper of one kind or another. What distinguishes one period from another?

But I am not as pessimistic as Walker. The flooding of money is, after all, worldwide at this point in the game. I note with fascination that we hear that the IMF is talking about issuing bonds that will be bought by the Chinese, Indians, Brazilians, and, God save us, the Russians. Who has the big dollar reserves and how can you get them to pump them? You get them to pump by giving them paper.

Half the population of the world is still looking forward to next year. The other half is looking forward with dread, but half of them will keep going. You combine that with this flood of money, and we may muddle through it.

Todd: Is the danger, though, that after you muddle through it, you reach the other side of the downturn and you look across and see the monetary tsunami coming back at you of all the liquidity you have created?

Mayer: And then what do you do about it? I agree with that. I think the people who are in office three or four years from now are going to face some really nasty decisions. But in terms of how much deeper does this go, I’ve become a little less pessimistic in the last month myself.

Kane: But when you say you’re less pessimistic, it is presumably because you expect inflation to cause a lot of nominal repricing that will make losses go away. It’s just a question of one poison for another. I don’t see how in the world the Fed can believe politics will allow it to extract even half of the huge amount of free reserves that are just waiting to become money supply.

Bill Bergman is a senior equity analyst with Morningstar. He also contributes to the Markets & Economy blog for MorningstarAdvisor.com.

Below is an excerpt:

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.

I. MISTAKING BEAUTY FOR TRUTH

It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes — or so they believed — were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making.

Last year, everything came apart.

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

And in the wake of the crisis, the fault lines in the economics profession have yawned wider than ever. Lucas says the Obama administration’s stimulus plans are “schlock economics,” and his Chicago colleague John Cochrane says they’re based on discredited “fairy tales.” In response, Brad DeLong of the University of California, Berkeley, writes of the “intellectual collapse” of the Chicago School, and I myself have written that comments from Chicago economists are the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten.

What happened to the economics profession? And where does it go from here?

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.

II. FROM SMITH TO KEYNES AND BACK

The birth of economics as a discipline is usually credited to Adam Smith, who published “The Wealth of Nations” in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the market. Yes, economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities” — costs that people impose on others without paying the price, like traffic congestion or pollution. But the basic presumption of “neoclassical” economics (named after the late-19th-century theorists who elaborated on the concepts of their “classical” predecessors) was that we should have faith in the market system.

This faith was, however, shattered by the Great Depression. Actually, even in the face of total collapse some economists insisted that whatever happens in a market economy must be right: “Depressions are not simply evils,” declared Joseph Schumpeter in 1934 — 1934! They are, he added, “forms of something which has to be done.” But many, and eventually most, economists turned to the insights of John Maynard Keynes for both an explanation of what had happened and a solution to future depressions.

Keynes did not, despite what you may have heard, want the government to run the economy. He described his analysis in his 1936 masterwork, “The General Theory of Employment, Interest and Money,” as “moderately conservative in its implications.” He wanted to fix capitalism, not replace it. But he did challenge the notion that free-market economies can function without a minder, expressing particular contempt for financial markets, which he viewed as being dominated by short-term speculation with little regard for fundamentals. And he called for active government intervention — printing more money and, if necessary, spending heavily on public works — to fight unemployment during slumps.

It’s important to understand that Keynes did much more than make bold assertions. “The General Theory” is a work of profound, deep analysis — analysis that persuaded the best young economists of the day. Yet the story of economics over the past half century is, to a large degree, the story of a retreat from Keynesianism and a return to neoclassicism. The neoclassical revival was initially led by Milton Friedman of the University of Chicago, who asserted as early as 1953 that neoclassical economics works well enough as a description of the way the economy actually functions to be “both extremely fruitful and deserving of much confidence.” But what about depressions?

Friedman’s counterattack against Keynes began with the doctrine known as monetarism. Monetarists didn’t disagree in principle with the idea that a market economy needs deliberate stabilization. “We are all Keynesians now,” Friedman once said, although he later claimed he was quoted out of context. Monetarists asserted, however, that a very limited, circumscribed form of government intervention — namely, instructing central banks to keep the nation’s money supply, the sum of cash in circulation and bank deposits, growing on a steady path — is all that’s required to prevent depressions. Famously, Friedman and his collaborator, Anna Schwartz, argued that if the Federal Reserve had done its job properly, the Great Depression would not have happened. Later, Friedman made a compelling case against any deliberate effort by government to push unemployment below its “natural” level (currently thought to be about 4.8 percent in the United States): excessively expansionary policies, he predicted, would lead to a combination of inflation and high unemployment — a prediction that was borne out by the stagflation of the 1970s, which greatly advanced the credibility of the anti-Keynesian movement.

Eventually, however, the anti-Keynesian counterrevolution went far beyond Friedman’s position, which came to seem relatively moderate compared with what his successors were saying. Among financial economists, Keynes’s disparaging vision of financial markets as a “casino” was replaced by “efficient market” theory, which asserted that financial markets always get asset prices right given the available information. Meanwhile, many macroeconomists completely rejected Keynes’s framework for understanding economic slumps. Some returned to the view of Schumpeter and other apologists for the Great Depression, viewing recessions as a good thing, part of the economy’s adjustment to change. And even those not willing to go that far argued that any attempt to fight an economic slump would do more harm than good.

