Get ready for the next 'Great Crash'

(Courtesy :New York Times, Jun 30, 2010, 03.02pm IST)

The next Great Crash is coming. Guaranteed. Maybe not today and maybe not tomorrow. But, in all likelihood, sooner than we think.

How can I be so sure? Because the history of modern markets is a story of meltdowns. The stock market crashed in 1987, the bond market in 1994. Mexico tanked in 1994, East Asia in 1997. Long-Term Capital Management blew up in 1998, Russia that same year. Dot-coms dotbombed in 2000. In 2007 — well, you know the rest.

And that was just the last 20 years or so. The stagflation of the 1970s, the Depression of the 1930s, the panics in the 1900s ... and back and back and back it goes, all the way to the Dutch and their tulip bulbs.

In those giddy years before the Great Recession, it seemed as if we’d grown accustomed to the wild ride. Wall Street certainly had. Jamie Dimon , the chairman and chief executive of JPMorgan Chase likes to say when his daughter came home from school one day and asked what a financial crisis was, he told her: ”It’s the kind of thing that happens every 5-7 years.”

No one should be surprised, Dimon insists, that booms go bust. That’s the way markets work. Most Americans probably find that answer unsatisfying to put it politely. After all, millions have lost their homes, their jobs, their savings. Perhaps something is wrong if CEOs expect the markets to break down every half decade or so.

But now here comes the Dodd-Frank Act, which is supposed to ensure that we never repeat that 2008 finale of Wall Street Gone Wild. The bill, if signed into law, might help us avoid another sorry episode like that. But one thing it won’t do is prevent another crisis — if only because the next one probably won’t be like the last one.

So amid all the back-and-forth over this bill, keep in mind that one of the most important aspects of the act: It would give Washington policy makers a powerful tool to mitigate the next too-big-to-fail blow-up, however that blow-up manifests itself.

For the first time, Washington would have what is known as resolution authority, that is, the power to wind down a giant financial institution that runs into trouble.

If policymakers had had that power during the tumultuous autumn of 2008, they might have averted the catastrophic failure of Lehman Brothers. They might have placed the teetering American International Group into conservatorship. And they might have taken over Bank of America and Citigroup, and possibly even Goldman Sachs and Morgan Stanley. Senior management would have been tossed out.

“We will have a financial crisis again — it’s just a question of the frequency,” said the economist Kenneth Rogoff, who, with Carmen M Reinhart, wrote a terrific book titled ‘This Time Is Different: Eight Centuries of Financial Folly’. The title says it all. We’ve been through this before and will go through it again.

While Dodd-Frank might avert another crisis in the short term, Rogoff says the legislation itself is less important than how regulators implement it — and keep on implementing it over the years. Before World War II, “banking crises were epidemic,” Rogoff said. Then things settled down because “regulation had become pretty draconian” and laws were actually enforced.

But memories fade. “Having a deep financial crisis is the best vaccination for another right away,” Rogoff said. Down the road, a lot will depend on the regulators. Ten or 15 years after a crisis, and sometimes a lot less, watchdogs start to doze. Political winds change. Regulators loosen up.

Many on Capitol Hill insist Dodd-Frank means the end of too big to fail, period. Many on Wall Street insist it means the end of American finance. Bankers and their lobbyists argue that American businesses and consumers will ultimately suffer, since all these rules will end up throttling the vital flow of credit through the economy.

Dodd-Frank, whatever its pros and cons, helps prepare us for the next Big One — whatever that might be.