Wall Street says Washington doesn't understand finance. Well, neither does Wall Street.
"What do you get when you cross a Godfather with an investment banker? Someone who makes you an offer you can’t understand."
That's from a talk Paul Krugman gave at the Levy Institute's 19th annual Hyman Minsky conference. The Economist's Ryan Avent also attended and walked away shaking his head. "I think that the most important thing to understand about financial reform is that its dynamics are simply too complicated to lend themselves to good policy," he wrote.
I'd take it a step further: Wall Street has gotten a lot of mileage out of the accusation that the political system simply doesn't understand how Wall Street works. And that's, well, correct. The problem is that Wall Street also doesn't understand how Wall Street works.. That was what caused the financial crisis. Bankers didn't understand the tail risk of collateralized debt obligations. Ratings agencies didn't understand the subprime mortgage market. Alan Greenspan didn't understand the risks posed by derivatives. Robert Rubin, the former co-chair of Goldman Sachs and one of Citigroup's directors, told the Financial Crisis Inquiry Commission that "all of us in the industry failed to see the potential for this serious crisis."
As the 10 percent unemployment rate and hundreds of billions in added government debt will tell you, when Wall Street gets too complicated to understand, bad things begin to happen. But complexity is core to the business of Wall Street. There's a lot of money to be had over there. About 40 percent of domestic profits, in fact. And you get more of that money if no one understands what you're doing. You can dictate terms to your customers, stay ahead of your competitors and confuse your regulators. And then, of course, there's the holy grail: a high-return product that's so complicated that people can't tell where its risks are and so it's treated as if it has no risk at all. That was the market for mortgage-backed securities. The stuff that got a AAA seal of approval -- that is to say, it was considered riskless -- before it crashed the global economy.
That doesn't leave us with many good options. Can we pass a law against complexity? Not really. Can we build a Wall Street where traders will stop trying to amp their profits by inventing new products that no one quite understands but that seem to offer an incredible return on investment? Seems unlikely. Can we build a class of regulators who will know more than Wall Street does about Wall Street's products and will be immune to the pressures of bubbles? Definitely not. Do we have the political will to make the banks smaller or to tell them that they can't borrow so much money or to tax the sector such that this behavior is no longer so lucrative? Doesn't seem so.
Avent says he's developed "a sense of resigned cynicism." Kevin Drum seems less resigned, but more cynical. I'm increasingly where Drum is. The best thing we could do, it seems to me, is slap a significant global tax on financial transactions such that the industry becomes a lot less profitable and these behaviors become less lucrative. It's like anything else: If you want less of it, tax it. But there's no chance that that will happen, either.
Photo credit: Jin Lee/Bloomberg News.