Michael Lewis and David Einhorn have a terrific couple of articles in the New York Times today. They cogently trace the structural causes of our current financial crisis and recommend a number of obvious fixes.

The critique which most resonated with me was the focus on short-term profits that leads to risky behavior and long-term failure. For example, starting three years ago, a private investor named Harry Markopolos repeatedly tried to sound the alarm about the Madoff Ponzi scheme, writing and speaking with S.E.C. regulators who did nothing to stop the enormous fraud. The reason no one stopped Madoff and the reason we are in this crisis is because all involved have misaligned interests.

OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.

The tyranny of the short-term manifests in credit rating agencies who make money off the firms they are supposed to rate honestly. It shows up in the S.E.C. where regulators seek good relationships with financial institutions in order to receive higher paying jobs in the private sector. It’s on display with bank executives who will be forced out if they don’t make short-term profits.

This is something about which I’ve worried for a while: how do we imbue our market-driven firms with long-term thinking? Quarterly earnings reports, expected to be better than 3 months before, seem like a good idea for shareholder accountability, but it also forces firms to make short-term decisions that may harm their long-term interests.

Lewis and Einhorn are dumbstruck that 18 months into this situation, next to nothing has been done to solve these structural problems. Although they have their disagreements with how Treasury Secretary Paulson is managing the problems (they advocate letting the banks fail), the more important, long-term problems haven’t been addressed.

Their solutions are:

1. Stop making regulatory decisions with long-term consequences in fear of their short-term effects
2. End the official status of the rating agencies – either privatize the rating or do it publicly
3. Regulate financial innovations like credit default swaps (see Bookstaber’s book for their danger)
4. Place capital requirements on banks or break up banks into parts that are small enough to fail
5. Don’t allow S.E.C. officials to work on Wall Street, but encourage the flow in the opposite direction

I’m glad sensible, structural proposals are being put forth and hope Obama and the incoming Congress heed them.