Not all macroeconomists were willing to go down this road: many became self-described New Keynesians, who continued to believe in an active role for the government. Yet even they mostly accepted the notion that investors and consumers are rational and that markets generally get it right.

Of course, there were exceptions to these trends: a few economists challenged the assumption of rational behavior, questioned the belief that financial markets can be trusted and pointed to the long history of financial crises that had devastating economic consequences. But they were swimming against the tide, unable to make much headway against a pervasive and, in retrospect, foolish complacency.

III. PANGLOSSIAN FINANCE

In the 1930s, financial markets, for obvious reasons, didn’t get much respect. Keynes compared them to “those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors.”

And Keynes considered it a very bad idea to let such markets, in which speculators spent their time chasing one another’s tails, dictate important business decisions: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a “casino.”

It’s hard to argue that this transformation in the profession was driven by events. True, the memory of 1929 was gradually receding, but there continued to be bull markets, with widespread tales of speculative excess, followed by bear markets. In 1973-4, for example, stocks lost 48 percent of their value. And the 1987 stock crash, in which the Dow plunged nearly 23 percent in a day for no clear reason, should have raised at least a few doubts about market rationality.

These events, however, which Keynes would have considered evidence of the unreliability of markets, did little to blunt the force of a beautiful idea. The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward — the so-called Capital Asset Pricing Model, or CAPM (pronounced cap-em) — is wonderfully elegant. And if you accept its premises it’s also extremely useful. CAPM not only tells you how to choose your portfolio — even more important from the financial industry’s point of view, it tells you how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators, and many of the theory’s adepts also received more mundane rewards: Armed with their new models and formidable math skills — the more arcane uses of CAPM require physicist-level computations — mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks.

To be fair, finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive. But this evidence was of an oddly limited form. Finance economists rarely asked the seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings. Instead, they asked only whether asset prices made sense given other asset prices. Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient.

But neither this mockery nor more polite critiques from economists like Robert Shiller of Yale had much effect. Finance theorists continued to believe that their models were essentially right, and so did many people making real-world decisions. Not least among these was Alan Greenspan, who was then the Fed chairman and a long-time supporter of financial deregulation whose rejection of calls to rein in subprime lending or address the ever-inflating housing bubble rested in large part on the belief that modern financial economics had everything under control. There was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as “misguided.”

By October of last year, however, Greenspan was admitting that he was in a state of “shocked disbelief,” because “the whole intellectual edifice” had “collapsed.” Since this collapse of the intellectual edifice was also a collapse of real-world markets, the result was a severe recession — the worst, by many measures, since the Great Depression. What should policy makers do? Unfortunately, macroeconomics, which should have been providing clear guidance about how to address the slumping economy, was in its own state of disarray.

IV. THE TROUBLE WITH MACRO

“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time.” So wrote John Maynard Keynes in an essay titled “The Great Slump of 1930,” in which he tried to explain the catastrophe then overtaking the world. And the world’s possibilities of wealth did indeed run to waste for a long time; it took World War II to bring the Great Depression to a definitive end.

Why was Keynes’s diagnosis of the Great Depression as a “colossal muddle” so compelling at first? And why did economics, circa 1975, divide into opposing camps over the value of Keynes’s views?

I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op.

This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby-sitting for one another’s children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time. Initially, members received 20 coupons on joining and were required to return the same amount on departing the group.

Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. . . .

In short, the co-op fell into a recession.

O.K., what do you think of this story? Don’t dismiss it as silly and trivial: economists have used small-scale examples to shed light on big questions ever since Adam Smith saw the roots of economic progress in a pin factory, and they’re right to do so. The question is whether this particular example, in which a recession is a problem of inadequate demand — there isn’t enough demand for baby-sitting to provide jobs for everyone who wants one — gets at the essence of what happens in a recession.

Forty years ago most economists would have agreed with this interpretation. But since then macroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and “freshwater” economists (mainly at inland schools), who consider that vision nonsense.

Freshwater economists are, essentially, neoclassical purists. They believe that all worthwhile economic analysis starts from the premise that people are rational and markets work, a premise violated by the story of the baby-sitting co-op. As they see it, a general lack of sufficient demand isn’t possible, because prices always move to match supply with demand. If people want more baby-sitting coupons, the value of those coupons will rise, so that they’re worth, say, 40 minutes of baby-sitting rather than half an hour — or, equivalently, the cost of an hours’ baby-sitting would fall from 2 coupons to 1.5. And that would solve the problem: the purchasing power of the coupons in circulation would have risen, so that people would feel no need to hoard more, and there would be no recession.

But don’t recessions look like periods in which there just isn’t enough demand to employ everyone willing to work? Appearances can be deceiving, say the freshwater theorists. Sound economics, in their view, says that overall failures of demand can’t happen — and that means that they don’t. Keynesian economics has been “proved false,” Cochrane, of the University of Chicago, says.

