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[Dec 31, 2009] Bernard D'Mello, 'Financialisation' and the Tendency to Stagnation by Bernard D'Mello

John Bellamy Foster and Fred Magdoff, The Great Financial Crisis: Causes and Consequences, New York: Monthly Review Press/Kharagpur, India: Cornerstone Publications, 2009, pp 160, US$12.95/Rs 100.

Beginning with the failure of two Bear Stearns hedge funds and the consequent freezing of the high-risk collateralised debt obligations market in June 2007, the financial crisis deepened in 2008, and at the time of writing in April 2009, the wheels of finance are yet to start turning again even though governments and central banks around the world have taken many measures -- "dropping money from helicopters", metaphorically speaking, into the financial markets, going much further than merely acting as "lenders of last resort", exercising their "too big to fail" policy, and so on. By all accounts, the financial catastrophe is the worst since the Great Depression, bringing in its wake a severe economic crisis, and it is time to seriously examine its causes and consequences, a challenge the book under review takes up quite admirably.

The feeding of the speculative bubble in the home mortgage market by massive credit expansion, the selling of large amounts of subprime mortgages, the peculiar securitisation of the mortgage loans and the speculative trading of such securities in the global financial markets, the credit rating agencies' fraudulent ratings, the off-balance sheet device of the structured investment vehicle, and role of credit default swap arrangements have, taken together, commanded a fair share of attention among financial analysts. To make sense of this whole host of factors, the authors, John Bellamy Foster and Fred Magdoff place their description of the unfolding of the crisis quite neatly into the basic pattern of speculative bubbles outlined by Charles Kindleberger in Manias, Panics, and Crashes: A History of Financial Crises -- a novel offering ("displacement"), credit expansion, speculative mania, distress, and crash/panic -- and, with the same clarity and wit so characteristic of the "literary economist".

Going by this, it might be tempting to view the crisis as a direct consequence of the deregulation of the financial system since the 1970s, especially the cumulative dismantling of Glass-Steagall that was finally buried when the then US President, Bill Clinton signed the Financial Services Modernisation Act in 1999. But this is not a liberal-left account. The authors come from an intellectual tradition (the Monthly Review school) that has its origins in Paul Sweezy's synthesis of Marx's political economy with J M Keynes' insights on investment, effective demand,1 and the structure and behaviour of modern finance, as well as the theory of oligopoly. They locate the roots of the financial bust in the "real" economy and in the underlying accumulation (savings-and-investment) process, both its financial and "real" aspects.

Finance to the Fore

Since the late 1970s, a gravitational shift of economic activity from the production of goods and non-financial services to finance has been underway. One indicator of this process has been the rapid growth since then of the share of financial profits in total corporate profits. Also reflective of this process of "financialisation" is the explosive growth of private debt -- household, non-financial, and financial business -- as a proportion of gross domestic product, and the piling of layers upon layers of claims with the existence of instruments like options, futures, swaps, and the like, and financial entities like hedge funds and structured investment vehicles. With financialisation, the employment of money capital in the financial markets and in speculation, more generally, to make more money, bypassing the route of commodity production, increasingly became the name of the game. In Marx's terms, financialisation entailed a shift from the general formula for capital accumulation, M-C-M', in which commodities are central to the generation of profits, to one "increasingly geared to the circuit of money capital alone, M-M', in which money simply begets more money with no relation to production" (p 133).

The flood of private debt to finance such activity has been sustained by successive booms in asset prices; indeed, such booms have, in turn, been fed by the explosion of debt.2 As long as the asset price bubble grows, consumers and businesses get access to more credit to buy more home or financial assets because their creditworthiness is determined by the market values of the assets they hold, which act as collateral. The rise of asset values and the intensification of the speculative mania contribute to the growth of borrowing, which, in turn, flames the fires of speculation and the further rise of asset values. On the supply side of the financial markets, in the competitive race to grab the hindmost of the profits in store, a whole array of players get into the act of frenzied "financial innovation", leading to the multiplication of financial assets of all kinds, for instance, the securitisation of mortgage loans through the collateralised debt obligation, or the credit default swap to speculate on the quality of credit instruments. It is only when the asset price bubble pops and the underlying collateral thus vanishes in thin air that all hell breaks loose across financial institutions and markets, and across countries in this world of globalised finance.

Weak Propensity to Invest

But what brought on the financialisation of the economy in the first place? The US economy entered a period characterised by slow economic growth, high unemployment/underemployment and excess capacity beginning with the sharp recession of 1974-75 after around 25 years of rapid ascent following the second world war. The inducement needed to generate investment high enough to sustain the vigorous growth of the so-called Golden Age was no longer to be found. But capitalism as a profit-directed system has an imperative to accumulate capital -- it cannot stand still; it either expands or it slumps. An important "solution" to the problem of long-term "stagnation" was found in financialisation, which proved functional for capitalism, in that, what growth the economy produced over the period of the 1980s to the present has, to a significant extent, been due to the financial explosion. Speculative finance became "the secondary engine for growth given the weakness in the primary engine, productive investment" (p 18). The system was now "more and more dependent on a series of financial bubbles to keep it going, each one bigger than the last" (p 18).

As the authors themselves give credit to, their analysis leans heavily on Paul Sweezy and Harry Magdoff's documentation and analysis of developments in the US and world economy in the pages of the Monthly Review over a period stretching from the late 1960s to the late 1980s (as also, short perspective articles by Sweezy up to the mid-1990s), a number of these pieces tracing the process of what later came to be called financialisation. The analytical framework of the book draws on Paul Baran and Paul Sweezy's 1966 classic, Monopoly Capital: An Essay on the American Economic and Social Order (New York: Monthly Review Press, 1966). Rather than a tendency for the rate of profit to fall,3 Baran and Sweezy hypothesised a tendency for the relative share of the economic surplus4 to rise. The main problem is one of finding ways to absorb this gigantic actual and potential economic surplus. "Underconsumption" -- the shift in the distribution of income from labour to capital exacerbating the problem of effective demand -- as an ex ante tendency draws the economy towards stagnation, for the process of accumulation of capital is predicated upon an increase in the rate of surplus value while at the same time having to rely on mass consumption to spur investment and economic growth. High levels of inequality hold down the relative purchasing power of the working class, weakening consumption and adding to overcapacity, thus lowering expected profits on new investment, and thereby dampening the willingness to invest.

Counteracting Tendencies

The problem of capitalism is that individual units of capital strive to expand their wealth to the maximum possible extent without considering the ultimate overall effect this would have on effective demand in the context of the economy's expanding capacity. Truly, "The real barrier of capitalist production is capital itself", as Marx once put it.5 Under monopoly capitalism, this barrier is raised even higher. First, in the class struggle -- the relationship between the two main classes, involving exploitation by capital and the workers' resistance to it -- capital has the upper hand, thus raising the rate of surplus value to attain a higher rate of profit, and thereby making possible a higher rate of accumulation. Second, with oligopolistic pricing, the uniform rate of profit of competitive capitalism gives way to a "hierarchy of profit rates" -- highest in "tightly" oligopolistic product markets and lowest in the most competitive ones. This leads to a skewed distribution of the surplus value generated, one that favours the larger, more monopolistic firms; they, in turn, could "re-invest" a larger proportion of their profits, making possible a higher rate of accumulation. But on the demand side, the large oligopolistic units of capital tend to regulate and slow down "the expansion of productive capital in order to maintain their higher rates of profit".

Underconsumption as an ex ante tendency and the problem of effective demand thus asserts itself even more under monopoly capitalism than under its competitive counterpart. But there are counteracting tendencies. Civilian government spending picks up some of the slack in effective demand; however, there are forces opposing such spending, especially where the projects or activities undertaken either compete with private enterprise or undermine class privileges. But there are other offsetting tendencies, such as militarism and imperialism, expansion of the sales effort, and financialisation,6 which have been the main external stimulants boosting effective demand and thus aggregate output. As already mentioned, financialisation has been functional for capitalism in the context of a tendency to stagnation; indeed, more recently, it has been the main "response of capital to the stagnation tendency in the real economy". But the present crisis of financialisation, symptomatic in the financial crash, "inevitably means the resurfacing of the underlying stagnation endemic to the advanced capitalist economy" and there now seems to be "no other visible way out for monopoly-finance capital" (p 133).

'The Truth Is in the Whole'

It must be mentioned that the book focuses almost exclusively on the financial crisis in the context of the US economy. No doubt this is the epicentre of the catastrophe. Nevertheless, in these times of financialisation of the capital accumulation process globally (albeit an Americanisation of global finance), if one were to go by Hegel's dictum that "The Truth is in the Whole", then to understand what is going on in the US, one has to also take account of what is happening in the whole world, just as developments in the US make a difference elsewhere. In particular, the structure and distribution of world effective demand along with the huge imbalances reflected in the massive deficits and corresponding surpluses in the current accounts of the balance of payments of the major economies, and the structure of capital flows7 thereby engendered, need to be brought into the picture. The neo-mercantilist direction of the Chinese, German (also, some other European economies), and Japanese economies come to mind, which needs to be taken together with the fact that despite the phenomenal rise in inequality in the US, the country's savings rate has secularly declined, in part due to the wealth effect brought on by financialisation. These developments have, in turn, led to increasing US current account deficits, matched by huge capital inflows, and reflected in the accumulation of massive non-resident holdings of dollar-denominated financial assets. To what extent has all of this buttressed the speculative mania and the crash?

Again, confronted with Hegel's dictum, and reminded of Rosa Luxemburg's thesis of capitalism's imperative to move into the non-capitalist regions of the world, we might also ask whether as time has gone by in this post-cold war era of a fully globalised capitalism, the system is now more prone to deep crises, given that it can now grow only by internal expansion.

'Monopoly-Finance Capital'

The main chapters, apart from the introduction, were "originally written as parts of a running commentary [in the Monthly Review] during the years 2006-08 as the present crisis took shape" (p 21). In fact, the four chapters following the introduction -- "The Household Debt Bubble" (May 2006), "The Explosion of Debt and Speculation" (November 2006), "Monopoly-Finance Capital" (December 2006), and "The Financialization of Capitalism" (April 2007) -- were all written before the crisis began. But this does not diminish their value. The chapter on "The Household Debt Bubble" presents interesting data, for instance, debt service payments as a percentage of disposable income by income percentiles, which together suggest that "financial distress is ever more solidly based in lower-income, working-class families" (p 31). The chapter on "The Explosion of Debt and Speculation", after presenting data on the sky-rocketing of debt -- household, non-financial sector, financial business, and government -- suggests a decline in the stimulatory effect of the expansion of debt on the economy as a result of its changing composition. In particular, "financial sector debt now larger than any other single component and growing faster than all the rest (a shift from M-C-M' to M-M'), may explain much of the decreased stimulation of the economy by debt expansion" (p 49).

Importantly, in the chapter on "Monopoly-¬Finance Capital", the authors argue that the new way monopoly capitalism has found of reproducing itself, namely, through the explosive growth of finance, suggests that it has moved into a "new hybrid phase", which they designate "monopoly-finance capital"8 (p 64). Drawing on Sweezy, the chapter outlines how the "financial explosion has reacted back in important ways on the structure and functioning of the corporation-dominated "real" economy"9 (p 66). And, in the chapter on "The Financialization of Capitalism", Foster and Magdoff profile its class and imperial implications (pp 84-88).

But, in order to absorb these and other insights in each of the six chapters, the reader will have to put up with a lot of repetition. And, there seems to be an analytical flaw. In chapter 6, in a section "From Financial Explosion to Financial Implosion" dealing with the instability and fragility of a system, while examining the massive increase in private debt, the authors state that "the problem is further compounded if government debt (local, state, and federal) is added in" (p 122). This is analytically untenable. Unlike private debt instruments, US Treasury securities have a zero default risk -- they can be held indefinitely (for they are continuously "rolled over") at no financial risk to the government or to the private sector holder, for the government can never become bankrupt if it borrows in the same currency it has the power to declare as legal tender (fiat money). In fact, in the midst of the present crisis, Treasury securities are preferred holdings, for they can be readily sold for money or pledged as collateral for availing of loans.10 But of course, Treasury securities face purchasing power risk -- inflation can erode their purchasing power or deflation can result in an increasing real value of the debt for the government.

There is apprehension though about the value of the dollar, the currency in which these securities are denominated -- a depreciation of the dollar relative to the asset holder's own currency -- but this foreign exchange risk is faced by such holders for all forms of dollar denominated assets that they may hold. A significant fall, though, in value of the dollar would adversely affect the very growth strategies of the US's neo-mercantilist rivals (China, Germany and some other European countries, and Japan), as also those of US financial interests (which exercise significant power and influence in shaping the US exchange rate policy), predicated as these grand designs are upon the maintenance of a "strong" dollar. Given this, and the fact that the portfolios of the foreign assets of the neo-mercantilist powers are largely dollar-denominated, presently, all the countries at the apex of the global pyramid of power and wealth want a "strong" dollar, and will thus do all they can to ensure this. So it is highly unlikely the neo-mercantilist powers will shift their foreign portfolios of wealth away from the dollar leading to a collapse in its value. However, with the plunge in the net worth of firms geared to the circuits of money capital alone, and the consequent decline in their relative power and influence, in the event of the dollar losing say 30-40% of its value, given its "overvaluation" in the light of persistently high US current account deficits, all hell is bound to break loose with a further deepening of the financial and economic crisis globally. The historical parallel over here is the loss of international confidence in the pound sterling in 1931 in the midst of the Depression and the many bankruptcies and financial failures that resulted therefrom. Is the international role of the dollar then at stake?11

Crying Out for Answers

Clearly, we are all crying out for answers and there is a lot to gain from working one's way through this book. However, with all its strengths, there is something, I feel, missing in this volume -- the authors refrain from taking on other Marxist writers on the subject. Marxists usually differ a great deal in many matters of interpretation and evaluation, and there is a lot to learn from their debates. There are, for instance, those who endorse Marx's falling rate of profit theory, with whom the Monthly Review school differs. The former focus on systemic tendencies that, they contend, have lowered the rate of profit, and seek to link these with the role of monetary and financial phenomena disrupting the accumulation process. The disinclination to debate with other schools of Marxist thought on the financial crisis is our loss. Picture the young Paul Sweezy, penning his The Theory of Capitalist Development in the 1930s, boldly taking on a whole bunch of Marxist thinkers on crisis theory, from Henryk Grossman to Mikhail Tugan-Baranovsky, and Marx too, and the positive "externalities" flowing from this initiative. Be that as it may, there is a whole new generation today wanting to know what caused the present financial catastrophe and what might be its likely ramifications. After all, not long ago, the cold war ended with the restoration and triumph of capitalism on a global scale, and then, less than two decades later, capitalism is bankrupt. This book, with its cogency that is the hallmark of the Monthly Review, needs to be widely read.


1 Keynes considered effective demand -- demand, at a profitable price, for the volume of goods and services that could be produced with existing capacity -- to be capitalism's most fundamental macroeconomic problem.

2 We follow what appears as the typical pattern of speculative bubbles from the 1980s onwards, as outlined by Paul Sweezy and Harry Magdoff, "The Stock Market Crash and Its Aftermath", in their book, The Irreversible Crisis (New York: Monthly Review Press), 1988, pp 43-55.

3 In Marxian terms, a rise in the "organic composition of capital" (the ratio of the value of used-up means of production and the value produced by "necessary labour") increases labour productivity, which raises the rate of surplus value -- the ratio of the value produced by "surplus labour" ("surplus value") and the value produced by "necessary labour". So an increasing organic composition of capital proceeds pari passu with a rising rate of surplus value, making the direction in which the rate of profit (the surplus value divided by the sum of the value of the used-up means of production and the value produced by "necessary labour") moves indeterminate. See Paul Sweezy's 1942 classic, The Theory of Capitalist Development (New York: Monthly Review Press, 1970), p 102.

4 The economic surplus is difference between total output and the "socially necessary" costs of producing it.

5 In this paragraph, we draw on Paul Sweezy's "Monopoly Capitalism" in John Eatwell, Murray Milgate and Peter Newman (eds.), Marxian Economics (London: Macmillan), 1990: 302.

6 Here, effective demand is stimulated via the "wealth effect" -- a tendency for consumption to grow, even in the absence of the growth of incomes, due to rising asset prices.

7 The increase in net liability of a country to the rest of the world, represented by the current account deficit, if persistent and high, as in the case of the US, leads to a huge cumulative build-up of net claims by non-residents on the domestic economy. In contrast, in the case of a country with a current account surplus, there is a net outflow of funds, and, if that surplus is persistent and high, as in the case of countries following neo-mercantilist growth strategies, it will result in a huge cumulative build-up of net claims by residents on the rest of the world's economies. But, of course, there are also autonomous capital flows -- strategic rivalry between nations is not merely manifested in trade; it also takes the form of controlling resources beyond national boundaries through foreign direct investment and militarism. And, given the role of the dollar as international money, the US has an advantage over its neo-mercantilist rivals, China, Germany and Japan, in this respect -- it can finance much of its foreign investment and militarism by creating monetary liabilities abroad.

8 According to Paul Sweezy, from the latter half of the 1970s a "relatively independent -- relative, that is, to what went before -- financial superstructure sitting on top of the world economy and most of its national units" began to take shape, emerging around the mid-1990s. See his perspective piece, "The Triumph of Financial Capital" (Monthly Review, Vol 46, No 2, June 1994, pp 1-11).

9 There is also the need to take account of the impact of increasing "openness" (in the trade and financial sense) on product market structures, for instance, the impact of foreign direct investment on transforming a "tight" oligopolistic market into a "loose" one, or the impact of price competition from imports on profit rates in oligopolistic industries facing global excess capacity. All this may call for a relook at the hypothesis of the relative share of the economic surplus to rise, using more recent data.

10 Prabhat Patnaik also finds it untenable to lump together the private and the public debt "to show the fragility of the system". See his "The Economic Crisis and Contemporary Capitalism", EPW, Vol 44, No 13, 2009, p 49.

11 The reference here is to the central role of the dollar in the gigantic web of global private capital flows. For a different but interesting approach to this question, see Ramaa Vasudevan, "The Global Meltdown: Financialisation, Dollar Hegemony and the Subprime Market Collapse", EPW, Vol 44, No 13, 2009, pp 193-99.

Bernard D'Mello is deputy editor, Economic & Political Weekly, Mumbai. This article also appears in the EPW on 9 May 2009.

[Dec 28, 2009] The Big Zero

We' also learned nothing about repeating the mistakes of the Vietnam peace initiative or whatever one wants to call the 10 to 30-year investment that keeps on killing our Veterans before their time. The 'Big Zeroes' on this account are those of the Bush (mis)Adminstration who experienced the 'Big O' as they chanted, in their safe bunkers, war room, behind teams of secret service personnel, "Shock and Awe!" Repeated 'surprise visits' to combat areas are nothing but cheap photo-op stunts.

I have nothing BUT contempt for the people responsible for starting the wars in Iraq and Afghanistan. Our military personnel can do the right job if they aren't bamboozled by the likes of Bush, Carpetbaggers and War Profiteers, LLC.


The Mobius Decade. The Vandal Years. Zip. The Null Set. Paradise Lies... and Lies... and Lies... and Lies.


Over the past few decades of crony capitalism, profiteering and asset stripping essentially all American institutions have been revealed to be made of cardboard, hollowed out and subject to complete collapse. Try to think of one that has lived up to our national ideals. This generation has failed in its duty to hand on a strong economy, and even worse, gutted the democracy that could reverse the decline.


Mr. Krugman, one more thing to remember about the last decade: it was the first "naked" decade without Glass-Steagall -- with zero protection against commercial banks also becoming investment banks and going on gambling binges. If the next decade is going to be better than the last one, we must have not only tough, cutting-edge financial regulation but also a reinstatement of Glass-Steagall that separates commercial and investment banks. Otherwise the next burst bubble will be even worse, though that's hard to imagine now. We also need Paul Volcker to replace Tim Geithner immediately and someone brilliant who also cares about employment to replace the lethargic, out-of-touch Summers.

And Happy New Year to you, too!

Ralph West

Wonderfully sardonic and apt column by Mr. Krugman. To his observation of zero achieved and learned in the econominc realm, I'd add the military realm. Just as we imbecilically conflated Hussein and binLaden to justify the pointless Iraq invasion, so, today, we are conflating the Taliban and AlQaeda; just as we attacked a tract of land to solve the problem of a free-floating terrorist operation, we are doing the same today. Vast sums of money spent, close to zero accomplished.


Well, at least we outlasted the communists by 20 years. Our capitalist system has failed, so what will we call this new economic order?

abhishek mamgain:

Paul, the big zero is A FINAL VERDICT on the failed ideologies of past.

Any Street can't sustain without the Main-street support. 1% cannot thrive when others lag.

Lessons need to be learnt. Hopeful one but one must be that leaders execute what they were mandated with.


It's the decade where the working people got stolen from and pretty much impoverished, and the rich made out like the criminals so many of them are by doing the stealing. Of course, this was all done by the Republicans and their policies, along with the Conservadems.


How can anyone read this indictment of our economic system and not conclude that it is fundamentally flawed?

The problem isn't dishonest businessmen or greedy investors or foolish bankers or oblivious politicians or misguided accountants. The problem is capitalism.


Thank you for saying like it is. To not have an outlet for my anger at the way our nation wastes our precious resource of rational reasoning it moves me to read this column. A sweet solace for a forgotten person living their life amidst those who would rather run to the bank than care about the future.

Wall Street has proven itself to be the ultimate ponzi scheme supported by our government because who else can run money in circles as fast and get nowhere but paid by the millions?

Cdr. John NewlinVista:

And happy New Year to you too, Mr. Krugman.

I read your essay twice looking for two words that best describe the decade that you so impotently tried to name. They are "blood" and "treasure."

Nine years of foreign soil steeped in American blood. And there is no one that can even come close to accounting for the number of Iraqi and Afghan lives sacrificed for America's "crusade." You prattle on like the bean counter you are about deflated bubbles and the like while not even mentioning the tremendous human sacrifices made by America's military. Perhaps you do have a sense of the enormity of the fiscal costs associated with that sacrifice, but you do not address it.

Then there's the wasted treasure. Since 2001 the cost of the war in Iraq has been $712.6 billion and the cost of the Afghan war has been $235 billion. That's nearly one trillion dollars invested in the insanity of war. The rate of return in that investment is negative given the blood that was spilled in the making.

So what, Mr. Krugman, is the use of naming the decade past, given that it was awash in the blood of American heroes and the ashes of burnt treasure, both provided by the waning American middle class?

You can call it whatever you wish, Mr. Krugman. I choose to call it the Era of Insanity.


"the decade in which we achieved nothing and leant nothing"

That is a stinging appraisal of a devastating decade but not harsh enough. The reality is far worse. Will America ever recover it's lost prestige and treasure.

RWeberPark Slope

"What was truly impressive about the decade past, however, was our unwillingness, as a nation, to learn from our mistakes."

To be expected, from amnesiacs. And it's corporate media's job to ensure we stay stuck in amnesia. "It's history" is a pejorative, and that even includes only yesterday.

bracketscontracting USA

Yes. All Bush's tax cuts did was exacerbate the housing bubble.

There was not much else new that was really profitable to invest in. (see Alan Greenspan in "Age of Turbulence")

That money could have paid down the debt, and we would be in better shape than we are today.

Spread the word.

cobbler Union County, NJ

It had been a decade of tremendous growth in national wealth and standards of living... in China.

Globalization which was promoted as a panacea beginning from the 80s finally revealed itself as a zero-sum game (another zero!). Yes, we can have cheap goods in Walmart, as long as they are not made in the U.S., and the hard-working people making these goods are willing to lend us money to buy them - as long as we don't try to keep the real jobs here.

Let's not deceive ourselves - 10s will be worse than the zeros, 20s worse than 10s and so on, as long as an hour of labor here costs more than somewhere else in the world, and as long as "tariffs" and "industrial policy" remain forbidden words among the political class and economists.

BobbyEugene, OR:

Thanks, Dr. Krugman. Without your wisdom, insight, and clear explanation of occasionally esoteric concepts, I may very well have lost my sanity during this last decade. I look forward to reading the next decade's worth of your columns.

spidermarkKoh Samui:

What Krugman does not really dwell on, is that it was the big zero for America. Not for the world. The rest of the world continues to enjoy growth, and continues to rebound from "the great american recession". It is America which continues to languish.

It is America, which has begun a long, slow decline, that may continue throughout our lifetimes, unless some bold politicians start to fulfill some of their campaign promises, like supporting "green energy", in a bold a dynamic enough way, to keep jobs in the US, and create real economic stimulus.

If now, where will the recovery come from? What industry? Creativity and boldness are what is needed to extricate the US from this self created morass it finds itself in.

[Dec 28, 2009] A ''Turning Point in U.S. Society''?

Did Enron change everything?:

Might Krugman's polemic prediction about Enron vs. 9-11 ever come true?, by Michael Roberts: I look at our financial and economic system in dumbfounded awe as to how it all works. We shovel trillions of dollars into banks, stocks and mutual funds, rarely knowing the first thing about how well the underlying companies are managed or how profitable they are or what they are truly doing with our money. While I think I'm more informed than the average investor, I couldn't tell you which 10 CEOs are most responsible for my investments. I couldn't even tell you the top 10 companies! ...
The fact that I do invest shows I have remarkable confidence in our financial system. That confidence is based on history, the fact that firms and CEOs have been honest and transparent enough in their accounting and that, over the long run, the stock market has performed extremely well. The long sweep of history says I'm crazy not to invest.
But then I look at recent history and I wonder how the long history came to be. Honest and transparent are not adjectives that come easily to mind when looking at our modern financial system and events over the last decade.
This issue is in fact the lynch pin to modern capitalism. At a fundamental level what makes it all work is to having institutions that deal effectively with asymmetric information (the econ jargon). If one cannot see exactly what they are buying with their investment money, little investment will take place, and economies don't grow. So modern capitalism requires rock solid institutions that reduce information asymmetries and allow dollars to flow toward investments with the greatest potential returns.
This is why, back in 2002, Paul Krugman made what I think was his most polemic prediction ever:
I predict that in the years ahead Enron, not Sept. 11, will come to be seen as the greater turning point in U.S. society.
Many, including me, thought this was a bit much, even if Krugman made some good points in that old column. His column today, a tribute the naughties, echos similarly to his 2002 prediction...
Krugman was worried about the collapse of our financial institutions and saw Enron as an omen. ... And here we are. Things didn't collapse completely but it wasn't pretty. While we've begun to recover (barely) many problems still need fixing, particularly re-regulation of financial markets.
I still think Krugman overstepped when he made that prediction in 2002, not just because the Enron fallout blew over relatively quickly, but because the sweeping fallout of 9/11 has been so great. But today I do think there is a chance ... that Krugman's prediction might eventually turn out to be right after all. ...

What's disappointing is that after Enron, and after what just happened, things might not change, at least not by very much. As Krugman notes, we seem unwilling to learn from our mistakes:

Even as the dot-com bubble deflated, credulous bankers and investors began inflating a new bubble in housing. Even after famous, admired companies like Enron and WorldCom were revealed to have been Potemkin corporations with facades built out of creative accounting, analysts and investors believed banks' claims about their own financial strength and bought into the hype about investments they didn't understand. Even after triggering a global economic collapse, and having to be rescued at taxpayers' expense, bankers wasted no time going right back to the culture of giant bonuses and excessive leverage.

Part of it is transparency, and more is certainly needed, and perhaps it is an inability to learn from mistakes, but a bigger problem is the distribution of economic and political power. Business interests are dominant in Washington, and these powerful interests will do what they can to resist constraints on their behavior no matter what lessons the rest of us may have learned from their actions in the past. It is not at all clear that the political will needed to overcome the opposition of business groups and make the needed regulatory and legislative changes is present. Unless and until the political will is there, and if this crisis doesn't do it I'm not sure what will, we'll be in danger of repeating the same mistakes yet again. Congress might surprise and take tough action if and when the financial reform process currently underway is complete, but I'm not expecting that to happen.

Posted by Mark Thoma on Monday, December 28, 2009 at 04:23 PM in Economics, Financial System, Politics, Regulation Tweet This Permalink TrackBack (0) Comments (22)

[Dec 27, 2009] Fear And Loathing In Manhattan

The most important is the need to end dangerous rent-seeking - pursuing explicit and implicit government subsidies - in the financial system. This distorts incentives, leads to crazy risk-taking episodes and ties up resources in unproductive uses. America needs to refocus on sectors that can generate real value - think nonfinancial technological innovation, which is our traditional strength.
The Baseline Scenario


Looking forward to reading William D Cohan's book "House of Cards, A Tale of Hubris and Wretched Excess on Wall Street" - take it from someone who actually had an inside perspective:

Best Baseline Scenario for 2009:

The most important is the need to end dangerous rent-seeking - pursuing explicit and implicit government subsidies - in the financial system. This distorts incentives, leads to crazy risk-taking episodes and ties up resources in unproductive uses. America needs to refocus on sectors that can generate real value - think nonfinancial technological innovation, which is our traditional strength.

Investopedia explains Rent-Seeking: An example of rent-seeking is when a company lobbies the government for loan subsidies, grants or tariff protection. These activities don't create any benefit for society, they just redistribute resources from the taxpayers to the special-interest group.

May be the above means that a semi-free market exchange of real and tangible products and services are the more sensible and enduring ways to operate, going forward. That initially, President Obama did express a kind of American glasnost in his inaugural day speech (but has since, hmmmm, fallen short…). And having about 1/3 of the national debt held by China isn't a good thing, on several levels (geo-political, militarily, environmental).

Best under-told story for 2009:

(for those who can't remember last year), PUMA is 'Party Unity My Ass'.


I'm afraid, Simon, that books are unnecessary to convince me of the reality that confronts us. Our present system is not only malfunctional, but, worse, dysfunctional at the core. These books only may accurately describe what has happened already, but the real story is being played out between the various lobbies and a Congress that has been paid to listen. After checking contributions and votes, there is almost no one on Capital Hill who has not been seriously compromised. They all find ways to spin their votes and positions to appear to be aligned with truth and beauty, but, the deals have been made, and souls have been sold. Yes, this has gone on for 233 years, but seems to have really mushroomed out of control lately, and it appears that most of the top corporate exectutives in all areas (but especially health care and finance) are feathering their nests as long as they can before it all heads seriously south for good. They are presently checking on the cost of a nice sized island to live on onece things do, and they will.


Simon Johnson does sound like a broken record in his review of these books. Obviously a good part of the current system is broken.

Contrary to what Mr. Johnson states in his article that propelled him to fame in the blogosphere, the situation is definetely not comparable to that of Russia in the 90´s or any of the tiger economies in that decade. The key difference is, that the financial elite in the US has (not only) been profiting at the expense of the domestic population, but rather that a large part of american consumption and investment (first and foremost in real estate) has been at least half financed by the rest of the world. Whilst this may seem unfair from a moral perspective, it hasn´t necessarily been net negative for the US.

Whilst a lot of Mr. Johnsons proposals are probably accurate and definetely correct from a moralistic point of view, they are not necessarily in the best interest of the United States. It´s allways easy to judge in hindsight and I would very much doubt that anyone who is in charge of US economic policy currently would, if given the chance to go back 20-30 years, run it in the same way again. What Mr. Johnson fails to recognize, is that this is not the current question.

The situation being what it is, the policy that Obama is currently pursuing actually does make sense. With consuption (to a good extent of imports, FIRE (Financial Sector, Insurance, Real Estate) constituting a large part(and up to ´07 most dynamic) of the US economy, it actually does make sense, not to bring in the wrecking ball, with regards to this sector.

The current strategy of shoring up what constitutes the strenghts of the US economy (in which the rest of the world is heavily invested), whilst at the same time attempting to build up new productive sectors (i.e. renewables) as well as shoring up social safety nets (i.e. health care), over 8 years(i.e. 2 terms) actually makes a whole lot of sense.

As a European I obviously hope that Mr. Johnsons proposals win the day. I have little sympathy for anyone living beyond their means, but I fail to understand why so many American commentators are so keen on such a development.


Because a great deal of the supposed value in the US economy does not involve the creation of anything that anyone truly values.

Because a great many very talented people spend a great deal of time trying to outwit each other for distributional gains, rather than employ their talents in productive enterprise. And, indeed, they continue to be paid far more than those who do invest their lives in productive enterprise.

Because the expanding-dollar party only goes until the dollar stops expanding (which it already has), and then we're left with a house that looks like any other post-kegger domicile.


The economic problem in the US is but a symptom of a political disease. (It's more likely a political form of malaria or other parasitic infestation, but i'll keep the disease analog for demonstration purposes.)

Treating the symptoms may cause relief for a while, but the disease remains to cause future problems.

The current response, IMO, has been to administer powerful painkillers to make the patient (Main Street) feel less uncomfortable. These do not solve the problems of the disease nor the symptoms. I really am afraid of what may happen when the opiates wear off – the sheeple may be collectively willing to trade security for freedom – again.

jake chase


FIRE may be dynamic, but I can't agree that adding several trillion of worthless drek to the Fed balance sheet and doubling the National Debt is precisely the way to go. Moreover, I doubt we can do it again next year or the year after, so maybe we ought to reconsider the FIRE strategy a wee bit.



I think Sorkin's book is more a history of who did what as the economy was tanking. It doesn't really go into detail on the causes of the problems facing the bankers and the government. If you'd rather read about the causes, then Bailout Nation is a better book. If you'd like some attitude then It Takes A Pillage is a good choice.
House Of Cards and A Colossal Failure give more detail about individual firms.


This is my clarion call to Mr. Johnson, Mr. Kwok et al.

It is time to step up!

Time to stop taking seriously these ridiculous arguments like how to regulate for "too big-to-fail".

Time to loudly, publicly, and consistently advocate for the return of Glass-Steagal.

Time to act more like Robert Skidelsky and less like Paul Krugman.

Time to bury the Anglo-American model of capitalism once and for all.

You know what to do!

Carthago delenda est!


I've revised one of my Baseline Fables, exercising a touch of artistic licence in James Kwak and Felix Salmon's conversation on


Thanks for the reviews.

Am reading John Perkins , Hoodwinked.
"An economic hitman reveals why the world financial markets imploded – and what we need to do to remake them"


Have you heard of if? If so what do you think?

Joseph Tibman

Try my book "The Murder of Lehman, An Insider's Look at the Global Meltdown." I was a sinior ivestment banker, there for about 20 years. It's an honest account. I'm cozy with no one, but the "villains" are not cartoons. They are people. Mine is a human tale as wellas an explanation of what set the stage for a Lehman failure both inside and ver man years outside Lehman's walls.

Matt Carmody

Want to know the real reason things won't be any different and why we'll have another one of these wonderful meltdowns real soon?

Read Hyman Minsky's books, "John Maynard Keynes" and "Stabilizing an Unstable Economy."

And there's always that classic, The Eighteenth Brumaire of Louis Bonaparte by Karl Marx.

The more things change, the more they stay the same.

[Dec 18, 2009] Is The Market Rigged - By Simon Maierhofer

December 18, 2009 | Yahoo! Finance

The government is pumping trillions of dollars into the economy in an effort to jump start business activity. Banks (NYSEArca: KBE - News) gratefully take the money and either horde it or buy government treasuries with short (NYSEArca: SHY - News) and long-term maturities (NYSEArca: TLT - News).

Real estate prices are still falling, unemployment is sky-high, consumer spending is down and corporate profits are nowhere near to last year's levels.

The only thing that provides comfort for the masses is rising stock prices. The S&P 500 , Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) have gained in excess of 65% in less than ten months against a backdrop of continuously less than stellar news. The government, banks and other financial institutions (NYSEArca: XLF - News) have a vested interest in rising stock prices.

Things would look grim if it wasn't for the hope provided by the Dow and S&P's of the world. But more than hope is at stake. Another drop in investor's perception would send real estate (NYSEArca: IYR - News) and equity prices (NYSEArca: IWV - News) tumbling. It could also push many financial institutions to the brink of ruin and discredit all government efforts.

Looking at what's at stake and the motivations involved, could it be that some of the big players are manipulating the market to keep prices artificially afloat?

