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By Nicole Gelinas

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

City Journal

Nicole Gelinas
Surveying the Wreckage
What can we learn from the top books on the financial crisis?
Summer 2010
Nouriel Roubini, a.k.a. Doctor Doom, calls for across-the-board limits on leverage.
Bruce Gilden/Magnum Photos
Nouriel Roubini, a.k.a. Doctor Doom, calls for across-the-board limits on leverage.

In January 2007, four small-time fund managers with few Wall Street connections invited themselves to a Las Vegas conference of players in the mortgage-bond business. The interlopers’ mission: to see if they were wrong in betting against subprime mortgage securities. They found a money manager who couldn’t care less if his clients lost everything on mortgage-related collateralized debt obligations (CDOs): he made money on quantity, not quality. They found a Bear Stearns CDO salesman more interested in playing cowboy at a shooting range than in discussing the housing market. They found ratings analysts utterly indifferent to their crucial jobs—assessing the risk of trillions of dollars’ worth of mortgage-related securities. And they learned about some of the average people who had taken out so many mortgages, including a stripper who was juggling five home-equity loans, all dependent on ever-rising home prices.

The four men went home surer than ever that “this is a fictitious Ponzi scheme,” as one of them told journalist Michael Lewis, who recounts the story in his gripping new book The Big Short: Inside the Doomsday Machine. “Convinced that the entire financial system had lost its mind,” they ramped up their bets. One of the men told his mother that America risked “the end of democratic capitalism”; she suggested that he take an antidepressant. But the four were right, of course, and once enough investors agreed with them, the housing and financial bubbles burst and drove the economy into a deep contraction.

It would be easy to read the Vegas story as one more piece of evidence that free markets in the financial world failed us over the past two years. How could the markets have been so wrong, so careless, and so wasteful? Even Steve Eisman—one of the four Vegas interlopers, who made a mint from their contrarian stand—sees the financial crisis as evidence of market failure. Eisman was shocked, he told Lewis, that “inside the free market” there hadn’t been any “authority capable of checking its excess.” This has become the casual mainstream narrative arc of the crisis: deregulation took the economy down, and the government had to step in to save us from free markets.

Over the past year, hundreds of authors have published books on the crisis. What becomes clear—often despite the authors’ own intentions—after reading ten of the most significant of these works is that the mainstream narrative is wrong. Over the two decades leading up to 2008, financial markets were anything but free. The nuts-and-bolts government infrastructure that free markets require to thrive—healthy fear of failure, respect for the rule of law, and fair rules for everyone—was crumbling. The crisis books make clear, too, that Washington’s extraordinary rescues of Wall Street have eroded much of what’s left of free-market infrastructure in finance. Worse, Congress’s efforts to reform the industry will do yet more damage. The next time the financial world implodes, it will hurt the economy even more severely.

Lewis kicks off The Big Short with a puzzle about Liar’s Poker, his debut tell-all about being a 24-year-old trader at Salomon Brothers, the now-defunct investment firm. “I thought that I was writing a period piece about the 1980s in America, when a great nation lost its financial mind,” Lewis writes. Instead, he realized, the excesses of the “financial 1980s” persisted for two more decades, to the point that “scandalous” $250 million trading losses from that era today look “quaint.” How could this have happened?

The answer lies in the United States government’s quarter-century-old policy toward the financial sector: to subsidize its growth at all costs. The delirious 1980s party on Wall Street lasted until 2008—and has even started up again—because a bailout-happy Washington hasn’t allowed finance to benefit from the market discipline of self-correction. This policy has been particularly damaging because the financial industry underpins the rest of the economy. Financiers determine which industries, which companies, and which individuals get investment capital, and on what terms. A distorting government hand in finance reaches past Wall Street into every industry and community in America and beyond.

