Paul Krugman, the Nobel Prize winning economist, has blamed lax regulation for the financial crisis. He said that unless there is an agency that has the sole responsibility of protecting consumers, we will not be immune from similar crises in future.
Krugman cited a paper from Irish economists that compared the crises in the U.S. and Ireland to draw parallels between the two and understand what common factors triggered the economic meltdown. The paper showed that unlike what some people seem to believe, the crisis was not caused by exotic financial derivatives or the greed of investment banks. Instead, it blamed simpler reasons like consumer exuberance and executive incentives for the problems.
A major reason of the real estate bubble, the paper said, was that there was irrational exuberance among the consumers. Although real estate prices were already at their historical highs, people refused to believe that prices could fall significantly. This led to continued demand for property, further inflating the bubble. And when the nasty price shocks came, most people were taken by a surprise. At the same time, there was too much cheap money in the system. The interest rates were low, and the Chinese were practically funding U.S. consumer demand by buying treasury bonds.
The paper also highlighted the fact that most bank executives had no incentive to be risk averse. When things were good, they made huge bonuses, and when things went horribly wrong, they still got their bonuses – though a little lesser than before. It meant that there was no penalty for making bad decisions, while if their actions were proved right, they could take home astronomical amounts.
However, the most important reason that the paper cited, was that there was no one looking after the consumers. There is currently no central consumer protection body to oversee the acts of large banks. The Fed is supposed to keep a check on the system, but it already has too many other responsibilities like interest rate decisions. Krugman argued that it is very important to have such an agency that has only one responsibility – to look after the interests of the consumers.
The need for a consumer protection agency has also been felt by the Obama administration, which had initially showed some intent of bringing in legislation for its creation. But with constant opposition from some lawmakers, especially from the Republicans, those proposals seem to have been nipped in the bud.
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