After The Fall: Saving Capitalism From Wall Street—and Washington

by Nicole Gelinas

As David Paterson succeeded Eliot Spitzer as New York’s governor yesterday, he referred to Wall Street’s continuing meltdown and noted that “our economy appears to be headed toward crisis,” adding that he’d meet with government and business officials to “adjust the budget accordingly.” Assuming this means budget cuts, he should stick with the strategy, despite likely pressure from others in Albany.

It’s probable that the governor will hear from legislators and lobbyists who’ll argue that we don’t know yet what’s going on with the financial world. One day the market’s up 400 points, another day it’s down 200. One day the talking heads are saying the crisis is over; the next day, huge investment bank Bear Stearns is going under. Given the uncertainty, Paterson may face pressure to avoid major changes for now and instead go forward with Spitzer’s proposed spending increases despite a $4.5 billion deficit—whether through borrowing, a temporary tax hike, or both—thereby placating lobbyists and their constituents. Next, stand by and hope that Wall Street’s problems mysteriously go away as mysteriously as they appeared, as sometimes happens.

But sticking to the status quo would be wrong, and ultimately far riskier than striking out in a new direction. Forget subprime mortgages, credit crunches, derivatives counterparties, and everything else. Just remember one thing about the state budget as it relates to Wall Street: assets create income. The state government gets its income—tax revenue, that is—from New York’s private-sector assets, and the largest concentration of those assets is in New York City’s financial industry. The trillions of dollars that Wall Street has lent to homeowners, commercial builders, buyout companies, and the like are assets, because Wall Street uses the profits from those loans to make new loans and employ tens of thousands of people. The value of the stock market is an asset. But financial firms and their workers are the biggest asset of all: the companies and people who are constantly thinking up new financial-industry products to make new profits and send new tax revenues straight to Albany.

Right now, the value of all of these assets is plummeting. Banks have seen $150 billion in assets vanish because of the crisis that began in subprime mortgages; the market thinks many of those assets are now worth almost nothing. Bear Stearns’s plight is another example: it was worth $20 billion a year ago, but J. P. Morgan and the Fed think it’s worth only $250 million today. More pain is coming because banks and their customers became reckless with lending and borrowing, and overconfident in their mathematical models, in an era of record-low interest rates as well as super-powerful computing. Before it’s all over, we’ll probably see hundreds of billions of dollars more in big asset write-downs on credit cards, commercial-building mortgages, and corporate debt.

Whenever Paterson hears the term “asset write-down” or “asset fire-sale,” he can be sure that New York will have a little less money to spend—not just this year, but probably indefinitely. The possibility of a protracted downturn for New York is very real, because the falling value of assets—mortgages, stocks, and so on—isn’t even the worst part. As the banks see the value of today’s assets fall, they have less money with which to create new assets. They can’t invest in new people or new products; they can’t even keep the old people or products around.

Plus, the investors whom those banks need to replenish their assets are rethinking the value of the banks’ human capital—that is, of New York State’s most lucrative assets. They’re wondering: if these bankers screwed up so badly, how much are they really worth? Is this industry worth any more of my money? It may take the financial world a long time to win back the trust of its investors and customers. Until it does, New York’s asset base will continue to suffer severely.

To see what that means for state spending, think of Wall Street’s assets as a trust fund that supports New York State’s spending, just as trust funds support the spending of some wealthy people. If the assets in a wealthy person’s trust fund stopped growing and even started losing value, that person’s investment adviser would say: “You’ve gotten used to spending a lot of money each year, but you’re going to have to cut back now, because your assets aren’t generating as much income as they used to. You’re not going to like it, but it’s better to cut back a bit now—say, 5 percent—than to have to cut back three times as much next year.” What if the client doesn’t listen? To fuel his excessive spending, he’ll have to sell off assets. By selling assets, he’s hurting future income. And he can’t do that forever—he is only delaying future pain.

It’s the same thing with New York State. If Governor Paterson chooses to go along with what the legislature might pressure him to do, and tries to borrow and tax his way out of this crunch, it’s no different from selling off one’s good assets to generate income today at the expense of the future. Raising taxes on the wealthy, for example, will push some high-income New Yorkers to leave. Borrowing for operating expenses similarly hurts assets, because every dollar we borrow to plug a deficit is a dollar that we don’t invest in vital infrastructure like roads and bridges—assets that help the private sector create future income.

The prudent thing for Governor Paterson to do is to start cutting spending now, to give the state’s private-sector assets a chance to recover. If the state recovers quickly, the worst that would happen is that next year or the year after, he’ll have to fend off the same lobbyists who will be back to push for yet higher spending. But if New York doesn’t recover quickly, delaying action now will only make recovery that much more difficult.

Nicole Gelinas is a contributing editor to City Journal and a Chartered Financial Analyst.