A decade before Lewis landed at Salomon, Wall Street was already becoming proficient in bailouts. In 1975, the City of New York looked close to defaulting on its municipal bonds, as Charles Gasparino, now a Fox Business reporter, recalls in The Sellout: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System. But a young bond salesman named Jimmy Cayne—the pot-smoking, bridge-playing future CEO of Bear Stearns—didn’t think his city would walk away from its debt. Cayne bought tens of millions of dollars’ worth of New York’s bonds from panicked investors, who were selling them for pennies on the dollar. When the state and the feds came through with a rescue, Cayne had made a “small fortune” for his firm. It was a great trade. But Gasparino fails to mention the most fateful part of the tale: Cayne undoubtedly absorbed the lesson that the federal government, fearful of the disruptive consequences, would not let big borrowers default. He was among the first to bet on bailouts.

Over the next decade or so, the lesson would be repeated, with financial firms becoming the borrowers considered “too big to fail.” In the early eighties, Washington bailed out lenders to the Continental Illinois bank. Later that decade and into the next, it rescued the bondholders of big savings-and-loan banks. As lenders to the financial industry grew comfortable, realizing that their money wasn’t at risk, and as interest rates and inflation plummeted, the banks and investment houses could borrow more, earning ever-fatter profits. Wall Street could help old-fashioned banks lend more to consumers, too, by transforming debt into tradable securities and getting it off small banks’ books quickly. Financiers became more and more creative, eventually threading untenable debt levels through the economy by using “exotic” debt derivatives—financial instruments whose value derived from the value of certain debt securities. These instruments were exotic only in that they escaped Depression-era rules limiting borrowing (so as to protect the greater economy from mass financial bankruptcy) and enforcing public trading of securities (so that everyone could see what was going on).

The problem wasn’t “Wall Street greed,” the first culprit implicated in Gasparino’s subtitle, but “government mismanagement,” the second. Finance was responding rationally to the government’s signal. That signal got stronger in 1998, when the Federal Reserve forced the nation’s big banks to rescue lenders to the Long-Term Capital Management hedge fund, which had relied on unregulated derivatives to make more than $1 trillion in promises to the rest of the financial system. The Fed stepped in because the hedge fund’s failure could have bankrupted two of its creditors, Lehman Brothers and Merrill Lynch, with their bankruptcy, in turn, bankrupting others. If the Fed had failed to avert the panic, “middle America” would have learned “the definition of systemic risk,” Gasparino writes. “The acute pain of systemic risk was certainly avoided, but so was a valuable lesson: that risk taking should have consequences.”

Wall Street easily converted its permanent subsidy into hard cash. The growth and consolidation of the financial sector over the last 20 years have been dizzying, note Simon Johnson, an MIT entrepreneurship professor, and James Kwak, a former McKinsey consultant, in 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. In 1985, Salomon Brothers boasted $122 billion in assets (in today’s dollars); by 2008, Goldman Sachs had amassed $890 billion. In 1985, Salomon chief John Gutfreund took home $5.8 million (also in today’s dollars); in 2007, Goldman Sachs CEO Lloyd Blankfein pulled in $54 million.

Not content with removing discipline from its own financial markets, America exported its “too big to fail” policy to the rest of the world. England’s version of Wall Street, the City of London, was more than happy to trade and structure the mountains of debt that the U.S. government’s backing enabled banks to issue. As former banker Philip Augar writes in Reckless: The Rise and Fall of the City, after the mid-nineties, “the perception that the U.S. central bank would bail out markets whenever necessary” helped propel the City to new heights.

The City got creative, too, turning American mortgage-backed debt into fodder for credit derivatives and “structured investment vehicles.” As the City, Wall Street’s chief competitor, gained market share, the fear that America would lose more of this lucrative business to London was another reason for regulators here to tolerate untenable risks. In failing to govern new derivatives markets with clear rules, regulators let financial engineers multiply many times over the danger that housing debt posed to the economy.

