Magazine | May 4, 2009, Issue

Laissez-faire Is French

There is much that’s Right in Europe’s thinking on the financial crisis

Pres. Nicolas Sarkozy desires to create a new global finance cop, or gendarme — this enforcer would speak with a Continental accent. At the G20 summit, Sarkozy even threatened to walk out over this demand. American conservatives, jealous of sovereignty and rightly skeptical of Sarkozy’s poking his Gallic beak into domestic affairs, have greeted these Euro-overtures with hostility.

Conservatives ought to take a second look: We may not want to hire Sarko’s sheriff, but we should borrow a few bullets from his gun. While the U.S. is busy quasi-nationalizing everything from AIG to GM, the ideas moving Europe are, in no small part, more market-oriented and more sensible than much of what is currently under discussion in Washington, and conservatives ought not to let an immature Europhobia prevent us from incorporating the best thinking into our own reform agenda. Step away from the freedom fries and shake hands with Jacques de Larosière.

Larosière is a French treasury official, a former managing director of the International Monetary Fund who became president of the London-based European Bank for Reconstruction and Development when that institution was mired in financial scandal — a perfect Eurocrat résumé. But his group’s recommendations to the European Commission bear consideration — and they do not go so far as Sarkozy and call for a single global regulator (or even a single European regulator), nor do they imply the need for one. The Larosière recommendations draw an important distinction between regulation and oversight, the latter understood here as the gathering and dissemination of critical information about deep risks in the financial system.

It bears repeating that on the subject of the financial crisis, the United States is, at present, to the left of Europe, meaning Sarkozy, Angela Merkel, and the broad consensus they represent. It was the United States that pressed the G20 for a $1 trillion global stimulus spending spree, and it was the Europeans who vetoed it. If the Larosière report and Sarkozy’s endorsement of its recommendations are any indication, the Europeans are at present far more market-friendly and less ideological than their counterparts in Washington: Larosière concentrates on misaligned incentives, flaws in the credit-rating agencies’ methodologies, the lack of sufficient long-term data to support risk models, the unhealthy pro-cyclical effects of mark-to-market and other accounting rules, and the like. Far from advocating Euro-statism, Larosière argues that excessive regulation should be avoided because “it slows down financial innovation and thereby undermines economic growth in the wider economy.”

The panel’s recommendations are less concerned with new police powers than with information-sharing and disclosure protocols. And the biggest regulatory stick in its proposed arsenal is one that needs swinging on both sides of the Atlantic: bringing accountability to the cartel of government-recognized credit-rating agencies — Moody’s, Standard & Poor’s, and Fitch — which the report rightly describes as “oligopolistic.”

The Europeans’ hostile attention to the credit-rating agencies is particularly timely. Known as NRSROs — that’s Nationally Recognized Statistical Rating Organizations — they constitute a cushy little cartel with which banks and insurance companies are obliged, by law, to do business: Banks have to hold AAA-rated securities, and it’s not Triple-A unless an NRSRO says it is. The general impression on Wall Street is that the SEC has been lax to the point of narcolepsy when it comes to the credit agencies: None has ever lost its NRSRO status, and if any proceeding is under way against one of them (the SEC won’t say), it hasn’t reached the point of a public inquiry. The agencies themselves are the stuff of B-movie villainy: In one e-mail message, an executive describes a set of investments as a “monster” and concludes, “Let’s hope we are all wealthy and retired by the time this house of cards falters.” Then he adds a smiley face. The Europeans propose to make the credit-rating agencies’ legal status performance-based. The SEC is skeptical of the proposal. Conservatives should press the issue.

The Europeans’ diagnosis of the financial crisis is persuasive, if over-interested in assigning special blame to les anglo-saxons: U.S. monetary authorities kept interest rates too low for too long because inflation was showing up in the one place where it is welcome: in asset prices. If the price of gasoline doubles, there’s a whole Wagner opera of angst. But housing prices doubled between January 2000 and November 2005, and then climbed another 13 percent by June 2006, and there was no howling, no angry congressional hearing — there was celebration. With real estate booming, the price of real-estate-backed securities boomed in echo. The Larosière report, unlike most members of Congress, forthrightly acknowledges that political meddling and tax-code social engineering have deeply distorted the housing market, expanding homeownership beyond its natural limitations and driving prices artificially higher. But prices do move both ways — eventually.

