It was a week for dramatic words and even more dramatic gestures. as the U.S. congress debated, then vetoed, and then revised and ultimately passed a $700 billion plan to bail out the country's failing banks, world stock markets rose and fell in what can really only be described as rollercoaster fashion. The Dow recorded its biggest loss in two decades before making up much of the ground, falling and rising again in triple digits each day of the week as Treasury Secretary Henry Paulson's plan wound its way through Congress. Among lenders, paranoia reigned—record-high interbank lending rates underscored the fact that after weeks of financial fall-out, nobody knew who was holding the next basket of exploding assets. Individual investors were gripped by siege mentality. The usual queues of limousines formed in front of London's posh Savoy Place were outnumbered by queues of customers inside, piling into a gold exchange looking to turn stacks of cash into bullion, many paying premiums of up to $100 an ounce above spot prices to walk away with coin and bars in hand. Demand for Krugerrands threatened to outstrip supply. "At least it's a safe bet," said one buyer. "I mean, what are these banks doing with our money?"
It's the question on everyone's lips. And increasingly, it's not just bank solvency that's being questioned, but the entire Anglo-Saxon capitalist system. Three decades of conventional economic wisdom said the markets were supposed to know best, but as U.S. politicians bowed to public outrage at the idea of average Joes spending nearly a trillion dollars of their hard-earned cash to bail out profligate masters of the universe who seemed to have in the end created nothing of real value (in fact, quite the opposite), it was clear that the idea that "what's good for Wall Street is also good for Main Street" is over.
Now, as the clout of Reagan–Thatcher ideology diminishes before our eyes, there's a palatable sense that a line has been drawn—we are leaving the golden era of free markets, easy credit, high-risk deals, and big paydays, and entering a new paradigm of tight money, tough regulation, less speculation and more government meddling in markets. Politicians everywhere, eager to reassert themselves, are calling for new regulation and "reform" of the financial system. Meanwhile, authoritarian capitalist states like China, along with social democratic nations like Germany and France, greeted the crisis with an attitude somewhere in between relief and "I told you so." Both have been fearful of the Anglo model, albeit for different reasons. The demise of Wall Street now meant that their own models might not only survive, but flourish.
In France, President Sarkozy is planning a world forum to "rethink capitalism," declaring "the legitimacy of public powers to intervene in the functioning of the financial system is no longer in question." Germany's Angela Merkel remarked last week, "A few years ago, it was fashionable to say that governments would be ever weaker in a globalized world. I never shared that view." She added that it was the Americans and British who rejected her calls for more financial regulation at the G8 meeting. Her finance minister, Peer Steinbrück, went a step further, saying the crisis would lead to "the end of America as a financial superpower."
It's a sentiment that will no doubt draw cheers in Russia, where Putin is busy blaming the "American contagion" for his market troubles, and in Latin America, where leaders from Hugo Chávez to Cristina Fernández de Kirchner to Evo Morales are declaring neoliberalism DOA. "The U.S. economic model is terminally ill," crowed Ecuador's Rafael Correa last week.
Certainly, there is no lack of schadenfreude surrounding the fall of Wall Street. But beyond that is a sense, even from many eminent players within the financial community, that things had indeed gone too far. "At a fundamental level, the model of globalization and deregulation has blown up, and that's what's caused the current crisis," says investor and philanthropist George Soros, one of the first to sound a warning about the dangers of complex securitization of nearly everything, from mortgages to credit-card bills. "We're now at the end of that ideology." The future, says Soros, will be "less freewheeling, less aggressively speculative, less leveraged, and tighter on credit. We're in the midst of a massive de-leveraging."
Indeed, the past twenty years of deregulation and financial liberalization set the stage for an era in which bank leverage ratios reached such nose-bleed heights as 33 to 1 for Morgan and 28 to 1 for Goldman Sachs and Merrill Lynch as these and other global financial giants wielded growing numbers of complex securities like mortgage-backed derivatives to boost their profits to record highs. Now, as such banks are more tightly regulated, their leverage will decrease, and with it, so will their profits. That's bad news not just for banks, but for the economy as a whole—over the past few years, financial firms have represented around a quarter of all corporate profits in the United States. Their shrinkage will take a significant chunk out of the country's national income.
Yet the riches were borne out of a system that had become so complex and opaque that many of the people doing the deals in the end had no idea about the value of the assets they were holding. "What ultimately needs to come out of this crisis is more judicious management of capital, more transparent financial instruments and institutions, and as a result, a system that is better aligned with the real economy that it was designed to serve in the first place," says Stephen Roach, chairman of Morgan Stanley Asia. "Finance has simply moved too far from its moorings in the real economy."