America also imported the developing world’s bad habits. Throughout the mid-nineties, the West had lent so much money to big, politically connected Asian industrial firms, particularly in South Korea, that the borrowers could never reasonably repay it. Global lenders had assumed that Asia’s political-corporate giants “were too important for the government[s] to let them go bankrupt,” Johnson and Kwak explain. The lenders proved correct in 1997 and 1998, when the Asian countries secured loans from the International Monetary Fund and rescued Western creditors with part of the money. The bailed-out lenders learned a dangerous lesson: “It’s always best to invest in the firms with the most political power.”

In America, Wall Street’s political power derived from a very different source, Johnson and Kwak continue: its “ability to wrap itself in the ideology of homeownership.” That brings us to Fannie Mae and Freddie Mac, America’s two home-mortgage giants—nominally private companies that nevertheless “met virtually nobody’s definition of firms in a free market,” economist Thomas Sowell writes in The Housing Boom and Bust. Fannie and Freddie enjoyed implicit government backing, meaning that they could borrow cheaply and use the money both to guarantee mortgages against default and to buy massive portfolios of mortgage securities from lenders, so lenders could then issue even more mortgages. Policymakers endorsed this system because it made people feel richer. Americans could buy homes that they couldn’t have afforded otherwise and then watch the values rise.

The government directed housing policy not by bald bureaucratic pronouncement but through financial markets. Presidents Bill Clinton and George W. Bush both had faith that markets could magically achieve government goals, with zero pain to the taxpayer and plenty of profit for the private sector. Back in the early eighties, pioneering bond guys at Salomon and Merrill Lynch, discerning that a wave of baby boomers equaled more demand for middle-class housing, had joined forces with Fannie and Freddie to churn out housing-backed bonds for the purpose, Gasparino writes. Clinton, a New Democrat who believed that “the business community could help achieve the aims of government,” later applied the same logic to the poor, asking Fannie and Freddie to buy more mortgages for affordable housing.

Fannie and Freddie helped distend a housing market that couldn’t withstand the slightest downturn. Housing, then, posed an ever-bigger danger to the economy. But regulators failed to do obvious things like requiring even modest down payments to cushion possible losses, since doing so would have made housing less “affordable” in the short term. As Sowell makes clear in detailing a century’s worth of “affordable” housing policies—from the construction of the first public-housing towers in the early 1900s to the ever-growing lending quotas that banks had to meet under the 1977 Community Reinvestment Act—making housing less “affordable” would have gone against every natural instinct of nearly every politician, not just in Washington but in states and cities, too (see “Obsessive Housing Disorder,” Spring 2009).

By the mid-2000s, the Wall Street firms that had so long worked with Fannie and Freddie decided that they could cut out the two lumbering middlemen and keep the profits for themselves. Banks issued mortgages without Fannie or Freddie guarantees and sold securities backed by the mortgages directly to international investors. For many critics, that’s evidence that free markets caused the crisis. The true problem was just the opposite—that financiers had grown accustomed to a quarter-century’s worth of risk-free, government-encouraged mortgage lending.

Meanwhile, free-market forces, hobbled though they were by governmental meddling, were trying hard to tell the world that the government’s economic-development policy—supporting ever-growing financial firms to serve as conduits of debt to overextended American home buyers—wasn’t working. The great thing about markets is that you don’t need special access to see the truth. The hedge-fund managers whom Lewis describes in The Big Short had nothing but information and analysis on their side.

Take Michael Burry, manager of the Scion Capital hedge fund. Burry knew as early as 2003, as he wrote in an e-mail then, that the consequences of a lending drought “could very easily be a 50 percent drop in residential real estate” with “collateral damage likely orders of magnitude worse than anyone now considers.” Burry has Asperger’s syndrome, an autism-spectrum disorder that makes him prefer reading to talking. He scrutinized the thousands of pages of required disclosures that mortgage-securities salesmen had to produce, and as the 2000s advanced, he realized that loan quality had declined. From 2004 to 2005, in one sampling, borrowers’ credit scores had remained the same, but they were taking out riskier mortgages. The percentage of teaser-rate mortgages had quadrupled in a single year.

