What wrecked the global economy

• Securitization. The process of taking individual loans and packaging them into bundles; paying rating agencies to attest to the safety of the bundles; and then selling those bundles to investors is the biggest culprit. Securitization creates securities which have no price because they don't trade. The reason they don't trade is that there is not enough information to evaluate them. And thanks to the buying off of the ratings agencies – they competed with each other for the big fees from the investment banks whose securities they rated -- there was no objective assessment of the risk of investing in these securities.
• Speculation. Commodities markets were initially established to let buyers and sellers of commodities such as wheat, pork bellies, and oil to set prices. Financial players have entered these markets. Their bets have distorted the prices to levels that damage the real – as opposed to their financial – economy. The absence of hard data on how much they move prices is making it difficult to know how much financial players are distorting the pricing mechanism.
• Excessive debt. Federal, bank, and consumer debt are at staggeringly high levels which would not be permissible if the risk of such debt had been priced accurately. The Federal budget is running at a record $410 billion deficit and borrowing of $9.3 trillion is at 66% of the $14 billion GDP. Banks and hedge funds borrow $32 for every dollar of equity. And with housing prices down 15%, consumers who have borrowed against those homes now owe more than the value of the asset. Thanks to the mispricing of the debt when it was initially taken on, society will continue to pay a huge price. Banks have already taken $300 billion worth of write-downs, some three million homes are in foreclosure, and inflation has cut the value of the dollar 72%.

There is no simple solution to these problems. However, the next president will need to fix the global economy that his predecessors have broken. Some ideas that come to mind would be to restore the pricing mechanism for goods and risk by fixing two of the biggest problems:

• Inequitable pay. The people who set prices and take on debt are paid to do big deals. They get a percentage of the deal size as a bonus. They do not have to pay for the losses that people suffer as a result of those deals. Charging decision-makers for those costs would lead them to take risk into account in setting prices for debt.
• Transparency. Buyers and sellers need objective data to arrive at accurate prices. Objective data is impossible when the providers of the data are paid by market participants. To fix this problem, participants should pay a fee into a government-administered fund. This fund would pay independent auditors to generate financial statements for publicly traded companies and to rate the risk of investments. If these independent auditors were unable to produce such information due to complexity and uncertainty, then the securities would not be permitted to trade.

What is remarkably bad is that our current leaders have succeeded in inflicting so much damage on the global economy. While Al Qaeda succeeded in killing thousands of people and destroying many buildings, the damage to the global economy of that attack was far less than what the enemy within has accomplished in the seven years that followed.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.