The tendency in the media and the Congress has been to blame the current depression on "stupid, greedy, and reckless" bankers. I believe that that is a mistake. I know bankers. They are not stupid; most of them are smart, and many of them are brilliant. If they are "greedy," it is largely so in the sense in which most Americans (most anyone, I imagine) could be called "greedy": they like money a lot. I read somewhere recently that bankers (a word I use loosely to cover financiers in general) derive their job satisfaction entirely from their monetary compensation, unlike other workers. But that is wrong. Rich bankers derive satisfaction not only from making a lot of money but also from a sense of outsmarting competitors, and in that respect they are not unlike highly paid athletes; in both cases the money the stars are paid do not merely enhance personal welfare, but also are indicators of relative performance. Money is a scorecard of success. Professors are different, it is true--but only in that their scorecard is different: for money income are substituted citations, pretigious appointments, honorary degrees, and prizes.
With "reckless" we get a little closer to the truth, which is that banking is an inherently risky activity. The basic reason is that bankers borrow most of their capital, then turn around and lend it, and cover their expenses and make a profit by lending at higher interest rate than they borrow--and the higher interest rate is generated by the bank's assuming a greater risk of default than the people who lend the bank its capital. Typically, banks borrow short term and lend long term, and by doing so they generate a spread because lending short is less risky than lending long and so short-term interest rates tend to be lower than long-term rates.
The taking of business risks implies a positive risk of bankruptcy. Bankers cannot be criticized for risking bankruptcy, because they couldn't survive in business otherwise; they would lose their capital to nonbank lenders willing to take risks, such as hedge funds.
In fact the bankers took too many risks from an overall economic standpoint, and that is the immediate cause of the economic hole we're in. They made too many risky loans, especially in real estate, and when the risks materialized the banks' assets, which included many real estate mortgages and securities backed by such mortgages, plunged in value. The banks found themselves undercapitalized and reduced their lending, which slowed economic activity, which began the downward spiral that we're in.
They were permitted and indeed encouraged to take risks that were too great from the standpoint of economic stability by the government itself, in two major respects. First, the regulatory controls that had once limited the amount of risk that banks could take, in recognition of the potentially catastrophic effects on economic stability of a collapse or near collapse of the banking industry, were gradually dismantled, beginning in the 1970s. Not completely dismantled, but enough dismantled to allow competition almost free rein to push the bankers toward taking more risks than were good for the nation's economic welfare.
And second, the Federal Reserve pushed interest rates too far down at the end of 2000 and kept them there longer than made economic sense. The results included a housing bubble, a credit bubble, the bursting of the bubbles, and the ensuing swoon of the banking industry--all of which I'll explain in the next blog in this series.