Setting National Priorities: Financial Challenges Facing the Obama Administration

During 2008, the U.S. financial system experienced extreme stress and came close to paralysis. The long-term health of the U.S. economy requires more than higher government spending, targeted Treasury bailouts, and unprecedented lending by the Fed. This article recommends four reforms to regain and maintain long-term economic health: (1) The markets for trading credit and its derivative instruments must include a clearinghouse; (2) the markets for credit and its derivative instruments must become public and transparent; (3) the size of companies must be limited, or certain activities that can lead to failure must be prohibited, so that no company can be allowed to become “too big to fail”; and (4) the observed failures in financial agents’ monitoring and in accounting practices must be rectified.During 2008, the U.S. financial system experienced extreme stress and came close to paralysis. The S&P 500 Index declined from a high of 1565.15 on 9 October 2007 to 752.44 on 20 November 2008, a retrenchment of −51.9 percent. The S&P 500 financial stocks declined by nearly −73 percent. The ostensible catalyst of the current crisis was falling home prices, which led to a loss of both capital and the ability to lend among financial institutions (i.e., deleveraging and credit contraction). Financial institutions lost confidence and trust in their counterparties’ ability to repay debt obligations. Financial networks began to implode, and the contagion spread to real economic activity.The current economic and political consensus seems to be that the U.S. economy needs massive government spending to stimulate aggregate demand. But the long-term health of the U.S. economy requires more than a higher level of government spending, targeted Treasury bailouts, and unprecedented lending by the Fed. At least four reforms are needed to regain and maintain long-term economic health.First, derivative and credit instruments should no longer be traded like used cars—that is, as completely private transactions between two parties. The market for trading derivative and credit instruments must include a clearinghouse. A clearinghouse, in conjunction with the regulators who oversee it, would determine the necessary rules and capital requirements to ensure a well-functioning market, one that would not need bailouts from taxpayers. More generally, mechanisms and regulations must be fashioned to track financial markets so that yet-to-be-created contracts cannot become widespread without a clearinghouse. After all, the goal is to avoid a future crisis.Second, markets for derivative and credit instruments must become public, transparent markets in which the prices, quantities, and identities of the traded securities are reported and available in real time. Public, transparent credit markets will aid the economy in the process of “price discovery” for credit and risk and ensure that buyers and sellers receive the best price for execution. The evolution of the NASDAQ stock market has shown that multiple-dealer markets work. Standardized, simplified credit securities that are well understood by buyers and sellers need to be developed. Simply put, securities that underlie the financing of much economic activity (including derivative and credit instruments) must be traded in public, transparent markets that can be supervised and observed.Third, no company should be allowed to become “too big to fail.” The proper functioning of competitive markets requires that companies be allowed to fail because failure directs society’s scarce resources away from inefficient activities and toward successful, innovative ones. In most economic writings, “too big” is associated with “too profitable and successful.” Too big to fail is more an idea associated with financial networks as opposed to monopolistic institutions. The failure of any investment firm in the financial network cannot be allowed to affect other firms in the network. New policies should strive to either limit the size of firms or prohibit activities within a firm that can lead to failure—or some combination of the two.Finally, the observed failures in financial agents’ monitoring and in accounting practices must be rectified. In particular, more stringent oversight and enforcement, as well as better risk-sharing arrangements, must be instituted in the loan origination/securitization process. Credit-rating agencies must be given proper incentives to eschew potential conflict-of-interest opinions. The compensation of financial executives must be tied to the time horizons of their investment decisions. On the accounting front, off-balance-sheet obligations need to be minimized; and the regulatory and oversight governing boards should make sure that all markets have honest, fair, and investorcentric accounting rules.Note: This article is based on a speech given by the author in November 2008 at Oberlin College for a symposium titled “Setting National Priorities: Economic Challenges Facing the New Administration.” The views expressed in this article are the author’s alone and do not necessarily reflect those of OppenheimerFunds, Inc.