A big surprise

Don't you hate it when juicy news is making its rounds but you are kept out of the loop? Welcome to the club. Already back in 1988, Ronald Reagan signed an executive order to establish various committees designed to prevent major market collapses.

As per this order, the Secretary of the Treasury, the chairman of the Federal Reserve, the chairman of the SEC and the chairman of the commodity futures trading commission make up the core of this team. By extension, major financial institutions like JP Morgan Chase and Goldman Sachs are used to execute their orders.

The existence of this team is said to have been confirmed by former Clinton advisor George Stephanopoulos on Good Morning America. Last year, former Treasury Secretary Hank Paulson called for this 'financial fraternity' to meet with greater frequency and set up a command center at the U.S. Treasury designed to track global markets and serve as headquarter for the next crisis.

There is much more to this unique arranged designed to keep a lid an potential market meltdown and use major Wall Street firms as marionettes to accomplish this goal. A detailed report about this secret team is available in the most recent issue of the ETF Profit Strategy Newsletter.

Buoy the market, how?

Supply and demand drives prices. Where the demand comes from does not matter. In emergency situations, the Federal Reserve is said to lend money to major banks, which serve as surrogates who will take the money and buy markets, predominantly futures, through large unknown accounts.

The timing of those buys will be such that those shorting the market will be forced to buy back shares. In theory, this eliminates the most pessimistic investors and causes others to buy. Soon sideline money from mutual and hedge funds comes in and the rally gathers a life of its own.

In Government Sachs we trust

One of the obvious suspects to serve as surrogate and carry out the government's plan would be Goldman Sachs (NYSE: GS - News). For years, the ties between the U.S. government and Sachs have been too close for comfort. Earlier this year the ETF Profit Strategy Newsletter touched on a case of 'indiscretion' which never received much publicity.

Stephen Friedman, the chairman of the New York fed was instrumental in orchestrating the multi-billion bailout for Goldman and AIG. AIG (NYSEArca: AIG - News) used nearly $10 billion of the initial $85 billion to pay Goldman.

Chairman of the New York Fed was not the only title Mr. Friedman held. He also happened to be on Goldman's board during that time and was Goldman's CEO in the 1990s. Also during that time, Mr. Friedman was actively buying Goldman stock and generated profits worth millions of dollars.

Other ties between government and Sachs include Hank Paulson, former Secretary of the Treasury and former Goldman CEO. When Mr. Paulson needed someone to oversee see the government's first $700 billion bailout, Paulson recruited an inexperience, 35-year old, former Goldman investment banker. The list continues, but we'll stop here.

A record winning streak and no taxes

The Financial Times reported that Goldman Sachs suffered only one losing day during the 65 business days of the third quarter. On 36 separate days during the quarter, the firm's trades netted more than $100 million.

In addition, Bloomberg reported that Goldman Sachs' effective income tax rate for 2008 was 1%. In dollars, Goldman's tax liability was $14 million. For the same year, Goldman reported a $2.3 billion profit and paid out $10.9 billion in bonuses.

One could argue that a record of 90%+ winning trades and a 1% tax rate could only be accomplished with certain connections to high-ranking government personnel.

Too good to be true

The notion that prices can be inflated artificially makes sense and sounds good in theory. Based on the evidence, this kind of maneuvering even seems to be more common than we think.

But a simple look at the chart shows that even the government and big banks do not have superhuman powers, at least not unconditionally.

In 2000, 2002, 2008 and 2009, the major indexes a la S&P 500 (NYSEArca: SPY - News), Dow Jones (NYSEArca: DIA - News) and Nasdaq (Nasdaq: QQQQ - News) declined 30% or more.

It is now known, as it was back then, that the nation's most powerful financiers got together on October 24, 1929 to prevent a major meltdown. Their plan succeeded on that very day which came to be known as Black Thursday. The recovery on Black Thursday was as remarkable as the selling that made it so Black.

On Friday, the Times reported that the financial community felt 'secure in the knowledge that the most powerful banks in the country stood ready to prevent a recurrence of panic.' In a concerted advertising campaign in Monday's papers, stock market firms urged to pick stocks at bargain prices. The rest is history and the Great Depression unfolded in all its cruel ways.

On of the flaws of artificial buying is that all the money used to buy stocks will eventually have to be taken out. As we know, banks are not immune to greed and once prices start declining, banks are likely to be the first to cut their losses and flee the sinking ship.

There are limits

In summary, we can conclude that there seems to be an organized committee with the job description of lifting markets. Quite likely, their efforts have contributed to the protracted rally in stock prices. However, as we've seen, the market is too wild to be contained. Normal market forces still apply.

One of those age-old forces is investor sentiment, possibly the best known and most accurate contrarian indicator around. Extreme levels of pessimism tend to signal market bottoms while extreme levels of optimism tend to signal tops.

The ETF Profit Strategy Newsletter used this contrarian indicator as a foundation to issue the March 2nd Trend Change Alert which foretold a massive rally with a target range of Dow 9,000 - 10,000 a mere seven days before the March lows were reached.

Now once again, we see an extreme of investor sentiment - this time it's optimism. According to the Investors Intelligence survey, this week saw the highest percentage of bulls since December 2007.

... ... ...

The question is this: Who are you putting your trust in, the market or big banks?

[Dec 18, 2009] Matt Taibbi join Bill Moyers to discuss Wall Street's power over the federal government

December 18, 2009 | Bill Moyers journal

BILL MOYERS: Welcome to the Journal.

Something's not right here. One year after the great collapse of our financial system, Wall Street is back on top while our politicians dither. As for health care reform, you're about to be forced to buy insurance from companies whose stock is soaring, and that's just dandy with the White House.

Truth is, our capitol's being looted, republicans are acting like the town rowdies, the sheriff is firing blanks, and powerful Democrats in Congress are in cahoots with the gang that's pulling the heist. This is not capitalism at work. It's capital. Raw money, mounds of it, buying politicians and policy as if they were futures on the hog market.

Here to talk about all this are two journalists who don't pull their punches. Robert Kuttner is an economist who helped create and now co-edits the progressive magazine THE AMERICAN PROSPECT, and the author of the book OBAMA'S CHALLENGE, among others.

Also with me is Matt Taibbi, who covers politics for ROLLING STONE magazine where he is a contributing editor. He's made a name for himself writing in a no-holds-barred, often profane, but always informative and stimulating style that gets under the skin of the powerful. His most recent article is "Obama's Big Sellout," about the President's team of economic advisers and their Wall Street connections. It's been burning up the blogosphere. Welcome to both of you.

BILL MOYERS: Let's start with some news. Some of the big insurance companies, Well Point, Cigna, United Health, all surged to a 52 week high in their share prices this week when it was clear there'd be no public option in the health care bill going through Congress right now. What does that tell you, Matt?

MATT TAIBBI: Well, I think what most people should take away from this is that the massive subsidies for health insurance companies have been preserved while it's also expanded their customer base because there's an individual mandate in the bill that's going to provide all these companies with the, you know, 25 or 30 million new people who are going to be paying for health insurance. So, it's, obviously, a huge boon to that industry. And I think Wall Street correctly read what the health care effort is all about.

ROBERT KUTTNER: Rahm Emanuel, the President's Chief of Staff, was Bill Clinton's Political Director. And Rahm Emanuel's take away from Bill Clinton's failure to get health insurance passed was 'don't get on the wrong side of the insurance companies.' So their strategy was cut a deal with the insurance companies, the drug industry going in. And the deal was, we're not going to attack your customer base, we're going to subsidize a new customer base. And that script was pre-cooked so it's not surprising that this is what comes out the other side.

BILL MOYERS: So are you saying that this, what some call a sweetheart deal between the pharmaceutical industry and the White House, done many months ago before this fight really began, was because the drug company money in the Democratic Party?

ROBERT KUTTNER: Well, it's two things. Part of it was we need to do whatever it takes to get a bill. Never mind whether it's a really good bill, let's get a bill passed so we can claim that we solved health insurance. Secondly, let's get the drug industry and the insurance industry either supporting us or not actively opposing us. So that there was some skirmishing around the details, but the deal going in was that the administration, drug companies, insurance companies are on the same team. Now, that's one way to get legislation, it's not a way to transform the health system. Once the White House made this deal with the insurance companies, the public option was never going to be anything more than a fig leaf. And over the summer and the fall, it got whittled down, whittled down, whittled down to almost nothing and now it's really nothing.

MATT TAIBBI: Yeah, and this was Howard Dean's point this week was that this individual mandate that's going to force people to become customers of private health insurance companies, the Democrats are going to end up owning that policy and it's going to be extremely unpopular and it's going to be theirs for a generation. It's going to be an albatross around the neck of this party.

ROBERT KUTTNER: Think about it, the difference between social insurance and an individual mandate is this. Social insurance everybody pays for it through their taxes, so you don't think of Social Security as a compulsory individual mandate. You think of it as a benefit, as a protection that your government provides. But an individual mandate is an order to you to go out and buy some product from some private profit-making company, that in the case of a lot of moderate income people, you can't afford to buy. And the shell game here is that the affordable policies are either very high deductibles and co-pays, so you can afford the monthly premiums but then when you get sick, you have to pay a small fortune out of pocket before the coverage kicks in. Or if the coverage is decent, the premiums are unaffordable. And so here's the government doing the bidding of the private industry coercing people to buy profit-making products that maybe they can't afford and they call it health reform.

BILL MOYERS: So explain this to the visitor from Mars. I mean, just this week, the Washington Post and ABC News had a poll showing that the American public supports the Medicare buy-in that-


BILL MOYERS: By a margin of some 30 points-


BILL MOYERS: And yet, it went down like a lead balloon.

ROBERT KUTTNER: Look, there are two ways, if you're the President of the United States sizing up a situation like this that you can try and create reform.

And you, as the president, be the champion of the people against the special interests. That's the course that Obama's chosen not to pursue.

MATT TAIBBI: And I think, you know, a lot of what the Democrats are doing, they don't make sense if you look at it from an objective point of view, but if you look at it as a business strategy -- if you look at the Democratic Party as a business, and their job is basically to raise campaign funds and to stay in power, what they do makes a lot of sense. They have a consistent strategy which involves negotiating a fine line between sentiment on the left and the interests of the industries that they're out there to protect. And they've always, kind of, taken that fork in the road and gone right down the middle of the line. And they're doing that with this health care bill and that's- it's consistent.

BILL MOYERS: If you were Republican, wouldn't you feel right now that it's going your way? I mean, the Democrats control the White House, they control Congress and the only thing they've been able to make happen this year is escalate the war in Afghanistan.

MATT TAIBBI: The Democrats are in exactly the same position that the Republicans were in once the Iraq War turned bad. All the Republicans have to do now is sit back and watch the Democrats make a disaster out of this health care effort. And they're going to gain political capital whether they're in the right or not. And I think it's a very -- it's a terrible thing for the party.

BILL MOYERS: Some of your progressive readers and colleagues are going to take issue with you, of course, because there are progressive figures like John Podesta, of the Center for American Progress, Kevin Drum, and others who say, look, this bill has its real problems. It's got some real toxic qualities to it. But it's not as bad as Kuttner and Taibbi think. This is the Senate bill, it covers 30 million-plus more people, has subsidies for low-income families, spreads the risk, lowers some premium costs, creates some exchanges where people can shop for better coverage and prices. You know, don't be too hard on it.

ROBERT KUTTNER: Well, my co-editor, Paul Starr in the editorial in the current issue of "The Prospect" takes exactly that position. Don't be too hard on Obama, he inherited a really difficult situation and we're making incremental progress. If we could've done better we would've. Paul and I disagree about that. I mean, I think one of the challenges of a president is to transform the reality rather than just work within its parameters. I think the other problem, frankly, is that those of us who consider ourselves progressives invested so much in this remarkable figure, Barack Obama. And we read our own hopes into him. We saw him as a potentially great president. We saw this as a potentially transformative moment, I certainly did, where he could've chosen to be the kind of president Roosevelt was. And it turns out that's not who is characteralogically and that's not how he chose to play the moment.

BILL MOYERS: Yes or no. If you were a senator, would you vote for this Senate health care bill?




BILL MOYERS: Why? You just said it's designed to enhance the fortunes of the industry.

ROBERT KUTTNER: Well, it's so far from what I think is necessary that I don't think it's a it's a good bill. But I think if it goes down, just because of the optics of the situation and the way the Republicans have framed this as a make or break moment for President Obama, it will make it easier for the Republicans to take control of Congress in 2010. It will make Obama even more gun-shy about promoting reform. It will create even more political paralysis. It will embolden the republicans to block what this President is trying to do, some of which is good, at every turn. So I would hold my nose and vote for it.

MATT TAIBBI: My feeling on it is just looking more concretely at the health care problem, this is a bill that to me doesn't address the two biggest problems with the health care crisis.

So, if a health care bill that doesn't address those two problems, to me, is- and additionally is a big give-away to the insurance companies because it provides, you know -- it creates this new customer base, it's something I personally couldn't vote for.

BILL MOYERS: Aren't you saying that in order to save the Democratic President and the Democratic Party in 2010 and 2012 you have to have a really rotten health insurance bill?

ROBERT KUTTNER: Well, when you come down to one pivotal moment where a bill is before Congress and the administration has staked the entire presidency on this bill and you're a progressive Democrat are you going to vote for it or not? Let me put it this way, if I were literally in the position that Joe Lieberman is in and it was up to me to determine whether this bill live or die, I would hold my nose and vote for it even though I have been a fierce critic of the path this administration has taken.

BILL MOYERS: But doesn't that further the dysfunction and corruption of the system that you write so often about? I mean, you said a few weeks ago that our failed health care system won't get fixed because it exists entirely within the confines of yet another failed system, the political entity known as the United States of America. You said we have a government that is not equipped to fix actual crisis. So if Bob votes for a bill that in his heart and in his mind he does not believe really helps the situation, isn't he furthering a government that can't solve the actual crisis?

MATT TAIBBI: I think so. I understand his point of view. But I my feeling is that if you vote for this bill and it passes, that's your one shot at fixing a catastrophic and completely dysfunctional health care system for the next generation maybe. And I think it's much better for the Democrats to lose on this issue and then have to regroup maybe eight years later, or six years later, and try again and do a better job the next time than to have it go through.

ROBERT KUTTNER: We're going to have to do that anyway. In other words, these fights never end. We're going to have to go back and make a fight another day. And hopefully, that won't be 20 years from now. Hopefully, it will be six years from now. I think if this bill goes down it's going to be even harder to get the kind of legislation we want because the Republicans are really going to be on the march. So, the Democrats are really between a rock and a hard place here, because if it loses, there's one set of ways the Republicans gain. If it wins, there could be another set of ways that the Republicans gain. And this is all because of the deal that our friend, Rahm Emanuel struck back in the spring of passing a bill that's a pro-industry bill that doesn't really get at the structural problems.

MATT TAIBBI: But that's the whole point. If the Democrats had used as a political strategy, we're just going to do what the vast majority of our constituents want and pass a bill that was real, that had real teeth to it, that provided real benefits and actually fixed the problems then, you know, the political benefits that the Republicans could've had after the passage of the bill would've been very limited it seems to me. They could've only gone that one direction and criticized that you know, as a, you know, a socialist give-away. They couldn't have criticized it as an industry give-away and ineffective.

ROBERT KUTTNER: Look, this is not Monday morning quarterbacking.


ROBERT KUTTNER: I mean, I was making the same criticisms that you were at the time. But now we're down to a moment of final passage. And maybe my views are very ambivalent. But I would still vote for it because I think the defeat would be absolutely crushing in terms of the way the press played it, in terms of the way it would give encouragement to the far right in this country that we can block this guy if we just fight hard enough, if we just demagogue it.

MATT TAIBBI: But couldn't that defeat turn into -- that crushing defeat, couldn't that be good for the Democrats? Couldn't it teach them a lesson that, you know, maybe they have to pursue a different course in the future?

ROBERT KUTTNER: Well, you're younger than I am.

BILL MOYERS: Matt, Senator Russ Feingold of Wisconsin, a very progressive member of Congress who's been at this table wanted a public option. He says this health care bill appears to be the legislation that the president wanted in the first place.

MATT TAIBBI: Yeah, I mean, I think that makes sense. Yeah, it's quite obvious that at the outset of this process, the White House didn't want, for instance, single payer even on the table, you know, when Max Baucus had his initial discussions in committee on this bill, he invited something like 43 people to give their ideas about, you know, how the bill might look in the future. And he didn't invite a single person from -- who was an advocate of single payer health care. So that was never on the table. And it's quite clear that the public option was looked at more as a political obstacle for the White House as opposed to something that they really wanted. They kind of used it as something to scare the Republicans and the moderates with. And that's really all it ended up turning out to be.

BILL MOYERS: Yeah, if he had wanted a public option, if he'd wanted a Medicare buy-in, he could have tried to persuade the public and the Congress.

ROBERT KUTTNER: That's what's so galling. Yeah.


ROBERT KUTTNER: I mean, if you if you roll back the tape he could've played it so differently and he could've gotten a better bill. But we are where we are.

MATT TAIBBI: I mean, that's what George Bush did when he wanted to get something unpopular passed or something that was iffy. I mean, he just took, you know, if there were any recalcitrant members, he just took him in the back room and beat him with a rubber hose until they changed their minds. I mean, he could've taken Joe Lieberman back there and said, look, if Connecticut ever wants a dime of highway money again, you're going to have to play ball on this thing. That's what the president does. I mean, the president has an enormous amount of power. The leaders, the majority leaders have an enormous amount of power. And if they want to pass something, they can do it. And especially when there's a tremendous public mandate to get something like this passed. I just- the idea that they couldn't do this was -- is a fallacy.

BILL MOYERS: But members of Congress, they take the same contributions from the same insurance and real estate and drug industry. You look at the list of contributions to members of Congress -- they are as saddled by obligations as the President, right?

ROBERT KUTTNER: Well, some are and some aren't. I mean, the House, at least, just passed a bill that's over $100 billion to extend unemployment, extend insurance benefits in the interim prevent lay-offs at the level of state and local government. Now, you have a group of Democrats, and this is the real pity of it. The Democrats are supposed to be the party of the average person. You have the so-called New Democrats who are really the party of Wall Street. And then you have the Blue Dogs who are fiscal conservatives. And if you look at what happened in Barney Frank's committee to the financial reform bill, he's a pretty good liberal, he ended up looking like a complete stooge for industry because in order to get a bill out of his own committee, he had to appease the 15 New Democrats, so-called, who were put on that committee mostly by Rahm Emanuel when he was the-

MATT TAIBBI: Sort of as a means to raise money.

ROBERT KUTTNER: As a means to raise money. So Melissa Bean, who's a two-term Democratic Congressman ends up being the power broker because she controls 15 votes on Barney Frank's committee of what she's going to allow out of committee and what she isn't.

BILL MOYERS: Why does she control 15 votes?

ROBERT KUTTNER: Because there are 15 New Dems, and this is the centrist caucus that particularly specializes in taking money from the financial industry.

BILL MOYERS: You call them centrist, don't you mean corporate Democrats? I mean-

ROBERT KUTTNER: Corporate, yes, sorry. That's too kind. They're corporate Democrats who were put on that committee because Rahm Emanuel felt that there's no better place than the House Financial Services Committee if you want to shake down Wall Street, to put it bluntly.

MATT TAIBBI: There's a great example of Melissa Bean's power was when the banks wanted to pass an amendment into the bill that would have prevented the states from making their own tougher financial regulatory rules. And Bean put through this amendment that basically said that the federal government would have purview over all these laws. And it passed. And this was the kind of thing that the banks wanted. They just go to Melissa Bean, she puts that amendment in there and it and it gets through.

BILL MOYERS: If you were Barack Obama in a city that's overrun by money, how would you try to fix it?

ROBERT KUTTNER: I would go over the heads of the special interests to the people. I think there's a lot of sullen apprehension, frustration out in the country. And I think the people are hungry for leadership. He's not doing that sufficiently.

MATT TAIBBI: It's absolutely a political winner for the president to hit Wall Street very hard and do all the things that he's supposed to be doing right now. You know, that all the things that FDR did. If he did those things, if he remade Wall Street in the way that it needs to be remade, he would do nothing but gain popularity. And I think that's the strategy he should have pursued.

BILL MOYERS: But what if by nature, that's not what he wants to do? What if, by nature, he prefers to head the establishment, than to change it?

ROBERT KUTTNER: Then he runs the risk of being a failed president. And I do have the audacity to hope that he's a smart enough, principled enough guy, that some time in his second year in office, he's going to realize that he's at a crossroads.

MATT TAIBBI: This isn't a purely political problem. This isn't just a question of how does Barack Obama get reelected. This is a serious problem. He has to put aside maybe his inclinations to think about what he can do to actually fix the country. And it's, you know, desperately in need of fixing. And so, if he's not that guy, he has to become that guy.

BILL MOYERS: You say it's a serious problem. But isn't from your own experiences, your long experience, your recent experience, isn't this the fundamental question issue of why it's not working, that there's too much money canceling out other imperatives, other needs, other possibilities?

MATT TAIBBI: This is the fundamental question. Is there a way that we can have a politician get elected without the sponsorship of special interests? Can we get somebody in the White House who's independent of the special interests that are in the way of real reform? And that's the problem. We haven't been able to have that happen. And we need to find a way to have that happen.

ROBERT KUTTNER: Right. And I think it's not accidental that the last three Democratic presidents have been at best, corporate Democrats. And one hoped because of the depth of the crisis and the disgrace of deregulation and ideology, and the practical failure of the Bush presidency, this was a moment for a clean break. The fact that even at such a moment, even with an outsider president campaigning on change we can believe in, that Barack Obama turned out to be who he has been so far, is just so revealing in terms of the structural undertow that big money represents in this country. The question is: Is he capable of making a change -- he's only been in office less than a year -- in time to redeem the moment, redeem his own promise?

BILL MOYERS: When you talk about corporate Democrats, exactly what do you mean?

ROBERT KUTTNER: I mean Democrats who are reluctant to cross swords with the corporate elite that has so much power in this country, whether it's the Wall Street elite or whether it's the health-industrial complex.

MATT TAIBBI: And I think, you know, back in the in the mid-'80s, after Walter Mondale lost, I think the Democrats made a conscious decision that they were no longer going to rely entirely on interest groups and unions to fund their campaigns, that they were going to try to close that funding gap with the Republicans. And they made a lot of concessions to the financial services industry to big corporations. And that's who they are now. I mean--

ROBERT KUTTNER: That's a little too harsh. Just the pity of it is there are probably 40 Democrats in the Senate who are not corporate Democrats. And there are probably 200 Democrats in the House who are not corporate Democrats. If we could push a little harder, we can take back our political system and have a democratically elected set of officials who are the kind of counterweight to big money that we need in order to get reform.

BILL MOYERS: So Democrats have their own obstructionists?

ROBERT KUTTNER: Yeah. You have Republican wall-to-wall obstructionism, which is partisan. And with a few exceptions, Republicans are totally in bed with big business. And you have just enough Democrats who are in bed with big business that it makes it much harder for progressive Democrats to follow the agenda that the country needs.

ROBERT KUTTNER: It just takes a lot of guts. It takes a lot of nerve. It takes a willingness to be somewhat radical.

BILL MOYERS: What you mean, radical?

ROBERT KUTTNER: I mean, confronting the elite that really has a hammerlock on politics in this country and articulating the needs of ordinary people. Now, in Washington, that's considered radical.

BILL MOYERS: I was thinking about both of you Sunday night when President Obama was on 60 MINUTES and he said...

PRESIDENT OBAMA: I did not run for office to be helping out a bunch of fat cat bankers on Wall Street.

BILL MOYERS: Then on Monday afternoon, he had this photo opportunity in which he scolded the bankers and then they took it politely and graciously, which they could've done because the Hill at that very moment was swarming with banking lobbyists making sure that what the President wants doesn't happen. I mean, what did you think as you watched him on 60 MINUTES or watched that press conference?

MATT TAIBBI: It seemed to me that it was a response to a lot of negative criticism that he's been getting in the media lately, that they are probably looking at the President's poll numbers from the last couple of weeks that have been remarkably low. And a lot of that has to do with some perceptions about his ties to Wall Street. And I think they felt a need to come out and make a strong statement against Wall Street, whether they're actually do anything is, sort of, a different question. But I think that was my impression.

ROBERT KUTTNER: I was appalled. I was just appalled because think of the timing. On Thursday and Friday of last week, the same week when the president finally gives this tough talk on "60 Minutes," a very feeble bill is working its way through the House of Representatives and crucial decisions are being made. And where is the President? I mean, there was an amendment to put some teeth back in the provision on credit default swaps and other kinds of derivatives. And that went down by a handful of votes. And to the extent that the Treasury and the White House was working that bill, at all, they were working the wrong side. There was a there was a provision to exempt foreign exchange derivatives from the teeth in the bill. That--

MATT TAIBBI: Foreign exchange derivatives are what caused the Long Term Capital Management crisis--


MATT TAIBBI: A tremendous problem.

BILL MOYERS: Ten or 12 years ago, right?


ROBERT KUTTNER: Yeah. And, Treasury was lobbying in favor of that. There was a provision in the bill to exempt small corporations, not so small, I believe at $75 million and under, from a lot of the provisions of the Sarbanes-Oxley Act requiring honest accounting. Rahm Emanuel personally was lobbying in favor of that.

BILL MOYERS: So you had the Treasury and the White House chief of staff arguing on behalf of the banking industry?

ROBERT KUTTNER: Right. Right. And so here's the president two days later giving a tough speech. Why wasn't he working the phones to toughen up that bill and, you know, walk the talk?

BILL MOYERS: Get on the phone with the Chairman of the Committee and say, if you want that dam in your district, I want your vote on this.



BILL MOYERS: And that's what you mean?


BILL MOYERS: You might praise them in public, but you threaten them in private, right?

MATT TAIBBI: Exactly, yeah. They have--

BILL MOYERS: Nobody's afraid of Obama, you know. You go to Washington as you do, report from Washington. Nobody's afraid of him.


ROBERT KUTTNER: This style is rather diffident. His style is rather hands-off. He's very principled. But, if you're going to be a politician, you have to get in there and mix it up. And to the extent that his surrogates are mixing it up, when it comes to reforming Wall Street, they're mixing it up on the wrong side.

BILL MOYERS: Well, explain this to me. What is your own take on why he chose Geithner and Summers and people from Goldman Sachs and Wall Street to come and be his financial advisors, instead of choosing Stiglitz--


BILL MOYERS: Some of his advisors from the progressive wing of the Democratic system?

MATT TAIBBI: Most people that I've talked to have taken one of two positions on this.

BILL MOYERS: But here's how they repay him. This is on "The Huffington Post:" "Bank lobbyists launch call to action to crush financial reform. The American Bankers Association issued a call to action on Wednesday urging its lobbyist and member banks to make an all-out effort to crush regulatory reform in the Senate." This is how they reward his own tolerance towards them, right?

ROBERT KUTTNER: Right. And you've got to play hardball against these guys now. I do not want to leave this show with your viewers thinking this has been just a council of despair. So will you allow me to play Pollyanna for 30 seconds? Because I think this guy is nothing if not a work in progress. He's nothing if not a learner. And I think there is a chance. I don't think I would bet my life on it but I think there's a possibility that by the fall of 2010, looking down the barrel of a real election blowout, you could see him change course, if only for reasons of expediency, but hopefully for reasons of principle as well, if he feels that the public doesn't have confidence that he is delivering the kind of recovery that the public needs. This is a guy who is a very smart, complicated man. And I think don't speak too soon, for the wheel's still in spin. I don't want to totally give up.

MATT TAIBBI: Yeah. I mean, obviously, it's too early to completely abandon hope that he's going to turn things around. But I think that's a belief that's not really based on evidence. If you look at the evidence of how he's behaved so far, and who he's got, you know, working in the White House, and who he's getting his money from, and how the party has behaved over the last couple of decades. You're really basically relying upon the impression that he gives as a kind, decent, warm-hearted intellectual guy. That's what the basis of that faith that there's going to be this turnaround. It's really not anything that's actually concretely happened that would give you reason to think that.

ROBERT KUTTNER: The other thing that's missing, if you compare him with Roosevelt or LBJ or Lincoln, the other thing that's missing is a social movement. In all of these great periods of transformation, you had social movements doing a complicated dance with the president, where sometimes they were working with him, sometimes they were beating up on him. That certainly describes the civil rights movement and Lyndon Johnson. It describes the abolitionists and Lincoln. It describes the labor movement and Roosevelt. Where's the movement?

BILL MOYERS: Coming down to the office this morning, the cab driver turned and said, "You see the newspaper this morning?" And he turns and hands me the NEW YORK POST. "It's Wall Good: Wall Street Earnings Soar to $49 Billion in the First Three Quarters of the Year ... Profitability has soared because revenues rose ... Wall Street bonuses for employees in the city may be as much as 40 percent higher than in 2008." What would you say to the President about this? Does he know?

ROBERT KUTTNER: I think, to some extent, the White House lives in an echo chamber. They do these public events that are intended to demonstrate that the president's listening, that he's feeling our pain. Congress gets a very bad rap. But I was invited to speak to the House Democrat caucus a couple a weeks ago. And they are furious. They can't publicly embarrass their president, but they go home on weekends and they talk to their folks and they hear the individual stories of suffering. And they feel that certainly the Treasury, to some extent the White House, just doesn't get it and the Republicans are going to end up with a narrative and the Tea Party folks, it's the far right that is on the march when ordinary people need a champion.

BILL MOYERS: So, what are people to do?

ROBERT KUTTNER: I think there are there are things that are not too complex for people to understand. If the value of your home is going down the drain because the government's not doing anything about an epidemic of foreclosures, that's the kind of thing that people can talk about across a kitchen table. They do talk about it across the kitchen table. And you need more leadership like a Marcy Kaptur or a Maria Cantwell, elected officials who get it, who have not been bought and paid for by Wall Street stirring up people and turning this into a movement.

MATT TAIBBI: And that's really where Barack Obama's failings are the biggest. This is exactly where we need a president with the communication skills that he has. I mean, he's probably the one person who could help all of America make sense of all this stuff. And he's not doing it. I mean, he's doing these photo ops, you know, earlier in the week, with a couple of bankers. It's a kabuki dance to show that he's against Wall Street. But he's not explaining to people how all this stuff works. And that's the problem.

BILL MOYERS: Are you a cynic after all your reporting this year?

MATT TAIBBI: No, not at all. I mean, I think on the contrary. I think cynicism is accepting all this as, you know, politics, as the way it is. I think we have to not accept what's going on. And that's not being cynical. That's being helpful.

BILL MOYERS: But is it naïve to think that in a country of so many clashing interests, we might get better results from the political system than we're getting right now?

ROBERT KUTTNER: I think there are periods of American history when the political system rises to the occasion. It certainly did with the civil rights movement. It certainly did in the 1930s. But there's no guarantee that it's going to come out the way it needs their come out. So I wouldn't give up on the political system. I mean, you have to keep fighting and working to rebuild democracy. Democracy is the only possible counterweight to concentrated financial power. And ideally, that takes a great president rendezvousing with a social movement. One way or another, there is going to be a social movement. Because so many people are hurting, and so many people are feeling correctly that Wall Street is getting too much and Main Street is getting too little. And if it's not a progressive social movement that articulates the frustration and the reform program, you know that the right wing is going to do it. And that, I think, is what ought to be scaring us silly.

MATT TAIBBI: We are starting to see signs of a little bit of a grassroots movement. I mean, the stuff, you know, people who are refusing to leave their homes after they've been foreclosed upon. There are little pockets of movements you know, groups that are organizing against foreclosures all across the country. And this is one small slice of the economic picture that where it's quite clear what's going on, and people can really understand the relationship that they have with the financial services industry. And I think if, you know, there it's possible to imagine a movement coalescing around something like that.

BILL MOYERS: Matt Taibbi, Robert Kuttner, thank you for being with me on the Journal.

MATT TAIBBI: Thank you.


[Dec 17, 2009] Bank of England Calls Bluff of Bankers Who Threaten to Depart UK to Avoid Taxes

In response to a 50% bonus supertax, bankers in the UK are threatening to decamp, as if that will move the authorities to relent. They are not blinking. And with good reason. The idea that everyone ensconced in a large financial firm can decamp to a hedge fund or a private equity fund, or start their own boutique is wildly exaggerated. Even though many traders like to cast themselves as solo producers, they have tremendous advantages by operating in a large firm, namely, access to concentrated capital and information flows, and in many cases leverage that either cannot be obtained at all in a smaller firm format or would be far more costly. Similarly, a lot of supposed "talent" in other businesses depends on the firm franchise to a greater degree than they fancy.

No less than a former co-chairman of Goldman, John Whitehead, disputed the idea that lofty pay levels were necessary (and he was criticizing 2006 bonuses, which were trumped by 2007 pay levels):

"I'm appalled at the salaries," the retired co-chairman of the securities industry's most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are "shocking," Whitehead said. "They're the leaders in this outrageous increase."

Whitehead went even further, recommending the unthinkable, that Goldman cut pay:

Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds. "I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends."

The Guardian tells us that Bank of England officials are telling unhappy bankers that they are free to take a hike, and England may well be better off without them. By contrast, every time US banks have gotten themselves all worked up (the list seems endless, plain vanilla products, mortgage cramdowns, usury ceilings, exiting the TARP so they can pay high bonuses) the US officialdom has caved. And this behavior simply encourages the banks to escalate their demands.

A senior bank of England official said that bankers moving overseas to avoid the bonus supertax could be price worth paying to achieve lasting reform of the sector.

Andy Haldane, the bank's head of financial stability, also said that banks had become too big and was sharply critical of a culture where bankers could take huge risks in the knowledge that the taxpayer would bail them out.

In an interview with the BBC World Service, Haldane said: "Some of the downsides of carrying around a big financial system are now evident to all.

"If some of that were to migrate overseas that would be unfortunate but given the costs of carrying that financial system around, it may be a price worth paying."

The Telegraph provides more commentary:

Haldane, as regular readers will know, stands out as one of the heroes of the crisis. In 2006 he was one of the lead authors of a Bank report which was among the first to warn of the impending crisis that could face the City as a result of the ballooning gap between what banks had in their vaults and what they were lending out to customers. In the past year or so he has given a number of speeches and papers which, among other things, have warned that the relationship between banks and the state is a "doom loop" in which banks continually try to "game" the regulators, and pointed out that the vast majority of banks' apparent earnings over the past century have been based not on actual performance but on leverage.

In the BBC interview, he goes one step further, making the point (which echoes one from BIS chief economist Steve Cecchetti) that regulators will face a "battle" with banks over the next year since, in effect, they are telling the banks to make less money. He also dismisses the notion that if some bankers move overseas (as they are currently threatening to do following the bonus tax), it would be a complete disaster for the UK economy…

The comments are bound to infuriate bankers, but they should not be blown out of proportion. Haldane is merely attempting to appeal to people not to assume regulation will have an apocalyptic effect – as is the message being dispensed by the banking lobby. Clearly neither he nor the Bank wants to trigger a genuine exodus from the City. But they want the debate to be rather more realistic than it currently is.

Quelle horreur! The Bank of England has said it is more beneficial to have a financial services industry that respects rules than one that is a dominant competitor. They have just rejected the industry's biggest threat, that London might lose its standing as a financial center. It is pathetic to see that no one in authority in the US is willing to tell the banksters no.

Now admittedly the Telegraph tries to play down the confrontational aspects of Haldane's remarks, but it fails to follow through on the implications of Haldane's earlier work: that bank profits have been exaggerated for a very long time, and by implication, most of the earnings-based compensation was looting. Much lower pay levels are therefore very much in order. Haldane's line of inquiry is a fundamental threat to fat banker bonuses.


That's good as an ad hoc measure but it's still just nibbling at the fringes.

If a society is to be a society and not just a war zone, then it needs a fair, rational tax code which aggressively prevents destabilizing wealth concentrations and antisocial incentives in the first place. Just a one-off "bonus" tax explicitly as a response to a crisis ain't gonna do the job.

