A year ago, the fall of Lehman Brothers marked the end of Wall Street. Fundamental reform was just around the corner. … Or so we thought. One year later, Wall Street has been reconstituted, refinanced, and refurbished. The biggest bull rally in history has followed swiftly on the heels of its greatest collapse. Top traders are still pulling in nine-figure salaries, and top banks are back to record-breaking profits. Why?
Part of the answer is that we went from a world in which regulators and politicians refused to see systemic risk to one where all they see is systemic risk. As a consequence, the lesson of Lehman was that not only are some banks “too big to fail” — we also found out that the system as a whole is “too big to bail.” This subtle change lies at the heart of our current regulatory climb-down.
Since Lehman’s collapse, rather than making the world safe from financial firms, we’ve made the world safer for them by socializing the risk and privatizing the profits. Governments in highly financialized economies like the United States and Britain prioritized shoring up financial firms rather than regulating them, turning Wall Street into something like a big inflatable bouncy castle for the kids — where they can bounce higher and harder than ever before, with the guarantee that the government will keep the whole thing inflated. How did we get here?
Part of the blame rests with the influence of three persistent, flawed ideas about markets. First is the “microfoundations critique”: Truths about aggregates must be ground in truths about individuals. As such, the financial system has no identity apart from the sum of its parts. Second is the “efficient-market hypothesis”: Prices of publicly traded assets like stocks reflect all known information — a theory mistakenly treated as a rule. Third is the proposition that investors have “rational expectations”: That is, investors use information efficiently so that while individual investors may make mistakes, the market as a whole tends to an optimum. Thus, the market price is by definition right.
These ideas, taken together, managed to convince governments and financial firms that regulation was part of the problem rather than part of the solution.