Over at another fund, a unit of the Morgan Stanley–backed FrontPoint Partners, Steve Eisman took a different approach and came to the same conclusion. Eisman knew that in the nineties, smaller predecessors to the subprime-lending industry had gone bankrupt after lending too much, too fast, too cheaply, often obscuring to their customers what the true costs would be a few years down the road. Now he saw the same thing happening again. This time, however, the enablers weren’t small-enough-to-fail firms; they were the giant Wall Street banks, which were packaging up the mortgages into securities, both to sell globally and to trade on their own books. Eisman’s colleague Vincent Daniel smelled trouble: nearly two decades earlier, he had quit his job as a junior Arthur Andersen accountant after finding it impossible to audit an investment bank’s books.

So the hedge-fund guys decided to bet against the gargantuan housing and finance businesses. They bought credit derivatives—unregulated financial instruments that would pay more and more as the value of a particular group of mortgage securities fell. The investors had no difficulty in getting Wall Street to sell them these derivatives. Burry, for one, was surprised that Deutsche Bank and Goldman Sachs, in early 2005, seemed unconcerned as he pored through lists of mortgage securities, trying to “cherry-pick the absolute worst ones” and amassing hundreds of millions of dollars in potential payoffs.

What did give the hedge-fund guys a hard time was the feds’ failure to maintain free-market infrastructure. The government didn’t require a fair, transparent trading exchange—as it requires for stocks and options—for mortgage bonds and their derivatives. So unlike the prices of stocks, the prices of mortgage bonds and their derivatives weren’t “determined by an open and free market,” Lewis writes. They were “determined by Goldman Sachs and Bank of America and Morgan Stanley, who decided each day whether Mike Burry’s credit default swaps had made or lost money.” The investors feared that when the mortgages went bust, the banks would wriggle out of their obligation to pay up. And for a while, the banks did use their discretion to claim that the price of the mortgage bonds was rising, which allowed them to avoid paying the hedge-funders until news of losses on similar investments became too insistent to ignore.

The investors also had to account for the government’s seemingly random decisions about who would get a bailout. By mid-2007, one small money-management outfit, Cornwall Capital, had bought hundreds of millions of dollars’ worth of credit derivatives that would pay off if mortgage values fell. But Cornwall had bought much of the protection from Bear Stearns, and that summer, two of Bear’s own hedge funds went belly-up because of mortgage losses. Realizing that Bear could likewise go bankrupt and fail to pay up on the derivatives, Cornwall quickly sold them to another bank, the Swiss giant UBS. UBS expressed not “the faintest reservations that they were now assuming the risk that Bear Stearns might fail,” Lewis writes. Why not? UBS likely understood the politics and figured that the U.S. government would keep Bear from collapsing. As it turned out, UBS was right, and Cornwall could have safely kept the derivatives. But if Cornwall had bought them from, say, Lehman—which the government decided not to bail out—they would have been worthless.

In the end, the market realized—with explosive consequences—that the hedge-fund managers were correct about the value of mortgage bonds. Remember Eisman’s complaint about the absence of an “authority” to check the excesses of the market? That authority was Eisman himself. He, his colleagues, and his competitors took on the twin pillars of stealthy central planning in America’s economy: our too-big-to-fail financial system and our government policy of universal homeownership. And they won.

In the late summer and autumn of 2008, the Treasury Department and the Federal Reserve embarked upon the deepest interventions in the (nominally) private sector that America had ever seen. Overseeing the Treasury was Hank Paulson, the former Goldman chief, who in his recent book, On The Brink: Inside the Race to Stop the Collapse of the Global Financial System, comes across as a decent man thrust into an unwinnable position. Paulson writes—in the passive voice, tellingly—that in September and October 2008, he “had been forced to do things I did not believe in to save what I did believe in.” But decent men are no substitute for consistent rules that mark a clear line between the public and private sectors. As Paulson’s book, along with New York Times reporter Andrew Ross Sorkin’s Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves, makes clear, rules and lines vanished altogether in autumn 2008—and Washington’s arbitrary actions back then created precedents that now seem certain to lead to the next crisis.