It didn't happen overnight. From the late 1970s onward, a slew of legal and technological changes unshackled the growth and earning potential of financial institutions—pension funds were allowed to start investing their portfolios in the stock markets, brokers were able to start offering mutual funds to individuals, different types of banks were allowed to merge and enter new areas of business, automatic teller machines and trading software created a 24/7 electronic finance network. From the 1970s to 2005, the percentage of Americans owning stock rose from 16 percent to more than 50 percent. As former Clinton labor secretary Robert Reich notes in his book "Supercapitalism," there was a profound change in the economic psychology of Americans. "Savers turned into investors, and investors turned active."
Driving it all were the investment bankers, who, in the post-Volcker era of low inflation, were looking for new ways to make double-digit returns. Financial innovation burgeoned, helped along by market-friendly politicians, mostly notably Ronald Reagan and Margaret Thatcher. There were bubbles and blips along the way—remember the S&L crisis of the 1980s? But they were quickly forgotten as growing prosperity continued to ensure that a "market knows best" philosophy reigned. Throughout the 1990s, the deregulation continued, one of the high points being the repeal of the Glass-Steagall Act that separated commercial and investment banking.
Banks took advantage of the subsequent economies of scale (and, say some, conflicts of interest) to grow even bigger, doing more and more highly profitable megamergers and underwriting ever-ballooning IPOs. The repeal of the act allowed retail banks like Citigroup and others to get into the hot new credit-derivative markets (which included products like mortgage-backed securities and CDOs, which represent the spliced and diced debt of many entities, and are at the heart of the current crisis). Investment bankers themselves became cigar-smoking, suspender-wearing Croesian archetypes immortalized in numerous books and films of the period. The rise of stock options throughout the decade further increased their wealth (along with that of the corporate executives they serviced) while at the same time making it more difficult to quantify the exact numbers. Most everyone now believes the two trends together created a toxic mix. "By allowing even commercial banks into this riskier territory, and encouraging stock options as pay, you had an increasingly short-sighted focus on immediate profits," says Nobel laureate Joseph Stiglitz. "It created a culture of gambling."
Of course, the economy had turned by 2001, making things a bit tougher at the roulette table, but thanks to lower and lower interest rates (the Federal Reserve, under Alan Greenspan, cut rates to 1 percent in 2003) easy money continued to flow. The decline in rates also had the effect of exploding the market for credit derivatives, those spliced and diced securities that are at the heart of the current crisis, as bankers looked for ways to boost returns in a low-interest environment. Between 2000 and its peak last summer, the market for credit default swaps, the main type of credit derivative, went from $100 billion to $62 trillion. While sages like Warren Buffett (who memorably called derivatives "financial weapons of mass destruction") and institutions like the Bank for International Settlements expressed concern, others like Greenspan insisted that they played an important role in spreading risk.
And there was plenty being spread, particularly after 2004, when another legal shift further increased the stakes of the game. The SEC, in order to gain more regulatory jurisdiction over the parent holding companies of investment banks (which it regulated), bartered away the traditional 12 to 1 cap on leverage in a Faustian bargain, allowing banks to take bets as big as they liked. On one level, the move made sense, since the holding companies were typically the entities taking the hazy credit-derivative bets that were making people increasingly nervous. Yet the result was a situation in which SEC regulators no longer had clear-cut capital guidelines to review when judging the solvency of banks; instead, they had to pour over incredibly complex models comparing the value of one group of assets with another at different points in time (it was perhaps apropos that these models were known as "Monte Carlo simulations"). It's not too difficult to imagine SEC staffers being paid five figures having a hard time keeping up with such high finance. "There are a lot of things that the SEC is good at, but that wasn't one of them," says Professor John Coffee, a securities-law expert at Columbia University. "The market for complex securities was growing too fast for them to keep up." (Coffee believes that regulation of such complex models is ultimately better left to the bankers at the Federal Reserve, which will be in charge of regulating banks such as Goldman Sachs and Morgan Stanley going forward.)
House prices, which had shot up between 2001 and 2005, plummeted, exposing poor credit standards (it didn't help that the credit agencies were paid by the companies they were supposed to rank). The bubble burst. The dominoes fell. And now Americans are left wringing their hands about the cost of a bailout package that would seem to reward the greed that created the mess to begin with. "Much of the anger over the past week has not been about the fact that the government has produced this massive safety net, but that the people who will receive it are the Wall Streeters who've made out like bandits in the past few years," notes Robert Reich. Meanwhile, average Joes are scared (a point worked to effect by both presidential candidates in the U.S.), and basic dreams like homeownership seem to be slipping away for many. Experts like Coffee predict that with the demise of securitized mortgages, the overall mortgage market in the U.S. will contract to one tenth its current size. The sort of Depression-era scenario of a one-lender town painted in movies like "It's a Wonderful Life" no longer seems so far away.
