Editor's note: Aug. 10, 2009

There have been many notes dropped into our suggestion box about how to fix Wall Street. Most are unprintable in a family publication. A handful involve the transfer of funds from an important official in Nigeria. Among the rest, there are the usual remedies like slashing pay, reviving stocks (the punishment, not the security) and generally making like the Romans at Carthage: plows, salt, hairy men with short skirts and spears. There have been suggestions that we break up every bank big enough to fill a tall building; eliminate every innovation after installment loans; ban any financial practice that begins with the word "naked." Speculation, low interest rates, hubris, greed, idiocy, insanity and arrogance recur, albeit with variant spellings. A number of readers have a hankering for a second dose of Glass-Steagall. A few suggest bringing back partnerships, with unlimited liabilities. One, at least, suggests chopping off the many wriggling limbs of Goldman, Sachs & Co., then driving a stake through its black heart. Excuse the metaphor's mixed provenance.

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We have had months of such suggestions; we may have many more. The populist fires burn and the populi would be happier if they could get bus fare to Broad and Wall and pitchfork a suit or two. Indeed, none of their suggestions (except the Nigerian businessman) are actually "wrong," but they miss a deeper, more fundamental dynamic. Wall Street is a living embodiment of what Joseph Schumpeter famously called creative destruction. There's always a latent Schumpeter vogue out there, particularly among the tech crowd. He's not as hot as Ayn Rand, maybe because he was a bald-headed economist from Austria (though quite a ladies man, apparently), not a didactic woman who beguiled Alan Greenspan. But that's a digression. The fact is, Schumpeter had a deeper critique of capitalism than Miss Fountainhead that seems appropriate today: The very success of capitalism, with its excesses and risk, he argued, would eventually undermine itself. Companies would get larger; we would descend into a kind of corporatism Mussolini looked favorably upon; entrepreneurs would be squeezed out; intellectuals would turn on capitalism as if it were a repellent blood-sucking Vampyroteuthis infernalis.

Some of this sounds familiar; some not. There is a dynamic discernible over, say, the past four decades of Wall Street that has elements of creative destruction and that is rarely (well, never, until now) aired as an origin of the crisis. An increasingly deregulated financial sector has proven to be ferociously competitive, despite the rapid growth of its largest banks. Part of this stems from the repeal of restrictions like Glass-Steagall; part from technological and financial innovation; part from globalization. But as quickly as firms consolidated, new players evolved (hedge funds, private equity, banking boutiques, foreign banks, nonbank banks, freelancers). Since at least 1975, when equity commissions were freed to float on May Day, one business after another (brokerage, underwriting, multiple trading markets) has experienced the same cycle: Fat profits attracted new competitors, tightened margins, spurred mergers, drove innovation, leverage and risk, setting off the quest for as-yet-uncrowded environs, sort of like the search for the perfect suburb. Several things can be said of this whirling cycle. It's a fairly common phenomenon, particularly in tech, with a chaser (that makes all the difference) of systemic risk. This risk stuff is dangerous. The cycle accelerates over time or, when suppressed, blows up with a bigger bang. Finance is, in this sense, an increasingly efficient market, and thus great at arbitraging away profits -- or inflating the whole shebang into a bubble of nitroglycerin.

This is not the usual way to look at Wall Street. But it does explain many aspects of the crisis. Consolidation, greater capital and leverage were responses to rampant commoditization. What about sky-high comp? There's a rough relationship between risk assumed and the propensity to pay folks vast sums to wield it. At least for a while, that risk may produce great rewards. When it doesn't, when it tips the overloaded cart, destruction and defenestration follow. This does not take Wall Street off the hook for being reckless or dumb, the Federal Reserve for low rates or China for existing. But it does provide an explanation for what often appears to be a case of mass delusion. It also suggests how difficult "fixing" Wall Street really is. Those destructively competitive dynamics may have momentarily stalled, allowing Goldman, Sachs & Co. and J.P. Morgan Chase & Co. to pig out, but that will not last. Regulatory reform is not restricting competition, and so far markets are not walling themselves off from competition. Shareholders are being empowered. Competition and risk will tango again. With recovery, banks will find themselves squeezed between relentless commoditization and great expectations, all the while jiggling the nitro. Suggestions anyone?

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