Much more to the credit crunch than sub-prime loans

There's a review of two different books on the credit crash in the April 28th edition of Business Week magazine: "The Trillion Dollar Meltdown" and "Bad Money." Both books posit that the credit crash is due more to the excess power of Wall Street and the financial community than sub-prime loans, which were merely a symptom of a style of free-market capitalism that got out of control. So what will the consequences be? Certainly some pain -- but not until those in power admit the extend of the problem. From the BusinessWeek website:

Are you confused about how so much American debt could vaporize so fast, threatening to take down the global financial system? Are you wondering what should be done to prevent another systemic crisis in the markets? Are you puzzled over what it all means? Two recent books offer answers to these vital questions. Both place the credit crash in historical context. Each author believes Wall Street and the financial community have far too much power. More controversially, both argue the fallout will result in a dramatic transformation of the U.S. economy. The Trillion Dollar Meltdown by Charles R. Morris deserves a spot on any bedside reading table. Morris, a former banker and sometime writer for The Atlantic Monthly, more than accomplishes his stated goal of telling his story "briefly and crisply." For instance, he manages to make clear both the mechanics of slicing and dicing collateralized debt obligations (CDOs) and why these and similar securitized credits and derivative securities went spectacularly bust. Bad Money by political analyst and author Kevin Phillips is more ambitious, tracing the current "global crisis of American capitalism" to the politics of peak oil, the rise of financial mercantilism, the triumph of market fundamentalism, and even the spread of religious conservatism...

Morris puts to rest any lingering notion that the credit crisis reflects merely an inflated housing market, let alone a simple subprime problem. He estimates that writedowns and defaults of residential mortgages, commercial mortgages, junk bonds, leveraged loans, credit cards, and complex securitized bonds could reach $1 trillion. (The International Monetary Fund recently picked that number for the global write-off.) The figure could double or triple should there be widespread market panic. Little wonder that the Federal Reserve Board has been working so hard to stave off financial contagion...

In essence, Morris traces America's credit madness to the rise of Chicago School free-market capitalism, best represented in the work of late Nobel laureate Milton Friedman. That ideology supplanted Keynesian liberalism, which gave government a key role in achieving low inflation, low unemployment, and fast economic growth...

Now, though, he believes Chicago free-market ideology is washed up, like Keynesian liberalism before it. "The current conservative, free-market cycle...seems to have long since foundered in the oily seas of gross excess," writes Morris.

Beneath the free-market paradigm, three trends conspired to create the great credit bubble. First, residential mortgages, leveraged buyouts, and other loans gravitated away from banks to global capital markets. Second, the securitization of everything meant that lenders ceased to care whether loans were good or not; they thought only about pocketing enormous fees. Third, portfolio managers' increased reliance upon quantification left them with a flawed image of reality—artificially tidy and apparently risk-free. A final culprit: former Fed Chairman Alan Greenspan, whom Morris faults for cheerleading the deregulated financial markets, allowing easy money to flourish, and failing to disabuse Wall Street of the notion that the Fed will always bail out the financial markets...

He also takes a stab at what might come next: a long-term decline of the U.S. economy, especially if political leaders and financial elites try to mask how deep the credit crisis runs. However, Morris holds out hope that better days lie ahead if elites exercise leadership in the mode of '80s Fed Chairman Paul Volcker, who slew inflation and restored trust to the U.S. economy. Nevertheless, Morris anticipates a nerve-wracking denouement...

The debate about the political significance and economic implications of the credit crash are just beginning. To varying degrees, these books stake out the arguments for returning to a world where finance serves society rather than the other way around.