While it's unclear yet how much help average Americans will get from the government's bailout package once details are finalized, what is clear is that the extremely free-wheeling capitalism of the past two decades is changing—if not into an entirely new ideology, then into a more moderate version of itself. For starters, old-school investment banks as we knew them are finished. Policed by the Fed, their ability to leverage themselves into big deals will shrink massively. "I think it's going to be back to basics," says Morgan Stanley's Roach. "More advice giving and less highly leveraged trading. Deals will be driven by the strategic needs of the clients—not the intermediaries—and we'll see deals themselves that are more strategic rather than financial."
Bankers' pay may even be capped (in the U.S., Reich and many others are calling for pay pegged to five-year rolling performance targets to help curb undue short-term risk-taking, in Europe there are plans to legislate delays in the vetting of options). Meanwhile, the complex derivative markets that made the bankers so rich are also liable to be constrained. In the U.S., there are calls for a clearinghouse that would make trades more transparent. In Europe, plans to regulate derivatives are already moving forward: last week, the EC drafted a proposal that would ban or limit CDOs and other banking magic tricks that turned risky debt into triple A securities.
German Finance Minister Steinbrück has even launched an official campaign to "civilize" financial markets. "Unrestrained capitalism like the kind we're experiencing right now with all its greed will in the end devour itself," he proclaimed, referencing Marx in a speech in an interview with a German weekly. Steinbrück is gunning for higher cash reserves for banks, prohibitions on short selling, bonus caps, and no more off-balance-sheet vehicles, among other things. "It must be clear that returns of 25 percent can't be attained without unreasonable risk or intentionally damaging other market participants," Steinbrück told the Bundestag last week.
Of course, it's worth remembering that some of the most highly leveraged deals in recent memory were done by state-regulated German banks rather than Wall Street giants. More government oversight itself is no guarantee that all will turn out well—regulations must be well crafted, well enforced, and to some extent, flexible. George Soros, for example, a strong critic of Wall Street excesses, advocates not lowering leverage ratios to a set rate, but giving the Fed the flexibility to raise and lower the rates as market conditions dictate.
It's also worth asking whether political proclamations can actually stop people from trying to make 25 percent returns. Can capitalism itself ever really be hobbled? Or will its more buccaneering side always re-emerge after periods of repression? Hedge funds, wounded by recent losses, may be heading for the hills (they've parked some $100 billion in money market funds in recent weeks). But there are currently no major proposals to regulate them, and at some point, their thrusting managers will be back, ready to take on the risk that investment bankers will no longer hold. Likewise, sovereign wealth funds and new emerging markets powers are flush with cash—Asian central banks alone have reserves of more than $4 trillion dollars, enough to fund several Paulson plans. This growing wealth was a major driver of financial innovation over the past several years. Now, all that money will inspire a new kind of creativity focused on circumventing any new regulations. Investors and the people who service them will seek ever more creative ways to dodge the rules.
A good chunk of the new money will undoubtedly end up in Western markets. And while that will certainly increase the power and political clout of emerging powers, and further catalyze the shift to a more multipolar world, it won't mean the wholesale demise of the free-market system. While China has used the crisis on Wall Street as an opportunity to tout its own authoritarian capitalism, the "Chinese model" resulted in market losses of 66 percent this year, and massive wealth destruction among ordinary people—hardly a comparative success. Europeans, despite their schadenfreude, don't really have anything better to offer than Anglo-style capitalism, either. Their own regimes simply tend to follow the Anglo-American lead, albeit with resentment, a few years later, and with a lot of brakes put on by the state.
That said, the world as it enters this new economic era may in fact end up looking more like Europe. "We will muddle through and complain a lot, with no major growth surges, but no disasters, either," says Bob McKee, chief economist at London-based Independent Strategy. We will once again be savers rather than investors. A culture of thrift will reign, as credit continues to be tight in the short term. And then, at some point, the money will flow again. New bubbles will be formed. Where they will be—in energy, or green technology, or space—is anyone's guess. But regardless of bailouts and new laws, they will come again. And when they do, everyone will have forgotten that the world almost came to an end in 2008.
With Stefan Theil in Berlin, William Underhill and Sophie Grove in London, Mac Margolis in Rio and Tracy Mcnicoll in Paris