As we await the stress tests, here is one perspective on what we need to do to remedy our economic challenges.

(1)  De-finance the economy: US and even the global economy has come to depend too much on financial services industry.  At the peak i.e. in the last few years, the US financial industry services contributed about 8 percent to nation’s GDP (compared to long held stable number of 4 percent).  So the contribution to GDP doubled in the last 20 years meaning that the size of the financial services industry is almost one trillion dollars now.  While about 20 years back, it was less than 300 billion dollars.  In the last few years, the profitability of the US financial services industry has constituted 41 percent of the total profitability of the private sector.  That is an astounding number.

The increase in the size of the financial services industry has come largely through integration of the activities of investment banks, commercial banks and insurance companies.  This integration has raised moral hazard and transparency problems.  This trend of deregulation began in the late 1970s (President Jimmy Carter era) and culminated with the elimination of the Glass-Steagall Act.  The value in the financial service industry has come from commissions which have incentivized the participants to enhance the value of assets, loans and credits not always based on sound principles.

(2)  Prudent Regulation: Excessive and unregulated securitization of loans, and credit default swaps have created major challenges.  For example, the derivatives and credit default swaps, which in 2002 were worth $1 trillion and today are worth $33 trillion.  It appears that derivatives undid AIG, a company that had 116,000 employees in 120 countries, and many other financial institutions and other companies.

The challenges of securitization of loans, and derivatives and credit default swaps can be categorized thus.  First, it has become impossible to do honest accounting and estimate the real value of assets because the securitization and swaps have created a chain of transfer of values.  Such transfers have occurred without clear accounting, assessment and/or record keeping at each stage.  So what is needed are a set of well-thought out accounting and financial regulations and rules that would produce more realistic and clear assessments and record keeping.  For example, what should be the level and mechanism of regulation of hedge funds?  Should we continue to permit the banks to operate at thirty-to-one leverage (In 2004 SEC allowed banks to go from ten-to-one leverage to thirty-to-one leverage).

Second, the compensation and bonus structure in the financial industry services is largely based on commissions on the volume of transfer of perceived wealth.  So, essentially, there is an incentive to inflate the value of financial instruments and to encourage as many swaps and transfers as possible.  Therefore, the immediate need is to review this compensation mechanism and examine what portfolio of norms, requirements of reporting, and regulations would discourage blatant inflation of the financial instruments and their excessive swaps.

The three main causes of our economic maelstrom in the U.S., and the world at large are –

(1)  Banking, investment and insurance activities had become inseparable and unproductively overlapping creating transparency and moral hazard problems.  The repeal of Glass-Steagall Act in 1999 was the final straw in the inexorable march that had begun in early 1980s.

(2)  The financial derivatives and securitization of loans had grown monumentally without even minimal regulation and supervision.  Such derivatives created over-stated and bubble assets. The Commodity Futures Modernization Act, and the imprudent sub-prime loans accelerated the growth of the derivatives.

The estimated value of the derivatives was about 1 trillion in 2002, and the value grew to about 33 trillion in 2008.  The U.S. Congress considered regulation of derivatives in 2003 but finally decided that market forces are best regulating mechanisms.

(3)  SEC increased the permitted leveraging by banks from 10 percent to 30 percent.  The banks took immediate advantage of this, and soon this action added to the the bloating of the over leveraged economy.

A confluence of all these three elements has created a glut in global savings and corresponding sharp decline in demand and investment.  The global economy now faces a situation deeper than the periodic recession.

However, the United States  appears to be better placed to stimulate the economy through timely and proportionate monetary (e.g., zero interest bank lending rates), fiscal (e.g., economic stimulus packages) and financial (e.g., recapitalization of the banks) policies.  Europe, comparatively, has lagged in timeliness and magnitude of response — so it is more likely that the recovery in Europe will take longer.  President Barack Obama, the Congress, and the Federal Reserve Bank deserve some credit for responding to the crisis prudently though more bold actions (e.g., letting zombie banks wither away instead of accepting the burden of their toxic assets) would have been even productive.

As the U.S. awaits the stress tests of the banks, the debate on how to restructure the U.S. and Global financial services industry continues.

The restructuring of the U.S. and Global financial industry will probably be successful only when two major issues are reviewed. The first relates to (generally non-transparent and sometimes excessive) securitization of loans, and the second relates to (sometimes indiscriminate and unsound) integration of banking, investment and insurance activities under one umbrella. Lack of evident transparency, and serious moral hazard problems make these two issues major challenges.

There are two empirical and policy questions.  One, does regulated and transparent securitization of loans help in the credit flow (with some multiplier effect) and business in general?  Two, does regulated and prudent level of integration of banking and investment activities add more value to the economy?

The answers are not evident, and the policy and expert opinions appear to be evolving as the evidence is not clear.

The vibrancy of the financial services industry and the U.S. economy from about 1981 (when President Ronald Reagan encouraged deregulation and liberalization) to about 2007-2008 appear to indicate that securitization and integration of financial activities have helped the U.S. and global economy.  What my have undone it are the excesses and complete dergulation.  So the answer to the structural issues might be consideration and legislation of thoughtful regulations(s) and regulatory mechanisms.  That’s the approach of Secretary Tim Geithner, and President Barack Obama’s economic team (they appear to tacitly agree that repeal of the Glass-Steagall Act, and the enactment of Commodity Futures Modernization Act may have accelerated such excesses).

The other view is that securitization of loans is empirically and theoretically unsound, and that banking and investment activities must be separated.  No amount of regulation will help if these fundamental changes are enacted.  Krugman says, “Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.”

Joseph Stiglitz observes, “In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option.”