As for these alleged "talents" decamping to some more lawless zone, good riddance. But I'd go much further in letting them be the outlaws they want to be. If they want to be gamblers, so be it, but there shouldn't be any legal casino established for them. Let their numbers rackets have to go truly underground the way it used to be. Don't let any of their bets be legal "contracts".

We'll see how well they do then.

Vinny G.

Let them come to the US. It's their kind of place.


d4winds says:

re "If some of that were to migrate overseas that would be unfortunate but given the costs of carrying that financial system around, it may be a price worth paying."

The Brits have always a talent for wry understatement.


When Banks or Corporations do business with in a Country it_is_at_the_citizens_leisure via duly elected officials and not some twisted world of reversed polarity.

Americans and others have sold their rights for a minimum wage job or if lucky a bit better and all upon sweet lipped words with out guaranty.

I say they should go to the places that they represent (no law, no responsibility, egregious profit, profit to enable the worst machinations man is capable of *offshore*) at least then when they rip us off, we can just drop a few bombs to rectify the problem. Better yet lets just keep a few Preaditor UMV over head as a reminder…hay!


On the other side of this "talent export", what country in its right mind would want to import a bunch of self-important walking time-bombs?

None of these other places could afford such dickheadery. On the contrary, they'd probably actually prosecute. So, yeah, go ahead and decamp to Hong Kong. You know they have the death penalty there, right?

[Nov 24, 2009] 15 signs Wall Street pathology is spreading Paul B. Farrell

Nov 24, 2009 | MarketWatch

Sadly for America Goldman's disease is rapidly becoming a pandemic spreading beyond Wall Street's too-greedy-to-fail banks, infecting our economy, markets and government as it metastasizes globally.

What are the symptoms of this growing "soul sickness," this "pathological mutation of capitalism" Bogle fears? Recently we reviewed the consequences of this "soul sickness."

Today we'll paraphrase news reports about 15 symptoms spreading "soul sickness" beyond the boundaries of this Goldman case study: These are the 15 signs of a moral pathology undermining not just banking but American democracy and capitalism.

1. Gross denial of any moral damage caused by their rampant greed

Seeking Alpha: "Goldman is America's most hated corporation." We cheer as Rolling Stone's Matt Taibbi calls Goldman "a giant vampire squid wrapped around the face of humanity." Banks triggered a global crisis. Main Street suffers. Greedy bank CEOs raid the Treasury then stuff $30 billion in their bonus pockets, up 60% from last year. They are our 21st century General Motors, convinced "What's good for Goldman is good for America." We saw how that arrogance ended. Wall Street has similar suicidal symptoms.

2. Narcissistic egomaniacs with secret 'God complexes'

London Times' John Arlidge interviewed Goldman CEO Blankfein: "He paid himself $68 million in 2007, now worth more than $500 million, yet insists he's a blue-collar guy. He says banking has a 'social purpose,' just a banker 'doing God's work.'" When I was at Morgan Stanley in the 1970s the firm ran an ad: "If God Wanted To Do a Financing, He Would Call Morgan Stanley."

Today, all of Wall Street is dual diagnosed: They're morally blind money addicts who believe they're "God's chosen." AA would say: They haven't "bottomed," won't recover from their disease till a disaster hits, with another market meltdown and the "Great Depression 2." Then maybe they'll "quit playing God."

3. Paranoid obsessives about secrecy, guilt and non-disclosure

Bloomberg: "New York Fed's Secret Deal: Taxpayers paid $13 billion more than necessary when government officials, acting in secret, made deals with banks on AIG, buying $62 billion of credit-default swaps from AIG." The government would eventually cover about $180 billion in AIG swaps backing toxic CDOs when Paulson and Ben Bernanke double-teamed to bailout Goldman, saving them from bankruptcy.

4. Power-hungry need to control government using Trojan Horses

Wall Street Journal: "For a year Goldman said it wouldn't have suffered damage if AIG collapsed. But a new report kills that claim. TARP inspector general found that then New York Fed Chair Tim Geithner gave away the farm. If AIG had collapsed, Goldman would have had to cover the losses itself. They couldn't collect on the protection of AIG swaps." Yes, Goldman was bankrupt. But friends in high places always save them.

5. Borderline personalities who regularly ignore conflicts of interest

New York Times: "Before becoming Treasury secretary in 2006, Hank Paulson agreed to hold himself to a higher ethical standard than his predecessors. He specifically said he'd avoid his old buddies at Goldman where he was CEO. Later Congress saw many conflicts of interest, not just meetings but favorable treatment for his buddies at Goldman."

6. Pathological liars incapable of honesty even with own investors

McClatchy News: "Goldman secretly bet on the U.S. housing crash after peddling more than $40 billion of securities backed by 200,000 risky home mortgages. But they never told their investors they were also secretly betting that a drop in housing prices could wipe out the value of those securities." Paulson knew, stayed silent. "Only later did their investors discover Goldman's triple-A investments were junk. Did Goldman's failure to disclose its bets on an imminent housing crash violate securities laws?" Boston University Prof. Laurence Kotlikoff says: "This is fraud, should be prosecuted." But it won't be in the new "mutant capitalism."

Members of AA say you know when an alcoholic is lying: Their lips are moving. Same with Wall Street: Think liar's poker. It's in their DNA. They're compulsive liars trapped in a culture of secrecy. They lie, the lies cascade, memory slips, more lies are necessary, they cannot stop lying. Goldman sure can't ... look, their lips are moving again.

7. Sole fiduciary duty to insiders, not investors, never the public

New York Examiner: "Goldman was at the heart of the subprime market, selling subprime junk as no-risk AAA bonds, then gambling, hedging, shorting their investors. Goldman traded like Enron. That set up the meltdown. The Fed and Goldman's ex-CEO at Treasury saved Goldman. Taxpayers got stuck with the bill. Bailout overseer Elizabeth Warren called this reckless gambling. Trend forecaster Gerald Celente calls it mafia-style looting.

8. Moral issues are PR glitches, violations of 'don't get caught' rule

USA Today says "Goldman Sachs should be celebrating. Yet, the mood at the investment bank seems to be one of crisis about the public backlash over employees' bonuses." So Goldman's on a PR blitz in a bid to undo the damage. They canceled their Christmas party. Also launched a $500 million program for small businesses. Get it? They can't see their moral failings, only a PR problem, so they hire PR agents and crisis managers first.

9. Charitable donations are tax and PR opportunities, not moral issues

New York Times: Examined Goldman charitable foundation's tax filing: Thick as a phone book with more than 200 pages of trades. "Never seen anything like it," said Verne Sedlacek, president of Commonfund, a $25 billion fund for universities and nonprofits. The money to Goldman's foundation is dwarfed by insiders' bonuses. The foundation got $400 million, gave away $22 million. Bonuses were 20 times more. Even the New York Post said "Goldman's Born Again Image is Laughable." They're sleaze-ball cheapskates.

10. When exposed in a massive fraud, feign humility, fake an apology

CBS MoneyWatch: "Blankfein now says he's 'sorry for the role Goldman played in the housing crisis: We participated in things that were clearly wrong.'" Wrong? Sounds more like he's admitting to something "clearly criminal." Reread: Isn't he admitting guilt to a fraud; cheating millions of homeowners, shareholders, taxpayers? Then laughs at us with phony "restitution," a fund of $100 million annually for five years to small-business owners. Financial Times says "$100 million is the profits from one good trading day. In 3Q '09 they had 36 days better than that." Unfortunately, these crooks will get away with it.

11. When bankruptcy threatens, bribe friends in 'Happy Conspiracy'

Barron's: While Geithner was "showcasing what a great investment Washington made in Goldman, the 23% return on the $5 billion of the taxpayers money, Warren Buffett's deal made him a fabulous 120% return. Goldman's stock ran up to $180 from $115, a gain of $2.8 billion. Add 8% discount on warrants, another $3.2 billion to him."

12. Engage co-conspirators to cover up, distract, do your dirty work

Reuters: "Former Merrill Lynch CEO John Thain was fired after a scandal over the billions in Merrill bonuses. He says big insider bonuses don't cause excessive risk-taking nor the financial crisis." He blames "poor risk management, excessive leverage and too much liquidity for too long. But even if they tie bonuses to long-term performance, that won't prevent the next collapse." Why? They'll find new ways to break the moral code.

13. As money-hungry vultures they will prey on vulnerable Americans

McClatchy News: "An obscure Goldman subsidiary spent years buying hundreds of thousands of subprime mortgages, many from the more unsavory lenders. They repackaged them as high-yield bonds. The bottom fell out. Now, after years of refusing to disclose they owned the mortgages, the secret is out and Goldman has become one of America's biggest, greediest foreclosers." Yes, the vampire squid wants pounds of flesh.

14. Treat everyone not in the 'Happy Conspiracy' with tough love

HuffPost's Leo Leopold warns: "Each day reveals how we've traded away our sense of decency and the common good in exchange for pure greed. Unemployment means hunger. The Agriculture Department reports 49 million Americans don't have enough food, up 13 million over the last year, highest number ever." Wall Street treats anyone not in the "Happy Conspiracy" as morally defective capitalists in need of "tough love."

15. Addicts consumed by money: 'Jesus would throw them out ...'

New York Times' Maureen Dowd: "Goldman's trickle-down catechism isn't working. We have two economies. In the past decade Wall Street's shared little with society. Their culture is totally money-obsessed. There's always room for a bigger house, bigger boat. If not, you're falling behind. It's an addiction. And Washington's done little to quell it. Geithner coddles wanton bankers. Obama's absent. 'Saturday Night Live' was tougher. And as far as doing God's work: The bankers who took taxpayer money, pocketing obscene bonuses: They're the same greedy types Jesus threw out of the temple."

Warning: Washington, Main Street, none of us has "clean hands." We're all in bed with the "Happy Conspiracy," touched by greed, turning a blind eye to Wall Street's rapidly metastasizing moral and spiritual pathology: So ask yourself, do you believe America's widespread "lack of a moral compass" will eventually trigger another, bigger market and economic meltdown, pushing America into the next "Great Depression II?"

[Nov 21, 2009] The Fed in a Corner

Fed Watch

From Tim Duy: The Fed in a Corner

...But what about the years before Lehman, when the crisis was building? Where was the Fed then? Did they abdicate regulatory responsibility? How did banks develop such incredible exposure to off-balance sheet SIV's? How could the Fed ignore increasingly predatory lending in the mortgage market? What exactly was Timothy Geithner, then president of the all important New York Fed, regulating and supervising? Clearly not Citibank.

... ... ....

I don't think the Fed can regain the trust of the public while at the same time protecting the secrecy of their actions to save Wall Street (moreover, it is not clear that such secrecy is now needed in any event). The relationship between policymakers and financiers is now seen as far too cozy from the perspective of the public. I think the Fed needs to make clear that they work for the people, not for Wall Street. A strong statement by Federal Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too big - that we should no longer tolerate the expansion of financial firms to the point that they pose systemic risk - would be a good start.

Simply put, Bernanke's choice set is dwindling - either risk losing independence, or step up to the regulatory and policy plate like you intend to hit one out of the park. If Wall Street is no longer working for Main Street, it is time to side with Main Street.

There is much more in the piece.

Clearly the Fed (and other regulators) failed to properly supervise financial firms. We need to understand how and why this happened. (See The Failure of Regulatory Oversight)

Nanoo-Nanoo :

I read that earlier and found it compelling. I know that Ron Paul's "Audit the Fed" got passed in the House. I seriously doubt it will pass the Senate but as everyone now knows, I'm the ultimate pessimist or maybe realist? The Fed has still not honored the Bloomberg lawsuit to name names in who got support claiming it would pose "systemic risk". There are also some articles about a new PR nightmare beyond the TBTF that now includes the federal reserve, treasury, the quality of data they produce in economic reporting and just whose interests they are serving.

I also found this an interesting read this morning and wonder if anyone wishes to comment further. I think it was Volker the Viking who stated this wasn't a recession as recessions, relatively speaking, are short lived. Semantics are silly in this crisis as there are lots of pigs with lipstick on them.

Generally speaking, (I'm no economist) I think central banks have run out of bullets. Monetary policy changes are basically exhausted, quantitative easing can go on just how long before the rubber band snaps back?

Effective Demand:

We need to understand how and why this happened.

How: Greenspan
Why: He believed in the free markets

The one problem with the one "Super regulator" model being bandied about what happens when the guy in charge of that agency doesn't believe in regulation? Then we get what we just had again. All the financial companies will be pushing to get the least restrictive person installed as the head of that agency.

Anne from Chicago:

"The purpose of Wall Street is supposed to be to channel investment funds into Main Street."

If there is anything the crisis has proved without a doubt is that Wall Street's purpose is to channel funds into their own bonus package.

We see that in GS's recent response to the shareholders who want a piece of the bonus pie - the PR spin from GS was that the shareholders are too stupid to realize that if GS employees weren't paid billions in bonuses, the company wouldn't be able to deliver whatever it is it delivers to customers and shareholders.

Blankfein and his colleagues seem incapable of understanding that the nation is in a terrible economic crisis right now and their bonuses, piled up to the stratosphere thanks to the actions of the fed and treasury, are an unseemly contrast to the wreckage spread out across the country. Wreckage resulting from a crash engineered in large part thanks to "innovation" at banks.

Their focus is on themselves. Main Street is flesh to be devoured. The Fed has been letting it happen for years. No wonder there's a crisis of "confidence."

John Huss said in reply to Anne from Chicago...

I'm not sure that Wall St fails to understand that the nation is in a terrible economic crisis.

I suspect that Wall St doesn't especially care, as long as the masters of the universe can continue to line their pockets.


Lay the blame at the feet of the banksters. These elites don't care at all about the millions of unemployed Americans. The elite banksters refused any sacrifice at all from their own pockets. They are letting their CEOs eat cake while millions go without a paycheck.

This is not fair. This is overreach by the banksters. If they really want to head it off, their needs to be some economic sacrifice by the bankster CEOs and their profits need to be taxed to pay back the revenues. HAIRCUT!!!

Three cheers for the death of old economics by Anatole Kaletsky

Times Online

One of the few benign consequences of last year's financial crisis was the exposure of modern economics as an emperor with no clothes. In February I argued that economists deserved as much blame as bankers, regulators and politicians. Quite a number of others, including Nobel laureate economists, made the same point that economics had to be urgently reinvented. These ideas have borne fruit much sooner than anyone expected with yesterday's announcement of an Institute for New Economic Thought.

INET, funded with an initial commitment of $50 million from George Soros and backed by a phalanx of distinguished academic economists, could lead to a flowering of original thinking in a profession whose creativity has been stifled by the intellectual monopoly of orthodox academic funding bodies. It could promote a much more serious debate about what governments can and cannot do to regulate the market. Eventually it could re-create an academic discipline capable of explaining reality and offering useful advice to policymakers facing unexpected events.

The dirty little secret of modern economics is that the models created by central banks and governments to manage the economy say almost nothing about finance. Policymakers who turned to academic economists for guidance in last year's crisis were told in effect: "The situation you are dealing with is impossible: our theories prove that it simply cannot exist."

New economic thinking could have an important political impact. For economics is not just the desiccated study of abstract equations. It is the foundation of all politics in capitalist nations. As Keynes wrote: "Practical men who believe themselves to be quite exempt from any intellectual influence are usually the slaves of some defunct economist."

The defunct economists today are the people who took control of the subject in the 1980s, with theories that closely coincided with the spirit of the Thatcher-Reagan revolution. Their three main ideas transformed the politics, as well as the economics, of the next 20 years. The first idea, known as "rational expectations", maintained that capitalist economies with competitive labour markets do not need stabilising by governments.

The second idea - "efficient markets" - asserted that competitive finance always allocates resources in the most efficient way, reflecting all the best available information and forecasts about the future.

The third idea stated that economics, previously a largely descriptive study of human behaviour, had to become a branch of mathematics, using assumptions on human behaviour that were clear enough to be expressed in algebraic formulae. Economic problems that could not be analysed with mathematics were deemed unworthy of consideration.

Between them, these three ideas had huge political effects. "Rational", "efficient" and mathematically inexorable economics seemed to legitimise whatever political results were decreed by markets: income inequalities, industrial dislocation, vast bonuses for top executives could all be presented as the impersonal result of scientific forces, rather than political issues.

Nobody seemed to notice that all this mathematical flummery left out the most crucial step of true science. Physics, chemistry and biology use mathematical models to draw conclusions that are then tested against reality. If reality contradicts these tests, then scientists reject the models. Today's academic economics reverses this process: if models disagree with reality, it is reality that economists want to change.

It is not surprising that the whole scaffolding of theorems, models and computer simulations came crashing down, along with the towers of bad debt and bad policy it supported. Today's academic approach prevented economists from thinking about a world that is, by its very nature, unpredictable and inconsistent - as Keynes and Hayek, at opposite ends of the political spectrum, both understood.

To gain a genuine understanding of unpredictable reality, some unorthodox economists may employ new mathematical techniques of non-linear dynamics and chaos theory. Others may revive the literary and anecdotal traditions of the great economists of the past, building on the work of sociologists, psychiatrists, historians and political scientists disdained by the present orthodoxy. INET will try to support these new schools of thought.

A good test of whether this venture proves successful will be to ask a simple question: Was Adam Smith an economist? Were Keynes or Hayek? By the standards of what is taught as economics today, the answer is "no". They may have explained some of the deepest mysteries of human life: why the pursuit of individual self-interest increases the wealth of nations; why market economies suffer prolonged slumps; why central planning never works.

Yet Smith and Hayek produced no real mathematical models. Their eloquent writing lacked the "analytical rigour" demanded by modern economics. And none of them ever produced an econometric forecast. If any of these giants applied for a university job today, they would be laughed out of court and their written works would not have a chance of acceptance in The American Economic Review.

This is the mentality INET hopes to overcome. If the next generation of academic economists aspire to succeed Smith, Keynes and Hayek, rather than ineffectually aping Euclid, Newton and Einstein, then the venture will have been worthwhile.

[Oct 13, 2009] A Good Day for Berkeley by Oliver Williamson

An institutional Economics Prize: Congratulations to Elinor Ostrom and Oliver Williamson. What a day for them!

The way to think about this prize is that it's an award for institutional economics, or maybe more specifically New Institutional Economics. Neoclassical economics basically assumes that the units of economic decision-making are a given, and focuses on how they interact in markets. It's not much good at explaining the creation of these units - at explaining, in particular, why some activities are carried out by large corporations, while others aren't. That's obviously an interesting question, and in many cases an important one. For example, in my own home field of international trade, the basic models don't assign any particular role to multinational corporations; how do we get them into the story, and what difference do they make?

There was an old tradition of economics that focused on the origins and nature of economic institutions. This tradition was very influential before World War II. But it proved not at all helpful during the Great Depression. My caricature version is that when the Depression hit, institutional economics, asked for advice about what to do, replied that well, it's all very complicated, and has deep historical roots, and … Meanwhile, Keynesian economists, using very simple mathematical models, basically said "Push this button - we need more G". And this had a somewhat perverse effect. The rise of Keynesian economics also meant the rise of the equations guys (Samuelson in particular), and in the end the equations crowded out institutional economics even as Keynes fell into disfavor. But the questions didn't go away. And institutional economics has been making a quiet comeback for the past several decades.

Oliver Williamson's work underlies a tremendous amount of modern economic thinking; I know it because of the attempts to model multinational corporations, almost all of which rely to some degree on his ideas. I wasn't familiar with Ostrom's work, but even a quick scan shows why she shared the prize: if the goal is to understand the creation of economic institutions, it's crucial to be aware that there is more variety in institutions, a wider range of strategies that work, than simply the binary divide between individuals and firms.

The prize is also, of course, a happy reminder that most of the profession is not caught up in the macro wars!

Add: Don't tell Senator Coburn, but the NSF Political Science program has supported a lot of Elinor Ostrom's research.

[Oct 10, 2009] "Clash of Autonomy and Interdependence"

Oct 6, 2009 | Economist's View

Something quick between classes - Jean-Paul Fitoussi says "Don't hold your breath" waiting for those who have found success within the free exchange system to acknowledge it was the result of more than their own meritorious achievement:

Clash of autonomy and interdependence, by Jean-Paul Fitoussi, Commentary, Project Syndicate: The bailout of the financial system was a bizarre moment in economic history, for it benefited those who benefited most from the markets' "irrational exuberance" - the bosses of financial firms.
Before the crisis hit, however, redistribution of wealth (and the tax and social security payments that make it possible) was considered the biggest obstacle to economic efficiency. Indeed, the values of solidarity had given way to those of individual "merit", judged by the size of one's paycheck.

The paradox is that a part of this evolution may be attributable to two positive factors: the slow work of democracy, which liberates individuals but at the same time leaves them more isolated; and the development of a welfare system that shares risks and makes individuals more autonomous.

With this isolation and autonomy, people increasingly tend to believe, for better or for worse, that they alone are responsible for their own fate.

Here lies the conundrum. An individual is free and autonomous only because of the collective decisions taken after democratic debate, notably those decisions that guarantee each person access to public goods such as education, healthcare, etc.

Some sense of social solidarity may remain, but it is so abstract that those for whom the wheel of fortune has spun so favorably feel little debt. They believe that they owe their status purely to merit, not to the collective efforts - state-funded schools, universities, etc. - that enabled them to realize their potential. ...

The central place where this self-(over)evaluation meets the fewest obstacles is the financial market. ... Of course, when the crisis hit, financial institutions were the first to argue that autonomy was unrealistic, and that we are all interdependent. After all, why else should taxpayers agree to rescue them?

But now these same institutions are deciding that they want to go their own way again. ... Dismissing the risks that taxpayers incurred, financial institutions used the bailout to restore profitability and are now reverting to their old habits...

No one should be surprised about this. ... The bailout of banks led to a wave of mergers. If they were already too big to fail, what should we now say when banks are even bigger? Their market power has increased, yet they know they incur no risk, owing to the aggravated systemic impact of their potential bankruptcy. Moreover... Working in so uncompetitive a market is a real stroke of luck. I do not know many businessmen who would not take advantage of this; to be honest, I do not know any.

The free-market doctrine, which has become almost a religion, reinforced this belief: markets are efficient, and if they pay me so much..., it is because my own efficiency warrants it. I also participate indirectly and abstractly in forging the common good, by creating value through my work, and I am rewarded for it.

But suddenly the system collapses, the creation of value turns into destruction and parallel universes collide ... with autonomy becoming (for the brief moment of the bailout at least) interdependence. ...
Eyes are opened... The crisis reminds us what each person owes to others, highlighting an ethical truth that we were quick to forget: the rich benefit more than the poor from their cooperation with other members of society.

Two conclusions can be drawn from all this.

The first is that we all owe at least some of our success to others, given the public goods that society provides. This calls for more modesty and restraint in determining the highest salaries, not for moral reasons but for the sustainability of the system.

The second conclusion is that the most privileged classes, which have benefited the most from the solidarity of others, notably the poor, can no longer deny the latter's contributions. But don't hold your breath waiting for them to agree.

[Oct 10, 2009] Skewed rewards for bankers by JOSEPH E. STIGLITZ

The Korea Herald
Borlaug provides an opportune moment to reflect on basic values and on our economic system. Borlaug received the Nobel Peace Prize for his work in bringing about the "green revolution," which saved hundreds of millions from hunger and changed the global economic landscape.

Before Borlaug, the world faced the threat of a Malthusian nightmare: growing populations in the developing world and insufficient food supplies. Consider the trauma a country like India might have suffered if its population of a half-billion had remained barely fed as it doubled. Before the green revolution, Nobel Prize-winning economist Gunnar Myrdal predicted a bleak future for an Asia mired in poverty. Instead, Asia has become an economic powerhouse.

Likewise, Africa's welcome new determination to fight the war on hunger should serve as a living testament to Borlaug. The fact that the green revolution never came to the world's poorest continent, where agricultural productivity is just one-third the level in Asia, suggests that there is ample room for improvement.

The green revolution may, of course, prove to be only a temporary respite. Soaring food prices before the global financial crisis provided a warning, as does the slowing rate of growth of agricultural productivity. India's agriculture sector, for example, has fallen behind the rest of its dynamic economy, living on borrowed time, as levels of ground water, on which much of the country depends, fall precipitously.

But Borlaug's death at 95 also is a reminder of how skewed our system of values has become. When Borlaug received news of the award, at four in the morning, he was already toiling in the Mexican fields, in his never-ending quest to improve agricultural productivity. He did it not for some huge financial compensation, but out of conviction and a passion for his work.

What a contrast between Borlaug and the Wall Street financial wizards that brought the world to the brink of ruin. They argued that they had to be richly compensated in order to be motivated. Without any other compass, the incentive structures they adopted did motivate them -- not to introduce new products to improve ordinary people' lives or to help them manage the risks they faced, but to put the global economy at risk by engaging in short-sighted and greedy behavior. Their innovations focused on circumventing accounting and financial regulations designed to ensure transparency, efficiency, and stability, and to prevent the exploitation of the less informed.

There is also a deeper point in this contrast: our societies tolerate inequalities because they are viewed to be socially useful; it is the price we pay for having incentives that motivate people to act in ways that promote societal well-being. Neoclassical economic theory, which has dominated in the West for a century, holds that each individual's compensation reflects his marginal social contribution -- what he adds to society. By doing well, it is argued, people do good.

But Borlaug and our bankers refute that theory. If neoclassical theory were correct, Borlaug would have been among the wealthiest men in the world, while our bankers would have been lining up at soup kitchens.

Of course, there is a grain of truth in neoclassical theory; if there weren't, it probably wouldn't have survived as long as it has (though bad ideas often survive in economics remarkably well). Nevertheless, the simplistic economics of the 18th and 19th centuries, when neoclassical theories arose, are wholly unsuited to 21st-century economies. In large corporations, it is often difficult to ascertain the contribution of any individual. Such corporations are rife with "agency" problems: while decision-makers (CEO's) are supposed to act on behalf of their shareholders, they have enormous discretion to advance their own interests -- and they often do.

Bank officers may have walked away with hundreds of millions of dollars, but everyone else in our society -- shareholders, bondholders, taxpayers, homeowners, workers -- suffered. Their investors are too often pension funds, which also face an agency problem, because their executives make decisions on behalf of others. In such a world, private and social interests often diverge, as we have seen so dramatically in this crisis.

Does anyone really believe that America's bank officers suddenly became so much more productive, relative to everyone else in society, that they deserve the huge compensation increases they have received in recent years? Does anyone really believe that America's CEO's are that much more productive than those in other countries, where compensation is more modest?

Worse, in America stock options became a preferred form of compensation -- often worth more than an executive's base pay. Stock options reward executives generously even when shares rise because of a price bubble -- and even when comparable firms' shares are performing better. Not surprisingly, stock options create strong incentives for short-sighted and excessively risky behavior, as well as for "creative accounting," which executives throughout the economy perfected with off-balance-sheet shenanigans.

The skewed incentives distorted our economy and our society. We confused means with ends. Our bloated financial sector grew to the point that in the United States it accounted for more than 40 percent of corporate profits.

But the worst effects were on our human capital, our most precious resource. Absurdly generous compensation in the financial sector induced some of our best minds to go into banking. Who knows how many Borlaugs there might have been among those enticed by the riches of Wall Street and the City of London? If we lost even one, our world was made immeasurably poorer.

Joseph E. Stiglitz, a professor at Columbia University and winner of the 2001 Nobel Memorial Prize, served as chairman of the Commission on the Measurement of Economic Performance and Social Progress. -- Ed.

(Project Syndicate)

[Oct 4, 2009] Welcome to America, the World's Scariest Emerging Market by Desmond Lachman

March 29, 2009 |

A singular characteristic of an emerging market heading for deep trouble is a seemingly suicidal tendency to become overly indebted to foreign creditors. That tendency underlay the spectacular collapse of the Thai, Indonesian and Korean currencies in 1997. It also led Russia to default on its debt in 1998 and plunged Argentina into its economic depression in 2001. Yet we too seem to have little difficulty becoming increasingly indebted to the tune of a few hundred billion dollars a year. To make matters worse, we do so to countries like China, Russia and an assortment of Middle Eastern oil producers -- none of which is particularly well disposed to us.

Like Argentina in its worst moments, we never seem to question whether it is reasonable to expect foreigners to keep financing our extravagance, and we forget the bad things that happen to the Argentinas or Hungarys of the world when foreigners stop financing their excesses. So instead of laying out a realistic plan for increasing our national savings, we choose not to face up to the Social Security and Medicare crises that lie ahead, embarking instead on massive spending programs that -- whatever their long-run merits might be -- we simply cannot afford.

After experiencing a few emerging-market crises, I get the sense of watching the same movie over and over. All too often, a tragic part of that movie is the failure of the countries' policymakers to hear the loud cries of canaries in the coal mine. Before running up further outsized budget deficits, should we not heed the markets that now see a 10 percent probability that the U.S. government will default on its sovereign debt in the next five years? And should we not be paying close attention to the Chinese central bank governor's musings that he does not feel comfortable with the $1 trillion of U.S. government debt that the Chinese central bank already owns, let alone adding to those holdings?

In the twilight of my career, when I am hopefully wiser than before, I have come to regret how the IMF and the U.S. Treasury all too often lectured leaders in emerging markets on how to "get their house in order" -- without the slightest thought that the United States might fare no better when facing a major economic crisis. Now, I fear time is running out for our own policymakers to mend their ways and offer real leadership to extricate the United States from its worst economic calamity since the 1930s. If we insist on improvising and not facing our real problems, we might soon lose our status as a country to be emulated and join the ranks of those nations we have patronized for so long.

Desmond Lachman, a fellow at the American Enterprise Institute, was previously chief emerging market strategist at Salomon Smith Barney and deputy director of the International Monetary Fund's Policy and Review Department.

Selected Commments


I am originally from Russia and I lived through all the debacle of Afghan war and collapse of the empire. And I've been taking notes of what's happening and trying to connect the dots.

According to my observations, unfortunately, Mr.Lachman is absolutely correct in his assessment of the situation. All the attributes proceeding the collapse of Soviet empire could be tracked in our current situation:

Mini22 commented that he/she is scared to death by this piece of Mr. Lachman. Yes, Mini22, you have all the reasons to be scared and anticipate the worst to happen.

And recession, depression or "lost decade" are, in fact, might not be the worst options...

Shichinin no Economusutai--NOT!! by Brad DeLong

Econoshmuks ;-) "The scary thing is the level at which they are wrong: these are all freshman (ok, sophomore) mistakes"
David K. Levine of Washington University in St. Louis:

"It is a daunting task to bring you [Paul Krugman] up to date on the developments in economics in the last quarter century. I know that John Cochrane has tried to educate you about what we've learned about fiscal stimulae [sic][1] in that period..." and "But the stimulus plan? How can you be arguing for more? Since we are recovering before most of the stimulus money has entered the economy--isn't that evidence it isn't needed? How can you write as if you are proven right in supporting it?"

John Cochrane of the University of Chicago:

"[That spending can spur the economy] is not part of what anybody has taught graduate students since the 1960s. They are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children but it doesn't make them less false..." and "Paul [Krugman's]'s Keynesian economics requires that people make logically inconsistent plans to consume more, invest more, and pay more taxes with the same income..."

Robert Lucas of the University of Chicago:

"Christina Romer--here's what I think happened. It's her first day on the job and somebody says, you've got to come up with a solution to this--in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning.... [I]t's a very naked rationalization for policies that were already, you know, decided on for other reasons..." and "If we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder--the guys who work on the bridge -- then it's just a wash... there's nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you've got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn't going to help, we know that..."

Edward Prescott of Arizona State University:

"I don't know why Obama said all economists agree on [the need for a stimulus bill]. They don't. If you go down to the third-tier schools, yes, but they're not the people advancing the science..." and "the period of the '20s was one of healthy growth, until Hoover's anti-market, anti-globalization, anti-immigration, pro- cartelization policies were instituted, brought this expansion to an end, and created a great depression..."

Eugene Fama of the University of Chicago:

"Sorry, but I'm not familiar with [Hyman] Minsky's work" and "Haven't seen it [Paul Krugman's article]. I pay no attention to him..." and "Government bailouts and stimulus plans seem attractive when there are idle resources - unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another..."

Luigi Zingales of the University of Chicago:

"Keynesianism has conquered the hearts and minds of politicians and ordinary people alike because it provides a theoretical justification for irresponsible behaviour. Medical science has established that one or two glasses of wine per day are good for your long-term health, but no doctor would recommend a recovering alcoholic to follow this prescription. Unfortunately, Keynesian economists do exactly this. They tell politicians, who are addicted to spending our money, that government expenditures are good. And they tell consumers, who are affected by severe spending problems, that consuming is good, while saving is bad. In medicine, such behaviour would get you expelled from the medical profession; in economics, it gives you a job in Washington..." and "Among the 37 Economics Nobel prize winners in the last 20 years, four received the prize for their contributions to macroeconomics. None of these could be considered Keynesian. In fact, it is hard to find academic papers supporting the idea of a fiscal stimulus..."

Michele Boldrin of Washington University in St. Louis:

"It is a fantasy that the economic profession at large finds the "stimulus" and the "bank bailout" plans sensible and adequate. Most economists we know oppose them.... Outside the administration, the convinced supporters of the plans are a small minority among academic economists working in those fields. Both plans contradict four decades of research and are designed to please special interest groups..." and "Is there a case for borrowing now to finance a stimulus package? People are worried about the future and are sensibly reducing their spending. Does this imply the government should step in and do the spending for them? Put that way, the idea seems like a non-starter..."

In case there is any doubt:

  1. Paul Krugman is reasonably up-to-date on research in macroeconomics over the past quarter century (Levine);
  2. that spending can spur the economy is part of what everyone who teaches their graduate students about the dot-com boom of the 1990s or about the housing-led expansion of the 2000s says, and the government's spending is as good as anyone else's as far as this is concerned (Cochrane);
  3. Christina Romer played a significant role in the design of the ARRA (Lucas);
  4. there is certainly debate over whether "advancing the science" means what Ed Prescott thinks it means (Prescott);
  5. Eugene Fama really ought to have paid a little attention to Minsky-Kindleberger at some point in his career (and really ought to be paying attention to Krugman now) (Fama);
  6. Luigi Zingales needs really, really badly to read John Maynard Keynes's "How to Pay for the War" before he embarrasses himself further (Zingales); and
  7. I don't think "working in those fields means what Michele Boldrin thinks that it means (Boldrin).

And in case there is any doubt:

  1. the fact that macroeconomic market failures are no longer getting rapidly worse is not a reason for immediately abandoning all of the policies to deal with thsoe failures (Levine);
  2. there is nothing logically inconsistent with models in which aggregate planned expenditure is different from income, and indeed Milton Friedman's, Knut Wicksell's, and David Hume's economic models are all of this type (Cochrane);
  3. even full Ricardian equivalence does not keep changes in government purchases from affecting total spending (unless government purchases are perfect substitutes for private consumption) (Lucas);
  4. Herbert Hoover was on the right wing of the American political spectrum and tried as best he could to follow pro-market, pro-globalization, pro-competition economic policies (Prescott);
  5. the savings-investment identity is an equilibrium condition, not a behavioral relationship. Thus it says nothing about how and whether changes in one form of spending will or will not call forth changes in the flow of spending as a whole (Fama);
  6. it is in fact rather easy to find academic papers supporting the idea of fiscal stimulus under appropriate conditions, if you look (Zingales); and
  7. when the prices of private bonds collapse and the prices of government bonds soar, that is a very powerful market signal that private businesses should borrow (and spend) less and the government should borrow (and spend) more (Boldrin).

The scary thing is not that Levine, Cochrane, Lucas, Prescott, Fama, Zingales, and Boldrin are wrong--people are wrong all the time. The scary thing is the level at which they are wrong: these are all freshman (ok, sophomore) mistakes--yet the seven include two past (and a year ago I would have said three future Nobel laureates in Economics).

If this doesn't frighten you, you aren't paying attention...

How Japanese tax-payers' money is lost in bid-rigging

The Japan Times Online
REIJI YOSHIDA Staff writer

Every few years, politicians, bureaucrats and construction company bigwigs get embroiled in bid-rigging scandals - and the public's faith in government sinks deeper.