Yet recessions do happen. Why? In the 1970s the leading freshwater macroeconomist, the Nobel laureate Robert Lucas, argued that recessions were caused by temporary confusion: workers and companies had trouble distinguishing overall changes in the level of prices because of inflation or deflation from changes in their own particular business situation. And Lucas warned that any attempt to fight the business cycle would be counterproductive: activist policies, he argued, would just add to the confusion.

By the 1980s, however, even this severely limited acceptance of the idea that recessions are bad things had been rejected by many freshwater economists. Instead, the new leaders of the movement, especially Edward Prescott, who was then at the University of Minnesota (you can see where the freshwater moniker comes from), argued that price fluctuations and changes in demand actually had nothing to do with the business cycle. Rather, the business cycle reflects fluctuations in the rate of technological progress, which are amplified by the rational response of workers, who voluntarily work more when the environment is favorable and less when it’s unfavorable. Unemployment is a deliberate decision by workers to take time off.

Put baldly like that, this theory sounds foolish — was the Great Depression really the Great Vacation? And to be honest, I think it really is silly. But the basic premise of Prescott’s “real business cycle” theory was embedded in ingeniously constructed mathematical models, which were mapped onto real data using sophisticated statistical techniques, and the theory came to dominate the teaching of macroeconomics in many university departments. In 2004, reflecting the theory’s influence, Prescott shared a Nobel with Finn Kydland of Carnegie Mellon University.

Meanwhile, saltwater economists balked. Where the freshwater economists were purists, saltwater economists were pragmatists. While economists like N. Gregory Mankiw at Harvard, Olivier Blanchard at M.I.T. and David Romer at the University of California, Berkeley, acknowledged that it was hard to reconcile a Keynesian demand-side view of recessions with neoclassical theory, they found the evidence that recessions are, in fact, demand-driven too compelling to reject. So they were willing to deviate from the assumption of perfect markets or perfect rationality, or both, adding enough imperfections to accommodate a more or less Keynesian view of recessions. And in the saltwater view, active policy to fight recessions remained desirable.

But the self-described New Keynesian economists weren’t immune to the charms of rational individuals and perfect markets. They tried to keep their deviations from neoclassical orthodoxy as limited as possible. This meant that there was no room in the prevailing models for such things as bubbles and banking-system collapse. The fact that such things continued to happen in the real world — there was a terrible financial and macroeconomic crisis in much of Asia in 1997-8 and a depression-level slump in Argentina in 2002 — wasn’t reflected in the mainstream of New Keynesian thinking.

Even so, you might have thought that the differing worldviews of freshwater and saltwater economists would have put them constantly at loggerheads over economic policy. Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, I believe, is that New Keynesians, unlike the original Keynesians, didn’t think fiscal policy — changes in government spending or taxes — was needed to fight recessions. They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed. At a 90th birthday celebration for Milton Friedman, Ben Bernanke, formerly a more or less New Keynesian professor at Princeton, and by then a member of the Fed’s governing board, declared of the Great Depression: “You’re right. We did it. We’re very sorry. But thanks to you, it won’t happen again.” The clear message was that all you need to avoid depressions is a smarter Fed.

And as long as macroeconomic policy was left in the hands of the maestro Greenspan, without Keynesian-type stimulus programs, freshwater economists found little to complain about. (They didn’t believe that monetary policy did any good, but they didn’t believe it did any harm, either.)

It would take a crisis to reveal both how little common ground there was and how Panglossian even New Keynesian economics had become.

V. NOBODY COULD HAVE PREDICTED . . .

In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted. . . .” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains.

Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.”

How did they miss the bubble? To be fair, interest rates were unusually low, possibly explaining part of the price rise. It may be that Greenspan and Bernanke also wanted to celebrate the Fed’s success in pulling the economy out of the 2001 recession; conceding that much of that success rested on the creation of a monstrous bubble would have placed a damper on the festivities.

But there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”

Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified. It’s ketchup economics, again: because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right.

In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.

Now that the undiagnosed bubble has burst, the true riskiness of supposedly safe assets has been revealed and the financial system has demonstrated its fragility. U.S. households have seen $13 trillion in wealth evaporate. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since 1940. So what guidance does modern economics have to offer in our current predicament? And should we trust it?

VI. THE STIMULUS SQUABBLE

Between 1985 and 2007 a false peace settled over the field of macroeconomics. There hadn’t been any real convergence of views between the saltwater and freshwater factions. But these were the years of the Great Moderation — an extended period during which inflation was subdued and recessions were relatively mild. Saltwater economists believed that the Federal Reserve had everything under control. Fresh­water economists didn’t think the Fed’s actions were actually beneficial, but they were willing to let matters lie.

But the crisis ended the phony peace. Suddenly the narrow, technocratic policies both sides were willing to accept were no longer sufficient — and the need for a broader policy response brought the old conflicts out into the open, fiercer than ever.

Why weren’t those narrow, technocratic policies sufficient? The answer, in a word, is zero.