That autumn was a watershed. The Treasury and the Fed spent the first weekend of September bailing out Fannie’s and Freddie’s creditors by nationalizing both behemoths. In the second weekend, the government refused to bail out creditors to Lehman Brothers. After Lehman’s collapse cratered the financial system, the Treasury and the Fed concocted the most complex bailout in history to save insurer AIG’s creditors, including banks owed tens of billions of dollars on mortgage-related credit derivatives. And in early October, Congress passed the Troubled Asset Relief Program (TARP). Using TARP’s authority and other measures, Paulson, along with the FDIC and the Fed, forcibly injected capital into the nation’s biggest banks. The government also guaranteed new debt issued by banks’ corporate holding companies, thus encouraging investors worldwide to buy it, which helped the banks and investment firms pay off their panicked short-term lenders.

TARP’s forced capital injections sought to thwart the markets’ distinguishing between good banks and bad. It had long been clear, as New York Times Magazine writer Roger Lowenstein shows in The End of Wall Street, that Citigroup’s executives were far less competent than, say, JPMorgan Chase’s. In late 2006, while Citigroup continued to lend freely, JPMorgan chief Jamie Dimon noticed that people had stopped paying their mortgages even as they paid other debt. Dimon told his employees to “sell or hedge” some of their exposure to mortgage and other debt, and in his annual report, he soberly projected losses, saying that his intention was not to worry shareholders but to prepare them. Meantime, in his annual report, Citigroup chief Charles Prince devoted “precisely two sentences to credit markets,” which he said could suffer only “moderate deterioration,” Lowenstein notes.

Since the crisis started, markets have easily distinguished between the well-managed JPMorgan Chase and the too-big-to-manage Citigroup. But the Citi bailout has kept the economy from benefiting enough from that distinction. To this day, investors continue to direct capital to Citigroup, knowing that the government will never let it fail. The economy could put that capital to better use elsewhere—in a superior bank, or a company outside finance altogether.

Similarly deep differences existed among investment banks—differences that bailouts muted but couldn’t obliterate. Bear Stearns, for example, relied dangerously on short-term funding markets, which left it acutely vulnerable to a panic. Conversely, Goldman Sachs was obsessed with having cash on hand for an emergency. “To be on the safe side, we kept a lockbox at the Bank of New York filled with bonds that we never invested or lent out,” Paulson remembers of his Goldman days. “Knowing we had that cushion helped me sleep at night.”

The extent to which government threw away the rule of law in 2008 was shocking. Paulson kicks his book off with a description of his forced nationalization of Fannie and Freddie, observing that his subordinates’ concern—that the politically coddled mortgage giants would fight the effort—was groundless: “I didn’t think they completely recognized the awesome power of government and what it would mean for Ben [Bernanke, the Federal Reserve chairman] and me to sit across from the boards of Fannie Mae and Freddie Mac and tell them what we thought was necessary for them to do.” Paulson instinctively used threats in his meeting with the two companies’ management. If they resigned and handed over the reins quietly, he told Fannie’s and Freddie’s executives, he wouldn’t blame them for the firms’ failure. “I left unspoken what I would say publicly if they didn’t acquiesce.”

Using government might to bully two nominally private firms makes it easier to do the same to others. As the crisis intensified in 2008, the government threw companies together in shotgun marriages, even as the firms sometimes resisted. Tim Geithner, then the president of the New York Fed, tried to force Jamie Dimon to merge JPMorgan with the flailing Morgan Stanley; Dimon repeatedly had to ward off Geithner and his colleagues with firm noes. On another occasion, Geithner “insisted” that Goldman’s Lloyd Blankfein call Citigroup chief Vikram Pandit to launch a merger. Blankfein was “shocked at the directness of the request,” Sorkin writes. Thanks to management resistance, the craziest of these mergers—Goldman and Citi—never happened.