In bid-rigging, or "dango," corporations ostensibly competing for a government contract ferret out the secret ceiling bid price. With that knowledge, they conspire to decide which among them will win the bid. Members of the circle take turns winning, or being "chanpyon" (champions).

The shady practice has a long history, and while it is most pervasive in the construction industry, other sectors have been involved as well, including defense contractors. Although company profits can be reduced by illegally skirting competition, the burden on taxpayers mounts.

In the latest dango affair, Agriculture, Forestry and Fisheries Minister Toshikatsu Matsuoka last month committed suicide amid a burgeoning investigation into suspected bid-rigging involving ministry-backed corporation Japan Green Resources. Separate bid-rigging scandals led to the arrest last year of the governor of Wakayama, and the former governors of Fukushima and Miyazaki.

Following are some basic facts about bid-rigging:

How common is bid-rigging and how much money does it cost the public?

Experts say bid-rigging occurs in every region of Japan. It is particularly rampant in construction because of the public's difficulty monitoring and understanding the cost structure of bids for public contracts.

The Japan Citizen's Ombudsman Association, a corruption watchdog, estimates local governments might have overpaid up to 1.16 trillion yen in public work budgets in fiscal 2005 alone due to big-rigging. Throw in decades of infrastructure-related projects that have drawn bid-rigging allegations, ranging from airports to subway systems to tunnels and highway bridges, and the tab the taxpayer has had to foot is incalculable.

Recently, however, heavier fines and more competitive bidding have apparently led to a decline in dango.

How can bid-rigging be detected?

According to the watchdog organization, one indication is a winning bid extremely close to the secret ceiling set by the government for a public contract.

If the winning bid is 95 percent or more of the secret price ceiling, "there is an extremely strong possibility" it was rigged, according to a report by the association.

In a study of major works bids across all 47 prefectures that was conducted in 2002 by the association, the average ratio of winning prices to government-set price ceilings was 95.3 percent - a damning sign of widespread corruption.

According to the association, however, recent increased competition in bidding has pushed prices down, causing the ratio to start declining in 2003, falling to 91 percent in fiscal 2005. Nagano Prefecture, which has taken especially robust steps to impose competition, boasted the lowest rate - 74.8 percent - that year.


Four years sought for ex-governor for bribery
Land ministry fingers bureaucrat over bid-rigging on river projects
Contractors punished for bid-rigging

What measures are in place against bid-rigging?

Article 96 of the Penal Code stipulates that any party compromising the fairness of public bids, by force or fraud, must be punished.

Dango can be punished under the Antimonopoly Law, which prohibits cartels, and the Penal Code, which prohibits bid-rigging and acts of hindering fair public bidding in general. If public servants are involved, they can be punished by another law specifically targeting bureaucrats.

The Antimonopoly Law was revised in January 2006 to raise fines. A construction company can now be fined the equivalent of 10 percent of the sale it raised through bid-rigging, up from 6 percent before the revision.

The fines, however, are still criticized as too low and thus a disincentive to fair play, compared with those in other countries, prompting a government expert panel to recommend further hikes in its latest report submitted last month to Chief Cabinet Secretary Yasuhisa Shiozaki.

FYI (For Your Information)

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Are big fish ever caught?

Officials at almost all major constructions firms - including Kajima Corp., Taisei Corp. and Shimizu Corp. - have been convicted of bid-rigging.

The biggest scandals were in 1993 and 1994, when 32 people from various companies, including Kajima, and from public offices were arrested for either giving or receiving bribes in connection with bid-rigging.

Among the disgraced was former Construction Minister Kishiro Nakamura, who was convicted of accepting a 10 million yen bribe from a vice president of Kajima Corp. to pressure the Fair Trade Commission not to file criminal charges against a suspected construction bid-rigging circle in Saitama Prefecture.

The Ibaraki and Miyagi governors, the mayor of Sendai and top executives at other leading general contractors were also arrested.

Of the 32, 30 have been convicted. Two former Kajima Corp. executives are still on trial, while former Ibaraki Gov. Yukio Takeuchi's trial was dropped after he died in September 2004.

The crackdown is believed to have helped weaken the shady financial ties between ruling-bloc politicians and construction companies.

What role do various power holders play?

Bureaucrats can exert great influence on the bidding processes, making government agencies hotbeds of corruption. Some become even greater sources of corruption by retiring and landing lucrative key positions in industries they once oversaw. This is known as "amakudari," literally "descent from heaven."

Most public bids at the central and local governments are based on the "designation-bid" system, in which construction firms are ranked by the government based on their technical capabilities and financial condition.

The government or government-affiliated agencies use the ranking to designate which companies can submit bids and set a specific limit. The standards of designation, however, are often criticized as opaque and arbitrary.

Perhaps more problematic is the tendency for corrupt bidders to build close ties with bureaucrats as a means of learning the secret ceiling price for public-works projects. Bidders that overshoot that price are disqualified.

Politicians, meanwhile, can exert power over bureaucrats through appointment of monitors overseeing bidding, prompting bureaucrats to favor contractors that contribute to their coffers.

How have bureaucrats achieved such such strong control?

In the years just after World War II, bureaucrats were unrivaled in their ability to estimate costs for large construction projects. The bidding system was designed to enable them to ensure smooth budgeting and expedite public projects.

Industry insiders and ministry officials, however, say that in recent years the government has lost its edge in accurately determining project costs because it now lags behind the private sector in knowledge of cost-reducing technological developments.

As a result, budgets often end up inflated, favoring contractors but costing the public dearly.

The Weekly FYI appears Tuesdays (Wednesday in some areas). Readers are encouraged to send ideas, questions and opinions to National News Desk

The GFC was not caused by Beer Swilling, Cocaine Snorting Traders

August 3, 2009 | naked capitalism

Satyajit Das, of Traders, Guns & Money fame, is keeping tabs on what he calls GFC plot lines, or what one might also call The Search For The Guilty.

The latest caught in the dragnet is...economists! But Das thinks some of the books still miss key issues.

From Das:

Just when I had finally worked out that the GFC had been caused by beer swilling, cocaine snorting, lap dancing club habitues who were irresistible to the opposite sex, I find I was wrong! It seems that the GFC was the work of economists who wish that they were beer swilling, cocaine snorting, lap dancing club habitues irresistible to the opposite sex.

This quartet of books focuses on the political economy of the GFC.

Andrew Gamble, Professor of Politics at Cambridge, in The Spectre at the Feast (2009; Palgrave MacMillan), provides a succinct overview of the economic background to the GFC. Gamble traces the shift in economic thinking and policy from Keynes/ Hayek through to the Friedman/Chicago School and its impact of the global economy. Gamble also assesses some of the current policies designed to restore the economy to health. A lively and eminently readable text provides the reader with a guide to how the present crisis is merely another chapter in the progression of the "dismal science" and familiar cycles driven by "animal spirits".

Restoring Financial Stability: How to Repair a Failed System (2009; John Wiley) is a collection of readings lightly edited by Viral Acharya and Matthew Richardson on the GFC. Organised around seven loose themes (causes; financial institutions; governance; derivatives; role of the Fed; the bailout; international coordination), the 18 policy papers of varying quality propose ambitious 'market based' solutions to the problems revealed by recent events.

Fifty years ago, C.P. Snow, in his "Two Cultures" lecture, identified the divide between literary and scientific intellectuals. Restoring Financial Stability reveals a similar divide between theoretical economics and market practitioners. The tired nostrums that are put forward rehash age-old proposals for more capital, increased transparency and 'better' regulation that have failed repeatedly in the past.

Many of the problems in financial markets revealed by the GFC relate to the detailed plumbing and interconnectedness of financial markets. Some of the essays show a fundamental lack of understanding of critical micro-structure issues of how financial markets operate that detract from the proposed solutions. As Yogi Berra once remarked: "In theory there is no difference between theory and practice but in practice there is."

Richard Khoo's The Holy Grail of Macroeconomics: Lesson from Japan's Great Recession (2009; John Wiley) and the Gary Saxonhouse and Robert Stern edited Japan's Lost Decade: Origins, Consequences and Prospects for Recovery (2004; Blackwell Publishing) provide fascinating insights into the problems of Japan that, despite protestations from Western officials, have striking similarities with the GFC. It seems that we are all in danger of turning Japanese.

Originally published in 2008 and now updated, Khoo argues that there are two phases in an economy – the "yang" ordinary phase when the private sector maximises profits and the "yin" post-bubble phase when the private sector moves to reduce debt and repair balance sheets. Khoo's interesting thesis is that conventional economic policy may not work in the yin phase. This essential insight is crucial in understanding the evolution of a post-GFC world and the impact of aggressive government policy actions and their eventual withdrawal.

Japan's Lost Decade, published earlier, provides a series of short perspectives on the collapse of equity and real estate markets bubbles and their relationship to Japan's persistent economic problems. Both books provide insights into the effect of price shocks, deflationary pressure and the failure of policies in Japan that hold important lessons for everybody in the aftermath of the GFC.

The GFC poses important challenges in our understanding of economic processes and policy options. The economy may simply be too complex and unstable to be controlled by simplistic government intervention. There may be inevitable boom-bust cycles that cannot be easily eliminated, as a whole generation of economist assumed. As Keynes observed "the difficulty lies not so much in developing new ideas as in escaping from old ones".

No Longer Alone, Ron Paul Fights the Fed By Sudeep Reddy

Rep. Ron Paul usually stands far outside the mainstream in Congress, particularly in his campaign to kill the Federal Reserve. But the Texas Republican now has the bulk of his colleagues standing alongside him in a fight against the central bank's autonomy.

His bill to audit the Fed, just three pages long, has 274 co-sponsors - every House Republican and almost 100 Democrats - and counting. "People are upset," he says. "People are demanding more transparency of the Fed, and they're supporting me on this."

The longtime Fed critic would prefer an economy without a central bank, where the market sets interest rates and troubled firms are left to sink. He blames the Fed for the past century's financial bubbles and worries about its ability to monetize debt to finance government spending, even though Fed officials insist they'd never allow it.

Mr. Paul sees transparency as a first step in making the public more aware of the Fed's ability to electronically print money to support the banking system. The revelations from an audit will "expose to the American people exactly how the Federal Reserve operates," he says. "Because when they fully understand how they operate, what they do, how they manipulate monetary policy and interest rates, they will finally figure out that it's the Fed that has caused all the mischief."

Most of the lawmakers who have signed on as co-sponsors of the legislation don't share Mr. Paul's anti-Fed stance. They say Congress has an oversight role and needs a full accounting of how much money the Fed has lent - and to whom.

Some lawmakers signed up as an expression of disapproval after learning more about the Fed's decisions to lend money to firms such as AIG. Many others say greater scrutiny is critical before any discussion of expanding the Fed's authority in other areas, as the Obama administration proposes. "Bringing transparency and accountability to the Federal Reserve through an audit will help ensure that tax dollars are not wasted," said Rep. John Boehner of Ohio, the House's top Republican.

Rep. Brad Sherman, a California Democrat, says none of the Depression-era lawmakers who gave the Fed its power to lend to nonfinancial institutions "ever thought it would involve trillions of dollars." He said the Fed system's unique structure, with private officials leading the regional Fed banks, also needs a review by congressional auditors. "Anyone exercising governmental power should be subjected to governmental oversight."

Even lawmakers who are less eager to sign on acknowledge the momentum. If the Fed gets added responsibilities, "there wouldn't be any question in my mind that a bill would be passed," said Rep. Paul Kanjorski, a senior Democrat who has not taken a position on the legislation. "They would have to buy into much more regular audit control of the Fed."

Mr. Paul recognizes that his movement to audit the central bank ultimately may help the Obama administration expand the Fed's oversight role in the economy.

"I think what they'll do is they'll give in to some of the transparency at the same time they'll give them more power," Mr. Paul said. "We're going to be bugging you a lot more. We're going to be keeping eyes on you. That might be the way. Maybe inadvertently I'll help them get more power at the Fed."

SEC Taking More Aggressive Stance on CEO Clawbacks

attempter said...
As someone who looks at these things purely politically (since that's all they really are), it seems to me that if regulators really were willing to aggressively use this approach, it could be used pretty much anywhere against these financial entities, all of whom are involved in accounting fraud.

(What's the whole point of the bailouts, other than to let these banks get away with fraudulent valuations of worthless "assets", and, if the administration could politically manage it, to force the taxpayers to buy at these fraudulent valuations?

And what's the whole point of the business press, other than to trumpet fraudulent "profit" reports from these banks, based on other accounting improprieties?)

So I can't imagine where you could fail to find opportunites. It's a target-rich environment.

And I love the concept of strict liability, given how the whole point of incorporation is to absolve actors of liability for their actions, i.e. to place criminals above the law.

But the whole thing boils down to the big "if", if they really intended to use this in a systematic way. And I agree there's no reason to believe they would.

So I guess the media hype is another pretense that something is being done when it's really not.

Hype would be warranted when they used something like this to claw back that laundering of public money to Goldman via AIG.

July 29, 2009 5:02 AM

Anonymous fresno dan said...
There are posts that you have had on this blog about "looting."
However, I am more inclined toward an enven more radical view of the stock market - that the theory that we are rational players selecting CEO's on their ability to manage the company is all hooey.

When something like 30% (or was it 60%) of all profit goes to the CEO of a bank, the risk reward for owning stock just doesn't make sense. The CEO's are acting rationally - they may not know how to run a bank, but they know how to get compensated. The question is: why do shareholders put up with this?

Speaking for myself, I thought I was well informed - stocks give the best return in the long term - yeah, if only I had a 150 year lifespan.

Blogger Yves Smith said...

I must beg to differ with you here.

No one has proven accounting fraud at the financial firms, and AS A MATTER OF POLICY no on is willing even to mention the F word.

Remember, mission number one is keeping bank stocks up so they can float new shares to chumps. Confidence is the order of the day. Lehman looked like a pretty clear cut case of fraud, and here we have Bryan Marsal, effectively head of the Lehman windown operation, bothering to go on the media to say the losses were entirely due to the disorderly unwind. If you believe that, I have a bridge I'd like to sell you.

And the fact case here is very specific: the fraud was big AND : the CEO was unaware of it. Do you think that applied on Wall Street?

Blogger skippy said...
SEC who? Ohh yeah the Regulators.

Did their prince kiss them and awaken them from their slumber or did the coffee haven/great deli on the corner close up, leaving them with out reward stimulus. I'll leave that question for readers to ponder.

Yves said...The problem is that boards (and the search firms that advise them, since a more difficult recruitment justifies the search firm fees) want CEOs from central casting, ideally someone who is a CEO somewhere else.

Skippy.. Now, what would replace the traditional alpha male/female hormonal victory chest beating upon a successful headhunting foray...complete w/ drinks at the bar rectum polishing session, all hail the conquering chieftain toast, "be gentle its my first time like that". With out blood, there is no Victory!

PS. Habits never die, just replaced.

attempter said...
Yves, I never believe the CEO is unaware of it, ever.

But wouldn't that be even more clearly culpable and actionable? I thought what was new here was the potential tool of imposing strict liability. That way you wouldn't have to prove anybody's knowledge and "intent". (And why should we have to? If any of these CEOs are worth one tenth of what they get paid, they can be assumed to have all the competence necessary to detect any fraudulent practice. Strict liability, absolutely.)

Like I said, I agree completely, it's against policy to acknowledge fraud or the possibility of fraud, and that's why I agree it seems far-fetched that there will be any there there in practice.

I was just ruminating on what could be, if a US government ever did miraculously decide to act in the public interest. In that case this sounds like it could be a useful tool.

Peripheral Visionary said...
Yves, on CEO selection, I totally agree. But this is, in my view, a symptom of the shift in hiring practices, from the old-school system controlled by the hiring manager (or for CEO, the firm's owners) to the new HR-centric system, or for CEOs, the executive search committee.

The HR- and committee-based systems are considered "better" than the older system because they are more even-handed and less influenced by personal connections; there is (in theory) less patronage and nepotism inherent in the process. But the downside is that they are very risk-averse; since one of the ostensible reasons for the new approach is to limit liability, they have a strong tendency to play it safe.

And they play it safe by hiring people for jobs who have already done that job. I have seen it many times: the job description which basically asks for someone who has already done the job in question.

Ironically, that ostensibly "fair" approach has resulted in a deeply unfair system, where it's nearly impossible to break into the top ranks of management, but that once somebody has broken that barrier, they get offer after offer with complete disregard for their actual competency (case in point: Bob Nardelli.) I see the exact same thing in politics: once people have risen to a certain level, they get appointment after appointment, with complete disregard for their actual competency. All that matters is that they've done it before; how well they've done it gets little attention.

That can be fixed, but to do so would be to abandon HR orthodoxy, which calls for hiring practices that are focused on getting the "most qualified" person possible. Instead, it would need to be recognized that the best person for the job might actually be somebody who is not currently qualified, but who can be brought up to speed while in the position--as happened routinely under old patronage-based hiring systems (e.g. partnerships, where rather than going outside the firm for a new partner, an existing member of the firm would be "groomed" for an upcoming partnership position.)

Again, that would mean abandoning much of the current recruiting "best practices", but some changes are needed to break down the barriers between levels of management that amount to welfare for incompetent managers and barriers to entry for competent employees.

Anonymous said...
I don't know, Yves... some CEOs are operators and try to leave the accounting aspects to the numbers wizards. If the CFO says everything is fine, and the auditors say everything is fine, well... a CEO has other things to think about.

I'm not saying that necessarily happened here, but the fact that a major accounting fraud has occurred in a company isn't in and of itself evidence that the CEO was in on it.

[Jul 20, 2009] Innovative Financial Shennanigans

Economist's View

Isn't this special?:

Cashing In, Again, on Risky Mortgages, by Peter Goodman, NYTimes:

... ... ...

"Our job was to get the money in and then we're done," said Paul Pejman, a former sales agent... He recounted his experience, he said, because "I really feel bad."

"I had people calling me crying, and we were telling them, 'You can pay me or you can lose your house,' " Mr. Pejman said. "People were giving me every dime they had, opening credit cards. But I never saw one client come out of it with a successful loan modification." ...

FedMod is among dozens of similar companies that have been accused by state and federal authorities of fraudulent business practices. ... Many of the companies formerly operated as mortgage brokers... The three original partners brought in [a lawyer] to gain a crucial asset: his law license. Having a lawyer in charge enabled them to market their venture as a law firm and thus collect upfront payments under California rules. ...

Mr. Pejman, 22, ... had worked at three wholesale mortgage brokerages. Now, a trainer emphasized he was at a law center.

"Our big sales pitch was that an attorney could do a better job with your loan modification," Mr. Pejman said. "If you told them these were basically washed-up people from the mortgage industry, or just people sending in paperwork, they would say, 'Well, why bother? I might as well do this myself.' " He went on: "It was misleading to the client. Attorneys never touched those files."

Among the 700-plus full-time employees who worked for FedMod this spring, only nine were lawyers...

Mr. Pejman and his fellow agents urged homeowners to send FedMod $3,495; the agents were promised a 30 percent commission for fees they took in. ... "They basically told us, 'Do whatever you need to do,' " he said. " 'It's a sales floor. You're here to sell.' People would quote success rates and just pull them out of thin air. People would say 60 percent, 80 percent, 90 percent. ...

"I'd hear people say, 'Would you pay $1,000 to save your home? To save your marriage? Your kids' education?' " he recalled. "I'd hear people say, 'Yeah, we're the federal government.' There were a lot of corrupt people working there." ...Each case manager was responsible for as many as 200 files at a time... "You're paying the sales agent upfront," ... "So what motivation does he have to get it closed?" .

See, the anti-regulation types are right.

Selected comments

bar exam purgatory says...

We already have the agency, actually we've got several. It's called the FTC, and they go after these types. We also have 50 state AG's offices. We don't need a consumer financial protection agency. We have one. FTC ACT section 5 covers everything these guys do.

At the FTC, the conservatives political forces kept the enforcement down, not to mention its underfunded, and understaffed. Also finance regs have their turf carved out. Even better than the CFPA idea, the FTC handles a wide range of industries. Thus, no industry capture. Give it time and the CFPA will join the views of Wall Street.

Also, in most states, the attorney's are, by my read, violating the PR rules. But who knows...

Speculative games stage comeback

Asia Times

The world's monetary and fiscal authorities appear by their feckless policies to have pulled off a feat that I didn't think was possible: resuscitating a bubble that came close to wrecking the world economy, and may still do so on a delayed-action basis.

John Allison, chairman of BB&T Group (about the best-run major US regional bank), spoke on Thursday to the Competitive Enterprise Institute, saying that apart from a gold standard (which he thought unlikely), the financial services business and the country in general needed to change its motivations from short-termism and altruism to enlightened long-term self-interest.

While his altruism/self-interest point is a long-standing one (which to the extent that it means not making "affordable housing" loans to people who can't afford housing, I agree with), the long-term/short-term point is different. It's a product of environment, not of innately bad philosophies. If a country's government engineers market conditions that lavishly reward foolish short-termism, foolish short-termism is what that country will get. Only by changing market structures, rules and incentives will behavior be changed.

In a well-run financial system, the free market automatically rewards prudence and punishes short-term greed and folly. That's not the system the United States has had since at least 1995, and it's certainly not the system that has been produced by the multiple bailouts and stimulus packages since last autumn.

... ... ...

...By rewarding incompetence in this way (for example allowing Vikram Pandit to keep both his job and the $600 million with which Citi purchased his failing hedge fund), the government has insured that we will get more of it, since the benefits from the juicy bonuses in good times are so great and the slaps on the wrist when the structure comes crashing down so painless.

Jeff Skilling of Enron was given a 25-year jail sentence for Enron's failure; that was grossly disproportionate to his offense but did ensure that future Enron perpetrators would be discouraged. The fate of Pandit, Ken Lewis of Bank of America and the AIG honchos offers no such deterrent to incompetent looting of the financial system.

A further effect of the TARP process has been to cause a number of perfectly healthy banks to slash their dividends - notably US Bancorp and Allison's BB&T. Should management of those banks, which have now repaid TARP, fail to restore their dividend forthwith while engaging in empire-building acquisitions of battered competitors, the "widows and orphans" who traditionally invest in bank shares because of their reliable income will be further discouraged, and shareholder control of banks will be left still more tightly in the hands of hedge funds and other cowboys.

Finally, we come to monetary and fiscal policy during the crisis. Monetary policy, which had been far too loose for the preceding 13 years, bore a large part of the responsibility for the period's excesses. If the monetary system is managed so that leverage is perpetually rewarded, it's not surprising that intelligent and aggressive bankers will devise new and ever more unsound means to create excessive leverage.

However, monetary policy has been loosened unimaginably further since the crisis, with the monetary base being more than doubled. It is very clear that only evidence of rampant inflation - which we can expect the Bureau of Labor Statistics to suppress for as long as possible - will cause the Fed to return to an appropriately tight monetary policy.

Thus the incentives for Wall Street to indulge in endless speculative games will still be present, complete with the implied taxpayer bailout when it goes wrong. No wonder Goldman Sachs is thinking of abandoning its banking license - why dawdle along with only 15-to-1 leverage when you have tasted the heady joys of 30-to-1 at taxpayer expense. It's also unsurprising that hedge funds have enjoyed their best month for nine years - for dodgy short-term speculators, Happy days are indeed here again!

Public interest RIP By Julian Delasantellis

Asia Times

It was after the fall last September 15 of Lehman Brothers and the horrifying stock market declines that ensued that the government of president George W Bush and Treasury secretary Henry Paulson, then only trying to wheeze its way out of office, realized that it had to do something to deal with the financial system's troubles in a systematic fashion. Since bad mortgage and mortgage-derived debt was the problem, why not just initiate a huge government program to buy it out of the banks' vaults, cleaning them out so as to free the banks to conduct new lending?

What was wrong with the plan? In short - everything. A popular grassroots resistance movement grew up overnight by people opposed to giving "our tax dollars" to greedy New York bankers. This smashed something of the begrudging bipartisan consensus in favor of the proposal; it wasn't until early October that the TARP bill passed, on its second attempt, through the US House of Representatives.

But then Paulson, having stuck his finger into the air to gauge the political winds and finding his digit nearly cut off, changed his mind. With TARP so unpopular, it became obvious that both pundits and politicians were desperately searching for any type of financial system support initiative that did not include the government's purchase of toxic assets. When, in mid-October, British Chancellor of the Exchequer Alistair Darling came up with one, namely, for his government to take ownership stakes in tottering private banks through the purchase of stock in them, and when Nobel economics laureate and New York Times columnist Paul Krugman wholeheartedly backed the measure, the writing was on the wall for toxic asset disposals.

Paulson announced a short-term delay for toxic asset sales in October, then a longer-term delay (that is, until after the inauguration of Barack Obama, the only timeframe that anybody in the Bush administration then cared about) in November.

The equity injection initiative involved the immediate usage of $250 billion of TARP's $700 billion for the purpose of the government purchasing the preferred stock and common stock warrants, similar to long-term call options, of the banks in question. Over the previous six months, the world had watched modern-day electronic mobs initiate bank runs that toppled at least two major US financial institutions - Bear Stearns and Lehman Brothers, so the government had no intention of painting a big red "I'm weak! Shoot me!" bull's eye on any potential number three.

The banks would be forced to sell the preferreds and take the government's money, which was generally thought to be intended for new lending. Also, in a mostly failed attempt to at least drum up some sort of popular support for the program, salary and income caps would be placed on the executives of institutions receiving the largesse. If the Paulson Treasury, which by then unofficially included future Obama Treasury Secretary Timothy Geithner, had been sufficiently outside of the American financial elite's governing superstructure so as to be able to see it in its full entirety, it would have seen that this, the pay caps, would eventually doom the TARP with more certainty than any initiative to run sumo wrestlers as jockeys in the Kentucky Derby.

As the Bush administration panted out of office and the full force of crisis hit the new Obama administration like an open furnace door, bhe Bush administration announced that funds from the program would be used to give emergency financial support to General Motors and Chrysler. Early in its time, the Obama administration announced that, although it didn't know just how it was going to do so just yet, when it finally did come around to addressing the toxic bank assets issue, TARP monies would be involved, as they would with the new administration's initiative to provide mortgage relief to US homeowners threatened with foreclosure.

Of course, using the TARP as a sort of all-purpose financial crisis Swiss army knife was nothing but a technique of bypassing any role in the matter by the US Congress, now obviously too hopelessly rent by extreme partisanship to do anything constructive on these issues.

By any measure, the TARP was providing capital to the banks on extremely generous terms; the only cost was a 5% dividend coupon payable to the government on the preferreds, and the warrants that would allow the government to pick up equity, stock, in the banks should the stock start to rise. Last October, these were very generous terms indeed, as those were the days that only while wearing a hazmat suit would anybody deal with an institution operating in the financial markets without an explicit government guarantee.

But as late winter ticked towards spring, the appreciation for the emergency assistance turned into something more akin to "Well, what have you done for me lately?" begrudgement, even though it was still obvious that many of the institutions, especially the large ones, would collapse should the government withdraw its explicit and implicit promises of support.

More executive pay restrictions on those institutions receiving TARP funds were implemented in late January and early February that, along with the crucifixes bearing AIG officials that Congress put along the Acela train route from Wall Street to Capitol Hill, put the Masters of the Universe well in the mood to make a meal out of the hand that was feeding it.

The only way that the banks could get out of the TARP pay restrictions was to give the money back, and also to come to an agreement valuing the warrants the banks had to buy back from the government. This would certainly be a challenge, as back then the markets hardly believed that bank balance sheets would support gum purchases from the newsstands in the lobby, let alone a good portion of the $250 billion the banks received in TARP.

Still, the banks wanted to be out from under the government's thumb immediately if not sooner; they were in no mood to wait for some manner of economic recovery that would inflate their balance sheets and fill their vaults. In short, the banks had to fool the markets into believing that the banks were a lot stronger than they seemed.

As Charles Baudelaire once said, "Speak of the devil, and the devil appears." Suddenly, mark-to-model bank asset accounting was added to the Newspeak financial dictionary, and mark-to-market cast out to the dustbin of history.

I've written before about how many free-market conservatives, believing that nothing so wrong as what we see in the present could possibly go wrong with their visions of endless laissez-faire paradises, chose instead to blame it all on an obscure accounting rule called "mark-to-market", contained in an industry document called FAS 157. The Obama administration had no cause to support free market fantasies, but, after everything else they were trying along the lines of bank rescue were either not getting off the ground or dying still-born, they realized that repealing mark-to-market in favor of letting the banks use computer models that produced current values to their liking was just about the easiest, cheapest thing they could do, at least in the short term. (See Bankers get a model rush, Asia Times Online, April 9, 2009).

Then, since the prospect and actual implementation of mark-to-model had done so much to support bank share prices during the late winter and early spring, the Obama administration decided to go for the gusto once more. They allowed the new, flexible accounting standards to be used in the so called bank "stress tests" being given to see if the banks and other financial institutions had sufficient capital for ongoing and forward operations.

Voila! By being able to report mortgage loan and mortgage loan derivative values at levels far in excess of what they would receive in the actual, traded markets, the "stress tests" came in far more favorable for the banks than previously expected. (See Oh, impotent Washington!, Asia Times Online, May 14, 2009.)

... ... ...

Therefore, with the TARP's function now degraded to be nothing much more than an income support operation for banking CEOs, it can hardly be surprising that the original function of the program, buying up toxic mortgage assets, is once again falling by the wayside. Recent reports have it that Geithner's Public Private Initiative Program (PPIP), designed to use leveraged TARP money to deal with the toxic assets problem, is on hold; the banks are, if anything, using their questionable mark-to-model valuations to demand even higher prices for the still, in reality, depreciating assets. "After all", Mr Bank Bigshot must be thinking, "If you're gonna pay me like it's 2007, my assets must be worth what they were in 2007."

The Economist magazine places these events within the context of something it calls "TARP revisionism". This is the new spin the bankers are weaving - that they were just sitting quietly and productively in their office when WHAM! - the government forced them to take all this money they really didn't want.

Like the fictions produced by the Ministry of Truth in George Orwell's 1984, these lies serve myriad purposes. It sends down the memory hole the real experience of last September, with the entire banking system perhaps just hours away from extinction due to the bankers' mendacities, in favor of fibs much more to the industry's liking, with, strong, determined, Ayn Rand-type banking/capitalist avatars steering through the rough seas of commerce, while shallow government guttersnipes forever blocked their path.

This, it is hoped, will forestall what the bankers really fear - the introduction of new banking and financial system regulations designed to prevent what the industry most wants, another gloriously irrational but wildly popular and profitable financial bubble. With the very real possibility that the Obama administration may simply run out of political time before its dream of an economic recovery based not on more financial leverage but on investments in infrastructure and green energy can be realized, the banking oligarchs may very well get their wish. As the oligarchs always do. It's a rare week that the people only suffer one shellacking from the elite, and last week was not a rare week.

Wall Street corruption is undermining America Democracy for Utah

Ben Stein

Conservatives have steadfastly blocked any attempt to hold accountable Wall Street's major investment banks and blue-chip brokerage houses for corrupt market practices. They ignore the evidence that these firms have repeatedly abused the trust of investors by deceiving them about the value of investments and placing their own profits above the interests of investors (think Drexel- Milliken junk bond scam; Savings-and-Loan debacle; tech-stock bubble of the 1990s; today's subprime disaster). Ben Stein says Wall Street corruption threatens free-market capitalism itself:

Without trust, there can be no free-market capitalism. [Fiduciary duty] standards of care required that those handling someone else's money behave with extreme rigor and honesty. Trustees always had to behave with the interests of the trustor [investor] uppermost. In the United States, the trustee had to disclose every fact or belief that might influence an intelligent, reasonable investor. But by the 1980s, the laws of fiduciary duty started to break down in a major way. Basically, a crossroads was passed in the Drexel-Millikan scandals. Although hundreds and perhaps thousands of men and women were profiting from misconduct, only a few went to prison. Today, in the midst of the mortgage mess, we see people breaching their fiduciary duty and getting away with it, while the ordinary stockholders are pauperized because of the losses. We surely cannot remain a republic under law if there is no law except the axiom from Richard II that "they well deserve to have, that know the strong'st and surest way to get."
Free Market is a misnomer.

John Lee said,

It's a regulated market, and without regulations, there can be no trust.

It's just a market

lucidity said,

That bugs me too -- liberals using the term "the free market." It's just "a market," and there's nothing inherently free about it. Conservatives are the ones who want it to be free, in the sense of completely unregulated. Every time a Dem talks about "the free market" I want to slap them.

[Jun 4, 2009] Regulate, Baby, Regulate by Thomas K. McCraw

March 18, 2009 | The New Republic

We're going to need a bigger Federal Register.

As the United States faces its biggest economic crisis since the Great Depression, Barack Obama and his team have been looking to Franklin Delano Roosevelt for help. The influence so far is obvious: The stimulus measure passed by Congress in February includes money for building infrastructure, strengthening unemployment insurance, and helping state governments--all reminiscent of FDR's New Deal.

It is now necessary for Obama to take the model one step further. In addition to spending, there was a less visible but equally important element of FDR's program: stringent financial regulation to drive what the president called "unscrupulous money-changers" from the temple. While Obama recently spelled out some admirable principles on that score, there are still obstacles to success. His pick to head the Securities and Exchange Commission (SEC), Mary Schapiro, is far better qualified than her Bush-appointed predecessor. But she seems less formidable than any of FDR's first three SEC chairmen: Joe Kennedy, whose stellar performance laid the foundation for the Kennedy political dynasty; Jim Landis, the chief draftsman of the major securities laws (and later dean of Harvard Law School); and William O. Douglas, who went from the SEC to become the longest-serving Supreme Court Justice in the nation's history. What's more, Obama will face stiff opposition from a political party that has depended very heavily on contributions from the industries he needs to regulate.

Putting money into people's pockets and into institutions is politically easy and economically sensible. But, if we don't reinvigorate regulation as well, the credit system will remain sick, banks won't fully recover, and investors and borrowers will keep on believing--correctly--that they've been hoodwinked and fleeced. Only a thorough repair of the agencies that handle securities and banking regulation--a repair FDR's model can help us achieve--can prevent new crises down the road. Without this reform, other shady financial practices will emerge, just as they've done throughout history, and the money poured into stimulus will have been wasted.

Like Obama, FDR inherited his economic problems. The 1920s were prosperous but were also wild and free-wheeling, a time when dubious mergers and rickety holding companies multiplied. The stock market, almost wholly unregulated, soared to record levels, and a self-satisfied Herbert Hoover predicted that "poverty will be banished from this Nation." Then came the Great Crash, and, by 1933, the task confronting the New Deal could hardly have been more daunting: The Dow Jones hovered in the fifties, down from a high of 381 in 1929. Issues of new corporate stocks and bonds totaled only $161 million for the entire year 1933, a decline of 98 percent from 1929. Unemployment stood at 25 percent.

In this state of emergency, the New Dealers quickly set out not only to stimulate the economy but also to create an effective regulatory system. Their goal, above all, was transparency, which FDR understood as the key to restoring consumer and investor confidence. Without that confidence, consumers would keep their money out of banks and, as FDR put it, "under the mattress." Investors, too, would refuse to buy stocks and bonds to finance business expansion. So FDR called for a Banking Act to assure depositors that their money would be safe, and securities legislation that, in his words, "adds to the ancient rule caveat emptor the further doctrine, 'let the seller also beware.'" Sellers who did not beware could end up in jail.

Both the Banking Act and the Securities Act were passed during the New Deal's first hundred days in 1933. The Banking Act, known as "Glass-Steagall," created the Federal Deposit Insurance Corporation (FDIC), which protected bank deposits and, almost by itself, stopped the epidemic of bank runs. Glass-Steagall also forced the separation of commercial banking from investment banking, thereby reducing bankers' ability to speculate with "other people's money," as FDR called it, quoting Louis Brandeis.