During a normal recession, the Fed responds by buying Treasury bills — short-term government debt — from banks. This drives interest rates on government debt down; investors seeking a higher rate of return move into other assets, driving other interest rates down as well; and normally these lower interest rates eventually lead to an economic bounceback. The Fed dealt with the recession that began in 1990 by driving short-term interest rates from 9 percent down to 3 percent. It dealt with the recession that began in 2001 by driving rates from 6.5 percent to 1 percent. And it tried to deal with the current recession by driving rates down from 5.25 percent to zero.

But zero, it turned out, isn’t low enough to end this recession. And the Fed can’t push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the “zero lower bound” even as the recession continued to deepen, conventional monetary policy had lost all traction.

Now what? This is the second time America has been up against the zero lower bound, the previous occasion being the Great Depression. And it was precisely the observation that there’s a lower bound to interest rates that led Keynes to advocate higher government spending: when monetary policy is ineffective and the private sector can’t be persuaded to spend more, the public sector must take its place in supporting the economy. Fiscal stimulus is the Keynesian answer to the kind of depression-type economic situation we’re currently in.

Such Keynesian thinking underlies the Obama administration’s economic policies — and the freshwater economists are furious. For 25 or so years they tolerated the Fed’s efforts to manage the economy, but a full-blown Keynesian resurgence was something entirely different. Back in 1980, Lucas, of the University of Chicago, wrote that Keynesian economics was so ludicrous that “at research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another.” Admitting that Keynes was largely right, after all, would be too humiliating a comedown.

And so Chicago’s Cochrane, outraged at the idea that government spending could mitigate the latest recession, declared: “It’s not part of what anybody has taught graduate students since the 1960s. They [Keynesian ideas] are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children, but it doesn’t make them less false.” (It’s a mark of how deep the division between saltwater and freshwater runs that Cochrane doesn’t believe that “anybody” teaches ideas that are, in fact, taught in places like Princeton, M.I.T. and Harvard.)

Meanwhile, saltwater economists, who had comforted themselves with the belief that the great divide in macroeconomics was narrowing, were shocked to realize that freshwater economists hadn’t been listening at all. Freshwater economists who inveighed against the stimulus didn’t sound like scholars who had weighed Keynesian arguments and found them wanting. Rather, they sounded like people who had no idea what Keynesian economics was about, who were resurrecting pre-1930 fallacies in the belief that they were saying something new and profound.

And it wasn’t just Keynes whose ideas seemed to have been forgotten. As Brad DeLong of the University of California, Berkeley, has pointed out in his laments about the Chicago school’s “intellectual collapse,” the school’s current stance amounts to a wholesale rejection of Milton Friedman’s ideas, as well. Friedman believed that Fed policy rather than changes in government spending should be used to stabilize the economy, but he never asserted that an increase in government spending cannot, under any circumstances, increase employment. In fact, rereading Friedman’s 1970 summary of his ideas, “A Theoretical Framework for Monetary Analysis,” what’s striking is how Keynesian it seems.

And Friedman certainly never bought into the idea that mass unemployment represents a voluntary reduction in work effort or the idea that recessions are actually good for the economy. Yet the current generation of freshwater economists has been making both arguments. Thus Chicago’s Casey Mulligan suggests that unemployment is so high because many workers are choosing not to take jobs: “Employees face financial incentives that encourage them not to work . . . decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).” Mulligan has suggested, in particular, that workers are choosing to remain unemployed because that improves their odds of receiving mortgage relief. And Cochrane declares that high unemployment is actually good: “We should have a recession. People who spend their lives pounding nails in Nevada need something else to do.”

Personally, I think this is crazy. Why should it take mass unemployment across the whole nation to get carpenters to move out of Nevada? Can anyone seriously claim that we’ve lost 6.7 million jobs because fewer Americans want to work? But it was inevitable that freshwater economists would find themselves trapped in this cul-de-sac: if you start from the assumption that people are perfectly rational and markets are perfectly efficient, you have to conclude that unemployment is voluntary and recessions are desirable.

Yet if the crisis has pushed freshwater economists into absurdity, it has also created a lot of soul-searching among saltwater economists. Their framework, unlike that of the Chicago School, both allows for the possibility of involuntary unemployment and considers it a bad thing. But the New Keynesian models that have come to dominate teaching and research assume that people are perfectly rational and financial markets are perfectly efficient. To get anything like the current slump into their models, New Keynesians are forced to introduce some kind of fudge factor that for reasons unspecified temporarily depresses private spending. (I’ve done exactly that in some of my own work.) And if the analysis of where we are now rests on this fudge factor, how much confidence can we have in the models’ predictions about where we are going?

The state of macro, in short, is not good. So where does the profession go from here?

VII. FLAWS AND FRICTIONS

Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions. The good news is that we don’t have to start from scratch. Even during the heyday of perfect-market economics, there was a lot of work done on the ways in which the real economy deviated from the theoretical ideal. What’s probably going to happen now — in fact, it’s already happening — is that flaws-and-frictions economics will move from the periphery of economic analysis to its center.