But the result of all the “successful” deals is an even more concentrated and hard-to-manage financial industry, made up of firms immune to market discipline because the economy can’t withstand their failure. Consider Bank of America’s purchase of Merrill Lynch. In December 2008, Bank of America head Ken Lewis came to Paulson, threatening to back out of the deal as Merrill Lynch’s losses piled up. Paulson asserted that such a decision could, in the government’s eyes, represent a catastrophic error in judgment—one that would justify the Federal Reserve in removing Bank of America’s management. (Lewis, for his part, probably made his threat in order to secure more bailout money; it isn’t good for the nation that financial executives have tried to hone their skill at gaming their arbitrary political overlords.)

It was Blankfein who best voiced the danger of the government’s actions. During that second week in September, the Treasury and the Fed sought to avert the Lehman bankruptcy by forcing the firm’s competitors to purchase its worst assets and then getting Britain’s Barclays Capital to buy the rest. “We must be responsible for our own balance sheet and now we’re responsible for others?” Blankfein objected at the gathering of bank chiefs that Paulson and Geithner had convened. Blankfein’s argument “had to trouble every free-marketer in the room,” Paulson muses. “Potential investors assessing any bank’s balance sheets would have to consider . . . whether it had properly accounted for the risk that it might have to bail out any one of its competitors.” But at the time, Paulson—who had once helped Goldman amass that big cash cushion to protect it from the unforeseeable—had no problem asking Goldman to endanger it to blunt the impact of a competing firm’s failure to do the same. Even aside from their unfairness, such government-arranged rescues of the weak by the strong injure the best-managed companies, thus hurting the economy.

It’s appalling, too, that Bush staffers toyed with the idea of asking the president to call Chinese leader Hu Jintao in order to arrange an investment in Morgan Stanley by a Chinese-owned financial firm. In Paulson’s plan, Bush would make clear to Hu that if the Chinese company invested, America would make sure that it wouldn’t lose its money. Paulson recalls that “any such contact would have to be set up carefully, because the president of the United States should not appear to directly ask the president of China to invest in a U.S. institution.” Indeed.

Washington’s extraordinary actions are now precedent, most of the authors agree. What was once a “vague expectation” that government would rescue financial firms in a crisis is now “a virtual certainty,” Johnson and Kwak write. Nouriel Roubini, the New York University professor who famously saw the disaster early, and Stephen Mihm, a history professor at the University of Georgia, note in Crisis Economics: A Crash Course in the Future of Finance that “the Fed has sent a clear message to the financial markets that it will do almost anything and everything to prevent a financial crisis from spinning out of control.” Says Lowenstein: “Wall Street institutions emerged from the crisis more protected than ever.” Even the one exception to “too big to fail” seems to prove the new rule: it’s now conventional wisdom in Washington that letting Lehman collapse was a mistake.

Federal officials are egotistical and short-termist enough to think that today’s pronouncements—No more bailouts, and this time we mean it!—matter more than yesterday’s actions. Paulson offers a few accidental laughs in this respect. When he was trying to strong-arm competing financial firms into bailing out Lehman, he recalls, he told executives and the press that “there could be no government money involved in any rescue. I knew that unless I explicitly said this, some of them might think that Good Old Hank would come to the rescue.” And in the case of Lehman, he was telling the truth. But why should the bankers have believed him when a quarter-century’s worth of precedent, including a bailout of Fannie’s and Freddie’s bondholders just a week earlier, contradicted him—and when, two days later, the government bailed out AIG?

