Edmund S. Phelps What Has Gone Wrong up until Now

Edmund S. Phelps, 75: It is preposterous to speak, as some Europeans have, of the "end of capitalism." A good life requires a rewarding workplace -- one of change and challenge -- and that requires some sort of well-functioning capitalism.

There is no question that the banking industry in the United States has gone awry. In buying mortgages for packaging in mortgage-backed securities, the banks exported to the rest of the world a profusion of assets that were overvalued by the financial companies that purchased them.

The ratings agencies, which made their calculations based only on rosy scenarios, and never on a worst-case basis, were complicit in this overvaluation.

In selling derivatives, such as default insurance and other collateralized debt obligations, the banks were selling assets that were too complex for a great many investors to understand.

Finally, the banks were their own worst enemies. The level of their loans and their borrowings to make those loans reached so high a level in relation to their capital, or equity, that any serious disturbance to asset prices -- a default shock or a shock to liquidity premia -- could have devastating effects on the equity of any bank and thus on its ability to function and to survive. At some banks, measured leverage was not extraordinarily high but the opacity of the assets and the resulting uncertainty over their future returns was very high.

That the banks chose to take on ever-greater levels of risk, with no end in sight until the collapse, was an effect of employee compensation: Fortunes could be made for each additional day that the bank could operate. There was no claw-back provision that would pay bonuses only for performance over the long term.

Is regulation required here? Undoubtedly some new regulations are required here and there.

Yet, many observers have argued the lack of restraints on the banking industry was more a failure of the regulatory authorities to exercise their powers than it was an absence of regulatory authority to act. A new mindset is required, above all.

A fundamental issue that regulatory discussions must confront, however, is what function society needs the banking industry to perform. Increasingly over the past two decades, the banks have tried to make money with mortgages, residential and commercial. As this has proved difficult, the banks will either have to shrink their supply of credit to the economy as a whole or else redirect some their credit to the business sector.

Unfortunately, the banks for the most part appear to have lost the expertise to make business loans and investments, which they once had in the fabulous years of investment banks such as Deutsche Bank and J.P. Morgan.

Wíll the big banks in the US be able to regain such expertise?

It seems likely that highly regulated banks are not the ideal sources of finance for business investment, particularly for innovative business investments. A natural source of finance for new startup firms are the rich uncles, called "angel investors," who know more about the startup entrepreneur than a banker would be in a position to know. Another natural source of finance is the venture capitalists, who also have the entrepreneurial background to be able to mentor as well as finance the young firms. Some of the hedge funds are also doing creative work in financing various innovative projects.

Clearly it is not in society's interests to regulate rich uncles, venture capitalists and hedge funds investing or lending to small or new businesses. If society makes the mistake of doing so, innovation will suffer. So will the rewards of work. And the supply of jobs.


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