There’s already a fairly well developed example of the kind of economics I have in mind: the school of thought known as behavioral finance. Practitioners of this approach emphasize two things. First, many real-world investors bear little resemblance to the cool calculators of efficient-market theory: they’re all too subject to herd behavior, to bouts of irrational exuberance and unwarranted panic. Second, even those who try to base their decisions on cool calculation often find that they can’t, that problems of trust, credibility and limited collateral force them to run with the herd.

On the first point: even during the heyday of the efficient-market hypothesis, it seemed obvious that many real-world investors aren’t as rational as the prevailing models assumed. Larry Summers once began a paper on finance by declaring: “THERE ARE IDIOTS. Look around.” But what kind of idiots (the preferred term in the academic literature, actually, is “noise traders”) are we talking about? Behavioral finance, drawing on the broader movement known as behavioral economics, tries to answer that question by relating the apparent irrationality of investors to known biases in human cognition, like the tendency to care more about small losses than small gains or the tendency to extrapolate too readily from small samples (e.g., assuming that because home prices rose in the past few years, they’ll keep on rising).

Until the crisis, efficient-market advocates like Eugene Fama dismissed the evidence produced on behalf of behavioral finance as a collection of “curiosity items” of no real importance. That’s a much harder position to maintain now that the collapse of a vast bubble — a bubble correctly diagnosed by behavioral economists like Robert Shiller of Yale, who related it to past episodes of “irrational exuberance” — has brought the world economy to its knees.

On the second point: suppose that there are, indeed, idiots. How much do they matter? Not much, argued Milton Friedman in an influential 1953 paper: smart investors will make money by buying when the idiots sell and selling when they buy and will stabilize markets in the process. But the second strand of behavioral finance says that Friedman was wrong, that financial markets are sometimes highly unstable, and right now that view seems hard to reject.

Probably the most influential paper in this vein was a 1997 publication by Andrei Shleifer of Harvard and Robert Vishny of Chicago, which amounted to a formalization of the old line that “the market can stay irrational longer than you can stay solvent.” As they pointed out, arbitrageurs — the people who are supposed to buy low and sell high — need capital to do their jobs. And a severe plunge in asset prices, even if it makes no sense in terms of fundamentals, tends to deplete that capital. As a result, the smart money is forced out of the market, and prices may go into a downward spiral.

The spread of the current financial crisis seemed almost like an object lesson in the perils of financial instability. And the general ideas underlying models of financial instability have proved highly relevant to economic policy: a focus on the depleted capital of financial institutions helped guide policy actions taken after the fall of Lehman, and it looks (cross your fingers) as if these actions successfully headed off an even bigger financial collapse.

Meanwhile, what about macroeconomics? Recent events have pretty decisively refuted the idea that recessions are an optimal response to fluctuations in the rate of technological progress; a more or less Keynesian view is the only plausible game in town. Yet standard New Keynesian models left no room for a crisis like the one we’re having, because those models generally accepted the efficient-market view of the financial sector.

There were some exceptions. One line of work, pioneered by none other than Ben Bernanke working with Mark Gertler of New York University, emphasized the way the lack of sufficient collateral can hinder the ability of businesses to raise funds and pursue investment opportunities. A related line of work, largely established by my Princeton colleague Nobuhiro Kiyotaki and John Moore of the London School of Economics, argued that prices of assets such as real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole. But until now the impact of dysfunctional finance hasn’t been at the core even of Keynesian economics. Clearly, that has to change.

VIII. RE-EMBRACING KEYNES

So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.”

When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right.

Paul Krugman is a Times Op-Ed columnist and winner of the 2008 Nobel Memorial Prize in Economic Science. His latest book is “The Return of Depression Economics and the Crisis of 2008.”

Simon Johnson and James Kwak have an important article on financial innovation in the latest issue of Democracy. The broad thrust of the article I agree with — as you might expect, given that after listening to my last debate on the subject, James Kwak came to the conclusion that “obviously I agree most with Salmon”. (Thanks, James!)

That said, there are significant chunks of the Johnson and Kwak article that I disagree with, and I feel that it’s probably long past time that the “financial innovation: good or bad?” debate allow itself to make some nicer distinctions than have generally been made until now. So with the clear proviso that I’m on the “financial innovation: bad” side of the broader debate, here’s where I take issue with Johnson and Kwak.

First, they address securitization:

Securitization—the transformation of large, chunky loans into small pieces that can be easily distributed among many investors—was a beneficial innovation, because it expanded the pool of money available for lending. And securitization on its own, before the new products of the late 1990s and 2000s, did not produce the colossal boom and bust we have just lived through.

Sure, nothing, on its own, produced the colossal boom and bust we’ve just lived through. But securitization is as much to blame as anything else, if not more so. Securitization absolved lenders from sensible underwriting, since they knew they were just going on onsell that debt anyway. And it made bond investors comfortable with the idea of buying structured products tested only by models, as opposed to actual analyzable liabilities of real-world entities. You can’t phone up the CFO of a special-purpose entity and ask him how things are going. And lending in general works when there’s a relationship between the borrower and the lender. Securitization severs that relationship, which is harmful.