The Securities Act compelled all companies issuing new stocks or bonds to disclose hitherto secret information: their balance sheets and income statements, the pay and perquisites of their top managers, and reams of other data. This was a radical move toward transparency, the more so because the act required that all reports be certified for accuracy by independent public accountants. Next came the crucial Securities Exchange Act of 1934, which extended these same requirements to every company whose shares were already being traded on exchanges--essentially the several thousand most important firms in the country. The 1934 act also created the SEC to enforce the new laws and to regulate the New York Stock Exchange and all other exchanges. Drafted with meticulous care, the Securities Act and Securities Exchange Act thrust the affairs of corporate America into the sunshine for the first time in the nation's history. The strategy of transparency was now firmly in place.

Four years later, Congress also brought under SEC control the "over-the-counter market"--that is, trading not done through an exchange. This informal operation had been run by thousands of brokers and dealers, many of them swindlers. Under SEC sponsorship, the industry created the National Association of Securities Dealers (NASD, which set up its own effective regulatory branch and, later, the nasdaq exchange). With all this legislation, administered by the elite civil servants who enforced it, the New Deal created the finest system of financial regulation in the world's history.

The obstacles to change, however, had been substantial. The new laws were very technical, and Wall Street and most other players fought regulation every step of the way. The easiest opponents to bring into cooperation were the accountants, whom the SEC courted aggressively. At first, accountants were terrified by the new legislation, which imposed criminal penalties for misrepresentation of "material fact" not only by corporations submitting reports but also by accountants who certified their accuracy. Historically, accountants had been cowed by corporate executives into shading their numbers according to the executives' wishes. The SEC pointed out that the new laws gave the profession its first chance to achieve real independence, and accountants embraced the opportunity with great enthusiasm.

The New Deal's conquest of the accounting profession and the over-the-counter market was far easier than its victory over Wall Street, investment banks, and exchange-traded corporations. For both the Stock Exchange and the big investment banks, opacity was the tradition: Their money and power came from their virtual monopoly on information about companies' operations. If the monopoly on information were broken, then individual investors--and, later, mutual funds, pension funds, charitable trusts, and university endowments--could make their own informed judgments about securities, and the expensive advice of investment bankers would be less necessary.

After three years of struggle, the SEC finally won this fight in 1937, with the help of a major scandal. Richard Whitney, an aristocratic pillar of Wall Street and the former president of the New York Stock Exchange, was found to have embezzled millions of dollars from his clients to cover losses from his own speculations. In a matter of weeks, he was sent to Sing Sing prison. With Whitney's disgrace, as SEC Chairman Douglas put it, "the Stock Exchange was delivered into my hands." The revolution in financial regulation was now complete.

Over the next four decades, the SEC built a reputation as the most effective of all federal regulatory agencies. It was respected and feared by nearly everyone involved in the trading of stocks and bonds, the issuance of new securities, and the governance of corporations. Even the Reagan transition team reported in December 1980 that "the SEC, with its 1981 requested budget of $77. 2 million, its 2,105 employees and its deserved reputation for integrity and efficiency, appears to be a model government agency."

But no revolution lasts forever. Starting in the 1970s, the New Deal's regulatory triumphs were systematically undermined. As a result, we have witnessed one scandal after another: Michael Milken's junk-bond operations; the savings-and-loan fiasco of the 1980s; the collapse of Long Term Capital Management in 1998; the failure in 2001 of Enron, whose house of cards not even its own lawyers and accountants could understand; the uncontrolled growth of the real-estate bubble; the invention of ever more complex derivatives--sliced and diced mortgage securities, collateralized debt obligations, credit-default swaps; the Bernard Madoff affair; and, finally, the meltdown of the whole financial system in 2008.

Many elements were responsible for the backsliding that led to these scandals, not least the Republican Party. The decline of regulation began in earnest with Ronald Reagan's inaugural address, in which he famously noted that "government is not the solution to our problem; government is the problem." Guided by excessive faith in "the free market," regulators in the SEC, the Fed, the nasd (which merged in 2007 with the regulatory arm of the New York Stock Exchange to form the Financial Institution Regulatory Authority), and other agencies had simply stopped doing their jobs. Even during the Clinton administration, the craze for deregulation had so worked itself into the national culture that Congress blocked major accounting reforms pertaining to stock options, and, in 1999, Clinton's financial advisers supported the very ill-advised repeal of Glass-Steagall. Worse, in 2000 they accepted the catastrophic exemption of credit-default swaps from any regulatory oversight at all. By the time George W. Bush became president in 2001, the SEC's strategy of transparency had been thoroughly undermined. The return of opacity was in full swing. The elements of a perfect storm were in place, and, by 2007, Bush's policies had brought them all together for the explosion of 2008.

While all this deregulation was going on, the financial services industry had found even more new ways to circumvent transparency. An unregulated shadow banking system arose, through hedge funds, private-equity funds, off-balance-sheet operations, offshore tax havens, and the widespread trading by money managers in completely opaque instruments, especially credit default swaps. Because of the enormous profit potential in these securities, the movement of vast sums from the regulated sunshine to the unregulated shadows became inevitable.

Today, banks and other institutions have a very uncertain idea of what their holdings of the new instruments are actually worth. Therefore, they cannot accurately calculate their own assets and liabilities, let alone those of others. This is why they are so reluctant to lend, and why the nation's credit system remains in gridlock despite the $700 billion bailout. Opacity has thus turned inward upon the very institutions that created it, which would be an ironic farce if its consequences weren't so tragic.

Obviously, there is much work to be done. The SEC still has an acceptable structure, but it needs robust infusions of talent, expertise, and money. The staffs of both the Fed and its twelve regional banks are far more sophisticated now than they were during the 1930s, and the fdic is working well under Sheila Bair, one of the few people who began warning years ago of potential catastrophe. But banking regulation remains extremely fragmented, with far too many players: the Fed, the fdic, the Comptroller of the Currency (a part of the Treasury Department), dozens of state banking commissions, and still other agencies. They are in desperate need of better coordination and, possibly, consolidation. What's more, the regulatory talent emblematic of the New Deal is not gone altogether, but it is thinner to the point of anorexia. After years of ideological hiring, large clusters of ineptitude bedevil the SEC, the Commodity Futures Trading Commission, the Department of Justice, and many other federal bodies. Nearly every important agency has long been starved of resources--and even of the elementary belief that regulation is necessary.

The political opposition to reform will be stiff. The Republican Party will likely fight every step of the way. So will the financial services industry, some of whose stalwarts are Democrats. Even now, Wall Street remains in deep denial: The lavishing of billions in executive bonuses by firms that received federal bailout money is all we need to know about this industry's feral determination to protect its outrageous pay scales.

Fiscal stimulus is the first priority now, but only with reinvigorated regulation can the economy operate effectively over the long term. Capitalism depends on credit, credit depends on transparency, and transparency depends on illumination. It's that simple. If the new administration can accomplish what the New Deal did in bringing finance into the bright light, it will be one of Barack Obama's greatest legacies, just as it is one of FDR's.

Thomas K. McCraw is a Pulitzer Prize-winning historian and the author of Prophet of Innovation: Joseph Schumpeter and Creative Destruction.

Selected Comments

Posted by toritto
5 of 12 | warn tnr | respond

Once upon a time (maybe 25-30) years ago there were lots of strong, well capitalized commercial banks. They were highly regulated and rarely failed. They had low leverage (by today's standards) of maybe 9 or 10X. A well performing bank earned 1%+ on total assets and 10%+ on equity. They loaned out perhaps 80% of their deposit base to local or regional customers. They rarely funded themselves with "hot" money. They paid solid if uninspiring dividends to the little old ladies and local businessmen who owned their stock. There were thousands of these banks from the largest cities to the most rural area. They operated in virtually protected franchises as hostile take-over, or virtually any take-over for that matter that didn't involve a failing bank was not an option. Banking regulators simply wouldn't allow it. Branching was severely restricted by state statues, protecting smaller banks from intense competition from major metropolitan area banks. There was plenty of credit available and plenty of banks from which to choose. Banks developed their own specialities in order to effectively compete.

Bank of Boston had vast trading contacts in Latin America. Irving Trust was the largest commercial factor in America. Morgan Guaranty was the premier corporate bank. Citi was NYC's largest retail bank. Regional banks dominated their geographic areas as branching restrictions kept others away. North Carolina allowed state-wide banking which nurtured NCNB, First Union and Wachovia.

The largest commercial bank failure during that period was Continental Illinois of Chicago. Illinois was a "unit" bank state - no branches were allowed. Continental Illinois was housed in one building in downtown Chicago. As a result of the Illinois branch restrictions, Continental had a relatively small retail deposit base. It funded itself each day in the overnight markets. It was a risky strategy. When it ran into credit difficulties its sources of funding dried up. It was seized by the FDIC and liquidated. The last real estate crisis brought down a few banks - Republic of Dallas, Texas Commerce - but nothing that would threaten the stability of the banking system as a whole. The system worked fine even if it could be criticized as dowdy. Banking was not the most exciting profession to be in.

Then came deregulation. Branching and nation-wide banking came into existence. With it came the hostile take-over. Glass-Steagle was revoked. Suddenly there was money to be made in bank stocks.. It all began when Bank of New York put a take-over offer in front of the Board of Irving Trust. Irving rejected th offer. BONY sweetened it. It was rejected again. Irving was counting of the Fed and regulators to do what they had always done - reject hostile takeovers. But the wind of change was in the air. Wall Street smelled defeat for Irving.

After battling BONY for a year Irving lost in court and the Regulators gave approval. The rout was on. Chairman Rice of Irving Trust caved the day after losing in Court and Irving was acquired. Rice immediately retired. Thus was set in motion the creation of the banking system we have today. Plenty of money was made by Wall Street, bank stockholders and insiders holding shares and options, including me. The major regional banks were acquired and disappeared along with thousands of jobs. "Growth, growth, growth!" was the mantra. "Marketing" rather than credit worthiness became the norm as loans were marketed as if selling soap.

Credit insurance from AIG made it possible to shovel billions of dollars into mortgage assets without worrying about the loans themselves - after all, they were insured by AIG and carried a Moody's/S & P investment grade ratings. Trading rooms expanded from foreign exchange and interest rate swaps to betting on credit derivatives - mark to market transactions which today can't be valued and are off balance sheet. Within all of the major banks in trouble today there were those who had serious doubts about how business was being conducted. "Nay-sayers". "Old fashioned". "Not up to date". They were ignored. There was no money in their Cassandra prognostications; not for "business development officers", executive management or shareholders. What was the matter with the old system? Not much. Deregulation, the revocation of Glass-Steagle and the cowboy mentality of growth brought us to where we are. Unfortunately, the banking system somehow needs to be rescued. It is more than the system deserves.

[Jun 1, 2009] Arthur Levitt Hired by Goldman Sachs by Jesse

"Hired" = "Bought". Levitt was up for some regulatory posts, and when he was the head of the SEC, exhibited a bit of backbone, enough so that he got perilously few board seats when he stepped down.

[Apr 26, 2009] Restoring The Old Order That Failed

Newsroom Magazine
Failed Establishment

The problem isn't that Blankfein or anyone else did something wrong in the decade before the collapse began, although they well may have done so. The problem is that the nation's banks and credit extenders failed to do what was safe, conservative of others' interests, and above board. The result has been cataclysmic– leading former Washington Post finance writer and author William Greider to surmise - the old order that's been running the American establishment for the last generation has demonstrably and miserably failed.

But so did we all - and, it now seems, so is our new president who is knowingly and one might presume intentionally trying to restore the old order establishment. There are many good reasons for doing so. Among them are stability, predictability and risk avoidance to an economy still in peril. Those who favor installing an new order are becoming more vocal in their assertions that perpetuating the systems and institutions that failed only treats the symptoms of what is clearly a potentially fatal disease.

What Matters Most Goes Unknown, Thus Unheeded

In a generation seemingly absent responsible adults, we knowingly and cheerfully chose to have a grand party at the expense of our children and grandchildren. In the doing, we effectively destroyed our great institutions of finance, journalism, education, banking, manufacturing, insurance, transportation and athletics.

As a nation our errors were of commission and omission. Our errors of commission were largely based on tilting the economic playing field to favor the wealthy and powerful among us by lessening governmental regulation and control. Deregulation became a game in which immense wealth was transferred from the nation's middle class to the mighty, rich and powerful. Absent responsible adults to remind us that American capitalism rests on a foundation of checks and balances, we systematically deregulated ourselves into disaster.

And now reality has set in, what matters most has become clear and painful. Over reliance on laissez-faire thinking, and the invisible hand first postulated by Adam Smith has failed. Neither we, nor the world around us is happy with the result. We know someone did us wrong and we rightly demand retribution. Until we accept the reality that as a nation we got exactly what we asked for, substantive change remains unlikely.

Angry And Confused

British Protesters

Angry Banker Protests In Britain

But we're mad as hell - and rightfully so. Our sense of betrayal is universal at home and abroad. Bankers we once held in high esteem we now flagellate as thieves and criminals. We overlook, for the moment, our own contributions to the problem. For as we collectively invested billions in market holdings based on short term earnings performance, our personal flight from reality sent our own jobs overseas, destroyed effective corporate governance and freed our bankers to do other, more risky things with our savings.

Our banks turned into failed enterprises by way of corrupt behavior and failed oversight because we, you, me all of us, sought to live better, become wealthier, or profit from failed governance. As long as deregulation favored our interests, our jobs, and our investments, we went along. We did so by permitting ourselves to be made ignorant of what matters most, to be herded to political extremes, and corrupted by single-issue thinking that concealed what was being done in our name. We allowed ourselves to be seduced by those who pandered to our desires and our need to be needlessly entertained. It it we who disdained things that really mattered - things we knew little about and cared less to know.

It was our making that produced a one party system comprised of two warring extremes. It was our demand that someone else do the work, take the risk, give of their lives so that we might prosper that made us a debtor nation. It was we who demanded that our once mighty financial empires be turned into wild-eyed speculators cunningly running criminal enterprises. Our government was permitted to run-amuck by failed political institutions, failed oversight, failed governance and the disembowelment of long respected journalistic institutions by people and organizations that surely knew better.

[April 25, 2009] A Good Share of the Blame

OK, I admit it: I missed seeing it the first time around. Regardless, as I was doing my usual search-and-sift for information and insights on the current crisis, I came across an interesting document, published in March by the Consumer Education Foundation, a California-based non-profit, non-partisan consumer research, education and advocacy organization.

Entitled "Sold Out: How Wall Street and Washington Betrayed America," the 231-page report makes the case that the current mess is the direct result of bad behavior on Wall Street and the corrupt connection between the powerful moneyed interests and those who make policy in Washington (and elsewhere).

Although I think there is a much more to it than that -- as I've noted in Financial Armageddon, many people played a role in getting us to this point, including ordinary Americans -- and that there are plenty of honest, hard-working people on Wall Street (and maybe even in our nation's capital), the argument certainly has merit.

Below is the report's "Executive Summary":

Blame Wall Street for the current financial crisis. Investment banks, hedge funds and commercial banks made reckless bets using borrowed money. They created and trafficked in exotic investment vehicles that even top Wall Street executives-not to mention firm directors-did not understand.

They hid risky investments in off balance- sheet vehicles or capitalized on their legal status to cloak investments altogether.

They engaged in unconscionable predatory lending that offered huge profits for a time, but led to dire consequences when the loans proved unpayable. And they created, maintained and justified a housing bubble, the bursting of which has thrown the United States and the world into a deep recession, resulted in a foreclosure epidemic ripping apart communities across the country.

But while Wall Street is culpable for the financial crisis and global recession, others do share responsibility. For the last three decades, financial regulators, Congress and the executive branch have steadily eroded the regulatory system that restrained the financial sector from acting on its own worst tendencies.

The post-Depression regulatory system aimed to force disclosure of publicly relevant financial information; established limits on the use of leverage; drew bright lines between different kinds of financial activity and protected regulated commercial banking from investment bank-style risk taking; enforced meaningful limits on economic concentration, especially in the banking sector; provided meaningful consumer protections (including restrictions on usurious interest rates); and contained the financial sector so that it remained subordinate to the real economy. This hodge-podge regulatory system was, of course, highly imperfect, including because it too often failed to deliver on its promises.

But it was not its imperfections that led to the erosion and collapse of that regulatory system. It was a concerted effort by Wall Street, steadily gaining momentum until it reached fever pitch in the late 1990s and continued right through the first half of 2008. Even now, Wall Street continues to defend many of its worst practices. Though it bows to the political reality that new regulation is coming, it aims to reduce the scope and importance of that regulation and, if possible, use the guise of regulation to further remove public controls over its operations.

This report has one overriding message: financial deregulation led directly to the financial meltdown.

It also has two other, top-tier messages.

First, the details matter. The report documents a dozen specific deregulatory steps (including failures to regulate and failures to enforce existing regulations) that enabled Wall Street to crash the financial system.

Second, Wall Street didn't obtain these regulatory abeyances based on the force of its arguments. At every step, critics warned of the dangers of further deregulation. Their evidence-based claims could not offset the political and economic muscle of Wall Street. The financial sector showered campaign contributions on politicians from both parties, invested heavily in a legion of lobbyists, paid academics and think tanks to justify their preferred policy positions, and cultivated a pliant media-especially a cheerleading business media complex.

Part I of this report presents 12 Deregulatory Steps to Financial Meltdown. For each deregulatory move, we aim to explain the deregulatory action taken (or regulatory move avoided), its consequence, and the process by which big financial firms and their political allies maneuvered to achieve their deregulatory objective.

In Part II, we present data on financial firms' campaign contributions and disclosed lobbying investments. The aggregate data are startling: The financial sector invested more than $5.1 billion in political influence purchasing over the last decade.

The entire financial sector (finance, insurance, real estate) drowned political candidates in campaign contributions over the past decade, spending more than $1.7 billion in federal elections from 1998-2008.

Primarily reflecting the balance of power over the decade, about 55 percent went to Republicans and 45 percent to Democrats.

Democrats took just more than half of the financial sector's 2008 election cycle contributions.

The industry spent even more-topping $3.4 billion-on officially registered lobbying of federal officials during the same period.

During the period 1998-2008: • Accounting firms spent $81 million on campaign contributions and $122 million on lobbying; • Commercial banks spent more than $155 million on campaign contributions, while investing nearly $383 million in officially registered lobbying; • Insurance companies donated more than $220 million and spent more than $1.1 billion on lobbying; • Securities firms invested nearly $513 million in campaign contributions, and an additional $600 million in lobbying.

All this money went to hire legions of lobbyists. The financial sector employed 2,996 lobbyists in 2007. Financial firms employed an extraordinary number of former government officials as lobbyists. This report finds 142 of the lobbyists employed by the financial sector from 1998- 2008 were previously high-ranking officials or employees in the Executive Branch or Congress.

* * *

These are the 12 Deregulatory Steps to Financial Meltdown:

1. Repeal of the Glass-Steagall Act and the Rise of the Culture of Recklessness

The Financial Services Modernization Act of 1999 formally repealed the Glass-Steagall Act of 1933 (also known as the Banking Act of 1933) and related laws, which prohibited commercial banks from offering investment banking and insurance services. In a form of corporate civil disobedience, Citibank and insurance giant Travelers Group merged in 1998-a move that was illegal at the time, but for which they were given a two-year forbearance-on the assumption that they would be able to force a change in the relevant law at a future date. They did. The 1999 repeal of Glass-Steagall helped create the conditions in which banks invested monies from checking and savings accounts into creative financial instruments such as mortgage-backed securities and credit default swaps, investment gambles that rocked the financial markets in 2008.

2. Hiding Liabilities: Off-Balance Sheet Accounting

Holding assets off the balance sheet generally allows companies to exclude "toxic" or money-losing assets from financial disclosures to investors in order to make the company appear more valuable than it is.

Banks used off-balance sheet operations-special purpose entities (SPEs), or special purpose vehicles (SPVs)-to hold securitized mortgages. Because the securitized mortgages were held by an off-balance sheet entity, however, the banks did not have to hold capital reserves as against the risk of default-thus leaving them so vulnerable.

Off-balance sheet operations are permitted by Financial Accounting Standards Board rules installed at the urging of big banks.

The Securities Industry and Financial Markets Association and the American Securitization Forum are among the lobby interests now blocking efforts to get this rule reformed.

3. The Executive Branch Rejects Financial Derivative Regulation

Financial derivatives are unregulated. By all accounts this has been a disaster, as Warren Buffet's warning that they represent "weapons of mass financial destruction" has proven prescient. Financial derivatives have amplified the financial crisis far beyond the unavoidable troubles connected to the popping of the housing bubble.

The Commodity Futures Trading Commission (CFTC) has jurisdiction over futures, options and other derivatives connected to commodities. During the Clinton administration, the CFTC sought to exert regulatory control over financial derivatives.

The agency was quashed by opposition from Treasury Secretary Robert Rubin and, above all, Fed Chair Alan Greenspan. They challenged the agency's jurisdictional authority; and insisted that CFTC regulation might imperil existing financial activity that was already at considerable scale (though nowhere near present levels). Then-Deputy Treasury Secretary Lawrence Summers told Congress that CFTC proposals "cas[t] a shadow of regulatory uncertainty over an otherwise thriving market."

4. Congress Blocks Financial Derivative Regulation

The deregulation-or non-regulation-of financial derivatives was sealed in 2000, with the Commodities Futures Modernization Act (CFMA), passage of which was engineered by then-Senator Phil Gramm, R-Texas.

The Commodities Futures Modernization Act exempts financial derivatives, including credit default swaps, from regulation and helped create the current financial crisis.

5. The SEC's Voluntary Regulation Regime for Investment Banks

In 1975, the SEC's trading and markets division promulgated a rule requiring investment banks to maintain a debt-to-net-capital ratio of less than 12 to 1. It forbid trading in securities if the ratio reached or exceeded 12 to 1, so most companies maintained a ratio far below it. In 2004, however, the SEC succumbed to a push from the big investment banks-led by Goldman Sachs, and its then-chair, Henry Paulson-and authorized investment banks to develop their own net capital requirements in accordance with standards published by the Basel Committee on Banking Supervision. This essentially involved complicated mathematical formulas that imposed no real limits, and was voluntarily administered. With this new freedom, investment banks pushed borrowing ratios to as high as 40 to 1, as in the case of Merrill Lynch. This super-leverage not only made the investment banks more vulnerable when the housing bubble popped, it enabled the banks to create a more tangled mess of derivative investments-so that their individual failures, or the potential of failure, became systemic crises. Former SEC Chair Chris Cox has acknowledged that the voluntary regulation was a complete failure.

6. Bank Self-Regulation Goes Global: Preparing to Repeat the Meltdown?

In 1988, global bank regulators adopted a set of rules known as Basel I, to impose a minimum global standard of capital adequacy for banks. Complicated financial maneuvering made it hard to determine compliance, however, which led to negotiations over a new set of regulations. Basel II, heavily influenced by the banks themselves, establishes varying capital reserve requirements, based on subjective factors of agency ratings and the banks' own internal risk-assessment models. The SEC experience with Basel II principles illustrates their fatal flaws. Commercial banks in the United States are supposed to be compliant with aspects of Basel II as of April 2008, but complications and intra-industry disputes have slowed implementation.

7. Failure to Prevent Predatory Lending

Even in a deregulated environment, the banking regulators retained authority to crack down on predatory lending abuses.

Such enforcement activity would have protected homeowners, and lessened though not prevented the current financial crisis.

But the regulators sat on their hands. The Federal Reserve took three formal actions against subprime lenders from 2002 to 2007.

The Office of Comptroller of the Currency, which has authority over almost 1,800 banks, took three consumer-protection enforcement actions from 2004 to 2006.

8. Federal Preemption of State Consumer Protection Laws

When the states sought to fill the vacuum created by federal nonenforcement of consumer protection laws against predatory lenders, the feds jumped to stop them. "In 2003," as Eliot Spitzer recounted, "during the height of the predatory lending crisis, the Office of the Comptroller of the Currency invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks."

9. Escaping Accountability: Assignee Liability

Under existing federal law, with only limited exceptions, only the original mortgage lender is liable for any predatory and illegal features of a mortgage-even if the mortgage is transferred to another party. This arrangement effectively immunized acquirers of the mortgage ("assignees") for any problems with the initial loan, and relieved them of any duty to investigate the terms of the loan. Wall Street interests could purchase, bundle and securitize subprime loans-including many with pernicious, predatory terms-without fear of liability for illegal loan terms. The arrangement left victimized borrowers with no cause of action against any but the original lender, and typically with no defenses against being foreclosed upon. Representative Bob Ney, R-Ohio-a close friend of Wall Street who subsequently went to prison in connection with the Abramoff scandal-was the leading opponent of a fair assignee liability regime.

10. Fannie and Freddie Enter the Subprime Market

At the peak of the housing boom, Fannie Mae and Freddie Mac were dominant purchasers in the subprime secondary market.

The Government-Sponsored Enterprises were followers, not leaders, but they did end up taking on substantial subprime assets-at least $57 billion. The purchase of subprime assets was a break from prior practice, justified by theories of expanded access to homeownership for low-income families and rationalized by mathematical models allegedly able to identify and assess risk to newer levels of precision. In fact, the motivation was the for-profit nature of the institutions and their particular executive incentive schemes. Massive lobbying-including especially but not only of Democratic friends of the institutions-enabled them to divert from their traditional exclusive focus on prime loans.

Fannie and Freddie are not responsible for the financial crisis. They are responsible for their own demise, and the resultant massive taxpayer liability.

11. Merger Mania

The effective abandonment of antitrust and related regulatory principles over the last two decades has enabled a remarkable concentration in the banking sector, even in advance of recent moves to combine firms as a means to preserve the functioning of the financial system. The megabanks achieved too-big-to-fail status. While this should have meant they be treated as public utilities requiring heightened regulation and risk control, other deregulatory maneuvers (including repeal of Glass-Steagall) enabled these gigantic institutions to benefit from explicit and implicit federal guarantees, even as they pursued reckless high-risk investments.

12. Rampant Conflicts of Interest: Credit Ratings Firms' Failure

Credit ratings are a key link in the financial crisis story. With Wall Street combining mortgage loans into pools of securitized assets and then slicing them up into tranches, the resultant financial instruments were attractive to many buyers because they promised high returns. But pension funds and other investors could only enter the game if the securities were highly rated.

The credit rating firms enabled these investors to enter the game, by attaching high ratings to securities that actually were high risk-as subsequent events have revealed. The credit ratings firms have a bias to offering favorable ratings to new instruments because of their complex relationships with issuers, and their desire to maintain and obtain other business dealings with issuers.

This institutional failure and conflict of interest might and should have been forestalled by the SEC, but the Credit Rating Agencies Reform Act of 2006 gave the SEC insufficient oversight authority. In fact, the SEC must give an approval rating to credit ratings agencies if they are adhering to their own standards-even if the SEC knows those standards to be flawed.

* * *

Wall Street is presently humbled, but not prostrate. Despite siphoning trillions of dollars from the public purse, Wall Street executives continue to warn about the perils of restricting "financial innovation"-even though it was these very innovations that led to the crisis. And they are scheming to use the coming Congressional focus on financial regulation to centralize authority with industry- friendly agencies.

If we are to see the meaningful regulation we need, Congress must adopt the view that Wall Street has no legitimate seat at the table. With Wall Street having destroyed the system that enriched its high flyers, and plunged the global economy into deep recession, it's time for Congress to tell Wall Street that its political investments have also gone bad. This time, legislating must be to control Wall Street, not further Wall Street's control.

This report's conclusion offers guiding principles for a new financial regulatory architecture.

Click here to read the rest of the report (in PDF format).

Are the Knives are Coming Out for Geithner?

The clout of the press has decayed enormously over the last 40 years. The fourth estate was feared, resented, and begrudgingly respected in the corridors of power. But rule by beancounters, savvy media spin, and access journalism (journalists who write pointed stories get frozen out) have largely leashed and collared the press. Indeed, a friend who grew up in Eastern Europe when it was Communist said as of roughly 2000 that the news felt controlled.

So to see a front page, and super long story in the New York Times honing in on Geithner's close, as in overly close, relationship with Wall Street executives, is a stunner. In the old days, a report critical of a prominent public official would be a leading indicator that they were at least facing headwinds, perhaps in bona fide trouble. But given the new rules of the game, one has to assume a story of this sort is a lagging indicator, that Geithner is perceived to be sufficiently at risk to be fair game.

Thus what is surprising about tonight's New York Times story, "Member and Overseer of the Finance Club," on Timothy Geithner is not its content, but that it was written at all, and moreover (as of now) is a front page item. It's extraordinarily long for a weekday story. the number of column inches usually reserved for natural, not bureaucratic disasters.

Any reader of any remotely plugged in econoblog, or savvy enough to read between the lines of MSM reports will know that Geithner is a creature of the financial establishment. Probably the most important element in his pedigree is that he is a protege of Larry Summers and Bob Rubin. It also appears that he and Summers are working fist in glove (witness the marginalization of Paul Volcker).

At a minimum, Geithner crony capitalist policies are finally leading to a hard look at his loyalties. There is no reason to think Geithner is personally corrupt (well, there was his little tax problem) but rather that he is as die hard a believer of finance uber alles as Alan Greenspan, albeit without the libertarian zealotry.

Of course, if one were Machiavellian, this move may be Team Obama realizing rather late that they have made the success of Obama's presidency contingent on the Summer/Geithner program, and now they are trying, even more so than before. to pin the policies on Geithner. That may work tactically but in the end, the banking mess is too central a problem for Obama to try to shift blame of policy failures onto his team. He picked the chefs, he has to eat the cooking. If the economy is still a mess in 2012, he will not escape the taint.

And as much as this piece signals that Geithner may be starting to be perceived as a liability, it seems unlikely that he is in serious trouble yet. Sadly, the programs have to flounder first (although with the PPIP, that could happen sooner rather than later.....).

And while the Times piece finally points to the elephant in the room, namely, how bankster friendly the new regime has been, it is far less pointed than it could have been. I suppose one has to treat Treasury secretaries with kid gloves The questionable incidents and relationships are diluted by a lot of narrative. But recall we never saw anything remotely like this treatment (save lots of grumblings) about Hank Paulson. Of course, handouts to the big end of town was standard operation in the Bush administration, so it was hard to work up much outrage about it (at least until the heinous TARP).

From the New York Times:

Last June, with a financial hurricane gathering force, Treasury Secretary Henry M. Paulson Jr. convened the nation's economic stewards for a brainstorming session. What emergency powers might the government want at its disposal to confront the crisis? he asked.

Timothy F. Geithner, who as president of the New York Federal Reserve Bank oversaw many of the nation's most powerful financial institutions, stunned the group with the audacity of his answer. He proposed asking Congress to give the president broad power to guarantee all the debt in the banking system, according to two participants, including Michele A. Smith, then an assistant Treasury secretary.

The proposal quickly died amid protests that it was politically untenable because it could put taxpayers on the hook for trillions of dollars.....

Yves here. The story fails to note this was almost assuredly the most bank friendly program possible. Back to the story:
But in the 10 months since then, the government has in many ways embraced his blue-sky prescription....

And more often than not, Mr. Geithner has been a leading architect of those bailouts, the activist at the head of the pack. He was the federal regulator most willing to "push the envelope," said H. Rodgin Cohen, a prominent Wall Street lawyer who spoke frequently with Mr. Geithner.

Rodg Cohen is the managing partner of Sullivan & Cromwell, which has long had an extremely close relationship with Goldman. Rodg is also considered to be the top bank regulatory lawyer in the US. It may seem like too much inside baseball to point out who Rodg is in more detail, but the fact that the Times quoted him as a defender of Geithner is telling. Back to the article:
Today, Mr. Geithner ....finds himself a locus of discontent... range of critics - lawmakers, economists and even former Federal Reserve colleagues - say that the bailout Mr. Geithner has played such a central role in fashioning is overly generous to the financial industry at taxpayer expense.

An examination of Mr. Geithner's five years as president of the New York Fed, an era of unbridled and ultimately disastrous risk taking by the financial industry, shows that he forged unusually close relationships with executives of Wall Street's giant financial institutions....

His actions, as a regulator and later a bailout king, often aligned with the industry's interests and desires, according to interviews with financiers, regulators and analysts and a review of Federal Reserve records.

In a pair of recent interviews and an exchange of e-mail messages, Mr. Geithner defended his record, saying that from very early on, he was "a consistently dark voice about the potential risks ahead, and a principal source of initiatives designed to make the system stronger" before the markets melted down.

Yves here. Revisionist history. See here and note the date of the speech. Back to the article:
Traditionally, the New York Fed president's intelligence-gathering role has involved routine consultation with financiers, though Mr. Geithner's recent predecessors generally did not meet with them unless senior aides were also present, according to the bank's former general counsel.

By those standards, Mr. Geithner's reliance on bankers, hedge fund managers and others to assess the market's health - and provide guidance once it faltered - stood out.

His calendars from 2007 and 2008 show that those interactions were a mix of the professional and the private.

He ate lunch with senior executives from Citigroup, Goldman Sachs and Morgan Stanley at the Four Seasons restaurant or in their corporate dining rooms. He attended casual dinners at the homes of executives like Jamie Dimon, a member of the New York Fed board and the chief of JPMorgan Chase.

Yves here. Presumably someone who was or is at the NY Fed who was plenty upset at the goings-on provided the calendar. Anyone who knows the NY Fed is encouraged to comment, but for a private company, this would be a major breech, and the Fed has to be at least as secretive. The Times has open sourced Geithner's calendar and is asking for further remarks. Back to the article:
...for all his ties to Citi, Mr. Geithner repeatedly missed or overlooked signs that the bank - along with the rest of the financial system - was falling apart. When he did spot trouble, analysts say, his responses were too measured, or too late.

In 2005, for instance, Mr. Geithner raised questions about how well Wall Street was tracking its trading of complex financial products known as derivatives, yet he pressed reforms only at the margins.....

To Joseph E. Stiglitz, a Nobel-winning economist at Columbia and a critic of the bailout, Mr. Geithner's actions suggest that he came to share Wall Street's regulatory philosophy and world view....

In theory, having financiers on the New York Fed's board should help the president be Washington's eyes and ears on Wall Street. But critics, including some current and former Federal Reserve officials, say the New York Fed is often more of a Wall Street mouthpiece than a cop.

Willem H. Buiter, a professor at the London School of Economics and Political Science who caused a stir at a Fed retreat last year with a paper concluding that the Federal Reserve had been co-opted by the financial industry, said the structure ensured that "Wall Street gets what it wants" in its New York president: "A safe pair of hands, someone who is bright, intelligent, hard-working, but not someone who intends to reform the system root and branch."....

Throughout the spring and summer of 2007, as subprime lenders began to fail and government officials reassured the public that the problems were contained, Mr. Geithner met repeatedly with members of Citigroup's management, records show.

From mid-May to mid-June alone, he met over breakfast with Charles O. Prince, the company's chief executive at the time, traveled to Citigroup headquarters in Midtown Manhattan to meet with Lewis B. Kaden, the company's vice chairman, and had coffee with Thomas G. Maheras, who ran some of the bank's biggest trading operations.

(Mr. Maheras's unit would later be roundly criticized for taking many of the risks that led Citigroup aground.)

His calendar shows that during that period he also had breakfast with Mr. Rubin. But in his conversations with Mr. Rubin, Mr. Geithner said, he did not discuss bank matters. "I did not do supervision with Bob Rubin," he said.

Yves here. Of course not. Rubin knew nothing about anything bad and was determined to keep it that way. Back to the piece:
In a May 15, 2007, speech to the Federal Reserve Bank of Atlanta, Mr. Geithner praised the strength of the nation's top financial institutions, saying that innovations like derivatives had "improved the capacity to measure and manage risk" and declaring that "the larger global financial institutions are generally stronger in terms of capital relative to risk."

Two days later, interviews and records show, he lobbied behind the scenes for a plan that a government study said could lead banks to reduce the amount of capital they kept on hand.

