Robert Reich: Government Needs to Rebuild Trust in the Markets

Wall Street's biggest problem right now is the collapse of trust, Robert Reich writes.

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While it's true that Hank Paulson didn't give Wall Street what it wanted to sweeten any potential takeover of Lehman Brothers—a guarantee akin to what Fannie, Freddie, and J.P. Morgan got when Morgan bought Bear Stearns—Wall Street's big banks continue to have access to the Fed's discount window, previously reserved for commercial banks. And because investment banks aren't regulated like commercial banks, that means they continue to get a free ride.

We're witnessing the most ambitious intrusion of government into the market in almost anyone's memory, and it's happening, ironically, under a free-market-loving Republican administration.

The problem is, government bailouts, subsidies, and insurance aren't really helping Wall Street. The Street's fundamental problem isn't lack of capital. It's lack of trust. And without trust, Wall Street might as well fold up its fancy tents. Financial markets trade in promises—that assets have a certain value, that numbers on a balance sheet are accurate, that a loan carries a limited risk. If investors stop trusting the promises, financial markets can't function.Yet it's turned out that many of these promises weren't worth the paper they were written on.The subprime mess triggered the collapse of trust, but financial markets were in danger of such a fall even before mortgage-backed loans were shown to be worth far less than anyone supposed. That's because when the market was roaring a few years back, many financial players had no idea what they were buying or selling. Even worse, they didn't care, as long as they were making money. Complex derivatives, collateralized debt instruments, SIVs, and the rest created an aura of solid value, but it was empty: They had very little value behind them. Credit default swaps may be next on the chopping block.

There seemed no limit to the leverage, the off-balance sheet liabilities, and what actions credit rating agencies would approve by the issuers who paid them. This meant almost no limit to what was promised. Regulators—Alan Greenspan in particular—looked the other way.Two years ago, I asked a hedge fund manager to describe the assets in his fund. He laughed and said he had no idea. Who cared as long as the money rolled in?And the system seemed to work great as long as everyone kept trusting and the market kept roaring. But all it took was a few broken promises for the whole system to break down.What to do now? Do not socialize capitalism with government bailouts and subsidies that put taxpayers at risk. If what's lacking is trust rather than capital, the most important steps policymakers can take would be to rebuild trust. And the best way to do that is through regulations that require financial players to stand behind their promises and tell the truth, along with strict oversight to make sure they do.

The best thing to come out of all this would be a new commitment on the part of Congress and the administration to get behind sensible regulation of Wall Street. Market participants need better information—and that information won't be available unless regulations require it, and financial overseers demand it. Conflicts of interest—such as credit rating agencies that are paid by the very issuers they're rating—must be stopped. Regulatory oversight must be consolidated—perhaps folded into a single consolidated regulator for all kinds of financial firms, similar to Britain's Financial Services Authority. There should be a central clearinghouse for credit derivatives, swaps, and trades.

In other words, our financial system has to become transparent.

We tell poor nations they have to make their financial markets transparent before capital will flow to them. Now it's our turn.

Lacking adequate regulation or oversight, our financial markets have become a snare and a delusion. Government has only two choices now: Either continue to bail them out, or regulate them in order to keep them honest. I vote for the latter.

Robert Reich, a former secretary of labor, is professor of public policy at the Goldman School of Public Policy at the University of California-Berkeley. He is the author of Supercapitalism: The Transformation of Business, Democracy and Everyday Life (Vintage Books, 2008).