I’d also take issue with the idea that anything which expands the pool of money available for lending is, ipso facto, a good thing. To the contrary, things which expand the pool of money available for lending can serve only to inflate credit bubbles. In general, lending shouldn’t be easy to come by; and it should in principle always be just as easy to issue equity as it is to issue debt. We’re nowhere near that point right now, and securitization only serves to drag us further away from it.

Johnson and Kwak then attack the credit default swap:

Another paradigmatic product was the credit default swap, which insured a security (like a CDO) against the risk of default. But by underpricing that risk, it essentially tricked investors into buying securities that they would not otherwise have bought. The losses were borne by the companies that underpriced the credit default swaps, such as A.I.G., and by the government, which had to bail out A.I.G.—leading to the misallocation of capital to value-destroying investments.

The CDS, pace financial innovation, did not in and of itself underprice credit risk: it was simply a measure of credit risk. And indeed for most of the history of the CDS market, the basis on CDS was positive: as you’d intuitively expect, the cost of insuring a certain credit against default was higher than the spread on that credit’s bonds. You couldn’t lock in a risk-free return by simply buying a security and insuring it against default. So if the CDS market was underpricing risk, the bond market was underpricing risk even more. It was only after the credit market imploded that the negative-basis trade started becoming possible. So you can’t really blame a negative CDS basis for any part of the crisis.

Yes, it’s clear, in hindsight, that AIG, in particular, was underpricing credit risk. But that has nothing to do with the structure of the CDS market more generally. Instead, the problems with AIG surrounded the fact that it only ever sold credit protection, and never bought it; and that once it had sold protection, it used its triple-A credit rating to avoid having to put up any collateral against those positions or otherwise be forced to protect itself against loss. AIG in general, and AIG Financial Products in particular, did a lot of things wrong. But that’s not the fault of the CDS market.

Johnson and Kwak are right that regulators should be inherently suspicious of financial innovation; they’re possibly too polite to mention that this is largely because most financial innovation comprises, at its heart, some kind of regulatory arbitrage. (Securitization being no exception.) I agree also with the idea of standardizing CDS documentation, although it should be said that that is already happening to a large extent. I’m not at all sure, however, that standardized CDS will be much easier to regulate than the customized CDS of old. It’s not the customization which is the problem, it’s trying to get a grip on net positions, in a market which is constantly in flux. The way to solve that problem is to simply let the market continue down the road of the past six months, where CDS are increasingly being shunned as an asset class in favor of good old-fashioned bonds.

Johnson and Kwak then finish with a list of good financial innovations we might encourage: banking the underserved (a no-brainer), reforming health insurance (yes, but let’s not debate that here), and finally this:

We need innovation in financial education. A large part of our regulatory system relies on consumers being able to make intelligent choices when faced by an ever increasing and ever more complex set of financial choices. The recent crisis has shown that even large and supposedly sophisticated investors, such as municipalities and pension funds, did not fully understand the products they were buying. Economist Robert Shiller has proposed government-subsidized financial advice; this may not be a sufficient solution, but it is a start. Obama’s proposed Consumer Financial Protection Agency (first proposed by Elizabeth Warren in Democracy, Issue #5, “Unsafe At Any Rate”) could also go far in improving consumers’ understanding of their financial options.

This I’m much less sure about. You can be sure that no matter how good the financial education provided, the consumers of that education won’t end up being better educated about financial affairs than large and supposedly sophisticated investors, such as municipalities and pension funds. The problem with investors who made bad choices during the boom wasn’t that they were insufficiently educated: it was rather that they were educated too much. Financial education breeds overconfidence, and overconfidence was a much more important cause of the crisis than insufficient education was. If a strong CFPA prevents truly harmful products being sold to consumers, that’s the best we can hope for: a mass education program isn’t practicable and wouldn’t work even if it were implemented. The last thing I want is Robert Shiller being unleashed on the public, telling them that they can hedge the value of the equity in their houses by buying derivatives on house prices.

So thank you, Simon and James, for fighting the good fight. But this clearly isn’t the last word on the subject.

An interesting article by Simon Johnson and James Kwak:

If innovation must be good, then financial innovation should be good, too. If finance is the lifeblood of our economy, then figuring out new ways to pump blood through the economy should foster investment, entrepreneurialism, and progress. Right? This, in any case, has been the mantra throughout three decades of deregulation and expansion of the financial sector.

And yet today, financial innovation stands accused of being complicit in the financial crisis that has created the first global recession in decades. The very innovations that were celebrated by former Federal Reserve Chairman Alan Greenspan—negative-amortization mortgages, collateralized debt obligations (CDOs) and synthetic CDOs, and credit default swaps, among countless others—either amplified or caused the crisis, depending on your viewpoint. The journalist Michael Lewis recently argued that the credit default swaps sold by A.I.G. brought down the entire global financial system—and found that the A.I.G. traders he talked to completely agreed.

Recent financial innovation is not without its defenders, of course. As current Fed Chairman Ben Bernanke said in a speech in May:

We should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks.

