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Financial Services and the Crash of 2008- Signs of a Failing System?

2010/12/30

David Morf’s recent post (“Economic Ecology Makes or Breaks Financial Systems”) raises an important question: how can we tell when a system is failing? What can we do to anticipate, correct, and prevent such failures? I have lived long enough to recall several “crashes”- the Savings and Loan debacle of the late 80s and early 90s, the bursting of the technology stock bubble in the late 90s and early 2000s, and now the subprime lending crash of 2008. After each one, we go through a cycle of fear (“could this be another Depression?”), blame (“how could this have happened?”; “Who did it?”), and denial (“Things are better now; the banks are profitable again, the stock market is doing fine, so we’re back on track”). David takes a longer and deeper view- I find his argument to be a very helpful perspective on how to tell when a system is truly at risk of self-destructing.

David uses the recent failure of the financial system as his primary example. In the process, he outlines characteristics of failing systems that are worth pondering. David suggests that failing systems can be recognized because they:
o Destroy the ecology in which they exist;
o Do not recognize negative externalities; and
o Are unable to recalibrate, adjust, and recover when they stray off course (thus they are brittle, bureaucratic, and slow-footed rather than nimble, flexible, and resilient).

By “ecology,” David means the set of elements that support and sustain a specific system. In the case of financial services, David includes Wall Street, investment banks, and commercial banks as key parts of the sector, with business and government closely tied to that sector. He paints the picture of a “jackpot” mentality that has grown recently in the financial services sector, a mindset that rewards short-term gain and looks for extreme spikes in return on investment. The effect is pressure on businesses to emphasize short-term gains in order to retain the favor of Wall Street, reinforced by the banks’ practice of rewarding speculation rather than steady, long-term growth. Further, David suggests, the relaxation of the boundary between “investment” and “commercial” banks has blurred the distinction between speculation and lending, thus increasing incentives for short-term profit-seeking by businesses and shareholders. All of this creates an ecology in which capital is directed toward short-term gain and away from long-term investment. David thinks a financial services system that reinforces this trend cannot last for long, because it is destroying the “ecology” on which it rests (in other words, the ability of investors, businesses, and private shareholders to obtain loans for businesses, housing, and other economic needs which otherwise go unmet). On this view, the crash of 2008 is merely an episode in the predictable erosion of economic strength in the U.S. and the ultimate failure of our “jackpot”-oriented financial services system.

Secondly, David says a failing system does not recognize “negative externalities,” or unintended consequences, of systemic actions. A parallel thought is that failing systems do not recognize “negative feedback.” In short, they do not see, or take into account, the unintended consequences of their actions. In the case of financial services, one could say that a “negative externality” recently was the preservation of bonuses by the large financial institutions while some credit-worthy borrowers have had trouble obtaining loans or mortgage extensions. This allocation of capital makes no sense if we are trying to maintain the original purpose of the financial services sector; but it makes perfect sense if we are trying to maintain the “jackpot” mentality (and the large rewards for those who run it).

David’s third point is that failing systems are unable to recalibrate, adjust, and recover when they stray off course (thus they are brittle, bureaucratic, and slow-footed rather than nimble, flexible, and resilient). He implies that the crash of 2008 was preceded by many signals that were ignored or misinterpreted by those who might have made adjustments, such as financial regulators and government policy-makers. Due to the major influence of the financial services sector, though, government itself became less able to “hear” these signals. And the reliance on monetary policy by the Federal Reserve, along with a mindset of extreme faith in the “free market” philosophy, led to a lack of appetite on the part of government to take a more active role in overseeing, and intervening, in the financial markets. The result was a near-collapse of the system and the government “bailout” of the large banks and investment houses.

Has our government lost its ability to serve the function of recognition and recalibration for the financial system? If so, this function needs to be performed by someone else, or we will have yet more crashes and may face worse outcomes than those of 2008. Can the system monitor itself? Prior to 2008, the assumption was that the market would self-regulate; but this assumption did not hold up. Is there a way to foster a more adaptive, flexible, self-regulating system? David suggests several policy prescriptions (i.e., narrow the income disparity in the U.S.) but says little about how they might be achieved. In my view, we will not have a more sustainable and productive financial system until we create and build a new social ecology (which would include David’s economic ecology). It is time to examine and adjust some of the guiding assumptions and paradigms that drive our economy- and look for ways of creating a more durable, sustainable economic cycle. More on this in later posts.

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