Postcrisis economy: calmer but slower

With no investment banks and tighter regulation, experts see a less dynamic recovery ahead.

The changes now convulsing Wall Street may have a longer-term effect on the US economy: less dynamism and growth but more stability.

This is the likely outcome because financial innovators – the people who dreamed up those risky mortgage-related investments – will now have regulators in their offices, economists say. Deals that used to bring in huge profits and also funded everyone from entrepreneurs to credit-card users will now be examined much more closely.

"We will be taking some of the zing out of the economy," says Fred Dickson, chief investment strategist at D.A. Davidson. "It will be a moderate to modest tempering over the next five to 10 years."

How much of a tempering?

Mr. Dickson estimates that once the economy recovers, it could reduce growth in the nation's gross domestic product by up to half. "In the first and second quarters of recovery, instead of growth of real GDP of 5 to 6 percent, it could put a cap on the recovery of 2.5 percent to 3 percent," he says.

The battle over regulation began in earnest Tuesday, as administration and Federal Reserve officials pushed Congress to act this week to pass a massive $700 billion rescue plan proposed last week by Treasury Secretary Henry Paulson. Any delay would be "unthinkable," said Tony Fratto, a White House spokesman.

"We believe that strong and timely action is urgently needed to stabilize our markets and our economy," Federal Reserve Chairman Ben Bernanke told the Senate Committee on Banking, Housing and Urban Affairs.

But in urging quick action to pass the bailout, Paulson and Mr. Bernanke both called for reform of the financial system. "It's critical," Bernanke said Tuesday. "The Federal Reserve will give full support for fundamental reform of the financial industry."

On Wall Street, the stock market recovered somewhat Tuesday morning from its sharp losses on Monday after doubts were raised the rescue plan would pass. Last week, euphoria about the plan had helped the Dow Jones Industrial Average gain over 778 points in two days. The price of oil, which had soared a record $16.37 a barrel on Monday, fell back somewhat in morning trading.

In the past, some Wall Street investment houses thrived in volatile markets. But now, many of them are seeking some stability. That is why Goldman Sachs and Morgan Stanley, the two remaining major independent investment banks, won approval Sunday night to become commercial banks.

"By shifting from an investment bank to a commercial bank, it gives them access to the Federal Reserve's discount window," says Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Fla.

The discount window allows eligible financial institutions to borrow money over the short term to meet short-term liquidity needs. But commercial banks are also more conservative, concerned about preserving assets while Wall Street is usually more risk oriented. In the past, Wall Street usually funded "the next new thing," growth drivers that led the economy out of its slump. After the last recession, this was housing and mortgages. In the recession before that, it was technology and telecommunications companies. This time, Dickson thinks it would have been alternative energy. But "that whole area is now going to take longer to develop than it otherwise would," he says.

Others aren't so sure the demise of the pure investment banking houses will have that large an impact.

"They can still run an investment bank, just more conservatively," says economist Lyle Gramley. It's hard to measure how much the investment banking community adds to economy, he adds. "Investment banking is like the dark matter in the universe. We know it's there, we're not sure what good it does, and we know it creates black holes."

Investment bankers, however, have a much higher tolerance for risk than commercial bankers. Sung Won Sohn, former president of Hanmi Bank, recalls "looking at deals that I would not touch with a 10-foot pole" and then watching investment banks snap it up. "Something like that is going to be less frequent," says Mr. Sohn, now an economist at California State University, Channel Islands.

With the greater risk that investment banks used to take came greater rewards. Investment banks have historically paid out enormous bonuses at year end. Last year, Wall Street handed out in excess of $30 billion in bonuses, according to Bloomberg.com. Goldman Sachs paid out $12.1 billion in bonuses, up from $9.88 billion the prior year, the news service reported. The chairman of the company, Lloyd Blankfein, made $54 million.

In the past, commercial banks used to pay out smaller bonuses. But that is no longer true. At JPMorgan Chase and Citigroup, the chairmen have made enormous bonuses.

"This has always been a problem but it's been between stockholders and activists and management," says Doug Roberts, director of research at Channel Capital Research Institute in Shrewsbury, N.J. "Now Congress is concerned: If they give money, should they still get these huge bonuses?"