The financial crisis that began in late 2007 continues to wreak havoc on individuals and communities (see “Painful Numbers”) and financial markets remain highly volatile. What has happened? Easy credit and the bursting of the housing bubble are widely regarded as key triggers of the crisis, but clearly far more is involved. Asset price bubbles of different kinds, from the Dutch tulip mania in 1636 to the dotcom blowup of 2000, are fairly common. Financial system meltdowns, on the other hand, are quite rare. The problem, like the bailouts, centers on the financial system itself.
Apart from yet interrelated to the “real economy”—the productive economy of goods and services—is another financial economy. We might call it “the phantom economy.” This economy is highly abstract and immaterial; it involves high-speed flows of “virtual money,” money that “isn’t quite there” in economist Elinor Solomon’s apt phrase. Its markets in exotic financial instruments, such as “derivatives” (bets on the future price movements of the underlying asset or reference rate they are linked to), have come to haunt the real economy, as the relation of these instruments to real economic assets has become ever more fleeting and elusory. Though designed to redistribute investor risk and manage volatility, they have also rendered risks more indistinct and inscrutable. A phantom is not amenable to due diligence, including by its putative regulators (see “The Madoff Affair”).
The phantom economy, which has grown exponentially over the past decade, is characterized by a deep rift between the worlds of Main Street and Wall Street, by the replacement of local know-how and relationship-based knowledge with computerized algorithms, blind diversification, and quantitative trading (see “The Derivative World”). The field of economics long ago laid the groundwork for this shift in knowledge by spinning out theories and mathematical formulas at odds with actual markets. Economists, augmented by physicists who worked in the financial industry, created the arcane models and legitimated the deregulation that spurred the phantom economy’s ascendance (see “The Great Mortification”).
Regulatory overhaul is underway. While necessary, it is not sufficient. We need, as Robert Jackall argues, a changed consciousness and a new ethic.