Nothing about this crisis is really a surprise. People have been warning about it for more than a decade, in academic studies, official reports, Wall Street analyses, even op-ed pieces. Our smartest financiers, Warren Buffett and George Soros, saw it coming clear as a bell.
This failure is especially clear in the case of three prominent people who are shaping the response to the crisis now: They saw the dangers building but failed to take decisive action -- for fear that a new financial architecture would frighten the markets.
The three who saw it coming are Robert Rubin, the treasury secretary during the Clinton administration; Lawrence Summers, Rubin's successor at Treasury and Barack Obama's chief economic adviser; and Timothy Geithner, who served under Rubin and Summers, then headed the New York Federal Reserve and now runs Treasury.
First, Rubin: During the boom years of the 1990s, he was deeply worried about the risk of systemic failure in the financial markets. He was especially nervous about derivatives, the exotic financial instruments that were being created willy-nilly on Wall Street. Rubin hadn't run Goldman Sachs that way, and he feared the new crowd was taking risks they didn't understand. In the event of a crisis, would the window of transactions be wide enough to maintain orderly markets? Or would liquidity simply disappear?
Rubin pinpointed all the right issues. And yet when pressed in interviews about a new financial architecture to reduce these systemic risks, he would shy away like a skittish colt. Famously, he balked at the recommendation of Brooksley Born to regulate derivatives at the Commodities Futures Trading Commission
The paradox is that many reforms of those years have actually made things worse, by building in pro-cyclical forces that accentuate the downturn. This was true with the so-called "Basel II" capital standards. By requiring banks to maintain high reserves during crises, it forced them to sell assets into a falling market, compounding the downward pressure.
Other reforms had similar unintended consequences. The mark-to-market rules adopted by the accounting profession had the perverse effect of forcing banks to write down their portfolios daily as the market for securitized assets collapsed. These "marks" were often imaginary, since there was no real market. But banks had to take huge write-offs anyway, accelerating the death spiral.