Intellectual conservatives and bankers have mounted an even more fervent defense of financial innovation. Niall Ferguson has claimed, “We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street.” Bernanke and Ferguson are being too generous. For the past 30 years, financial innovation has increased costs and risks for both individual consumers and the global economy. To take the most obvious example, consumers bought houses they could not otherwise have bought using new mortgages they had no hope of repaying, creating a housing bubble, while new derivatives helped hide the risk of those mortgages, creating a securities bubble. The collapse of those bubbles has shaken the world for the last year. Today’s challenge is to rethink financial innovation and learn how to separate the good from the bad.

Financial innovation is different from what we traditionally think of as innovation, which, in recent years, has occurred most visibly in the field of information technology. Certainly, the financial services industry has taken advantage of technological innovation; you can now access your financial statements and pay your bills online, for example. However, these innovations do not affect the core function of the financial sector, which is financial intermediation—moving money from one place where it is not needed to another place where it is worth more.

The classic example of financial intermediation is the community savings bank. Ordinary people put their excess cash into savings accounts; the bank accumulates that money by paying interest and loans it out at a slightly higher rate as mortgages or commercial loans. Savers earn interest, households can buy homes without having to save for decades, and entrepreneurs can start or expand businesses.

The main purpose of financial innovation is to make financial intermediation happen where it would not have happened before. And that is what we have gotten over the last 30 years. As Ferguson said, “New vehicles like hedge funds gave investors like pension funds and endowments vastly more to choose from than the time-honored choice among cash, bonds, and stocks. Likewise, innovations like securitization lowered borrowing costs for most consumers.” But financial innovation is good only if it enables an economically productive use of money that would not otherwise occur. If a family is willing to pay $300,000 for a new house that costs $250,000 to build (including land), and they could pay off a loan comfortably over 30 years, then that is an economically productive use of money that would not occur if mortgages did not exist. But the mortgage does not make the world better in and of itself; that depends on someone else having found a useful way to employ money.

In addition, financial innovation can go too far much more easily than innovation in other sectors. Financial intermediation creates value by making credit more available to people who can use it effectively. But it is possible for the economy to be in a state where people have too much access to credit. With the benefit of hindsight, it is easy to see how the U.S. housing sector passed this point earlier this decade. With negative-amortization mortgages (where the monthly payment was less than the interest, causing the principal to go up) and stated-income loans (where the loan originator did not verify the borrower’s income), virtually anyone could buy a new house, leading developers to build tens of thousands of houses that are now rotting empty, their current value far less than their cost of construction. In short, excess financial intermediation, the result of hyperactive financial innovation, destroys value by causing people to make investments with negative returns. Put another way, we cannot say that innovation is necessarily good simply because there is a market for it. The fact that there was a market for new houses does not change the fact that building those houses was a spectacularly destructive waste of money. Therefore, when it comes to financial innovation, we must distinguish beneficial financial intermediation from excessive, destructive financial intermediation.

In the early 1970s, Mohammed Yunus lent $27 to 42 female basket weavers in a village in Bangladesh; they repaid the loan, with interest, from the proceeds of their sales. In 1976, he founded Grameen Bank to make small loans to poor villagers, often to fund startup costs for small ventures. Grameen Bank was the first modern provider of microcredit. Yunus’s innovation was to recognize that poor people could be good borrowers but had been ignored by a traditional banking sector that refused to or was unable to serve them. In other words, he found an economically productive use of money that was not otherwise occurring. How does recent financial innovation in the developed world compare?

Defenders of unfettered financial innovation depict the alternative as a stale, constricted market. As Bernanke said in April, “I don’t think anyone wants to go back to the 1970s. Financial innovation has improved access to credit, reduced costs, and increased choice. We should not attempt to impose restrictions on credit providers so onerous that they prevent the development of new products and services in the future.” However, as finance blogger Ryan Avent pointed out on Portfolio.com, Bernanke’s examples of beneficial innovation–credit cards, the Community Reinvestment Act, and securitization—all date back to the 1970s or earlier. True, securitization—the transformation of large, chunky loans into small pieces that can be easily distributed among many investors—was a beneficial innovation, because it expanded the pool of money available for lending. And securitization on its own, before the new products of the late 1990s and 2000s, did not produce the colossal boom and bust we have just lived through.

But more recent innovations in securitization led to a new generation of increasingly arcane, increasingly risky products that Bernanke, Ferguson, and others like to overlook. One of the paradigmatic products of the last ten years was the collateralized debt obligation (CDO), in which a structurer combined a pool of assets and sold off the cash flows from those assets to investors. CDOs did promote financial intermediation; those initial assets represent loans to real people and companies, and without the CDO market to absorb them, those loans might never have been made in the first place. But, as with negative-amortization mortgages, the key question is whether those loans should have been made at all.