The story continues with many of the key decisions of the crisis. The narrative detail has the effect of somewhat dliuting the focus on what Geithner did when, but it also highlights some now largely forgotten incidents like no-bid contracts to BlackRock (most notably, managing the assets the Fed took on in the Bear Stearns deal). And it has some new revelations:
A bill sent recently by the Treasury to Capitol Hill would give the Obama administration extensive new powers to inject money into or seize systemically important firms in danger of failure. It was drafted in large measure by Davis Polk & Wardwell, a law firm that represents many banks and the financial industry's lobbying group. Mr. Geithner also hired Davis Polk to represent the New York Fed during the A.I.G. bailout.

Treasury officials say they inadvertently used a copy of Davis Polk's draft sent to them by the Federal Reserve as a template for their own bill, with the result that the proposed legislation Treasury sent to Capitol Hill bore the law firm's computer footprints. And they point to several significant changes to that draft that "better protect the taxpayer," in the words of Andrew Williams, a Treasury spokesman.

But others say important provisions in the original industry bill remain. Most significant, the bill does not require that any government rescue of a troubled firm be done at the lowest possible cost, as is required by the F.D.I.C. when it takes over a failed bank.

This is damaging in the eyes of the great unwashed. But there is nothing here that was presumably not fully known by the Obama vetters. This storm, like the tax fracas, will pass. But Geithner is nevertheless looking more and more like damaged goods.

This story now makes official what only those who kept tabs on these matters knew, that Geithner is captured by the industry. It will now be much easier for Obama to cut Geithner loose should that prove necessary. But with Summers still in the mix, I'm dubious that even an outster of Geithner would produce much of a change in policy direction.

Guest Post: The horrible self-dealing of Ken Lewis and the principal-agent problem by Edward Harrison

Credit Writedowns

I don't much like Ken Lewis. It should be fairly obvious to everyone that he is a man who has only his own interests at heart. But, his revelation that BofA bought Merrill Lynch for the agreed-upon September price, despite Merrill's having an additional $7 billion in losses is grounds for legal action.

Let's review the situation.

In September, Hank Paulson, Ben Bernanke, and Tim Geithner committed the financial blunder of the century in allowing Lehman to fail spectacularly without any contingency plan for the probable market fallout. (Yes, Tim Geithner was a principal actor in this fiasco.) Now, there was nothing wrong in letting Lehman Brothers fail. However, there was something very wrong with bailing out Fannie Mac and Bear Stearns and allowing everyone on Wall Street to believe Lehman was too big to fail. And there was even more wrong in having no contingency plan for the fallout.

So as a direct result of that fallout, Merrill Lynch was poised to be the next to go under. Enter Ken Lewis, our White Knight. I have to admit to being idiot enough to have thought the Bank of America - Merrill deal was a good one. It seemed all was well when Ken Lewis plunked down $44 billion in September (even though Barclays got much of the Lehman assets for a song days later). But, as markets went into freefall, so too did Merrill Lynch, hemorrhaging losses. So why did Ken Lewis buy the company without at least trying to negotiate a lower price tag?

Answer: self-dealing.

It was the real thing. The banker, as you may have guessed, is Ken Lewis, CEO of Bank of America. And the bad guys harassing him are Hank Paulson, then Treasury secretary, and Ben Bernanke, head of the Federal Reserve, aided and abetted by shadowy henchmen.

The script for this stranger-than-fiction melodrama was provided by that rabid (and fiercely ambitious) bulldog New York state attorney general, Andrew Cuomo. Mr. Cuomo, back in February, had been grilling Mr. Lewis on what his keen canine eye detected as another indignity -- the awarding of $3.6 billion to employees of Merrill Lynch, the giant brokerage firm acquired by BofA on Jan. 1 of this year.

What had Mr. Cuomo frothing at the mouth was that the $3.6 billion was shelled out even though Merrill suffered losses upwards of $15 billion in 2008's fourth quarter alone.

We must point out how fortuitous it was that losses had not reached, say, $30 billion, since by the peculiar calculus being used to reward red-ink, that would have boosted Merrill's bonus tab to $7.2 billion. And enraging the chronically enraged Mr. Cuomo all the more was that the bonuses were distributed even while the losses manifested themselves but were not disclosed, least of all to the bank's shareholders.

According to Mr. Cuomo's dour narrative, the product of four hours of interrogation of Mr. Lewis, the merger with Merrill was proposed in September after two days of due diligence (sounds more like due negligence to us). It gained approval of shareholders of both companies on Dec. 5. Barely a week later comes the revelation: Merrill's losses were spiraling ever higher, causing an increasingly frantic Mr. Lewis to weigh calling the marriage off.

He reckoned he could legally do so thanks to MAC (material adverse event), recognizing that $7 billion more in losses than had been projected when the merger was agreed to was a very big MAC, indeed. He diffidently informed the powers-that-were of his plan to nix the nuptials and was summarily summoned to powwow with them in Washington that very evening. And it was there that Messrs. Bernanke and Paulson put the screws to him to not break the deal lest he trigger a systemic calamity.

On Dec. 21, Mr. Lewis, still of a mind to ditch the merger, communicated his determination to Mr. Paulson, who bluntly warned that he would give the boot to Mr. Lewis and his board unless the acquisition went through. To that bald threat, Mr. Lewis' retort was a resounding purr: "That makes it simple. Let's de-escalate."

And de-escalate he did. The merger became a done deal right on schedule. To help salve any hurt feelings, Bank of America got $118 billion in loan guarantees from rich Uncle Sam to absorb any potential losses from Merrill.

To me, this sounds like a deal was worked out whereby BofA got a bailout if it went through with the deal. But, it should be plain from the events above that Ken Lewis did NOT have his fiduciary responsibilities for his shareholders top of mind.

So, let's recap.

This whole episode stinks to high heaven and Ken Lewis doesn't even look the worst of the lot here. That honor goes to Paulson and Bernanke.

But, what about the shareholders? Oh, those people, right. Don't they deserve better? Yes, they do. But, they are not going to get better because mega-corporations are run by managers who are in it for their own enrichment and shareholders have zero say. This is a classic principal-agent conflict.

The essence of the principal-agent problem comes when a principal (let's call them the owners) hires an agent (we'll call them the managers) to act on her behalf. Often times, one is just too busy - or too inexperienced - to manage a business or negotiate a contract or what have you. So, one hires a professional steeped in experience to do it.

For instance, sports agents, made famous by the film Jerry Maguire, are the classic agents to the sports stars principal. As it happens, the agent has his own agenda - and this may or may not be the same as the principal's employing him. You will recall the 2007 incident when Alex Rodriguez negotiated his own contract with the New York Yankees baseball team in order to make sure the result was one that was most favorable to his wants and needs (See NY Times article here.)

In business, the same dynamic is at play. While a dry cleaner can be the owner-proprietor of his own store, he cannot run two stores or ten stores at the same time (think George Jefferson). George needs to hire managers to run those stores - and he better hope those managers don't have their hand in the till.

In today's age, corporations are absolutely enormous, globe-spanning enterprises whose owners - the shareholders - individually have no influence over decision-making. What's more is, the larger the organization, the less likely anyone is to have sway over the company's managers. Supposedly, that's why there is a board of directors, right?

A board of directors is a body of elected or appointed persons who jointly oversee the activities of a company or organization. The body sometimes has a different name, such as board of trustees, board of governors, board of managers, or executive board. It is often simply referred to as "the board."

A board's activities are determined by the powers, duties, and responsibilities delegated to it or conferred on it by an authority outside itself. These matters are typically detailed in the organization's bylaws. The bylaws commonly also specify the number of members of the board, how they are to be chosen, and when they are to meet.

In an organization with voting members, e.g., a professional society, the board acts on behalf of, and is subordinate to, the organization's full assembly, which usually chooses the members of the board. In a stock corporation, the board is elected by the stockholders and is the highest authority in the management of the corporation. In a nonstock corporation with no general voting membership, e.g., a university, the board is the supreme governing body of the institution.

So, where was Bank of America's Board of Directors? Didn't they see that Merrill had imploded. Why did they allow this travesty to take place? Shareholders had approved the merger on 5 Dec 2008, 16 days BEFORE Ken Lewis had said he was willing to back out. So they obviously had no say here.

Only the board of directors could have stopped Ken Lewis consummating a merger that should never have taken place or that had been re-negotiated. You should notice that this is the exact same run of events that we witnessed in the Countrywide transaction as well.

But, in the end, the deal went ahead as planned and Bank of America shareholders got their clocks cleaned as a result.

[Apr 25, 2009] The ideology that dare not speak its name by John Quiggin

April 22, 2009 | Crooked Timber

The set of ideas that has dominated public policy around the world for the last thirty years has been given a variety of names – neoliberalism[1], economic rationalism, the Washington Consensus, Reaganism and Thatcherism being the most prominent. Broadly speaking, this set of ideas combines support for free market (or freer market) economic policies with agnosticism[2] about both political liberalism and the relative merits of democracy and autocracy. Since demands for definition are inevitable, I'll point to mine here.

A striking feature of all of these terms is that they are currently used almost exclusively by opponents of the viewpoint being described, to the point where any use of such terms invariably provokes protests about unfair labelling (this is true even of the most neutral term I can find, "economic liberalism"). Even more striking is the fact that these terms were originally used in a broadly positive sense by supporters of the ideas concerned. I've done the story on economic rationalism, Don Arthur covers neoliberalism (with links to more from Taylor Boas and Jordan Gans-Morse (pdf) and you can check Wikipedia for the others.

Why is it that neoliberalism seems to be subject to a political version of the euphemism treadmill? A look at the history will help a bit.

For each of the sets of ideas in question, two things happened. First, the ideas described by the terms evolved in the direction of a more tightly defined and hardline free-market ideology – this happened both because (positive) users of the term became more consistent in their ideology over time and because some with more moderate views ceased to identify with the term.

Second, advocates of neoliberalism gained political power without, in general, convincing the majority of the public. In Australia and New Zealand, there was a bipartisan elite consensus in support of economic rationalism during the 1980s and early 1990s. In the UK, Thatcher won a series of elections with minority support thanks to a weak and divided Opposition. In Latin America, neoliberal policies were implemented by dictators like Pinochet, and quasi-dictatorial strongment like Fujimori.

Finally, as this process took place, the term was taken up by critics, who needed a descriptive label for the set of ideas they were criticising, and, soon afterwards, abandoned by its original advocates. In Australia, the crucial event was Michael Pusey's book Economic Rationalism in Canberra. In the case of neoliberalism, the change occurred after the Pinochet coup.

[Apr 21, 2009] Leading Economist Decries Power of Wall Street Oligarchs by Henry Blodget

"So now we can recognize that 'oligarch' is a word in America as well. Excellent!! Identifying the ailment is the first part of getting well."
Apr 21, 2009 | Yahoo! Finance

In a fascinating piece in the latest issue of The Atlantic, Simon Johnson, former chief economist at the International Monetary Fund, outlines what he sees as the alarming influence of Wall Street firms over the American economy. He expounds on his thesis in our interview, making several points:

America's Crisis Resembles that of Emerging Markets: While at the IMF, Johnson saw so many financial crises that the core problem became old hat: In the free-wheeling growth years of an economic boom, the politicians and oligarchs of an emerging market like Russia or Argentina would get so close that eventually they would meld into a politico-industrial complex. As long as the boom lasted, this cozy relationship never bothered anyone--because everyone was getting rich. Fast forward to the latest market crisis--the one in the United States. The pattern is exactly the same, Simon Johnson says, with a mutually beneficial money-and-power corridor now running between Washington and the modern oligarchs Wall Street.

But There Are Key Differences: In the emerging markets, eventually, the bubble would burst. The banks and corporations would collapse, and suddenly it would be up to the government to seize and restructure the insolvent banks. In America, though, there will be no such defining collapse, nor a quick recovery, he argues. Instead, we face a "painful" L-shaped recovery, drawn out over 3-5 years.

Wall Street: "It's Too Big, Too Powerful. It's Dangerous" Simon argues that the U.S. should invoke anti-trust laws to break up Wall Street, whose power poses a material threat to the American economy.

Simon Johnson is a senior fellow at the Peterson Institute and a professor at MIT's Sloan School of Management. He is a co-founder of the popular economics blog, BaselineScenario.

Selected Comments
Yahoo! Finance User - Tuesday April 21, 2009 08:02AM EDT

A voice of reason. America is enduring this economic downturn because of greed, disdain for law and regulation by those who control private business and financial systems, and less than honest politicians who receive wealth in return for their legislative cooperation. Johnson has a valid point, and he hits a home run, because wall street and pols are the cause of this recession - not the "liars" - like so many are convinced.

tenbips - Tuesday April 21, 2009 08:26AM EDT
I am your Robin Hood! If you want to stop the banks from raiding the Treasury direct and via the Federal Reserve Corp the answer is simple. At the next rally Taxpayers are staging bring up two important elements. Tell every informed citizen to immediately transfer their accounts from these large commercial banks to community or State chartered thrifts that did not leverage deposits 50 - 1. Call your local congressperson and tell them that a better plan exists which includes the immediate revocation of the Federal Reserve Corp's charter. Until the citizens of this Country unleash themselves from the FRC's fractional banking methods why should other banks even bother to take notice. The true problem is that currency creation pinnacled in 2000 and again in 2005. the first time we had a convenient war to stimulate lending and the second time we removed M3 as a GDP factor. if we do not know how much the FED is flooding, how can we tell how the economy is reacting. If you want transparency we must remove the cloak from the top to the bottom. This will take a major change in how the US creates currency and will hurt a few extremely wealthy folks that are not even Americans. The coming carry-trade crisis, pension fund problems and commercial paper fall-out will make the residential paper mess look like a walk in the park. Many trillions to go guys. The commercial banks will require almost a trillion a quarter for the rest of the year to even suggest solvency (farce). Give me 4 trillion and a 39 cent Bic and I can churn out an operating profit too! Easily!
Bill W - Tuesday April 21, 2009 08:27AM EDT
Goldman Sachs owns this country and maybe most part of world, if Goldman short a company, that company can not alive. Like what he said, Goldman has not only super cash power, political power but also media power. They hire many many Analysts, economists and writers, to either hype a company or kill a company to their best interests. Many examples can be listed. Citi is one of the victim. Goldman probably still have numerous short position in Citi and many other companies.
brucebango - Tuesday April 21, 2009 08:39AM EDT
It's all about making sales commissions. Making 5% on a mortgage was not enough they had to build a ponzi, selling and reselling mortage securities to the point the paper was 40 to 1. They knew it was going to burst. And they knew they would get bailed. Reason: The gov't and wall street are all the same business. Now the wallstreeters want to take over the insurance sales business. Since everyone is putting money into annuities, SEC just ruled that indexed securities will soon become a security. You must be licensed security broker to sell securities... So soon wallstreeters will take all that annuity business from insurance sales people. It won't belong that in order to sell food you'll need broker dearlers license. They want all the commissions. All industries of the US, who have salespeople, do not have these advantages. These guys make up paper products out of nothing and grow them getting rich. There really needs to be an all industry wide revolution against the financial industry as they've ruined all other industries for their own interests. - Tuesday April 21, 2009 08:42AM EDT
Why arn't the RICO anto racketeering laws applicable here for say Mr. Fuld, CEO of the once most trusted name on Wall ST, Lehman Brothers. The original Lehman Brothers must be spinning like tops in their graves at what this dunce/thief did to their company and clients. He engaged in out and out fraud and moved money gleaned from illegal activiteis across state and national lines. I assume at some point he used the mail system in his racket so he seems a prime candidate for a racketeering charge. Where the heck is the IRS anyway as he probably has money hidden somewhere he isn't reporting. - Tuesday April 21, 2009 08:50AM EDT
Great ideas! The fatal flaw: It would require people to cooperate and work together. Read some of the comments and do the math. The United States is foo-ked and will carry this burden for the next 2 generations. The Tea Parties were great bitch sessions that did absolutely nothing. The American voter still has yet to grasp the concept that when re-electing the same people, you continue to get the same results. This fascination the American voting public has on Democrats and Republicans is self destructive. One is not any better than the other. Bush is voted out and replaced by Obama and the economy still blows. Hey, did it occur to the voting public that maybe the people in Congress should have been voted out as well? Duh! It's like right now with the "stress test". Many people do not believe the results, but no one does shit about it. The Tea Parties are passed off as right-wing conspiracies and Obama asks for .0002% departmental cuts while signs a PORK bill blaming, no kidding, Bush for all the PORK??? All you party hangers sit back are either too stupid, or blind to figure out the politicians are screwing us are all excited about ... what? Continue believing what you want, but until the Tea Parties turn into something significant and people like Chris Dodd, Geithner, Frank and whomever continues to serve, America goes no where. At the very least Chris Dodd should be impeached and brought before the Senate Ethics Committee to explain his actions... But, as I have said, that would mean the taxpayers are united .... until then, please be quiet and take the beating you asked for and are receiving.
Keith Moser - Tuesday April 21, 2009 09:03AM EDT
Listen to what he says about oligarchs. He's not necessarily wrong about the rest, but that's not the most important point in the article (that this blog is about). Just remember the oligarchs, and when people start complaining that the USA is becoming a socialist state, let them know the truth: America has been taken over by fascists (aka oligarchs). Trust busting is exactly what is needed, but the pols are all owned by the fascists, who allow them their pet projects so they can continue to buy votes.
Yahoo! Finance User - Tuesday April 21, 2009 09:08AM EDT
This is news?! A few powerful companies at the center of the political and economic universe. Say it isn't so! Next I supposed we all be "shocked" to learn that the media, government, and our education system are all linked together to f* over the American people. What ever. But hey, at least the guy has the balls to write it down. As far as congress changing anything..good greif. Congress couldnt wipe themselves without tiolet paper from a lobbyist.
Vinny - Tuesday April 21, 2009 09:14AM EDT
Actually it's not Wall Street that's too powerful, it's the Federal Reserve and the international influences who run it. Wall Street is an after thought. This propaganda distracts us from the fact that the enter credit expansion and inflation which turn this country into a credit and debt free for all is at the hands of the Federal Reserve. Support HR1207 and lets get our country back. Write your Congress person and demand they cosponsor HR1207. Audit the Fed.

[Apr 15, 2009] Can 'Government Sachs' Fix the Economy by Michael Hirsh

Back in the '90s and through the mid-'00s, major figures from Goldman Sachs such as Robert Rubin, Gary Gensler and Hank Paulson stood fast against derivatives regulation (Rubin and Gensler) and lobbied successfully for higher leverage ratios so they could bet more of their capital on the market boom (Paulson). When those policies came to grief and Wall Street imploded, and the Feds scrambled to rescue stricken insurance giant AIG, Goldman CEO Lloyd Blankfein was reportedly the only bank executive invited to an emergency meeting at the New York Federal Reserve (convened by then-Fed president Tim Geithner).

Now Treasury Secretary Geithner-a Rubin protégé, of course-has assigned two more ex-Goldman men to fix the vast mess their colleagues helped to create.

They are Steve Shafran, a former favorite of Paulson's, and Bill Dudley, Goldman's former chief economist and now the successor to Geithner as head of the New York Fed. Shafran and Dudley have been given the mind-bending task of resurrecting the market for securitized assets, a policy that is linked to an effort to lure the private market back in to bid on the toxic securitized assets that sit like dead weight on major banks' balance sheets. This vast project is being designed in two parts. First, revive the asset securitization market, frozen since last year's crash, through the TALF, the Term Asset-Backed Securities Loan Facility (don't try to say this at home!), started up on Tuesday. This program will bundle triple-A-rated loans into new securities and market them. Second, begin to sell off the toxic assets to private funds, in hopes that some day the TALF-revived securitization market will create demand for the lower-rated assets as well. According to a Treasury spokesman, the TALF plan and the troubled-asset buy-up program are "operating on parallel tracks."

The key now is to bring in hedge funds and other hoards of private capital by giving them government guarantees limiting their potential losses. The pitfall is that if the American public, already riled to populist fury over Wall Street's postcrash perks, finds out what a sweet deal these new investors are getting-without any limitations on executive compensation like those imposed on banks-people might get more upset.

This is not to speak ill of Shafran and Dudley or, for that matter, Geithner. The plan his Treasury team is working on is intricate, and it may well be the only way to bring the private sector back in-and get the rest of us, the taxpayers, out. A Treasury spokesman says that Shafran and Dudley are not the only ones working on the plan, which Geithner is personally overseeing. "It's been a group effort," he says, adding that there are no price guarantees. The private funds and the government will "share" first losses and profits, though details haven't been fleshed out. Nor should we ignore the fact that Goldman's "best and brightest" have sometimes dug us out of holes in the past. Former Treasury Secretary Robert Rubin, for example, is often criticized these days (by me, among others) for quashing then-Commodity Futures Trading Commission Chairwoman Brooksley Born's 1998 proposal to discuss derivatives regulation. What is rarely noted is that Rubin, at the time, was in the middle of resolving the Asian financial contagion, and he was justly concerned with sending a chilling message to Wall Street.

Still, the omnipresence of Goldman Sachs does make one wonder about the insularity of this world-what economist Jagdish Bhagwati once called the "Wall Street–Treasury complex." Or as another joke has it, Goldman is so politically savvy in Washington, it should be called "Government Sachs." Is there no one else to fix the crisis but specialists from the company that helped create it? According to a new report out by the public advocacy group the Consumer Education Foundation, over the past decade Wall Street investment firms, commercial banks, hedge funds, real-estate companies and insurance conglomerates forked over $1.725 billion in political contributions. They spent another $3.4 billion on lobbyists.

"Our government has been misappropriated by Goldman Sachs," says Christopher Whalen of Institutional Risk Analytics, a long-time critic of Geithner, whom Whalen likens to Chauncey Gardiner, the clueless hero of "Being There," who is manipulated by everyone around him. And if Wall Street elites continue to make government policy, will the new regulatory controls we hear so much about-the ones that are supposed to prevent this from happening again-ever really be adopted?

This is the critical question. Despite continued public support for President Obama and early signs that Geithner's various rescue plans-including the $75 billion mortgage bailout scheme announced this week-may be starting to reassure the markets, there is little sign as yet that the administration is engaged in the kind of fundamental rethinking of financial safety and soundness that we need. The problem is not just that Wall Street giants like Goldman, Citigroup and AIG ran wild over the past 20 years, it is that they exist in their current form at all. These institutions are too big and too systemic to be allowed to fail according to normal free-market rules, and if they remain that way we will inevitably find ourselves in a situation where taxpayers must rescue them once again.

We have been through this nightmare before, almost step by disastrous step. From 1932 to 1934 the Senate banking and currency committee held hearings on the 1929 crash and found that commercial banks had misrepresented to their depositors the quality of securities that their investment-banking sides were underwriting and promoting. According to a history posted by the Federal Deposit Insurance Corp. on its Web site, among the culprits was First National City Bank (now Citigroup), which was found to have repackaged the bank's Latin American loans and securitized them without disclosing its own confidential findings that the loans posed adverse risks. Sound familiar? The response of the government in that era was decisive: the Glass-Steagall Act, which separated commercial banking from investment banking. It is a supreme historical irony that 65 years later it was Citigroup, grown monstrous again, that pushed hardest for the destruction of the Glass-Steagall reforms. And it had a big assist from Goldman grads such as Bob Rubin, who was soon afterward hired as chairman of Citi's executive committee.

As the new Consumer Education Foundation report concludes: "Glass-Steagall was a key element of the Roosevelt administration's response to the Depression and considered essential both to restoring public confidence in a financial system that had failed and to protecting the nation against another profound economic collapse." Even if we believe that the economic and financial system may be stabilizing five weeks into Obama's presidency, it's hard to conclude that fundamental confidence has been restored.

Perhaps the Obama administration will see the light and at some point forthrightly address the "too big to fail" problem that even Federal Reserve chairman Ben Bernanke said again this week was "enormous." But it is hard to imagine that a team composed largely of Wall Street's former finest will, all by themselves, push for the breakup of the firms that nurtured and enriched them. And there is scant evidence that Geithner is now soliciting advice from others on the outside, including the new panel led by Paul Volcker-a diehard skeptic of Wall Street's agenda-that Obama set up precisely for this purpose. Who is the Treasury secretary relying on? We don't really know, but certainly one close adviser must be Mark Patterson, Geithner's new chief of staff. Patterson is the former Washington lobbyist for Goldman Sachs.

[Apr 15, 2009] Is America the new Russia By Martin Wolf

April 14, 2009 |

... In an article in the May issue of the Atlantic Monthly, Prof Johnson compares the hold of the "financial oligarchy" over US policy with that of business elites in emerging countries. Do such comparisons make sense? The answer is Yes, but only up to a point.

"In its depth and suddenness," argues Prof Johnson, "the US economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets." The similarity is evident: large inflows of foreign capital; torrid credit growth; excessive leverage; bubbles in asset prices, particularly property; and, finally, asset-price collapses and financial catastrophe.

"But," adds Prof Johnson, "there's a deeper and more disturbing similarity: elite business interests – financiers, in the case of the US – played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse." Moreover, "the great wealth that the financial sector created and concentrated gave bankers enormous political weight."

Now, argues Prof Johnson, the weight of the financial sector is preventing resolution of the crisis. Banks "do not want to recognise the full extent of their losses, because that would likely expose them as insolvent ... This behaviour is corrosive: unhealthy banks either do not lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won't pay off at all. In either case, the economy suffers further, and, as it does, bank assets themselves continue to deteriorate – creating a highly destructive cycle."

Does such an analysis make sense? This is a question I thought about during my recent three-month stay in New York and visits to Washington, DC, now capital of global finance. They are why Prof Johnson's analysis is so important.

Unquestionably, we have witnessed a massive rise in the significance of the financial sector. In 2002, the sector generated an astonishing 41 per cent of US domestic corporate profits (see chart). In 2008, US private indebtedness reached 295 per cent of gross domestic product, a record, up from 112 per cent in 1976, while financial sector debt reached 121 per cent of GDP in 2008. Average pay in the sector rose from close to the average for all industries between 1948 and 1982 to 181 per cent of it in 2007.

In recent research, Thomas Philippon of New York University's Stern School of Business and Ariell Reshef of the University of Virginia conclude that the financial sector was a high-skill, high-wage industry between 1909 and 1933. It then went into relative decline until 1980, whereupon it again started to be a high-skill, high-wage sector.* They conclude that the prime cause was deregulation, which "unleashes creativity and innovation and increases demand for skilled workers".

Deregulation also generates growth of credit, the raw stuff the financial sector creates and on which it feeds. Transmutation of credit into income is why the profitability of the financial system can be illusory. Equally, the expansion of the financial sector will reverse, at least within the US: credit growth and leverage masked low or even non-existent profitability of much activity, which will disappear, and part of the debt must also be liquidated. The golden age of Wall Street is over: the return of regulation is cause and consequence of this shift.

Yet Prof Johnson makes a stronger point than this. He argues that the refusal of powerful institutions to admit losses – aided and abetted by a government in thrall to the "money-changers" – may make it impossible to escape from the crisis. Moreover, since the US enjoys the privilege of being able to borrow in its own currency it is far easier for it than for mere emerging economies to paper over cracks, turning crisis into long-term economic malaise. So we have witnessed a series of improvisations or "deals" whose underlying aim is to rescue as much of the financial system as possible in as generous a way as policymakers think they can get away with.

I agree with the critique of the policies adopted so far. In the debate on the Financial Times's economists' forum on Treasury secretary Tim Geithner's "public/private investment partnership", the critics are right: if it works, it is because it is a non-transparent way of transferring taxpayer wealth to banks. But it is unlikely to fill the capital hole that the markets are, at present, ignoring, as Michael Pomerleano argues. Nor am I persuaded that the "stress tests" of bank capital under way will lead to action that fills the capital hole.

Yet do these weaknesses make the US into Russia? No. In many emerging economies corruption is egregious and overt. In the US, influence comes as much from a system of beliefs as from lobbying (although the latter was not absent). What was good for Wall Street was deemed good for the world. The result was a bipartisan programme of ill-designed deregulation for the US and, given its influence, the world.

Moreover, the belief that Wall Street needs to be preserved largely as it is now is mainly a consequence of fear. The view that large and complex financial institutions are too big to fail may be wrong. But it is easy to understand why intelligent policymakers shrink from testing it. At the same time, politicians fear a public backlash against large infusions of public capital. So, like Japan, the US is caught between the elite's fear of bankruptcy and the public's loathing of bail-outs. This is a more complex phenomenon than the "quiet coup" Prof Johnson describes.

Yet decisive restructuring is indeed necessary. This is not because returning the economy to the debt-fuelled growth of recent years is either feasible or desirable. But two things must be achieved: first, the core financial institutions must become credibly solvent; and, second, no profit-seeking private institution can remain too big to fail. That is not capitalism, but socialism. That is one of the points on which the right and the left agree. They are right. Bankruptcy – and so losses for unsecured creditors – must be a part of any durable solution. Without that change, the resolution of this crisis can only be the harbinger of the next.

*Wages and Human Capital in the US Financial Industry 1909-2006, January 2009,

[Apr 12, 2009] Useless finance, harmful finance and useful finance by Willem Buiter

Useless finance

A derivative is a contingent claim whose payoff depends on the performance of some other financial instrument or security. For instance, an American equity call option gives the purchaser of the call the right (but not the obligation) to buy a share of equity from the issuer or writer of the call option at or before some future date at a price determined today. A credit default swap (CDS) is a credit derivative contract between two (counter)parties in which the holder makes periodic payments to the issuer in return for a payoff if the underlying financial instrument specified in the contract defaults.

A derivative contract is formally identical to a lottery, a (simple or compound) bet or gamble. Like any financial claim, any derivative is an 'inside asset' - it is in zero net supply. Because pay-offs associated with a derivative contract are functions of observable properties of other financial claims (prices, interest rates, default states), the derivative contract either re-packages existing underlying uncertainty or creates additional 'artificial' uncertainty. It would create additional extraneous uncertainty if it added some noise of its own to the fundamental, exogenous uncertainty that is presumably reflected in the features of the underlying security that determine the pay-offs of the derivative contract.

If the creation and trading of derivatives were costless, derivatives result in zero-sum redistributions of wealth between the issuers and the owners of the derivative contracts. Costless derivatives would be redundant if markets were complete. When markets are incomplete, as they are in our unfortunate universe, introducing derivatives can either lead to an increase or to a reduction in efficiency and social welfare. Lower efficiency and social welfare are possible even if creating and trading derivatives were costless. Derivatives may improve the allocation of risk, but there is no guarantee that they will. It is my contention that the unbridled explosion of certain categories of derivatives has done considerable harm, and that it is necessary to regulate all derivatives trading.

How can creating lotteries, even if they only mirror fundamental underlying uncertainty, be welfare increasing? The usual argument involves examples where there is a given quantum of 'objective' or 'exogenous' uncertainty in the world, e.g. uncertainty about endowments, technology and tastes (all assumed exogenous - only economists would treat technology and taste as exogenous, of course!). Markets for risk trading are incomplete and creating derivatives markets does not alter the objective/exogenous uncertainty in the world. Creating and trading derivatives is costless.

In such a world one can imagine a pension fund that wishes to hold default risk-free 10 year government securities, but unable to find them in the market, instead holding 10 year AAA corporate bonds and CDS to cover the default risk of these corporate securities. Provided the writer of the CDS is creditworthy, the pension fund could achieve its preferred portfolio mix. If the writer of the CDS has the appropriate capital structure and balance sheet, it could be both willing and able to bear the default risk on the corporate bonds than the pension fund. For the lottery created by a derivative contract to be welfare-increasing, it will have to produce a positive monetary pay-off for the purchaser of the derivative in exactly those 'states of nature' where the purchaser will be worst off, while at the same time ensuring that the corresponding negative monetary pay-off for the writer of the derivative does not hurt the writer of the derivative too badly.

It would of course be more direct to draw up contracts contingent on the exogenous uncertainty directly. If the pension fund's 'endowment' were to be negatively correlated with that of some other legal entity, and if the two endowments could be observed and verified, an endowment-sharing rule could be specified that would make both parties better off. You would not start looking for contracts specifying payments that are contingent on endogenous risk, such as default risk or the behaviour of some price or interest rate.

Derivatives, insurance and gambling

Consider the CDS. The purchaser pays a premium to the writer of a CDS. That is the price of the lottery ticket, or the price of the betting slip. If the underlying security specified in the contract defaults, the writer of the CDS pays the owner of the CDS a specified amount of money. That's the lottery prize, or the winnings of the bet. In the UK where there are more legal forms of gambling than in most other countries, many conventional financial instruments or securities have been 're-engineered' as formal bets. Spread betting on exchange rates, interest rates, stock prices and now also house price indices is a popular form of investment. The reason is that earnings from gambling are not taxed. The government presumably does not tax the gains and losses from gambling because (ignoring the value added of the gambling industry) gambling winnings equal gambling losses, so if the tax code allows loss offsets, there is not much point (ignoring progressivity of taxation & other complications) in taxing the gains and losses from gambling.

Derivatives can be used to provide insurance (paying a premium to buy protection against a possible loss) or to gamble (paying a premium to acquire the opportunity to benefit from a possible gain). CDS can provide either insurance against loss or an opportunity to gamble. This is because the buyer of a CDS does not need to own the underlying security or other form of credit exposure. The buyer does not have to suffer any loss from the default event and may in fact benefit from it.

When purchasing an insurance contract, the insured party is generally expected to have an insurable interest in the event against which he takes out insurance. This simply means that he cannot be better off if the insured against event occurs than if it does not occur. Determining what constitutes an insurable interest is often complicated in practice, but simple in principle: you have an insurable interest if, when (a) the future contingency you insure against occurs and (b) the insurance contract performs (something you cannot necessarily count on, without assistance from the tax payer, if you buy your CDS from AIG), you are not better off than you would be if the insured-against future contingency did not occur.

Clearly, CDS contracts don't require an insurable interest to be present. Many other derivatives likewise don't require an insurable interest to be present. Short selling a share of common stock in the hope/expectation of a fall in the price of the equity without either owning or borrowing the stock (naked short selling) is an example of a derivative contract without an insurable interest.

Why should the state care about gambling through derivative contracts?

Harmful finance

(1) Gambling is addictive

Like all forms of gambling (deliberate risk-seeking), gambling in the derivatives markets can be addictive. This may create a paternalism-based argument for regulating, restricting or even banning the activity. Having observed derivatives writers, purchasers and traders in action, it is clear that the thrill of the gamble is part of the motivation behind this activity. The monetary gains and losses figure prominently, of course, but the bungee-jumping, sky-diving, tight-rope-walking-without-a-net dimensions of derivatives trading definitely play a role. It cannot be a coincidence that there are so many more male than female traders and other operators in the financial markets. Testosterone is not underrepresented in the trading room. And the thrill of taking a wide-open position can be addictive. I wouldn't be surprised if Gamblers Anonymous had a special chapter for derivatives gambling.

I am generically underwhelmed by arguments for protecting compos mentis adults against themselves based on paternalism, but the list of arguments would not be complete without it.

(2) Moral hazard or micro-level endogenous risk.

This is the familiar argument already mentioned before, that if the insured party (the purchaser of a CDS, for instance) can influence the likelihood of the insured-against contingency (the default of the underlying security) occurring without the writer of the insurance contract (the issuer of the CDS) being aware of this, there is an obvious case of market failure and potential source of inefficiency. It's also likely to be an illegal form of market manipulation.

(3) Derivative contracts as "bearer lottery tickets"

Unlike most conventional lotteries, the lottery tickets created as part of many derivatives contracts are traded in secondary markets, sometimes over the counter (OTC markets), sometimes on organised exchanges. These lottery tickets or betting slips are not just traded after they are issued (sold by the writer in the 'primary issue market'), most of these derivative contracts are bearer securities: their ownership is not registered. The owner is anonymous. Listed common stock, by contrast, is an example of what I have called a 'registered security'. There is an ownership register, which is, at least in principle, in the public domain. Clearly, establishing the beneficial ownership of an equity share may not be a simple matter of looking in the shareowners register in the jurisdiction where stock is listed, but with bearer securities the task is hopeless.

