“Why didn’t we see this coming?”

Paul Krugman talks of economists’ dismay that they didn’t foresee the impending collapse of US financial institutions. The truth is, however, that it was foreseen by people who hadn’t taken leave of their senses.

Some people say that the current crisis is unprecedented, but the truth is that there were plenty of precedents, some of them of very recent vintage. Yet these precedents were ignored.

Just as regularly occurs every generation, an irrational exuberance brought with it complacency. Whether it was deregulation, or the housing bubble, or the mortgage Ponzi scheme built upon it, or the substitution of leveraging for reserves, or the ability of the Federal Reserve to act as a firewall, or the supposed “resilience” of the financial system – financial wise guys saw only what they wanted to see. Whatever evidence didn’t fit into their complacent view of unlimited horizons of wealth, got ignored or dismissed.

For example, how much concern was raised last December when the reserves held by US banks dropped 50%? Or in January when the continued plunge in banks non-borrowed reserves dipped into negative numbers? By September bank reserves had reached negative $187 billion.

When these declines first appeared, they were called a ”false alarm,” and the results of a ”change in definition” and ”arithmetic” calculations.”

The “false alarm” was said to be due to a new way of calculating non-borrowed reserves – one that was in fact more accurate. But as the author Kamran Afshar points out, even factoring out that changed definition the national banks’ reserves clearly had plunged dangerously early in 2008. Smaller banks too were in trouble, with their non-performing loans and leases approximately tripling between 2007 and mid 2008 (rising to about 50%).

Very clearly, since the end of 2007, the banking system showed a significant drain on its reserves. The Federal Reserve’s own data show the drain was not limited to the larger national banks, but hit small banks, as well.

Somehow, this data had morphed from ”false alarms” in February to catastrophe in September 2008. There were plenty of signs early this year that regulators should have recognized and then, by taking early action, averted the full $700 billion bailout.

But that would have required Henry Paulson and his gang of incompetents to leave the Wall Street world of make believe for the harsher and less well upholstered world of reality. In the complacent world of too many financiers, a statistic matters only when it bolsters their fantasies. And as Krugman warns, the world of make believe will be back in fashion sooner than we care to believe.

And because we’re all so worried about the current crisis, it’s hard to focus on the longer-term issues — on reining in our out-of-control financial system, so as to prevent or at least limit the next crisis…

For once the economy is on the road to recovery, the wheeler-dealers will be making easy money again — and will lobby hard against anyone who tries to limit their bottom lines. Moreover, the success of recovery efforts will come to seem preordained, even though it wasn’t, and the urgency of action will be lost.

So here’s my plea: even though the incoming administration’s agenda is already very full, it should not put off financial reform. The time to start preventing the next crisis is now.

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