A New York-based friend who happens to be a writer for the Singapore Strait-Times e-mailed me today seeking my perspective on yesterday’s Market, ummm, action. Specifically she inquired if I thought human error was the sole cause of the sell-off. The answer, my answer, is no, not human error. To be sure, the transposed digit on a sell order for Proctor & Gamble did contribute to the sell-off, but it wasn’t the primary cause because the Markets were already in incremental decline in response the armed protests over the Greek sovereign debt crisis which were rattling both US & European Markets. And as I wrote this post in the comfort of my study last evening, I was listening to the din of ITN in the background as Asian Markets sell-off – a sure indicator of tomorrow’s Market performance. The “human error” narrative, I believe, is the reason being ascribed in order to calm investor fears so that U.S. Markets don’t have a “double-dip” scenario where the Markets plunge or perform again as it did during the height of the global financial crisis. I also believe the rebound just before the close was due to two factors: (1) there was Federal Reserve intervention — they pumped liquidity and stock orders into the Markets to fuel a rebound before the close; and (2) the Hedge Funds, flush with cash, saw a HUGE buy opportunity in the sell-off so they bought low. Adding tertiary fears to the global Markets is the uncertainty of UK elections and the milquetoast treatment of financial industry reforms in Washington. In my professional judgment, the take-away from today’s sell-off is: it is and will continue to be a fragile recovery. Tread lightly.
But this brings me to my next point. If you want a great reason to reform Wall Street, what happened to the Markets is as sure as a reason you need: that a single “human error” can stir investor fears enough to evaporate 1000 points off the Dow, bring the Markets to its knees in a singlehour, and un-do $2 Trillion worth of Federal bailouts, then seriously folks, it needs fixing. The current Market is stillhighly over-leveraged, under-regulated and waaayyy too volatile. This is a recipe for allowing a handful of traders and Market-makers — or worse, a hacker or “human error” — enormous power over the global economy. This is no longer Democrat vs Republican: this is an urgent matter of national economic security.
With the above context in mind, yesterday’s precipitous sell-off in US Markets – the most volatile single day of trading in Wall Street history – my most recent read, After the Fall: Saving Capitalism From Wall Street & Washington, by Nicole Gelinas of the Manhattan Institute, is suddenly very relevant.
Her premise is that robust financial markets support capitalism, they don’t imperil it. I, of course, take issue with that premise. There are, in fact, better forms of economic systems than our ‘cowboy’ brand of capitalism. Washington’s actions weren’t the start of government distortions in the financial industry, Nicole Gelinas writes, but the natural result of 25 years’ worth of such distortions. The conclusion, as you might guess, is also preposterous. Yet, she outlines a list of what I believe are sensible policy prescriptions, though she never quite holds Wall Street as accountable as it should. It would seem, in fact, there is no such thing.
In the early eighties, modern finance began to escape reasonable regulations, including the most important regulation of all, that of the marketplace. The government gradually adopted a “too big to fail” policy for the largest or most complex financial companies, saving lenders to failing firms from losses. As a result, these companies became impervious to the vital market discipline that the threat of loss provides.
Adding to the problem, Wall Street created financial instruments that escaped – thanks to the industry’s Republican supporters – regulatory oversight and other reasonable limits, including gentle constraints on speculative borrowing and requirements for the disclosure of important facts. The financial industry eventually posed an untenable risk to the economy—a risk that culminated in the trillions of dollars’ worth of government bailouts and guarantees that Washington scrambled starting in late 2008. Even as banks and markets seem to heal, lenders to financial companies continue to understand that the government would protect them in the future if necessary. This implicit guarantee harms economic growth, because it forces good companies to compete against bad.
History and recent events make clear what Washington must do. First, policymakers must reintroduce market discipline and a sensible regulatory framework to the financial Markets. They can do so by re-creating a credible, consistent way in which big financial companies can fail, with lenders taking their warranted losses. Second, policymakers can reapply prudent financial regulations so that markets, and the economy, can better withstand inevitability of greed and volatility. Sensible regulations, she argues, have worked well in the past and can work well again. As Gelinas explains in this richly detailed book, adequate regulation of financial firms and markets is a prerequisite for free-market capitalism—not a barrier to it.
Nicole Gelinas, a Chartered Financial Analyst (CFA) charterholder, is a Manhattan Institute senior fellow and contributing editor to City Journal. She lives in New York City.