The writer of the derivative contract does not in general know the identity of the current owner of the contract. If the writer does not know this, the supervisor and regulator, or the state agency in charge of macro-prudential supervision (typically the central bank) does not know it either. There is therefore absolutely no way to determine whether the current distribution of the ownership of derivative contracts is systemically stabilising or destabilising, whether it is too concentrated or too dispersed. When a notional gross $60 trillion worth of CDS outstanding at the peak (yes, I know it's 'only' $30 trillion now and much of it is 'offsetting' in some ill-defined way) and possibly around $400 trillion gross outstanding of total derivatives, we are talking ignorance on a cosmic scale.

(4) Risk-seeking by the over-confident

Even if the secondary markets for derivatives functioned properly (no bubbles, no liquidity seizures, no wide-spread defaults), these secondary markets can, like the primary issue market, redistribute the additional risk represented by any derivative either in a way that improves the ultimate allocation and sharing of risk or worsens it. Once a new derivative market is created, this market can either be used to hedge existing risk or to take on additional risk. I have seen no reliable statistics on the identities of the counterparties in the leading derivatives markets. My best guess is that most of the activity is not between households and financial intermediaries or between non-financial enterprises and financial intermediaries, but among financial intermediaries, mainly among different banking or shadow-banking player. Much of this trading appears to be driven by overconfidence and hubris. I have yet to meet a trader who did not believe that he or she could not beat the market. Because collectively these traders effectively are the market, they are collectively irrational, as they cannot beat themselves. So the risk ends up being concentrated not among those most capable of bearing it, but among those most willing to bear it - those most confident of being able to bear it and profit from it.

(5) Churning

The collective hubris of the banking sector (broadly defined to include all the shadow-banking sector institutions like hedge funds, private equity funds, SIVs, conduits, other investment funds, AIG-style insurance companies etc.) means that enormous volumes of bets are placed on the behaviour of endogenous variables. The first consequence of this is that, since derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution. Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game.

The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults. Defaults, insolvency and bankruptcy are key components of a market economy based on property rights. There involve more than a redistribution of property rights (both income and control rights). They also destroy real resources. The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved. There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners. But there is such a thing as insolvency for losers, if the losses are large enough.

The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple. The party purchasing the insurance should be able to demonstrate an insurable interest. CDS could only be bought and sold in combination with a matching amount of the underlying security. Ideally, it ought to be possible to for me to buy a CDS by demonstrating an insurable interest in terms of my "utility", i.e. by demonstrating that, should the underlying security default, I would be worse off in one way or other, not necessarily because I own the underlying security. In practice, this would be wide open to abuse and manipulation.

(6) Macro-endogenous risk

Financial markets are inefficient in any of the ways specified by James Tobin in a great 1984 paper - information arbitrage efficiency, fundamental valuation efficiency, functional efficiency or Arrow-Debreu full insurance efficiency.[1] Financial markets even often are technically inefficient. A market is technically or trading efficient if it is liquid and competitive, that is, it is possible to buy or sell large quantities with very low transaction costs, at little or no notice and without a significant impact on the market price. We have seen many examples, from the ABS markets and the commercial paper markets to the interbank markets of massive and persistent failures of technical or trading efficiency.

Even in those financial markets that are reasonably technically efficient, like the US stock market, the foreign exchange markets and the government debt markets, Tobin saw frequent departures from efficiency in the less restricted senses of the word. He accepted that financial markets possessed what he called 'information arbitrage efficiency' that is, that they were informationally efficient in the weak and semi-strong sense. You cannot systematically make money trading on the basis of generally available public information. Clearly, however, trading profitably on the basis of insider information is possible.

He did not believe that financial markets consistently possessed 'fundamental valuation efficiency': financial asset prices do not necessarily reflect the rational expectations of the future payments to which the asset gives title. Key financial markets, including the stock market, the long-term debt market and the foreign exchange market are characterised both by excess volatility and persistent misalignments, that is, prices deviating persistently from fundamental valuations.

Tobin also contested the notion that the financial markets delivered 'value for money' in the social sense. "the services of the system do not come cheap. An immense amount of activity takes place, and considerable resources are devoted to it." (Tobin [1984, p. 284]). Tobin referred to this aspect of efficiency as 'functional efficiency'. Finally, the system of financial markets can be efficient in the technical, information arbitrage, fundamental valuation and functional senses without possessing what Tobin called Arrow-Debreu full insurance efficiency, that is, without supporting Pareto-efficient economy-wide outcomes. The reason is that real world financial markets interact with labour and goods markets that are inefficient in every sense of the word.

When financial markets are inefficient, the distinction between fundamental, exogenous variables and endogenous variables disappears. CDS prices can become quasi-autonomous drivers of the bond prices. The tail can wag the dog. The redistributions of wealth associated with the execution of derivatives contracts can trigger margin calls, mark-to-market revaluations of assets and liabilities, forced liquidations of illiquid asset holdings through fire-sales in dysfunctional markets, defaults and bankruptcies. Activities in derivatives markets, including futures markets, can feed back on sport markets and real production, consumption and storage decisions.

Unbridled derivatives markets may be liquid, but the question is, to what purpose? If, as I believe, there is no economic rationale for 'naked' CDS positions (that is, CDS that do not insure an open default position in the underlying security), then liquidity of the CDS market only serves those who want to trade naked CDS. This, in my view, only wastes real resources through (a) churning and (b) unnecessary bankruptcies.

Useful finance

I want to end on an upbeat note. I believe that effective and efficient financial intermediation is a necessary condition for prosperity. To those who doubt this, I recommend a reading of two books about the true microfoundations of financial intermediation, Hernando de Soto's, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, New York: Basic Books (2000) Prosperity Unbound: Building Property Markets with Trust, by Elena Panaritis (Palgrave MacMillan 2007). If you have only time for one, read the shorter work by Elena Panaritis. It describes the fascinating story of how personal possessions (characterised through informal, insecure property rights) were turned into secure property rights and thence into productive capital through a World Bank project in Peru. The book shows the importance of local knowledge and of a deep understanding of the institutional prerequisites for a successful market economy based on collateralisable wealth (especially real estate). To raise the quality of the rule of law in the property sector to the point small businesses can credibly offer land and other real estate as collateral for formal sector finance requires a formal titling authority, a state capable of reliably maintaining property records, a functional judicial system, corruption levels bounded from above etc.

The world described in these books, where the foundations of a productive market economy are being put in place, appears light years removed from the world of Wall Street and the City of London. In Peru, access to formal sector finance on reasonable terms thanks to the newly created ability to offer collateral and perfect security interest, has lifted many out of grinding poverty. In Wall Street and the City of London, massive resources and lobbying power were devoted to turning complex, long-term relationships into tradable securities - preferably into tradable bearer securities, even when the informational preconditions for this transformation to be effective were not satisfied. Increasingly, as in the case of bearer instruments like mortgage-backed securities for instance, the ultimate issuer and the current owner of the instrument knew nothing about each other. And even with simpler bearer securities, most of the time no-one knows who the current owner is, not even the supervisor and regulator.

The endless churning of contingent claims, including derivatives, when the purchaser has no identifiable insurable interest, turns financial intermediation into a market-mediated betting shop. Then the betting slips become bearer securities and are themselves traded, either OTC or on organised exchanges, and the derivative transactions volumes expand to dwarf the transactions in the markets for the underlying financial claims (let alone the markets for the underlying real resources). At that point, the betting tip of the financial tail of the real economy dog does all the wagging. It does not create value but redistributes it in a way that consumes real resources and exposes the real economy to unnecessary risk. It's time to tame the tiger.

[1] Tobin, James [1984], "On the Efficiency of the Financial System", Fred Hirsch Memorial Lecture, New York, Lloyds Bank Review, No. 153, July, pp. 1-15, reprinted in Tobin [1987], Policies for Prosperity; Essays in a Keynesian Mode, Edited by Peter M. Jackson, Wheatsheaf Books, Brighton, Sussex. pp. 282-296.

Selected Comments

Many posts here seem to feel that as long as the act of gambling helps the market in price discovery, there are no economic reasons to control it. In my opinion they overlook one major assertion Prof Buiter made, that markets are not frictionless. If the outcomes of the bets exact no social costs, we wouldn't have to burden ourselves with moral suasions to regulate the market. This, as we have seen, is also not the case (AIG bailouts being case in point). I don't profess to have the answer, but what do to with the derivatives market is a question worth asking. To pin it on 'real people who misued these instruments' and believing that holding them to account will right the ship, is akin to saying murders won't happen as long as the police arrests the murderers.



this is an excellent article. I wish there were more academics making the plain case that:

- Derivatives unlike equity where real companies create real value are just a zero sum game.

- Churn only profits the intermediaries who make transactional commissions (keep the fight Willem, those who criticize you are clearly in that category).

- Let's stop the joke about price discovery: I recommend a fantastic article from John Dizard in the FT last year: "Put the credit default swaps market out of its misery" (google that name to find the full article)
"The value of CDS for price discovery. Bad joke. Price discovery is a useful economic function; that's the rationale for commodities markets. But CDS are derivative instruments, whose price is "discovered" these days as a function of equity volatility, since buying equity puts is one way to dynamically hedge the illiquid legacy books. So CDS dealer sales of Citigroup equity through derivatives means higher equity volatility, then higher CDS spreads, leading to more margin calls, leading to more sales of bank stocks . . . This has become a system-wide tail-swallowing exercise in lunacy. If the default rates implied in investment grade CDS spreads were to occur, the only economic activity would be court-supervised reorganisation. The CDS market has been preventing efficient price discovery."

No one needs to sell insurance on my house to 10 different gamblers to help my mortgage lender figure out how much my house is worth.

- Unless you own the underlying asset, dealing with derivatives = casino style banking.

- What is wrong with all that? Absolutely nothing, as long as the taxpayer does not have to foot the bill! The regulation we need is one that makes sure that no derivative player is too big to fail.
We should operate a break down now, to carve out gamblers from deposit banks.

May I also quote George Soros in "We Need to Regulate the Financial Instruments That Took AIG Down", FT, March 25 2009

"CDS came into existence as a way of providing insurance on bonds against default. Since they are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. What makes them toxic is that such speculation can be self-validating.

[...] Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies. "


  1. Note: typical libertarian nonsense that ignore question of parasitic finance altogether:

    If these arguments are to be taken seriously, we should also ban interest-rate swaps, currency forwards, call and put options on equities, index futures, bond futures, currency futures, commodity futures and options. Many of these have been around for hundreds of years, and are an important way to control risks, express relative value insights (making the market more efficient) and provide liquidity.

    Credit derivatives are useful just like these other forms; it would probably be better to have them traded on an exchange, and other reforms are probably needed, including regulation.

    But these instruments are not mere lottery tickets, and WB's draconian reforms (similar to those who want to ban shorts in stocks) are surprisingly misguided for someone who is usually so wise and whose ideas are well thought out.

    Posted by: UberDave | April 13 06:42pm |
  2. 10. UberDave,

    this is a way to easy attempt to ridicule serious people attemplting to provide solutions to a real problem.

    We understand the role of commodity futures (for farmers, ore producers...) and currency futures (for international companies).

    I believe that $170 billion of CDS related losses at AIG footed by the US taxpayer is a real problem, don't you think?

    Willem, just like George Soros is not suggesting to get rid of those instruments but to regulate them.
    In the case of CDS the proposal is to have them allowed only to be used by those who own the bonds.

    That some are just speculating on derivatives (be it commodities, currency - and I guess Mr Soros knows about that one- or CDS) is fine as long as society does not have to bail any market participant out. We have witnessed failure on a massive scale. Something needs to be done. Willem's proposal makes full sense to me. Do you have a better one?

  1. Bill Hodgson | April 13 08:44pm | Report this comment
  2. 13. One problem with the CDS market is that there is a conflict between requiring an 'insurable interest' and providing a thick market in which there are a large number of (hopefully competitive) trades. In many cases it is not possible to buy a CDS on the bond that the investor actually holds - instead the settlement rules state that in the event of default the holder of the CDS can deliver a range of bonds issued by the firm concerned. This is a bit like saying that I can buy insurance on my car, and be paid off if I deliver a 'similar' car to the insurance company. It's open to manipulation - I have seen statements that when Freddie Mac collapsed investors tried to deliver principal-only bonds (which, because of the zero coupon, would trade well below par even if there were no default) and demand full repayment at par. But if there were a separate CDS market for each bond (and each tranche of every CDO) there would be very few participants in each market.
    Those who operate in the CDS market must decide if they are providing something like home insurance (individual-specific, nonassignable, contracts which require an insured interest) or gambling facilities (standardised, and assignable between individuals - I can buy another punter's betting slip). At the moment it seems to me that they want the best of both worlds - to operate like bookies, but to be bailed out as if they were responsible insurance companies.


As you say "In the UK where there are more legal forms of gambling than in most other countries, many conventional financial instruments or securities have been 're-engineered' as formal bets. Spread betting on exchange rates, interest rates, stock prices and now also house price indices is a popular form of investment"

I agree except with the last word, 'punt' might be more appropriate than 'investment'. The reality is that gambling seems to be endemic in the UK, encouraged by this government I might add, who wish the UK to be the gambling capital of Europe. Derivatives are largely a zero sum game. As is marketing these derivatives to retail investors through spread betting. A recipe for disaster for the customers, which is why it is reported that 4 in 5 lose, and 15% develop serious gambling problems. No wonder that spread betting firms have no need to hedge much of the bets made with them. Let's reverse the trend of the gambling culture. In the city and in the home. Or does the government think that the UK economy should be based on a nation of buy to let landlords, indebted homeowners, and gamblers. Given all are a zero sum game as well who is paying the price?


  1. About non-naked CDS as insurance:

    Look, you better have a fire insurance on your house: you need a place to live and the small chance of a burned-down house comes with a price tag too high for most.

    But why-oh-why would one need insurance on the bonds you hold? The comparison to your house fails, as you can easily get rid of those bonds or of bonds altogether. If for whatever reason you consider these bonds too risky, you sell. You may sell at a loss, but then next time you hopefully invest more prudently.

    Some time ago I read a blog explaining that CDS as a bond insurance cannot even work: a reasonable (from the point of view of the insurer) price for the insurance fee would be such that the net yield of these bonds would make them unattractive for the buyer.

    Hence we better get rid not only of naked CDS, but of all CDS (the world was a much better place before this particular financial innovation).

    Also: ¨Key financial markets, including the stock market, the long-term debt market and the foreign exchange market are characterized both by excess volatility and persistent misalignments, that is, prices deviating persistently from fundamental valuations.¨

    Bravo! As I commented before: why the recent outrage about not rigidly holding on to mark-to-market? (FASB rule relaxation: with e.g. many market values for stocks decreasing/increasing by more than 50% in just 3 weeks, there is no need to enhance the already huge problems by toppling financial institutions which still have enough cash flow, but mark-to-market ¨deviating persistently from fundamental valuations¨ paper losses.)

    Posted by: carol | April 14 10:16pm | Report this comment
  1. ===

    23. Wasn't going to post this, but felt obliged to add to Ming's mirth.

    It seems as though the first two commenters, Don and Warfield, either did not read Buiter's post or were not equipped to understand it. The third, Ming, focused on some of the key points, but not the basic logic of the argument. According to Buiter:

    "When financial markets are inefficient, the distinction between fundamental, exogenous variables and endogenous variables disappears."

    To translate this out of econ-speak, this means: We have every reason to believe that the prices produced by derivative markets are wrong. This leads rather immediately to the following conclusion:

    "Unbridled derivatives markets may be liquid, but the question is, to what purpose? If, as I believe, there is no economic rationale for 'naked' CDS positions (that is, CDS that do not insure an open default position in the underlying security), then liquidity of the CDS market only serves those who want to trade naked CDS."

    In other words, to the degree that prices move because of derivative trades (and I challenge the "price discovery" crowd to demonstrate that these movements are meaningful in a fundamental sense) those price movements may well be of value only to the price discoverers themselves. As long as they were passing money amongst themselves nobody cared, but when the taxpayer got involved, they proved indisputably that their activities were a negative-sum game.

    Ming's existential approach would be fine, if – and only if – the taxpayers were not involved.

    As for commenter #4, Nuti: "But the cost of derivatives markets can be deemed to be covered by transactors; otherwise derivatives markets would be closed down." It is precisely because the costs of the markets were not covered by transactors that the taxpayers are considering closing them down.

    Posted by: atlarg | April 15 07:09am | Report this comment

[Apr 10, 2009] What Next For Banks By Simon Johnson

The Baseline Scenario

The case for keeping banks in something close to their current structure begins to take shape. It's not about traditional claims that big banks are more efficient, or Lloyd Blankfein's argument that this is the only way to encourage risk-taking, or even the House Financial Services Committee view that immediate resumption of credit flows is essential for preserving jobs.

Rather, the argument is: those opposed to banks and bankers are angry populists who, if unchecked, would do great damage. Bankers should therefore agree to some mild reforms and more socially acceptable behavior in the short-run; in return, the centrists who control economic policymaking will protect them against the building backlash. This is a version of Jamie Dimon's line: "if you let them vilify us too much, the economic recovery will be greatly delayed."

There are three problems with this argument: it is wrong, it won't work, and it doesn't move the reform process at all in the right direction.

The "center vs. the pitchforks" idea fundamentally misconstrues the current debate. This is not about angry left or right against the center. It's about centrist technocrat (close to current big finance) vs. centrist technocrat (suspicious of big finance; economists, lawyers, nonfinancial business, and - most interestingly - current/former finance, other than the biggest of the big, particularly people with experience in emerging markets.)

Just as an example, a broad range of entirely centrist people (including in and around the IMF; former Treasury; you'd be amazed) are expressing support for the ideas in our Atlantic article. People on the left are, not surprisingly, also in line with this view; but we're also hearing convergent thoughts from some on the right - many who emphasize improving the environment for entrepreneurship don't see big finance as their friend. So far, the only person who called to complain works for an "oligarch."

You might think the "anti-pitchfork" strategy might work, particularly as it has in the past (e.g., in the early Clinton years). The problem for this strategy now is not just the fragile state of banks - by itself this can be ignored for a long while through forbearance, behind a smokescreen of complicated schemes with confusing acronyms - but the ways in which the markets they created now operate.

Just as global financial liberalization created the potential for capital to move violently across countries and greatly facilitated speculative attacks on currencies, so financial deregulation within the United States has made it possible for capital markets to attack - or, in less colorful terms, go short or place massive negative bets on - the credit of big banks and, in the latest developments, the ability of the government to bailout/rescue banks.

The latest credit default spreads data for the largest banks show a speculative run underway. As the system stabilizes, it becomes more plausible that a single big bank will fail or be rescued in a way that involves large losses for creditors. This would like trigger further speculative attacks on other banks, much as the shorting of countries' obligations spread from Thailand to Indonesia/Malaysia and then to Korea in fall 1997.

The government's own policies are facilitating these attacks, because as the Fed and Treasury make progress towards easing credit conditions, this makes it easier and cheaper for large hedge funds and others to take large short positions. And keep in mind the underlying loss of confidence is self-fulfilling: as you lose confidence, you want to go short, and selling the credit causes further loss of confidence - and banks are forced out of business.

The government's entirely reasonable and long overdue request for a resolution authority will set up runs on that authority. If the authority is not granted, the runs will be on the government's low and failing ability to save banks - given that the trust of Congress has been lost and no more cash for bailouts is likely forthcoming (presumably until there are large further shock waves or until Goldman Sachs itself is on the line.)

The continuing pressure on banks has nothing to do with populism and everything to do with the internal contradictions of the house of cards they built. Now they will scramble to limit short selling or find other emergency measures that will protect their credit. Such partial fixes would do nothing to stop the underlying deterioration of their credit; think about how countries facing currency attacks throw up futile defenses, try to change the rules, and squander their reserves on the way down.

You can see where this is going, but do not cheer. The likely result will be misery for many and further financial chaos around the world.

The big issue is of course the financial sector reform process. Some of my colleagues expressed great satisfaction with the progress made by the G20. But progressing down a blind alley is not something to be pleased about. I have yet to hear a single responsible official in any industrial country state what is obvious to most technocrats who are not currently officials: anything too big to fail is too big to exist.

If the bankers were just stupid, as suggested by David Brooks, then regulatory fixes might make some sense. But we know that bankers are smart, so it is their organizations that became stupid. What is the economic and political power structure that made it possible for such stupid organizations to become so large relative to the economy? Answer this and you address what we need to do going forward.

At a high profile conference in the run-up to this crisis, someone destined to become a leading official in the Obama Administration responded to a sensible technocratic critique of the financial system's incentive structure (from the IMF, no less) by calling it "Luddite". By all accounts, this is the prevailing attitude in today's White House.

But the right metaphor is not breaking productive machines, or peasants with pitchforks, or even the poor vs. the rich. It's as if the organizations running the nuclear power industry had shown themselves to be stupid and profoundly dangerous. You might wish to abolish nuclear power, but that is not a realistic option; storming power plants makes no sense; and the industry has captured all regulators ever sent after them.

The technocratic options are simple, (1) assume a better regulator, of a kind that has never existed on this face of this earth, (2) make banks smaller, less powerful, and much more boring.

By Simon Johnson

Selected Posts

  1. I find Simon's analysis compelling, as usual. I also find a few points of convergence with David Brooks, except for his last statement about inbred oligarchs vs. dufusness, (is that a word?).

    Not to sure about the inbreeding, that was more during the days of monarchies, but the CEOs of Bank of American, et al, are for sure, oligarchs.

    In fact, in the various companies I've worked for in the IT industry over the last 28 years, (with the conspicuous exception of Digital Equipment Corporation under Ken Olson, may it rest in peace), the boards of these big companies behave and live as oligarchs as well.

    This was especially notable under Lou Gerstner when I was with IBM, (in one year, he took away $20 million in just stock options, forget his multi-millon dollar salary). That same year, I got layed off and was out of work for 25 months, went broke, and got a different view of the world.

    I think Lou did ok, though, thank goodness. He also spent 2.2 billion buying Price Waterhouse Cooper to replace the group I was in that was getting whacked. This all happened in 2001, and just as Enron tanked.

    In a lot of ways, I did not really see the U.S. recover from the tech and Y2k bubble, we just moved into a housing bubble with cheap money and greedy investors that allowed the financial industry to complete their going completely nuts with money.

    "And - here - we - go!" - The Joker

    Just my 2 cents,

  2. Simon wrote:

    "The "center vs. the pitchforks" idea fundamentally misconstrues the current debate. This is not about angry left or right against the center."?

    Not yet, anyway. But there is more brewing (in the States, anyway)than meets the eye. As long as people keep thinking that most of what they have lost will eventually come back, things will be heated, but non violent. But if it begins to dawn on people (correctly or not) that that 401K plan, and that job, and that pension, and the value of that house, and that health insurance policy, are not coming back, there will be big, big, trouble.

[Apr 7, 2009] Investors accuse fund chief over Bernard Madoff losses

April 7, 2009 | Times Online

James Bone in New York

The hedge fund manager J Ezra Merkin, a pillar of New York society, was accused of fraud yesterday for allegedly funnelling investors' money to Bernard Madoff, the Wall Street swindler.

New York State alleged that Mr Merkin, president of the wealthy Fifth Avenue synagogue founded by his father, had failed to tell his well-known clients - including Elie Wiesel, the Nobel laureate and Holocaust survivor - that he was placing their money with Madoff.

The state's complaint alleged that Mr Merkin had channelled about $2.4 billion (£1.63 billion) to Madoff, while collecting $470million in fees and performance bonuses.

"Merkin duped individual investors, non-profits and charities into believing he was responsibly managing their investments, when in actuality he was dumping them into history's largest Ponzi scheme," Andrew Cuomo, the New York attorney-general, said.

The civil charges also allege that Mr Merkin mingled his personal funds with the accounts of Gabriel Capital Group, his management company, and used some of the company's money for personal purchases, including $91million worth of artwork for his Park Avenue apartment.

[Mar 17, 2009] The Button-Down Mafia: How the Public Accounting Firms Run a Racket on Investors and Thrive While Their Clients Fail

There's a popular Sicilian proverb:

Cu è surdu, orbu e taci, campa cent'anni 'mpaci.
"He who is deaf, blind, and silent will live a hundred years in peace."

Enron, WorldCom, HealthSouth, Tyco, Parmalat, Adelphia...You would think enough lessons had been learned. The financial markets are a mess and the capitalist system threatened. The systems in place to anticipate and preempt market risk failed completely. Financial firms leveraged their capital to an unprecedented extent with no checks and balances. Companies took on enormous risks with minimal disclosure to their shareholders.

And the largest global public accounting firms -- KPMG, PricewaterhouseCoopers, Deloitte, and Ernst & Young -- again failed to prevent, warn, or mitigate the desperate financial situation, the national crisis of significant proportions we now find ourselves in.

"...There were systematic failures in the checks and balances in the system, by Boards of Directors, by credit rating agencies, and by government regulators..."

Even the US Treasury Secretary doesn't hold the public accounting firms accountable for the problems we now face. The Big 4 public accounting firms haven't yet been asked the hard questions by governments, legislators, or regulators.

They're getting a free pass.

The global public accounting firms have worldwide, government-sanctioned franchises as market watchdogs. They are supposed to be working to protect shareholders' interests. Financial statement audits are required by most global exchanges -- to provide a seal of approval on the financial disclosures of public companies. The accounting firms employ accountants, licensed by local authorities and trained as auditors. These "professionals" audit the financial statements of public and private companies, governments, and not-for-profit organizations worldwide. Public accountants must express an opinion on those financial statements.

In the United States, certified public accountants are the only authorized non-governmental type of external auditors who may perform audits of financial statements and provide reports of those audits for public review, submission to the SEC, and to comply with exchange listing standards. In the United States, the firms and their licensed professionals are required to be independent of the entities being audited.

The Big 4 public accounting firms are very big business themselves. As an industry, the top firms generate more than $100 billion in total revenues globally and employ hundreds of thousands of people. As auditors and advisors, they work inside the banks, brokerage firms, auto manufacturers, mortgage brokers, and homebuilders. They're "in the know" about every public company and most large private companies, earning millions of dollars in fees, for audit opinions that have ultimately proved worthless. They were right there in the boardrooms when the US government took over Fannie Mae, Freddie Mac, and AIG. They are still at executives' right hands, earning more fees helping the US federal government under TARP to organize and control the taxpayers' new investments in subprime loans, non-liquid assets, and exotic financial instruments. The public accounting firms make money whether companies thrive or whether they fail. The Big 4 firms are now charging billions to advise each other's clients as those companies file for bankruptcy protection.

According to a study by David L. Carter, Ph.D. at Michigan State University's School of Criminal Justice, the basic characteristics of organized crime are:

• Profit accumulation • Longevity • An organizational structure that facilitates criminal activity • Efforts to corrupt government officials, police, and corporate official • The use of violence

Profit accumulation

Big 4 firms continued to see significant double-digit growth in top line revenue during 2007-2008, even though the recession had already started. Who else besides pimps, loan sharks, and illegal gambling had such a great year last year? Such monopolistic growth and profit is due in large part to the lack of competition within the industry. The largest four global public accounting firms audit almost 99% of public company revenue in the United States and all but one of the UK's top 350 companies.

Since the passing of the Sarbanes-Oxley legislation in 2002, public companies have complained that audit fees have tripled or even quadrupled. They are still increasing, albeit at a slightly decreasing rate. But the combination of mandated audits and the addition of Sarbanes-Oxley requirements prompted many companies to use words like "extortion" and "protection money" to describe their feelings regarding the cost of pieces of paper that seemed to provide so little tangible value to shareholders. Paying for an audit, defined as broadly by the auditors as they chose, became an "offer you can't refuse."


The Big 4 public accounting firms are loose confederations, combinations of firms, many of which started all the way back in the late 19th Century. Firms have merged and grown, some dying along the way, and others becoming predators of the weaker ones. The largest four firms compete on paper, yet coexist in a cooperative manner -- much like the five New York City crime families: the Bonannos, the Colombos, the Genoveses, the Gambinos, and the Luccheses -- in order to achieve common objectives via industry lobbyists such as the Center for Audit Quality.

An organizational structure that facilitates criminal activity
The public accounting firms are organized as partnerships, like law firms. They recruit and promote less like a business, based on merit, and more like a secret society or fraternity.

"Becoming a made member of La Cosa Nostra requires serving an apprenticeship and then being proposed by a Boss. This is followed by gaining approval for membership from all the other families."

Acceptance and success in the Big 4 public accounting firms requires selection based on university credentials, referrals from professors, family background, and business ties, as well as having political beliefs and economic philosophies that are aligned with firm values. Internal operations are conducted in a secretive manner. Financial results and common business metrics are minimally disclosed to the outside and on a "need to know" basis internally.

There's a type of Big 4 omertà, the extreme form of loyalty and solidarity in the face of authority usually attributed to the Mafia. Once initiated into firm culture, survival requires adoption of this informal oath of allegiance that makes it shameful to betray even one's deadliest enemy, your competitors, to legal and regulatory authorities. Examples of this extreme sense of loyalty to even those who've disgraced the profession can be found when partners that have been sanctioned by the SEC, forbidden to audit public companies, are later reinstated by the SEC. Deloitte, for example, maintained the partners responsible for Adelphia and Navistar on their payroll during their SEC suspension and they lived to audit another public company another day.

Efforts to corrupt government officials, police, and corporate officials

All the public accounting firms spend a lot of time and money publicizing their good works. There's a ton spent on volunteerism and donations to foundations. There's a press release a day about some or another warm and fuzzy diversity initiative in spite of the documented lack of progress in getting women and minorities to partner positions in proportion to their numbers in universities and entry level positions. They spend a bucketful of money to erase the fact that they're otherwise sucking money out of the economy for essentially worthless audit opinions.

There's also a big spend on political campaigns. For example, all of the US based public accounting firms like US Senator Christopher Dodd. It's not the man, his party, or his politics, but his position that attracts the dollars. The Chairman of the Senate Banking Committee has significant influence over the legislation affecting the Big 4 public accounting firms.

Another big recipient of the audit firms' largesse is US Senator Charles Schumer. Early in the subprime crisis, he was heard demanding action from, of all people, the accounting firms. This is comical. After all, the public accounting firms pay Schumer to protect their interests, not the other way around. Ernst & Young is one of his all time career big donors. Deloitte is one of his largest campaign contributors. As a matter of fact, E&Y and Deloitte are in his top 20 all time greatest contributors.

The use of violence

Violence is the only thing left that the firms haven't depended on to accomplish their goals. That we know of... However, their labor practices have been the subject of class action lawsuits in the US and Canada during the last few years. It appears they do not pay overtime when they should and work their professionals like the interns on TV's ER.

We've all seen what sleep deprivation can to do the quality of medical care. Imagine what being overworked and underpaid does to the quality of accounting and audit work performed by thousands of new college graduates hired each year. These are the foot soldiers doing the hands-on work to insure the accuracy of the financial information published by your employer or the companies in your 401k. There's even a case from 2007 when a poor young woman in Romania working for Ernst & Young died from exhaustion. She was working long hours without rest under pressure to keep her job.

The Ratings Agency Circle Jerk

Controlling and making money from all sides of a transaction is another potential sign of a criminal organization at work. In the aftermath of the financial crisis, the press, global legislative bodies, and regulators all got sidetracked by concerns over the issue of culpability of the ratings agencies. What they missed is the unholy alliance between the rating agencies, the auditors of the ratings agencies, the companies whose bonds were being rated, and the auditors of those bond issuers.

• The public accounting firms certified financial statements and gave clean audit opinions for companies that issued mortgages and mortgage-backed securities.

• The ratings agencies counted on these audit opinions and performed no further due diligence to ascertain those opinions were justified.

• The public accounting firms audit the ratings agencies. The three largest ratings agencies, Standard & Poor's (part of McGraw-Hill), Moody's, and Fitch (part of Fimalac, a French company) are all public companies that are required to have their financial statement audited by KPMG, PricewaterhouseCoopers, Deloitte, or Ernst & Young.

• The public accounting firms audited the failed companies that issued the mortgages such as New Century, Countrywide, Northern Rock, and American Home.

• They also audit the firms such as Bear Stearns, Citibank, Bank of America, and Merrill Lynch that created, marketed and invested in the packaged mortgage securities -- many of which ended up off balance sheets. And they audit the monoline credit risk insurance providers MBIA and AMBAC.

The public accounting firms and their hundreds of thousands of auditors should be an investor's first line of independent defense. But these firms turned a blind eye to the excesses, mismanagement, and fraud of executives managing their client firms. The public accounting firms issued clean financial opinions for all of the firms that eventually, most less than a year later, failed, were taken over, or nationalized. And the regulators slept.

There's something about the Big 4 public accounting firms, and to a lesser extent their next tier firm colleagues, that allows them to make money, to thrive, in spite of failure all around them. They continue on, oblivious to accelerating rates of litigation against them and the realistic threat of a catastrophic lawsuit.

Their solution to the legal threats resulting from their clients' frauds and failures?

Liability caps.

Governments all over the world are protecting and shielding the public accounting firms from failure under any circumstances, even in the face of repeated failure on their part. The current business model for global public accounting firms no longer promotes the safeguarding of shareholder interests in the modern publicly traded multinational. Shareholders, and other stakeholders, are being shafted. The firms and their partners may be corrupt. They are unequivocally self-interested.

When it comes to the Big 4 public accounting firms, the official word is still, "Too few to fail. Too powerful to call to account."

Steve Waldman Believes Banking Industry Sick Since At Least the S&L Crisis

Steve Waldman makes some bold claims in tonight's post:Work makes a comeback
A "lifetime" of work has until recently usually meant just that, with no notion that it be followed by retirement and ease. The West's baby boomers, their pensions disintegrating just as they were coming into reach, are very painfully about to rediscover history.
naked capitalism
In two recent Surowiecki posts (here and here), Surowiecki points out that during the banking crises of the early eighties and early nineties, banks were arguably as insolvent as our banks are today, but hey, with a little time and without any radical changes, everything turned out great....

The fundamental difference between my perspective and Surowiecki's is that I don't think those previous recoveries were real. My view is that the crisis that we're in now is precisely the same crisis we've been in since at least the S&L crisis. We've had a cancer, with some superficial remissions, but fundamentally, for the entire period from the 1980s to 2008, our financial system in general and our banks in particular have been broken. They have profited from allocating capital poorly, from funneling both domestic loans and an international deficit into poor investments (current consumption, luxury housing) rather than any objective that might justify arduous promises to repay. We all got a reprieve during the 1990s, because internet enthusiasm persuaded many investors to fund our consumption via equity investment, which we could wash away relatively painlessly in a stock market crash. Debt investors don't go so quietly. Thanks to the cleverness of our banking system, we have a very great many lenders, both domestic and foreign, who've invested in trash but who demand to be made whole at threat of social and political upheaval. That is the failure of our banks. That they are insolvent provides us with an occasion to hold them accountable, and to reshape them, without corroding the rule of law or respect for private property...

There are profound economic problems in the United States and elsewhere that our financial system has proved adept at papering over rather than solving. Those of us who've played Cassandra over the years have been regularly ridiculed as just not getting it, as economic illiterates and trade atavists. Unfortunately, as Dean Baker frequently points out, the people who could never see the problems are the only ones invited to the table when the world cries out for solutions. The solutions on that table are those Surowiecki tentatively endorses, weather the storm, take some time to repair, the temple is structurally sound. But the temple is not sound. We either build a decent financial system, or suffer real consequences, in unnecessary toil and lost treasure, in war and conflict over false promises set down in golden ink.

The banking crisis and the high unemployment rate are not the crisis, they are symptoms. This is not "dynamo trouble", it is a progressive disease, and what is failing is the morphine. Those of us who believe that financial capitalism is a good idea, that it could be the solution, not the problem, do their cause no favors by resisting radical changes to a corrupt and dysfunctional facsimile of the thing. We need to approach financial capitalism as engineers, and to largely rearchitect a crumbling design. If we don't, we may be so unfortunate as to suffer yet another superficial remission. But error accumulates, and error on the scale now perpetrated by national and international financial institutions are unlikely to be without consequence.

I'd love him to tease this out further, and I am a bit too fried to give this a long form treatment, but let me volunteer a few thoughts:

But the interest rate volatility was and still is a real mess for banks. From what I can tell, the hedges (using product design to put more of the risk back on customers, explicit hedges, astute asset liability management) only partly remedy this problem. In an increasingly competitive environment, my impression is banks have not been able to extract enough additional margin for assuming this risk. Anyone know of any work in this area?

