Learning Lessons the Hard Way

Here's an article by Robert Schiller in the Washington Post that is well worth reading. The four key points are:

The current crisis offers us a singular opportunity to reevaluate fundamentally the safety and permanence of the master financial institutions that we have come to take for granted...

1. Handle moral hazard better. The term "moral hazard" refers to the pernicious tendency some people have of failing deliberately if they think it's advantageous to do so. Moral hazard is used to justify teaching people a lesson for their failures... the meaning of a contract.

By rescuing Wall Street tycoons who succumbed to the lure of an irrationally exuberant housing bubble, the bailouts today do pose something of a moral-hazard problem. But we can more than repair it by defining a new generation of financial contracts ... reflecting greater enlightenment, greater understanding of human psychology and the means to deal with financial failure. ...

2. To limit risks to the system, build better derivatives. Some of today's derivatives ... turned out to be "financial weapons of mass destruction,"... The problem isn't derivatives per se but a certain kind... Some kinds of derivatives, such as those maintained by futures exchanges using procedures that effectively eliminate the risk that the other party in the agreement will default, are more useful -- and far safer -- than others. It is high time to redesign derivatives...

3. Trust markets, not Wall Street titans. If institutions can be said to have charisma, such giants as Lehman Brothers and Merrill Lynch certainly had it in spades. But these firms proved not to be the sole source of financial intelligence. They were merely meeting places for smart, financially savvy people -- and for some reckless folks besides. We need to learn to trust people and markets rather than institutions...

4. Ideas matter. Maybe next time, we will listen more closely to financial theorists who think in abstract, general terms. Consider the Long-Term Capital Management debacle in 1998... Lots of people hold that the moral of the LCTM story was the failed thinking of two of the firm's founders, Robert Merton and Myron Scholes, both of whom were Nobel Prize-winning financial theorists. In fact, the collapse of LTCM was largely due to the overconfidence of bond trader John Meriwether and some of his other LTCM colleagues, who were gambling in the markets. The disgraced Merton has been working for the last decade trying to build better risk-management systems, mostly to little avail. Maybe he will be heard now. People still seem to want to trust businessmen who have made bundles and have a huge investment bank behind them, rather than listen to experts who are thinking about the fundamentals of risk management. We would have been better off this month if we'd been ignoring the former and listening to the latter. ...

If we move smartly, Americans can have a better, more robust financial democracy.... The current crisis does not mean the end of American capitalism. But if we are lucky, it will mean an important step in its evolution.