What the Public Understands – and What it Can’t

Some defects in our financial system are easy to grasp.  Paying excessive salaries and bonuses to those who made disastrous mistakes is something the public understands very well.  Being deemed “too big to fail” is also pretty obvious, as it entitles some firms to unearned insurance at taxpayer expense.  But how to cure the excesses that produced our financial meltdown – that’s another matter.

In Sunday’s New York Times, Gretchen Morgenson noted that according to some acute observers, Washington’s moves to cut executive pay was “tinkering around the edges and did nothing to prevent another disaster.”  She added, it “looks like a way for the government to reassure an angry public that they are making genuine changes. But compensation is a trifling matter compared to, say, true reform of derivatives trading.”

She quoted Michael Greenberger, a law professor at the University of Maryland: “In essence, the compensation problems, as bad as they are, are a sideshow to the casino-like nature of the economy as it existed.”  (See “Wall Street Follies: The Next Act.”)

We all understand bigness and unfair competition, or greed and exploitation.  But what about derivatives and credit default swaps?  How many of us understand asset pricing and the risks of leveraging?   The risks were taken with our money, but most of us don’t really understand what happened.  And in the absence of public understanding and pressure for change, change is not likely.

Morgenson went on to quote Neil Barofsky, special inspector general of Treasury’s Troubled Asset Relief Program.  Asked on CNN last week about changes that could prevent another financial disaster, he said he saw thing moving in the other direction: “These banks that were too big to fail, are now bigger. Government has sponsored and supported several mergers that made them larger….  The idea that the government is not going to let these banks fail, which was implicit a year ago, its now explicit.”

As a result, he concluded: “Potentially, we could be in more danger now than we were a year ago.”

So who is trying to convey to the public the “casino-like nature of the economy”?  I don’t think we all need to understand what a derivative actually is, but we need some concepts and metaphors to bring home to us what we don’t know we know about the extravagant risks the high-flyers took with our money.  “Casino” might be a good place to start.