While the US economy seems to recovering at least to some degree, the question is, are the underlying problems being addressed? The answer is basically a resounding no.
In our view, two forces can explain the financial crisis: rising inequality and financial deregulation. Together, these produced an increase in demand for credit (rising inequality) and an increase in supply of credit (financial deregulation), leading to an asset price bubble which inevitably popped - with disasterous consequences.
Rising inequality has been an important cause of the financial crisis. Median wages growth started to seriously lag the growth at the top, but perhaps even more importantly, they started to seriously lag increases in labor productivity.
The postwar arrangement (often called "Fordism") in which wage growth and productivity increases grew hand in hand had brought so much prosperity, but was no more. The only way for median wage earners to join in the increasing prosperity was to borrow, which they did with abandon (made easier by financial deregulation).
The credit bubble produced a housing bubble (which served as the main collateral, so it was a self-reinforcing loop). When the bubble inevitably burst, the asset value of household balance sheet imploded by more than $9 trillion, while much of the debt remained, not to speak of the damage to bank balance sheets. The economy entered a balance sheet recession, in which households cut spending and borrowing, and increased saving in an effort to repair their ravaged balance sheets.
However, the underlying rise in inequality is simply continuing. Absolutely nothing has been solved there, according to Emmanuel Saez:
In 2010, average real income per family grew by 2.3% ... but the gains were very uneven. Top 1% incomes grew by 11.6% while bottom 99% incomes grew only by 0.2%. Hence, the top 1% captured 93% of the income gains in the first year of recovery.
This is pretty awesome. That means that for every extra dollar gained, 93 cents went to 1% of the earners, leaving the other 99% with a whopping 7 cents.
Rising inequality produces other problems. It can lead to disaffection when people start to think the system is stacked against them, both within an organization (top executive pay) and in society at large. Ultimately, this could undermine the legitimacy of the present institutional arrangements, which could have very serious consequences and lead to unwanted effects.
This is perhaps why people like Alan Meltzer argue that it is a world-wide phenomenon, giving it something of an inevitability, the result of immutable market forces. But the facts prove him wrong. Work by Atkinson, Piketty and Saez show that US (and to some extent the UK) are really in a place of their own with respect to rising inequality.
More important for our purposes, according to Acemoglu and Robinson, "there seems to be no equivalent of the 40-year stagnation of median wages in Europe."
That is, the breakdown between productivity growth and the median wage (or the breakdown of Fordism) hasn't happened in Europe, it's something uniquely American. Yet, Europe also had a fair amount of credit infused asset bubbles, so this could, at first sight, still debilitate our thesis that the specific form of rising inequality in the VS (median wages stagnating versus productivity growth) has mostly been responsible for the dramatic rise in credit demand.
However, Europe had its own peculiarities, engendered by the euro. Precisely those countries experiencing the biggest asset bubbles (Ireland, Spain) had a euro-induced enormous capital inflow.
Other eurozone countries (like Greece, Italy, and Portugal) also had large capital inflows as a result of the elimination of exchange rate risk when joining the euro. However, they had more stringent regulations of financial markets and/or mortgage markets, preventing the asset bubbles from forming in the first place.
So these data actually confirm our hypothesis that the financial crisis was the product of both rising credit demand (produced by rising inequality in the US and UK, produced by an influx of foreign capital in Ireland and Spain) and rising credit supply due to lax regulation of financial and mortgage markets.
Increasing complexity and specialization make markets in general, and financial markets in particular, prone to information asymmetries (where one party knows more about the product or service than the counter-party and might exploit that information advantage). We believe this has been at the heart of the financial crisis.
Banks were able to exploit information asymmetries at both ends of the mortgage market. First, by providing mortgages to people who couldn't afford them, secondly by repackaging and sell those mortgages into extremely complex, tradable products to remove the risk from the bank balance sheet.
Some banks, like Goldman Sachs, managed to exploit their information advantages in even more ways, letting favored clients construct the products and bet against them, while keeping this hidden from the regular investors.
Has anything been done to address these (and other) risks from the financial markets?
Well, we've have Dodd-Frank bill but is this enough? And there is a rather large back-lash against regulating the financial markets. Is that really because we believe that financial markets should be regulation free zones, or is it because a lot of politicians get their campaign contributions from the financial industry? You'll decide.
Then we have the JOBS Act that is supposed to spur job creation by stimulating the IPO market. A statistic purportedly showing that 92% of job growth occurs after a company's initial public offering, but this statistic is highly misleading, attributing causality where none is present. If it were true, as Paul Kedrosky has observed, we could solve unemployment by having every private company to go public. There really isn't much of a clear-cut case to be made for that. Much of the famous German Mittlestand, the small and medium sized companies that form the backbone of the German economy, are private, family-owned companies. They thrive nevertheless.
In fact, the JOBS act seems a step backwards from financial re-regulation, which is why only 29% of chartered financial analysts are in favor of the bill, while 69%:
believe it would create gaps in investor protection and transparency. The basic idea of the Act is to make it easier for companies to go public, but easing regulations may not be the most appropriate way to help companies make the jump. A big problem that the CFA community sees is that the bill would allow analysts to evaluate initial public offerings that their own firms are underwriting. [Michael Fowlkes]
In the light of recent revelations by a Goldman Sachs employee, do we really want to tempt analyst to look over those Chinese walls that are supposed to hermetically close them off from the underwriters in the same firm?
Simon Johnson, former chief economist of the IMF, calls the JOBS bill a "colossal mistake of historic proportions:
abandoning much of the 1930s-era securities legislation that both served investors well and helped make the US one of the best places in the world to raise capital. We find ourselves again on a bipartisan route to disaster.
He argues that the premise that the IPO market is held back by overregulation is false. Good securities regulation is basically a public good, it protects everyone but the scammers, and by doing that, it leads to lower capital cost as investors demand a smaller risk premium for the risk of being provided false and/or incomplete information. This is easy to see in practice. Do we really want our financial markets to become like the underregulated, shark-infested waters that are the pink sheets, where no piece of information can be trusted?
We think, if anything, financial regulation should err on the side of caution, as we think underregulation is a much bigger risk for the economy than overregulation. While there are benefits from financial innovation, much of it is rather marginal or even dubious, but the risks of financial instability (with possible disastrous consequences, as we've witnessed in 2008) that is the result of underregulation is a clear and present danger.
While we think that banking should become a bit more boring, as it was in the more financially regulated 1950s and 1960s. But for investors, the stakes are even higher. As investors, we need to be sure that the information we are provided with that inform our investment decisions is correct. That is a paramount pre-condition for investing. Do we really want to go back to this era?