Main St., Wall St., and the Garden Path*

I have been astonished and angered, in recent days, by all this hogwash coming out of America - OK, from populist corners mostly - positing some sort of opposition between the interests of Wall Street as against "Main Street", meant as a kind of shorthand for the little guy. In this line, the Joe Blow in the street who is seeing his mortgage foreclosed, or job threatened by banks pulling the plug on credit to his struggling employer, is perceived as the unwitting dupe of cynical and greedy millionaire bankers who will go to any length and run any risk to secure their mega-bonuses. It seems to me that this characterisation, which emerged in the posturing and debate about the $700 billion Paulson bailout plan, misses several important points at once.

First, and probably most irritating of all, it avoids the point that it is "Main Street" who elected this crowd of plundering, treasure-squandering, free-wheeling carpet-baggers to eight years of power and policy control in the first place. The whole slant of policy, from massive tax cuts, ever-receding regulation and blind neglect of the "Shadow Banking system"** (including preposterously benign tax treatment of non-salary financial earnings) has been to encourage, enable and accelerate the culture of risk-taking and cowboy capitalism that has held sway in Wall Street in recent years. Make no mistake: the form and substance of regulation does matter, and a less laissez-faire and more engaged approach to the rise of a gigantic non-regulated financial intermediary sector would have made some difference to recent developments.

Second, Main Street has also to answer for its all-too-eager embrace of the sort of dodgy mortgage and consumer lending which has triggered the home loan collapse which in turn mushroomed into the global credit and financial crisis. US consumers have been addicted to unbridled credit for a long time - so much so that it has become a structural element of the economy, but the so-called "Ninja" mortgages ("No Income, No Job, No Assets") may be the enduring icon of the worst practices in this respect. Why has this class of assets, the UK partially excepted, been largely absent in Europe or other major countries? More careful regulation and more serious consumer protection is the answer - another illustration of the Republican failure of the national interest. People who are terribly keen to own a house are only too willing to believe the mortgage broker who sells a happy-talk line about rising property values and interest rates that will always stay low. It shouldn't be allowed, and in most civilised markets, it isn't. But you get what you vote for - even if you don't "deserve" it.

So much for Main Street. It goes without saying that Wall Street has a great deal to answer for in all of this. Beyond pushing stupid lending into the consumer markets, at the next derivative level - the bundling and reselling of such speculative junk to institutional investors worldwide - the bankers got it badly wrong. The whole rotten food-chain of low-end mortgage lenders, investment bankers, rating agencies with conflicted interests, and insufficiently critical institutional investors worldwide managed to spread this particular financial virus well and truly into every corner of the globalised financial system. More on this presently.

It is now obvious that lots had gotten out of hand in Wall Street. Ill-conceived bonus and option deals for executives that prejudiced short-term returns over prudent business development is an obvious one. The spectacle of Robert Fuld, fallen boss of Lehman Brothers, in the Senate this week trying, amongst other things, to defend the half-billion odd of value he took out of the firm in recent years is simply pathetic. The SEC's failures in overseeing these institutions is now emerging and illustrates the criminal neglect that has set the tone in regulatory Washington under Bush. It must be assumed that some of these things will be addressed in the coming period.

The lobby power of Wall Street generally is far-reaching. Often, this is for the good: real practical knowledge of how markets work, investors think and institutions function is absolutely required in order to set sensible policy. Goldman Sachs is full of intelligent, thoughtful and well-meaning people. By all means let them contribute. I myself make my living giving financial sector advice to other countries, based on the fact that I have lived and worked through crises in the past and have experience grounded in practice (trial and, yes, error), as opposed to purely academic knowledge. But with influence should come responsibility as well. It seems clear that the thrust of recent policy input has been unbalanced, and an anything-goes, the market will take care of itself attitude seems all too eagerly to have been accepted by the current crop of regulators. More distance and skepticism is required, as well as a far more substantive approach to regulation as opposed to the rule-based bias of the US legal tradition, unfortunately mimicked in much of the developing world, which leads to the creation of ever-inventive structures which are designed to achieve things the regulators don't want, but which avoid non-compliance with the "rules", narrowly interpreted.

Finally, a word about the generally less-remarked effects of all this on the smaller financial markets of the emerging world. The North's financial industry lobby efforts have in recent years also made great inroads into forcing "market entry" into many emerging markets around the world. This translates to more open capital accounts (easier speculation), access to foreign firms for brokerage business and banking franchises, and the ability to sell foreign securities to the locals (including toxic rubbish). To be fair, it also can lead to better skill levels, more financing options and deepened local markets. Generally, this has proceeded under the relatively benign banners of Free Trade, or World Trade Organisation membership requirements, but occasionally also as plain old-fashioned bilateral arm-twisting. The irony of this is that those markets seen by the international financial community as particularly protectionist, retrograde and generally ornery in this respect - China, India, Malaysia spring to mind - have fared best in the current crisis. Those countries we bankers appreciate most for their policy "progress": the co-operative, rapidly opening markets in Eastern Europe and Central Asia for example, have fared worst. Open financial arteries have left them badly exposed to rapid infection by the crisis's effects in vanishing credit and panicky portfolio flows.

Happily for the very poorest markets, they are by and large insufficiently integrated into global markets to have been hit hard. But do not underestimate this: according to industry data, a startling 80% of developing countries have accessed international bank lending and 40% international bond markets in the last 25 years. Apart from the strongest and most heavily collateralised deals, all this is well and truly gone, for the time being. The extra-territorial effects of regulatory failure in the US and other major markets hit not just Wall Street and Main Street, but they lead the world's poorest up the Garden Path as well.

Hong Kong, 7th October

*With thanks to students and others attending the Economen Congres Groningen, Rijksuniversiteit Grongingen, 3 October 2008, in the discussion at a Masterclass on ‘Privatising Development Finance’ given by Jan Cherim.
**A phrase I first saw in the NYU economist Nouriel Roubini's blog.