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Capitalism's beneficiaries must compete in reworked market

BY ELIOT L. SPITZER | Eliot L. Spitzer is a former governor of New York. He was state attorney general from 1999-2006. This is excerpted from The Washington Post.

November 24, 2008

President-elect Barack Obama will soon face the extraordinary task of saving capitalism from its own excesses, much as Franklin D. Roosevelt had to do 76 years ago.

The new president's team must get to the root causes of the mistakes that have brought us to the economic precipice. The explosion of leverage, the failure to regulate derivatives, the flood of subprime lending and the excesses of chief executive compensation are all manifestations of three deeper structural problems: misconceptions about what a "free market" really is, a continuing breakdown in corporate governance, and an antiquated and incoherent federal financial regulatory framework.

First, we must confront head-on the pervasive misunderstanding of what constitutes a "free market." For long stretches of the past 30 years, too many Americans fell prey to the ideology that a free market requires nearly complete deregulation of banks and other financial institutions and a government with a hands-off approach to enforcement.

Those of us who raised red flags about this were scoffed at for failing to understand or even believe in "the market." When my office, along with the Department of Justice, warned that some of American International Group's transactions were little more than efforts to create the false impression of extra capital, we were jeered at for attacking one of the nation's great insurance companies, which surely knew how to balance risk and reward. And when the attorneys general of all 50 states sought to investigate subprime lending, we were blocked by a coalition of the major banks and the Bush administration.

Time and again, those who tried to enforce the basic principles that would allow the market to survive were told that the "invisible hand" of the market and self-regulation could handle the task alone.

No major market problem has been resolved through self-regulation, because individual actors care only about performing better than the next guy, doing whatever is permitted - or will go undetected. Those who truly understand economics do not preach an absence of government participation. A market doesn't exist in a vacuum. Rather, it's a product of laws, rules and enforcement. It needs transparency, capital requirements and fidelity to fiduciary duty. The alternative, as we are seeing, is anarchy.

Second, our corporate governance system has failed. We need to re-examine each of the links in its chain. Boards of directors; compensation and audit committees; the lawyers, investment bankers and auditors whose job it is to create the impression of legal compliance; and shareholders - all abdicated their responsibilities.

Finally, we need to completely overhaul the federal financial regulatory framework. The divisions of the past - commercial banking vs. investment banking vs. insurance vs. hedge funds vs. private equity - have become distinctions without a difference. But these old boxes and formalities still determine how entities are viewed and regulated.

We need a unified approach that addresses the underlying issues: what kinds of leverage we wish to tolerate, how to measure risk, how much disclosure various trading products should provide. We cannot survive with the current system: the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Fed, the Office of Thrift Supervision, and on and on. We must go from the Rube Goldberg structure we now have to a sleek iPod design that is cleaner and has better operating software.

We began to try to craft such a unified model in New York, as did Treasury Secretary Henry Paulson in Washington last year. But it is urgent that we finish the job. Having flooded the market with cash and seen the government take a chunk of many of our largest financial institutions, we now need to craft the rules that will apply to all market participants.

First, we need better control of systemic risk. Second, investors must be protected with adequate, accurate information. Firms must offer transparency both to individual investors and to government regulators.

And third, as Eric Dinallo, the superintendent of the New York State Insurance Department, has wisely pointed out, we will have to step back from the current environment in which government has become a guarantor of all major risk. Only if private actors have to bear the real risks they incur will the market function properly. We are now perilously close to nationalizing risk.

As the rules of modern capitalism are rewritten over the next year, those who benefit from the enormous flow of cash being spread throughout the U.S. economy must be expected to compete within a system of rules that creates a true market - based on sound, skilled regulation, vigorous corporate governance and transparency.

Although mistakes I made in my private life now prevent me from participating in these issues, I very much hope and expect that President Obama and his new administration will have the strength and wisdom to do again what FDR once did.