The ecology of Wall Street

In his column today, Two Cheers for Wall St. – New York Times, David Brooks is peddling something call the Ecology Narrative of innovation on Wall Street. It goes like this:

When a new instrument enters the market, it takes a while before people understand and institutionalize it. Whether the product is high-yield bonds or mortgage-backed securities, there’s a tendency to get carried away.
In the first stage of this adolescence, investors look around and see everybody else making money off some new instrument. As Nicholas Bloom of Stanford notes: “They assume they are fine because they see everyone else buying it.” Individual bankers have a special incentive to get in on the ride because their yearly bonus is determined by how they do in the short term.
Then there’s a moment when people realize how stupid they have been. They’ve bought a pile of subprime mortgages without really knowing what they’ve purchased. The ratings agencies suddenly don’t look so reliable. The cycle of overconfidence becomes a cycle of underconfidence because nobody knows who is holding worthless paper.
Then, finally, maturity sets in. Those who have lost great gobs of money get fired. People still find the new product useful, but within parameters and with greater safeguards.
The lesson of the Ecology Narrative is that, in most cases, the market corrects itself. Maybe this year banks will change their pay structure so there’s not so much emphasis on short-term results. Maybe companies will change their boards to improve scrutiny over complex new instruments. In short, markets adapt.

There is some truth to this. But he misses a couple of key points. First, he sets this Ecology Narrative as a counterpoint the Greed Narrative:

The financial markets are dominated by absurdly overpaid zillionaires. They invent complex financial instruments, like globally securitized subprime mortgages that few really understand. They dump these things onto the unsuspecting, sending destabilizing waves of money sloshing around the globe. Economies melt down. Regular people lose jobs and savings. Meanwhile, the financial insiders still get their obscene bonuses, rain or shine.

This Greed Narrative is, of course, a strawman caricature. Brooks does this for a very simply reason: the Greed Narrative requires government intervention and the Ecology Narrative is self-correcting. Political point made.
In truth, both of these narratives are at work. They are not opposites. And both require a role for government. Governments have always played the role of stepping in and limiting and correcting the abuses of the capitalist system. Stemming those abuses is the genius of modern capitalism.
In the Ecology Narrative, regulation also plays a role in stemming not the just the abuses, but also the “adolescent” over exuberance. Regulation helps the markets adapt and regulations build the firewalls that prevent that adolescent from burning down the entire house. If the current meltdown turns out to be worse than we originally thought, it will be because we didn’t have the regulatory systems in place to prevent the meltdown from spreading – the dreaded “contagion”.
As Brooks points out, there is the balance between innovation and creativity. To survive, any ecology system has to have mechanisms in place that make sure that bad innovations don’t completely imperil the system. In the case of financial markets, we have learned that government regulation is part of the ecosystem, playing that key role.
In creating policy for the I-Cubed Economy, we need to put out brainpower to work getting the regulations right. Not simply writing them off.
Update: I just ran into this recent quote from Stephen Roach in > Global Economy” href=”http://www.theglobalist.com/DBWeb/StoryId.aspx?StoryId=6732″>The Globalist:

The Fed’s seemingly open-ended support of unfettered and unregulated financial innovation facilitated a derivatives-based revolution that turned out to have been a good deal riskier than the Greenspan libertarian mantra ever presumed.

Interesting.

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