What Washington has created, then, is best summed up in Johnson and Kwak’s title. The “13 bankers” are the CEOs of the surviving big banks, whom President Obama summoned to the White House just weeks after his inauguration. Obama had convened the bankers to show the public that he was firmly in command of the institutions that the government had rescued. But what markets perceived was protection. “It was clear that the thirteen bankers needed the government,” Johnson and Kwak write. “But why did the government need the bankers?” In pumping trillions of dollars in cash and guarantees into the financial system without demanding change, Johnson and Kwak say, we risk creating a “uniquely American oligarchy”—one that will harm America’s growth, just as similar oligarchies have harmed other nations’ growth throughout history.

The financial fixes that Congress seems about to pass as City Journal goes to press would further entrench this oligarchy and institutionalize Washington’s 2008 powers. Consider the creation of a “financial stability oversight council,” a centerpiece of the new financial-regulatory reform bill. The council would supposedly end “too big to fail” by preventing failure in the first place. But markets will know that this is impossible. A stability overseer can’t predict the future any better than other Washington bureaucracies could. As Paulson admits about his first Camp David meeting with President Bush in 2006, “notably absent from my presentation was any mention of problems in housing or mortgages.” This omission came at a time when the hedge-fund guys whom Lewis chronicles were largely done making their bets against the mortgage market. Couldn’t the council just listen to guys like Mike Burry? Impossible: Washington groupthinkers are never ever going to take advice from people who don’t spout the conventional wisdom.

Congress also seems oblivious to the fact that, throughout history, financial crises have come about because of two factors: too much debt and too much hidden risk. That’s why Roubini and Mihm rightly call for a “robust set of simple rules”—not coincidentally, largely the same ones that governed finance from the thirties through the eighties, when financial crises were rarer and milder than today—to prevent future crises. Forcing credit derivatives onto stock-market-style public exchanges and limiting borrowing across financial firms and instruments “should be absolute and should be applied across the board,” they say, with heavy borrowing restrictions and disclosure requirements for any “customized” derivatives. In fact, they would go even further, separating commercial and investment banks to break “too-big-to-fail” giants into smaller units that pose less risk to the economy. Not even the more modest of these steps, however, is in the congressional bill.

Somewhere, small-time money managers are making bets against the new conventional wisdom, just as they bet against the government’s housing-and-banking monolith half a decade ago. But it’s harder now. Banks can borrow at the Federal Reserve’s zero-percent interest rates, artificially inflating asset prices. The Fed itself has bought a trillion dollars’ worth of mortgages, keeping securities and home prices too high. Washington has let banks carry overvalued securities on their books, delaying necessary price corrections to jump-start the real market. The too-big-to-fail financial firms, thanks to mergers encouraged by the government, are bigger and more powerful than ever, with just five banks controlling nearly all of the credit-derivatives market, meaning that they can delay the results of their future mistakes for longer. Investors can’t analyze just markets and companies any more; they also have to figure out what arbitrary moves the government will make. And as Wall Street and Washington both depend increasingly on the issuance of cheap government debt, the two partners have an even bigger incentive to warp the free-market infrastructure so that dissenting voices have a harder time getting vital information across to the economy.

Most American politicians would laugh at solutions like the ones that French economist Jacques Attali proposes in his book After the Crisis: How Did This Happen? Attali would like to see “a Keynesian state on a global level” that would “set up supranational regulation and governance” and “launch great worldwide projects aimed at reorientating growth” toward government-approved projects. Central planning? How un-American!

Yet to some degree, we’ve already been following this path for decades: deficit spending and willfully “orientating” growth toward the housing and financial sectors, expanding on John Maynard Keynes’s suggestions that government control demand. America’s pols should be honest about what their fixes and non-fixes amount to: yet more central planning, which jeopardizes our sovereign credit, endangers the Western world’s ability to grow its way out of a crippling recession, and makes it even harder for free markets to fight government mistakes.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst and the author of After the Fall: Saving Capitalism from Wall Street—and Washington.

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