The magic of a CDO, as explained in the research paper “The Economics of Structured Finance” by Joshua Coval, Jakub Jurek, and Erik Stafford, lies in how CDOs can be used to manufacture “safe” bonds (according to credit rating agencies) out of risky ones. Investors as a group were willing to buy CDOs when they would not have been willing to buy all the assets that went into those CDOs. We don’t have to decide who is to blame for this situation—structurers, credit rating agencies, or investors. The fact remains that at least some CDOs boosted financial intermediation by tricking investors into making investments they would not otherwise have made–because they destroyed value. Another paradigmatic product was the credit default swap, which insured a security (like a CDO) against the risk of default. But by underpricing that risk, it essentially tricked investors into buying securities that they would not otherwise have bought. The losses were borne by the companies that underpriced the credit default swaps, such as A.I.G., and by the government, which had to bail out A.I.G.—leading to the misallocation of capital to value-destroying investments. In other words, while securitization on its own provided real economic benefits, it is harder to defend the very popular, very destructive specific innovations it engendered. Contrary to Bernanke, maybe the regulatory world of the 1970s doesn’t look so bad after all.

The role of financial regulation should be to discourage innovation that produces excessive intermediation and promote innovation that delivers financial services that people need. The key to any successful regulatory regime is therefore discerning the difference between good and bad financial innovation. Right now, ours doesn’t. Unfortunately, the Obama Administration’s financial regulatory reform proposal, despite its improvements over the status quo, follows the old conventional wisdom—that innovation is inherently good, and regulators need only watch out for abnormal excesses or “bad apples.” Instead, the presumption should be that innovation in financial products is costly—it increases transaction costs, the cost of effective oversight, and the risk of unanticipated consequences—and should have to justify itself against those costs.

Instead of a regime where any product is allowed so long as it is sufficiently disclosed, we should consider a regime where only certain types of products are allowed to exist, and they are allowed to vary only along specific dimensions. Georgetown law professor Adam Levitin has argued that all of the “innovation” in the credit card industry has simply been the invention of new, more complicated, and less transparent fee structures, while the underlying product has remained the same for decades. He proposes that regulation should standardize the terms of credit cards, so that charges cannot be hidden in fine print, and issuers should be allowed to compete on the interest rate, the annual fee, and the transaction fee. This would ensure price competition while making it harder for consumers to end up with dangerous products that encourage excessive borrowing.

This model could be applied to a wider range of financial products, even to commercial products such as interest rate swaps and credit default swaps, which baffled a fair number of supposedly sophisticated players during the boom. For example, credit default swaps could be limited to a set of standardized terms—the security being insured, the premium, the length of time, the definition of a default event, the settlement date and mechanism—eliminating the complexity that makes customized CDS difficult to price, difficult to trade, and difficult for regulators to assess. While this could reduce the ability of firms to “perfectly” hedge their risks, it would also reduce transaction costs and, most importantly, reduce the systemic risk created by large, unknown derivatives positions. Customized credit default swaps could still be allowed but should be deterred (through taxation or other means) to ensure that they are only used when “vanilla” swaps are truly inappropriate.

At the same time, regulators should look to promote those forms of financial innovation that the economy sorely needs. One is better ways of providing financial services to the “unbanked” poor and minorities. Today, many inner-city neighborhoods are forced to rely on payday lenders and other high-cost intermediaries for basic banking services. Manuel Pastor of University of Southern California’s Program for Environmental and Regional Equity has shown that traditional banks can succeed in opening ordinary branches and offering ordinary services—savings accounts and accounts, mortgages, among others—in these neighborhoods. In addition to benefiting these communities, this would increase net savings and promote economic development.

Though it is not often thought about in these terms, reforming health insurance—to make it universally accessible and stable in its premiums—would be another financial innovation that would accrue both social and economic benefits. Because individual households’ economic fortunes are volatile, insurance is one of their core financial needs. It is generally possible to buy adequate auto, home, and life insurance, but for most people true long-term health insurance is simply not available. While a majority of Americans get health insurance through their jobs, many would be unable to remain insured should they become unemployed. What they have is subsidized health care during their term of employment; they don’t have true insurance. While there are several ways to do it, making individual health care policies available to everyone (and not subject to an accident of fate like a layoff or divorce) would allow consumers to better plan their economic lives. There could be no better embodiment of positive financial innovation.

Just as importantly, we need innovation in financial education. A large part of our regulatory system relies on consumers being able to make intelligent choices when faced by an ever increasing and ever more complex set of financial choices. The recent crisis has shown that even large and supposedly sophisticated investors, such as municipalities and pension funds, did not fully understand the products they were buying. Economist Robert Shiller has proposed government-subsidized financial advice; this may not be a sufficient solution, but it is a start. Obama’s proposed Consumer Financial Protection Agency (first proposed by Elizabeth Warren in Democracy, Issue #5, “Unsafe At Any Rate”) could also go far in improving consumers’ understanding of their financial options.

Simplifying the landscape of financial products, particularly those sold to consumers, will reduce the opportunities for service providers to generate non-interest fees from customers and will reduce the risk that households will make catastrophic financial decisions. Slowing the tendency toward excess financial intermediation will make it harder for the next credit bubble to form and reduce the severity of the next crisis. In these ways, a more critical eye toward financial innovation will help restore the balance that the American economy needs to produce long-term, sustainable growth.