#page#The global context for the collapse of the U.S. housing bubble was pretty hairy: Innovations in finance had radically expanded the global volume of credit, recent booms had given governments unrealistic expectations for future growth, and strategically critical economies, such as China’s and Saudi Arabia’s, had pegged their currencies to the dollar, thereby importing the Fed’s loosey-goosey money trouble as they exported sneakers and crude oil to the United States. It didn’t take much to set fire to this kindling: Inflation started seeping out of the U.S. real-estate market into the rest of the economy, the Fed hiked rates to put on the brakes, and everybody from Wall Street to Shanghai found out the hard way that those subprime borrowers weren’t going to make their higher house payments. There were failures across the range of private and regulatory players, an inverse “wisdom of crowds” — because, as Despair, Inc. puts it, none of us is as dumb as all of us.

There’s no cure for stupid, but information helps. And it is here that the Larosière recommendations should be attractive to market-minded conservatives: More than heavy-handed regulation, what the Europeans are pushing is surveillance: gathering and disclosing the data necessary for measuring and managing systemic risk in the financial system. Among other things, the Europeans want financial regulators to keep closer tabs on “off-balance-sheet vehicles,” the constructs by which banks hold assets that are kept off the books. The four largest U.S. banks had off-balance-sheet assets valued at $5.2 trillion at the end of 2008, according to the Wall Street Journal. That’s more than one-third of U.S. GDP. Europe’s banks had accumulated a lot of subprime exposure in their off-balance-sheet holdings, too. Taken with the explosive worldwide growth of credit derivatives, these holdings constituted an enormous accretion of risk that more or less flew beneath the regulators’ radar. It’s one thing for a bureaucrat to tell banks and funds what they can and cannot do; it’s a different thing for regulators to know what those institutions are doing.

Markets need information to work. Regulators need information to work, too. It seems reasonable that those of us who want market-based approaches to finance and those who seek tighter regulation should be able to agree on data gathering and disclosure as a mutually acceptable starting point. This is particularly true in light of the intelligence failures that preceded the current crisis.

Those failures were both private and governmental. Among other things, Wall Street firms based their risk estimates for hideously complex financial instruments on an elegant equation, the now-famous “Gaussian copula” (explored in Felix Salmon’s engaging and important Wired article “The Formula that Killed Wall Street”), but relied on only about ten years’ worth of house-price data to feed the formula — data from the boom decade. Most of those serving on corporate boards didn’t have the quantitative chops to appreciate just how far over the edge they were hanging their assets, and the regulators were even more poorly equipped. Meanwhile, as the SEC reports, some of the credit-rating agencies grading risky assets were using criteria that were substantially different from the ones they published for their clients — that is, investors using the Big 3 ratings agencies didn’t always know what the information they were paying for was based on.

As with the national-security intelligence failures that led up to 9/11, the financial-intelligence authorities proved unable to “connect the dots” between lax lending standards, over-leveraged financial institutions, mispriced risk, off-balance-sheet vehicles, and global imbalances. And the securitization of mortgage debt, which was intended to help reduce banks’ exposure to housing-based risks, ended up mostly just shifting the risk to other banks, in the United States and around the world. It’s not clear that any regulator, no matter how powerful its tools or sweeping its portfolio, could have prevented this storm. But better disclosure and information sharing would have helped them see it coming, giving both governments and financial institutions an opportunity to dampen the boom and thereby soften the bust. And that’s what conservatives should be fighting for as we reform the financial system: radical openness.

The new mandates that are on the way after the G20 summit are largely informational in nature. Among the changes agreed to, hedge funds that grow large enough to be of systemic importance will be required to register and disclose certain financial information. How big “systemically important” is remains up for interpretation, but it’s assumed to mean $1 billion or $2 billion in assets. About 15 percent of U.S. hedge funds have more than $1 billion in assets. And even here, the Europeans are less restrictive than the heartland Republicans who sometimes distrust them: Sen. Charles Grassley of Iowa has introduced legislation to regulate all hedge funds with more than $50 million in assets.

Offering the right response to the financial crisis is crucial for conservatives. The last grievous global financial convulsion, the Great Depression, legitimized expansive government and intrusive financial regulation in the American mind for generations, and free-market conservatives still haven’t recovered that political ground. We need to take the best ideas from wherever we find them — even from Paris.


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