The One Phrase That Explains the Great Recession

Have we seriously forgotten 2008?

Today the Federal Reserve has an economic policy that not only fosters crisis, but introduces a Darwinian process that selects leaders who are uniquely unfit to deal with it.

Let’s step back to 2008, when the investment bank Bear Stearns failed with leverage of 35 to 1, the danger of which should be obvious to anyone who's taken fifth-grade math. Wall Street embraced these dangers to the point where it nearly went extinct. Not only did our government miss the risk, but the head of the Federal Reserve described derivatives, the centerpiece of the crisis, as  "a useful risk management tool" held in the hands of the well-capitalized hands of sophisticated investors. Six months later, virtually every government employee would describe the financial crisis as a fast-moving event.

How does this happen? Economic Darwinism. Whether it is getting elected or getting promoted, Economic Darwinism selects people by success. The Federal Reserve's 20-year policy of easy money created an environment virtually assured to select bankers, bureaucrats, educators, and elected officials who least understood the consequences of a credit crisis.

The process of Economic Darwinism works within a corporation surprisingly similar to how Darwinism operates in nature. The only difference between evolution in nature and evolution in a corporation is the speed of the transformations. Economic Darwinism moves much faster because humans can learn traits, whereas a bird in the Galapagos requires generations to grow a longer beak.

Natural selection in organizations feeds on its reward system. If the system rewards long hours, you will find people at the company who are willing to sacrifice personal lifestyle for the good of the company. It isn’t that they are more selfless, but anyone unwilling to work within the system of rewards normally leaves or is pushed out.

When the Federal Reserve forced interest rates lower, it altered the balance and outcome of risk in favor of risk-takers. That step led to greater earnings streams, or sales, or some measure of profitability. Stupid transactions seemed wise, and foolish risks were rewarded. The most important thing to understand about booms and Economic Darwinism is that when it happens, the statistical likelihood of any system promoting someone with a sensible risk perspective becomes lower and lower. Capitalism acts as a steroid, drawing cash into a successful companies. This process encourages other companies to emulate the practices that made certain companies successful.

Thinking back to 2007, it should surprise no one that Darwinism had selected companies like Bears Stearns for survival. The economy had made its corporate culture wildly successful. It made billions packaging and selling loans. When one bet was rewarded, the firm took on more risk in the next one. This is how you expand from prime loans to alt-A to sub-prime. Bankers call this universe expansion. The bankers didn't make the era. The era made the bankers.

By 2008, Darwinism had selected bankers and regulators who never considered that a credit crunch was even possible. Decision makers were oblivious to the cost of capital. The head of Bear Stearns appeared on CNBC to assure his investors days before the company was to be forced into bankruptcy. Lehman Brothers had a secondary offering to raise money only months before its bankruptcy, yet it sold only $3 billion in preferred stock. The survivors of 20 years of success were simply unable to grasp the idea that they could finally start to lose their bets.

The boom times enabled animals called bankers grow to massive size. Nature selected those who were the fittest for that environment. When the environment changed, these animals were like dinosaurs staring at the glaciers. The interest rate policy of the Federal Reserve today is designed to keep those dinosaurs warm and well fed.

The people who run our country were largely selected by Economic Darwinism from a pool of people who owe their success to cheap interest. It is no surprise that these people see cheap interest as the only solution to our economic woes. This policy is about rebuilding their past rather than improving your future

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Brenton Smith

Professionally, I manage credit risk in bank deriviatives. Politically I write commentary for www.FixSSNow.Org on the issue of Social Security reform.

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