The End of Arrogance: America Loses Its Dominant Economic Role

By SPIEGEL Staff

Part 3: Wall Street's Central Values: Avarice and Greed

It is an optimistic scenario, but with no guarantee of success. Still, what's the alternative? "Maybe we can let Wall Street implode," writes Princeton economist Paul Krugman in the New York Times, "and Main Street would escape largely unscathed." But, he continues, "that's not a chance we want to take."

The effects of the financial crisis are already serious, both for the American taxpayer, who will end up footing the bill no matter what, and for the relationship between the government and the economy. An era of American economic policy is coming to a close. Ironically, and surprisingly to many, the last few months of the Bush administration will mark the end of the so-called "Reagan revolution."

Since the early 1980s, the United States has radically emphasized deregulation, which has meant lowering taxes, eliminating regulations and generally leaving the markets to their own devices. Ronald Reagan began his presidency in 1981 with this program, and it was following by a prolonged economic upturn.

It was driven in part by an aggressive policy of cheap money, for which a second icon of the American boom was responsible: former Fed Chairman Alan Greenspan. During the 18 years of his tenure, whenever there was trouble brewing in the stock market and financial markets, Greenspan would drown the crises in a flood of fresh money. Whether it was the 1997 market crash in the Asian tiger countries, the selloff of Russian government bonds a year later, the collapse of the LTCM hedge fund or, finally, the bursting of the New Economy bubble at the beginning of the new millennium, Greenspan's rescue operations could be counted on to return growth to the world's markets. But there was one thing Greenspan overlooked: By repeatedly printing money, he also laid the foundation for the next financial bubble, and its destructive energy grew from one intervention to the next.

Over the last 15 years, Greenspan was opposed to oversight and control over those companies that used the ready cash made available by his policies to introduce a wave of so-called financial innovations. As long as he was in office, he blocked all attempts to impose government collateral requirements on the credit, stock and financial markets. In Greenspan's view, it would only hamper "necessary flexibility."

His policies were borne out by the successes of two decades. Fed by cheap money and freed of most regulations, the American financial industry experienced an unprecedented boom. The industry's excessive growth was reflected in exorbitant salaries and ostentatious skyscrapers but also in the withdrawal of a large share of American value creation.

In 2007, at the beginning of the crisis, the American financial and lending sector was responsible for 14 percent of economic performance, while collecting 33 percent of all corporate profits.

The financial boom also set the turbo-charger in motion that would lend a new face to worldwide capital from then on. Avarice and greed have always been the central values on Wall Street, but now they had become a benchmark for the real global economy. The American banking industry paid for globalization and the Internet revolution, the Asian upswing and the boom in the commodities markets. "We need a 25-percent return," or else his bank would not be "competitive internationally," Deutsche Bank CEO Josef Ackermann said, thereby establishing a benchmark that would soon apply not just to banks but also to automobile makers, machine builders and steel companies.

But, as is often the case with recipes for success, at some point the healthy dose is exceeded and soon the risks and side effects begin to accumulate. The result: The supposed medicine instead becomes a pathogen instead.

In the United States, this process began after the collapse of the New Economy. Once again, Greenspan flooded the economy with money and, yet again, Wall Street started looking for a new market for its growth machine. This time it discovered the American homeowner, convincing him to take out mortgages at favorable terms, even when there was practically no collateral.

The total value of all outstanding mortgage loans in the United States -- $11 trillion (€7.6 trillion) -- is almost as large as the country's gross domestic product. At the same time, with the help of Wall Street's financial engineers, the Americans managed to sell a portion of the risk to other parts of the world, reasoning that if the risk was out of sight it would be out of mind.

But the fact that risks do not disappear when they are distributed around the world became clear at the beginning of last year. Interest rates rose across the board and house prices came down, triggering a chain reaction with collateral damage that was bringing down ever-growing segments of the financial sector from one week to the next. Today, 18 million single-family homes and condominiums in the United States are empty. More and more Americans can no longer afford the high interest rates they are being charged. Many consumers have even been forced to bid farewell to their beloved credit cards because the banks are no longer willing to extend credit to them.

To make matters worse, because a large share of the mortgage loans are now distributed all over the world, the crisis is spreading halfway around the globe like an infectious disease. In recent years, many of the industrialized countries deregulated their financial markets based on the American model. This has led to a relatively unimpeded flow of capital around the world today.

The financial assets that economies hold abroad have grown more than sevenfold in the past three decades. By late 2007, the market volume for derivatives, which are used to bet on interest rate, stock and credit risks worldwide, had reached a previously unthinkable level of $596 trillion (€411 trillion).

At the same time, the number of players has multiplied. The banks stopped being the only ones in control of the industry some time ago. Nowadays, hedge funds bet on falling stock prices and mortgage rates, private equity companies buy up failed banks and bad loans, and wealthy pension funds keep the fund managers afloat.

The "greater complexity of linkages within and between the financial systems" now has one man worried, a man whose profession ought to provide him with a better idea of what's going on: Jean-Claude Trichet, president of the European Central Bank. In a recent speech at New York University, Europe's highest-ranking central banker complained about the "obscurity of and interactions among many financial instruments," often combined with a "high level of borrowing."

The inventors of these complex securities hoped that they could be used to distribute risk more broadly around the globe. But instead of making financial transactions more secure, they achieved the opposite effect, increasing the risks. Today the notion of using "many shoulders for support," the constant mantra of the gurus of financial alchemy, has proved to be one of the catalysts of the crash.

American economist Raghuram Rajan, whom ECB President Trichet is frequently quoting these days, had a premonition of the current disaster three years ago. The total integration of the markets "exposes the system to large systemic shocks," Rajan wrote then in a study. Although the economy had survived many crises before, like the bursting of the Internet bubble, "this should not lead us to be too optimistic." "Can we be confident that the shocks were large enough and in the right places to fully test the system?" Rajan asked. "A shock to equity markets, though large," he continued, "may have less effect than a shock to credit markets."

There was certainly no shortage of warnings, and there were many voices of caution. As long ago as 1936, John Maynard Keynes recognized the risk that "speculation may win the upper hand" in the markets. Its influence in New York, the British economist wrote, was "enormous," and the situation would become serious "when the capital development of a country becomes the by-product of the activities of a casino."

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