Second is that investment banks ate commericial banks lunches for a very long time. I read from time to time that the reason securitization became more prevalent was that banks felt it was less attractive to hold assets on their balance sheets, i.e., this was an opportunistic move.

While technically, that isn't wrong, that isn't how I'd frame it. I recall when I was at McKinsey in the mid 1980s and securitization was taking off that one of the standard charts showed banks that securitization was cheaper than on balance sheet intermediation due to the cost of bank equity and FDIC insurance. That was seen as a bad thing for banks back then because it meant they were losing market share big time to investment banks.

Third is bank consolidation proved to be a very bad idea, and I see NO ONE addressing this issue. It isn't simply because it created huge concentration and too many too big to fail banks (a lot of countries have highly concentrated banking systems, such as Canada and Australia, but their banks are kept on shorter leashes).

The reason is that bank consolidation delivers NO economic benefits. The big lie is big banks are more efficient. They aren't. Every study ever done of banks in the US has found that once banks reach a certain size threshold, they exhibit a slightly increasing cost curve, meaning they are more expensive to operate.

But you might protest, when those banks buy each other, they may big noises about cutting costs. Right. They could have taken those costs out without a merger. It just gave cover for measures that would be too painful to execute in stand-alone entities.

The real reason for bank mergers is CEO pay is highly correlated with a bank's total assets (and the CEO of the acquired bank is enriched sufficiently to get his acquiescence).

And worse, big banks have completely abandoned the notion that the knowledge that local managers have by virtue of being in a community (in terms of improving lending decisions) has value and can be leveraged. Instead, they all went full bore for FICO and other faux-science credit scoring models, and have perilous little to fall back on now that those have proven to be badly flawed.

I do think Waldman is on to something here, and hope his post elicits further comment. I'd be particularly curious to see John Hempton pick this one up, since he keeps defending the native earning power of US banks.

[Mar 14, 2009] Merrill Bonus Dispute May Be Decided Within a Week, Judge Says

March 14, 2009 |

Cuomo said in a Feb. 10 letter that Merrill "chose to make millionaires out of a select group of 700 employees," and that a smaller group was awarded "gigantic bonuses."

The top four recipients received $121 million, the next four a combined $62 million, and the next six a combined $66 million, he said.

Overall, the top 149 people who got bonuses received a total of $858 million, according to Cuomo's letter. He said 696 people got bonuses of $1 million or more.

Thain was dismissed in January by Bank of America Chief Executive Officer Kenneth D. Lewis. The move came after disclosure of the bonuses and Merrill's fourth-quarter loss.

The case is People v. Thain, 400381/2009, New York state Supreme Court (Manhattan).

Selected comments

Anonymous said...
My father worked for the Coc during the 80's. He couldn't believe that anyone would want to BUY and securitized mortgage.

On selling them, he was also less than thrilled. Why, if you believe it was a good loan, would you sell it?

I heard about this when I was young. He spoke of banks that when they had to sell loans, sold the best they had, in order to maintain the reputation of the bank among its peers.

What happens when they don't have peers? Or equity?

My favorite line from him I have repeated several times before here- Don't buy bank stock, put your money in the bank, its much safer.

He also added that if you had enough money in the bank, soon enough you could end up as an owner of the bank anyway, at a much better price.

March 14, 2009 4:29 AM
Matt said...
Buffet clearly seemed to subscribe to Surowiecki's view during this marathon CNBC interview. Obviously, Buffet is talking his book. But Geithner et. al. seem to have embraced the idea that with interest rates so low and spreads so wide, banks will have tremendous earning opportunities in the next year or so (despite the McKinsey report to the contrary), and that if Treasury gives the banks enough capital to tide themselves over, they can earn their way out of their holes. Hoping your problems will go away is not a policy. And we do need to fundamentally reform the banking system. Hopefully Obama will start listening to Volcker (assuming Summers doesn't completely marginalize him).

March 14, 2009 4:54 AM
Oregon Guy said...
Hempton won't pick up on Waldman's theme because he doesn't see or care about the issue raised. Hempton's (and Geithner's, Summer's, Bernancke's) principle concern is restoring the financial system status quo, making sure all debt holders are kept whole even if it impoverishes the debtors, and profiting on the rising share prices of re-capitalized banks. It's a great trade for folks with money.

Waldman, Simon Johnson, Chris Whalen and others are primarily concerned about something else - restoring integrity and transparency to the financial system and clearing the enormous moral hazard the Fed and Treasury have wrapped around the system. That is hard work - it can't be fixed by printing money - and is either beyond the abilities of Geithner and Bernancke or, more likely, they are so captured by the kleptocracy they will resist any real reform.

I have to laugh when wing nuts complain that Obama is a socialist. He isn't even a progressive - picking Geithner and Summers proved that. A progressive would have folks like Joe Stiglitz and Michael Hudson on his team.

Anonymous said...
"I have to laugh when wing nuts complain that Obama is a socialist."

Well, Real Americans obviously know better: he is upholding what they see as a regime of Communist terror and extortion with holdups like the minimum wage, and letting taxes on the productive, deserving Real Americans go back up to the punitive levels they had under Clinton.

"He isn't even a progressive - picking Geithner and Summers proved that. A progressive would have folks like Joe Stiglitz and Michael Hudson on his team."

My hope is that he is playing a long game. He probably knows that the first 2 years will be hell, so he has nominated all his best enemies to take the heat of those and get burned out.

Would you appoint your best team to get their reputation shredded and their stamina stressed out by being pummeled by the aftermath of 8 years of unrelenting Bushness?

He may hope that containing trouble in the next 2 years will burn out Gates, Hillary, Geithner, Summers and the other culprits, and then he will bring out when there is hope for a rebound and a chance to fix things instead of just trying to contain the mess.

wintermute said...
The roots of the banking crisis founded in events of the 1980s fits with another important event. Abandonment of the gold standard in 1972. "The inflation of the 1970s created a huge mess for this model." Exactly - once the discipline of the gold-standard was completely abandoned - simple bread-and-butter banking became a broken model - leading to all the distortions still seen today.

The perceived "failure" of the gold-standard since the 1930s is really governments breaking out of the money supply structures of the gold-standard. A breakout which produced a multi-decade credit-bubble boom, doomed from the beginning.

Anonymous said...
The 80s S&L event, was a miami coke dream that, after the first years high, ran into the manic stage of addiction or SDOs and their party friends. I still look at the tall piles of coke..I mean buildings in down town miami, as the power of one drug that still echos in time or the opening bell on wall st.

Grosse pointe...damm my batt score and that little white paper I signed in the accustic tiled room FTA.

Anonymous said...
"Mr Welch argues that focusing solely on quarterly profit increases was "the dumbest idea in the world". "Shareholder value is a result, not a strategy," he says. "Your main constituencies are your employees, your customers and your products."

In other words, stock price is not the 'purpose' of the business.

Business schools have been teaching that shareholder value comes first since the 1980s.

And, I believe, CFO responsibility to shareholder value became the law. (the excuse for perpetuating the university teaching against all common sense)

The debate for regulation of stock options for compensation and violation of insider rules has begun. That's my hope. For without it, now that gov is in on it (Citi exec insider gains on leaked info openly), the destruction of trust of America and its markets can only gain momentum with consequences for everyone, not just shareholders.

Welch's statement could also mean we can look forward to the end of Congressional posturing about caps on compensation and get on with real regulation of stock options to eliminate short term incentives at the expense of economic stability and real value to consumers and workers.

Stock options for executive compensation is a conflict of interest and incentive for the legal looting as well as the 500X disparity in executive pay that has taken place the last couple of decades.


Stephen said...
So this is somewhat related.

If there is such an opportunity in banking why isnt there private capital being put together to form a brand new bank that is unemcumbered by the past.

Shouldnt it be able to go around picking up some bad banks and working them out OR grow organically by picking off the customers of the nasty banks?

Just curious why this doesn't seem to be happening if the at an industry level the opportunity is so attractive.

VoiceFromTheWilderness said...
The point about bank mergers is an excellent one, and one that not enough people are talking about.

It's not just bank mergers but PE, and LBOs, that have created most of the entities being bailed out these days. From that perspective the governments activity over the last year starts to look more and more like a rescue of the LBO industry. Why is hard to fathom, but methinks invidious comparison is at the root of it.

It is beyond hilarious that the 'market always knows best' has become 'there really is a 'true' value not reflected in the price' in the mouths of the very same people and economic/political actors. The clear implication is that what we are really going through is the attempt (for whatever reason) to prop up investment values, and in particular, stock prices.

That is to say, to make the world safe for those who would become billionaires by buying and selling little strips of white paper.

maynardGkeynes said...
Waldman is talking forest, but Yves is responding tress. Bit of a disconnect....
Anonymous said...
Interesting post for its broader perspective, more like this are needed that are even broader in nature ...

The very noticeable shift in the past forty plus years has been politically driven and willfully intentional. And if one looks carefully it is more global in nature and effects all sectors of all societies ... it is a shift from plain old fashioned vanilla greed to a newer more vile gangrenous elite greed ... a shift in the ruling class from the driving force of the profit motive to the driving force of the control motive ...

It is that shift in the ruling class that has caused the attendant societal motivation to be changed from one of desire and opportunity as the norm of the world's zeitgeist, to fear and anxiety being the norm. That very intentional zeitgeist shift has been, and is now, meant to create perpetual conflict in the masses so as to effect a ruler and ruled world societal model.

Unsustainability of consumption and the role of increased population was recognized long ago. Those now in control have very skillfully acted upon those insights by hijacking and co-opting key components of world governments and societal sectors through deception.

We need to "rearchitect" a new system. It begins with removing the controlling ruling elite. But first the deceptions need to be exposed and we must deprogram from those deceptions.

Even at this point it is still possible to have a sustainable and harmonious world. It won't happen if scamericans occupy their valuable time watching the deflective antics of Cramer and Stewart ...

Deception is the strongest political force on the planet.

I on the ball patriot

Anonymous said...
If the banking system is sick it seems to have infected everything else and that makes forecasting especially perilous.

Yes, the banks COULD make a lot of money based on their interest spreads but to whom do they make these loans? A year ago oil and gas
seemed to be a sure bet. Building a natural gas pipeline from Alaska
to the US would've have been a sure
thing? Until... now. A Toyota plant
in Mississippi? Can't miss, er, oops don't need it anymore.

We've seen every hot thing be it housing, commercial construction, LBO's, mining, drilling, LBO's, ethanol, bio-diesel, railroads,etc. etc. go from best bets to total write offs in months.

You can't make loans with the world in such chaos and have any assurance, absent government guarantees, that the project you lend money to today will be viable by the time it is completed.

David Pearson said...
I think Waldman is making a fundamental point, and here's an attempt at teasing it out.

The economic rationale for banks arises from information asymmetry and the agency problem. In a nutshell, borrowers have the knowledge (about their own risk) and incentive to game lenders. Banks exist to obtain enough information about borrower risk to eliminate this asymmetry. For this act, they earn a profit.

Of course, you can argue that banks long ago gave up their ability to assess credit risk. Sure they credit departments, but these arguably have been taken over by "blind" decision rules and models. Essentially, credit departments, in competition with securitization, decided that if you can't beat them, join them.

The result was chronic mis-allocation of credit. The more that the growth in leverage pumped up the economy, the more mis-allocation occurred, the more systemic risk accumulated.

So Waldman implies that banks should go back to the business of assessing credit risk. This argues for smaller banks taking discrete (rather than pooled) risks at a higher cost (credit assessment and monitoring is expensive).

Printfaster said...
This brings to fore two of my pet issues: The demise of the small independent bank under a bank holding company and Paul Volcker's role in the destruction of US industry.

The small bank under a bank holding company was a result of a lot of abuses of large banks and their many branches during the period surrounding the Great Depression. Minnesota, Iowa and and a number of midwestern states banned branch banking as a result of the rapacious removal of wealth from farmers and small communities by large money center banks.

The result of the ban of branch banking, was a robust system of small banks that either had a correspondent relationship with a money center bank or partial ownership. These banks were not unlike today's credit unions and were independent in their policies regarding loans and business relationship. They were very agile, as compared to today's monster banks with rigid procedures, and hamstrung managers, or worse yet buccaneer managers that are bonused on next quarter's loan production quotas.

The large branch banks are unmanageable and unable to deal with local needs and problems. They collapsed because of their detachment from risk, and inabilty to foster real local industrial and retail development instead of the faux housing and retail booms.

As for Volcker, he is completely responsible for the credit explosion. His push to higher interest rates, demise of usury bans, and rescue of the dollar in the face rising imports pushed wealth into money center monster banks, denuding the countryside of productivity and wealth.

I think that summarizes my regard for branch banking and Volcker.

Anonymous said...
"Of course, you can argue that banks long ago gave up their ability to assess credit risk. [ ... ] credit departments, in competition with securitization, decided that if you can't beat them, join them."

That's a fairly large misunderstanding of what went on. It is not that credit assessment became too expensive compared to securitization...

It is that it became too expensive compared to the cheap cost of money and the ability to buy AAA ratings for any loan. If you can borrow at 0% (Japan) or 1% (USA) before inflation, and your friendly rating agency gives AAA to any MBSes, how can you justify wasting money that could go to enrich your bonus on assessing borrowers?

Printfaster said...
Need to add one more point on the issue of branch banking.

One key point is that banning branch bank actually means less regulation of banking than more. By banning branch banking, banking excesses are self limiting to a small bank, and those failures can easily be covered by FDIC. With large branch banks, excesses require massive regulation and supervision, and massive insurance.

We can see that internal branch bank supervision is wholly inadequate. Federal supervision would need to be of such a massive scale, it would take the US Air Force and its personnel. Federal insurance is wiping out Federal finances today. Even all of FDIC is inadequate.

The only viable solution to managing bank excesses is not regulation, but limitation on banking reach, and overreach.

PS, two of the most profitable current large banks, Wells Fargo (formerly Northwest Bank), and US Bank (former First Bank) were bank holding companies in the Midwest.

Blissex said...
"the rapacious removal of wealth from farmers and small communities by large money center banks."

In Real America, losers' money is there for the taking...

"buccaneer managers that are bonused on next quarter's loan production quotas." the winners.

How does it feel for midwesterners to be the new Indians?

Those small farmers and communities have been in a depression for the past 20-30 years; the bonused managers are enjoying their early retirements in very comfortable wealth.

That comparison is all that matters in Real America. How many of those midwestern small farmers and communities have been voting steadfastly for the Republicans?

Blissex said...
"By banning branch banking, banking excesses are self limiting to a small bank,"

Sure, and mortages losses are always uncorrelated! The whole of Texas never had a simultaneous slump, and so on.

The S&L crisis was a totally random event, and the large percentage of small thrifts that went all busts at the same time was a statistical oddity, not because they were run by a herd of greedy idiots responding to the same perverse incentives in the same way...

If there are good reasons to prefer small banks to large ones they are that they are more efficient, and usually they have less political power, and less market power.

The Mess That Greenspan Made The Greenspan

WSJ op-ed

Yesterday's lonely defense of Federal Reserve actions during the gestation period of the largest asset and credit bubble in the planet's history by the man once called "The Maestro" seems to have gone over like a lead balloon if today's reactions are any indication.

Following the op-ed piece adamantly titled The Fed Didn't Cause the Housing Bubble, long-time critics again sharpened their pencils and did their best to encourage the former Fed chief to just fade away from the spotlight, a graceful exit now clearly out of the question.
Caroline Baum at Bloomberg offered up this commentary earlier today:

Even if one missed the headline ("The Fed Didn't Cause the Housing Bubble") and the byline (Alan Greenspan) on the op-ed in yesterday's Wall Street Journal, there could be no confusion over authorship: That "Master of Garblements" and former Federal Reserve chairman was back to defend his legacy.

Greenspan lays out his case that the Fed's easy money policies can't possibly be to blame for "the U.S. housing bubble that is at the core of today's financial mess." It is long-term interest rates that determine "the prices of long-lived assets," such as housing, he writes. And those rates, which stayed low as a result of a "global savings glut," are out of the Fed's control.

Yes, the well documented "conundrum" caused by millions of laborers coming down from the mountains in rural China that left the second most powerful man in the world powerless to prevent a housing boom from turning into what increasingly looks like another depression.

Putting a little meat onto the bones of yesterday's Alan Greenspan still hasn't got a clue when it comes to the argument of just how much long-term rates factored into the mid-decade housing mania, Caroline notes the following:
Banks and other mortgage lenders were happy to arbitrage the spread between the free money provided by the Fed and the rate they charged for an adjustable-rate mortgage. The share of ARMs as a percentage of total mortgage loans averaged 10 percent in 2001; by 2004, it was 32 percent, according to the Mortgage Bankers Association. The dollar volume swelled to more than 50 percent that year.

It was Greenspan who sang the praises of ARMs from his Fed pulpit in a Feb. 23, 2004, speech. American consumers "might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage," which may be "an expensive method of financing a home," he said.
There's much more over at Bloomberg, though the image conjured up by Northern Trust's Paul Kasriel of 'ol Greenie sitting down to read Charles Kindleberger's classic "Manias, Panics and Crashes" is beyond my ability to comprehend.

Tom Petruno consulted Ian Shephardson of High Frequency Economics in debunking the saving's glut/conundrum defense in an article at the LA Times today.
Shepherdson wrote:
"The single biggest driver of the recession today is the meltdown in the adjustable-rate mortgage market, and in particular the subprime adjustable-rate mortgage market. The explosive growth in that market is directly attributable to Fed policy.

"When the Fed cut to 1% in mid-2003 -- we said at the time it was an enormous mistake -- it pulled into the adjustable-rate mortgage market millions of people who liked the rates but did not understand the adjustable part of the deal."
Adjustable-rate loans typically were priced off short-term interest rates, including the one-year Treasury bill yield and the London Interbank Offered Rate, or LIBOR.

As housing bubble inflated, Shepherdson notes:

"Mr. Greenspan lauded lenders' 'innovations.' The number of subprime ARMs rose more than ninefold from late 2000 until the peak in mid-2007, with three-quarters of the increase coming between mid-2003 and mid-2005.

"The delinquency rate on these loans, by the way, now stands at 24.2% and it is still rising rapidly. Prime fixed-rate deliquencies are at 3.92%.

"Mr. Greenspan ought to have used the pages of the Journal to apologize to the nation. Instead, his piece will stand as a testament to his hubris, or perhaps his delusions."

Don't look for an apology anytime soon - the guy will probably go to his grave believing that he did nothing wrong.

History will not be kind.

Links to more reactions are provided below and, for those of you who might be interested, more are likely to appear at this Alan Greenspan News website.

Greenspan: Fed could not have stopped US housing bubble - Telegraph
Who's to Blame for the Economy? The Fed
Greenspan: Fed Not to Blame for Recession - Fox News
Greenspan's Denial - The Big Picture
Alan Greenspan: "Don't Blame Me" - Baltimore City Paper
Greenspan Yet Again Blames Others for Housing Bubble - Seeking Alpha
Greenspan Responds to My Blog Post on the Financial Crisis - US News

If anyone comes across any positive reactions, please leave a note in the comments section.

[Mar 12, 2009] Class Warfare?

March 12, 2009

John Berry:

If Tax-Cut Lapsing Is Class Warfare, Let's Fight, by John M. Berry, Commentary, Bloomberg: If letting top income-tax rates go back to where they were in 2000 is class warfare against the rich, I'm ready to snap to attention with my old M1 rifle on my shoulder.

What a ridiculous label, class warfare. It's hardly aggression against any class to have a progressive income-tax system in which fairness and ability to pay are important considerations in setting rates for different income groups.

As far as the top tax rates are concerned,... The law already calls for today's 33 percent rate to go to 36 percent and the 35 percent rate to rise to 39.6 percent, in 2011.

Why did a Republican Congress and President George W. Bush countenance the 2011 expiration dates in the 2001 tax-cut bill? It was one of several deceitful provisions that made rate reductions temporary to hold down estimates of revenue loss. Of course, the GOP intended all along to make the rate cuts permanent.

Obama would let the Bush rate cuts expire only for couples with incomes above $250,000 ... and raise the rates for them on capital gains and dividends to 20 percent from 15 percent.

Unfair? I don't think so, given these earners' relatively greater ability to bear the added burden. There's no doubt that a larger share of the nation's income has become concentrated at the very top of the distribution.

The extra revenue would be used to help finance the government's necessary role in dealing with the dangers of climate change and improving access to health care and control of its costs. ...

The Obama plan would give most taxpayers small reductions in tax liabilities...

When Clinton proposed raising the top rates to 36 percent and 39.6 percent in 1993, there were plenty of predictions that the higher marginal rates would hurt Americans' willingness to work and invest. Some economists argued that so many people would opt for leisure instead of work that the higher rates would raise no additional revenue.

Instead, a boom ensued in the latter 1990s... What did Bush's lower rates produce? Mediocre growth, very large deficits and financial-market manipulation.

The reality is that tax rates aren't nearly as powerful a force as some people think they are. ...

Dave says...

I would have thought a better definition of "class warfare" was putting $700 bn into the pockets of bankers and their equity-holders, not to mention the untold billions paid in undeserved "performance bonuses" over the last ten or more years.

Class warfare is alive all right - perpetrated by society's wealthiest echelon on the common man.

hari says...

American politics is still hiding its head in the sand behind egregious ideological pretense - in an age of post-industrial global developments - forgetting what equity and fairness mean in terms of social policy.

In Europe we've passed that stage of (infantile) political pretense and foolishness because class warfare is no longer a political solution going forward in a globalized world.

VAT is universal form of consumption tax (15-19%). Taxation is progressive by objective social-economic criteria in a national political economy - more or less imitating progressive Scandinavian social politics and trends.

Me thinks, although US is still +200 yrs old and getting morbidly moderate, historical trend lines indicate US will eventually duplicate OECD/European macroeconomic developments and social policy.

reason says...

Republican war on science? How about the even more dangerous Republican war on language?

James Kroeger says...

This is actually kind of amusing. Class warfare has been waged continuously over the past 30 years by wealthy Republicans with little response from the lower classes they've victimized. They don't even realize it, but they are guilty of investing themselves in collectivist schemes that seek to improve the welfare of all affluent individuals in utter defiance of market realities:

Perhaps now it is easier to see the folly of Collectivist Schemes. What kind of schemes are we talking about? Well, there's the "everybody needs a tax cut" ploy. What happens if all taxpayers receive an income tax cut [in a way that preserves all taxpayers' rankings within the hierarchy of disposable income distribution]? Answer: none of them experiences any real gain in purchasing power. We can be certain that prices will rise in the marketplace until all of the extra 'purchasing power' is nullified (because sellers can always be counted on to charge whatever prices the markets will bear).

Likewise, it is also true that increasing the income tax obligations of all citizens in a way that preserves each taxpayer's ranking within the hierarchy of disposable income distribution ensures that none of them experiences any real loss in purchasing power. Prices will drop until all citizens can afford what they would have been able to afford if they had not had to pay more in taxes. The Progressive Income Tax is widely misunderstood today because people do not realize that it collects money from taxpayers in a way that ensures that each is spared the decline in purchasing power she would otherwise have experienced if only she had paid the tax.

Another example of collectivist folly is the legislation passed by Congress that seeks to help all businesses by reducing their costs. If all firms benefit from the same kind of government-sponsored cost reduction (like a tax cut), then none of them ultimately benefits. A firm can increase its market share only by obtaining more disposable cash than its competitors. If all firms experience the same gain in profits, then prices in asset/resource markets will simply be bid up until the "gain" that every firm received is wiped out. In business, the only way it is really possible to get ahead in a competitive environment is by cutting your costs more than your competitors.

Likewise, when government edicts force an increase in costs on all firms, they are all spared the hurt that each of them would have experienced if only they had been forced to absorb the cost. For example, we know that if/when an individual firm gives all of its employees an extra week of paid vacation, its costs increase in a way that could put it at a competitive disadvantage. But if all firms are forced to give all of their employees an extra week of paid vacation, then none of them is actually hurt by the requirement. Either (1) they will all be able to pass on the extra cost to their customers or (2) they will all have to accept lower profits. In the latter case none of them would lose out because all would be experiencing the same drop in net profits, which means price levels in resource markets would drop to levels they could afford.

Business owners in a market economy need to focus on two things if they want to optimize their "Real Wealth enjoyment": (1) They must optimize society's overall productive output generally, while (2) seeking also to minimize their own costs (maximize their own disposable incomes) vis-à-vis their rich peers/competitors. If they seek instead to increase the disposable incomes of all rich people in a way that does not directly help to eliminate unemployment, then they reveal themselves to be deluded fools who end up victimizing themselves as well as others through their ineptitude.

Yes, I would never criticize a rich person for being Smart Selfish, but only for being a Stupid Selfish Republican

sewells says...

Class warfare is mainly accomplished by people pulling the levers of government power to favor particular interests. Bush 43, for instance, abused the power of imminent domain to screw a family farmer to get the land for his ballpark. He didn't have money of his own to speak of before that. Regular welfare, so often the object of contempt and revulsion on the part of the well-off pales in comparison to the corporate welfare that is doled out on a regular basis. Collectivize losses and privatize profits seems to be the order of the day.

It seems axiomatic to me that the more powerful government becomes the more of this that will go on. It's the basic freeloader problem. People gaming the system reap concentrated benefits and those screwed experience diffused losses. The people gaming the system will always have higher motivation to game than the screwed will have to resist right up to the point that the whole system comes crashing down.

Beezer says...

Class warfare? That battle's been long lost. The rich won.

Unfortunately, it will turn out to be a very bitter victory because as the pendulum swings in reaction to basic unfairness, the real warfare will return with a vengeance and all will suffer. Rich and poor.

Life is dynamic and complicated, but the concepts of virtue and honesty aren't. We all need to take a step back and undergo an "attitude adjustment" about what's truly important in life.

From my little, unimportant seat in life, I see Obama as someone who has strong beliefs about virtue and honesty, but needs a little more experience. Fortunately, I'm pretty certain he's a quick learner

bakho says...

Nate Silver has some great charts showing the changes in who pays the top rate over time. He asks what happened to the $ Million tax bracket?

eightnine2718281828mu5 says...

The left claims that economic mobility isn't what it used to be, and complain about the fairness of a system that locks people in place based on their birth status. The right claims that this is nonsense; that economic mobility is alive and well in the US.

Well, let's take the right at their word. I propose that we increase taxes on high income individuals (income taxes, payroll taxes, social security taxes) and lower them for the low income individuals since the right claims that these are just the same folks at different periods of their lives. It therefore all balances out since a single individual gets the benefits of low taxes early in life, which allows them to accumulate capital quickly so as to be more productive and engage in risk taking/wealth-generating activities earlier than they would otherwise.

And later, when they are reaping the benefits of their accumulated wealth, we raise their taxes so that we can extend the same courtesy to those coming up the ladder behind them.

If there is true mobility, no one should complain since they reap the benefit at one stage of their life and pay the costs at a later stage of life.

[Mar 12, 2009] Bank Failures and C&D Loans

Calculated Risk

"Everyone in the media is focused on consumer foreclosures," said Ivy Zelman, a housing analyst at Zelman & Associates. "What they're not focused on is the builder-developer foreclosures, which are only in the early innings and which will continue to wreak havoc as these assets are liquidated at depressed prices. Until they are cleared, there can't be a stabilization in home prices."

Rob Dawg says:

Thus starts the negative feedback loop as failed CRE projects are resold at firesale prices stressing any other properties in a a glutted market.

Rob Dawg says:

Some of these projects I read are applying for stimulus money. I'll finds a link. The argument here is that they will create retail jobs. YAY

The Charlie Rose interview was fascinating in that it revealed the basic assumption of the current administration: Preserve the existing system.

The current system is broken. They are advocating the retention of dysfunction. Not "fix," not "change," not "replace." Rather "preserve." The Rolling Stones had a song "19th [1920s] Breakdown" that talked about the same thing. How did that work out?

Dust Bowling for Dollars says:

I second that this is an outstanding CR post. When this s blows up the recovery in 2H09 it will take everyone by surprise... except the CR faithful.

Jas says:

very good read... The Looting of America's Coffers

"Sixteen years ago, two economists published a research paper with a delightfully simple title: "Looting… "The investors displayed a "total disregard for even the most basic principles of lending," failing to verify standard information about their borrowers or, in some cases, even to ask for that information. The investors "acted as if future losses were somebody else's problem," the economists wrote."

Amazing! For five years I was warning about "the System of the Crooks, by the Crooks, and for the Crooks."

Manhattan is a breeding ground for fraud. Evildoers like Greenspan, Rubin, Summers, Paulson and Bernanke, as Fed Chairman and Treasury Secretary, were simply looking the other way because they wanted the looting to go on for the simple reason that they were, and still are, agents of what I had called, in 2003, Bankrupters and Fraudsters of New York City.

These people were "raised in a culture of fraud" and until that culture is exterminated there will be no economic prosperity in America again. Unfortunately, democracy is not unto the task and some form of dictatorial regime, even first elected democratically, not unlike Hitler, will take on these perennial Crooks and parasites.

Also, for eleven years I have been warning about "It is the debt, Stupid!" Jas

Greenspan's Denial By Peter Boockvar

March 11th, 2009

Since I've been critical of the unstable monetary policy of Greenspan, Bernanke and the Fed for many years, I can't help myself but to respond to Greenspan's editorial today in the Wall St Journal, where he pleads 'not guilty' for causing the housing bubble. His main thesis being that since he only controlled the fed funds rate, he had little influence on longer term rates which are directly correlated to mortgage rates and it was the "decline in long term interest rates across a wide spectrum of countries" that was the "most likely major cause of…the global housing price bubble." He specifically points out 'global' to further distance himself from what the Fed specifically did.

What the Fed did under his stewardship and with great influence from Bernanke in response to the 2001-2002 recession was cut rates from 6.5% in Dec '00 to 1% in June '03 and left them there for one year even as the economy was averaging 4% growth (including 7.5% in Q3 '03 alone) before raising rates in June '04 to 5.25% over time through June '06. The 1% rate was predicated on the belief that deflationary pressures were strong and thus gave the Fed leeway to be extremely accommodative with its policy. This deflation forecast which reached its pinnacle in mid '03 was in the face of the CRB index having already rallied by 26% off its Oct '01 lows. The 10 yr bond yield began its fall in Dec '00 from over 5% to a low of 3.17% in June '03 and the average 30 year mortgage rate fell from over 7% to below 5%. It was this that set the stage for the housing bubble in addition to the artificially low rates that penalized savings and resulted in an unprecedented binge of US spending that perpetuated the boom and enhanced the wealth effect that further exaggerated the bubble.

Lever up was Greenspan's goal for the rest of us.

The more goods Americans bought from overseas where the US trade deficit exploded, the more foreign money was parked in US Treasuries. In addition, Greenspan's debasement of the US$ with his rate cuts in combination with the export led growth in China, India, etc.., where the US consumer became 20% of global GDP, led to the rise in commodity prices which buoyed all commodity producing nations, who then parked more money in US Treasuries, thus keeping a lid on longer term interest rates even in the face of the Fed raising rates beginning in June '04 and thus giving the housing market further rope. Foreign holdings of US Treasuries rose 21% in '04 and 23% in '05.

The point being is that the seeds of the bubble were planted way before the extremes in '06 and '07 and longer term rates remained contained due to the 'savings glut' that the US consumer helped to put in the hands of overseas investors through more borrowing and spending who in turn parked it back in the US. The global search for yield began with artificially low short term rates induced by the Fed and resulted in a massive misallocation of capital through more and more risk and higher and higher leverage that of course blew up and foreign banks and consumers couldn't help themselves either as trade and credit became more globalized. With credit (booze) free flowing, many abused it and did stupid things but it was Greenspan and Co that brought the excess credit (booze) to the party.

The Fed Didn't Cause the Housing Bubble
WSJ, MARCH 11, 2009

Now is the time for a less selfish capitalism By Richard Layard

March 11 2009 |

What is progress? The Organisation for Economic Co-operation and Development has been asking this question for some time and the current crisis makes it imperative to find an answer. According to the Anglo-Saxon Enlightenment, progress means the reduction of misery and the increase of happiness. It does not mean wealth creation or innovation, which are sometimes useful instruments but never the final goal. So we should stop the worship of money and create a more humane society where the quality of human experience is the criterion. Provided we pay ourselves in line with our productivity, we can choose whatever lifestyle is best for our quality of life.

And what would that involve? The starting point is that, despite massive wealth creation, happiness has not risen since the 1950s in the US or Britain or (over a shorter period) in western Germany. No researcher questions these facts. So accelerated economic growth is not a goal for which we should make large sacrifices. In particular, we should not sacrifice the most important source of happiness, which is the quality of human relationships – at home, at work and in the community. We have sacrificed too many of these in the name of efficiency and productivity growth.

Most of all we have sacrificed our values. In the 1960s, 60 per cent of adults said they believed "most people can be trusted". Today the figure is 30 per cent, in both Britain and the US. The fall in trustworthy behaviour is clear in the banking sector but can also be seen in family life (more break-ups), in the playground (fewer friends you can trust) and in the workplace (growing competition between colleagues).

Increasingly, we treat private interest as the only motivation on which we can rely and competition between individuals as the way to get the most out of them. This is often counterproductive and does not generally produce a happy workplace since competition for status is a zero-sum game. Instead, we need a society based on positive-sum activities. Humans are a mix of selfishness and altruism but generally feel better working to help each other rather than to do each other down.

Our society has become too individualistic, with too much rivalry and not enough common purpose. We idolise success and status and thus undermine our mutual respect. But countries vary in this regard, and the Scandinavians have managed to combine effective economies with much greater equality and mutual respect. They have the greatest levels of trust (and happiness) of any countries in the world.

To build a society based on trust we have to start in school, if not earlier. Children should learn that the noblest life is the one that produces the least misery and the most happiness in the world. This rule should apply also in business and professional life. People should do work that is useful to society and does not just make paper profits. And all professions – including journalism, advertising and business – should have a clear, professional, ethical code that its members are required to observe. It is not for nothing that doctors form the group most respected in our society – they have a code that is enforced and everyone knows it.

So we need a trend away from excessive individualism and towards greater social responsibility. Is it possible to reverse a cultural trend in this way? It has happened before, in the early 19th century. For the next 150 years there was a growth of social responsibility, followed by a decline in the next 50. So a trend can change and it is often in bad times (such as the 1930s in Scandinavia) that people decide to seek a more co-operative lifestyle.

I have written a book about how to do this and there is room here for three points only. First we should use our schools to promote a better value system – the recent Good Childhood report sponsored by the UK Children's Society was full of ideas about how to do this. Second, adults should reappraise their priorities about what is important. Recent events are likely to encourage this and modern happiness research can help find answers. Third, economists should adopt a more realistic model of what makes humans happy and what makes markets function.

Three ideas taught in business schools have much to answer for. One is the theory of "efficient capital markets", now clearly discredited. The second is "principal agent" theory, which says the agents will perform best under high-powered financial incentives to align their interests with those of the principal. This has led to excessive performance-related pay, which has often undermined the motive to work well for the sake of doing a good job and introduced unnecessary tension among colleagues. Finally, there is the macho philosophy of "continuous change", promoted by self-interested consulting companies, which disregards the fundamental human need for stability – in the name of efficiency gains that are often not realised.

We do not want communism – as research shows, the communist countries were the least happy in the world and also inefficient. But we do need a more humane brand of capitalism, based not only on better regulation but on better values.

Values matter and they are affected by our theories. We do not need a society based on Darwinian competition between individuals. Beyond subsistence, the best experience any society can provide is the feeling that other people are on your side. That is the kind of capitalism we want.

Lord Layard is at the London School of Economics Centre for Economic Performance. He has written 'Happiness' (2005) and co-authored 'A Good Childhood' (2009)

Cuomo Asserts That Traders Looted Merrill

naked capitalism

The latest wrinkle, which generated a flurry of press reports, was that Cuomo had taken a new tack, charging that Merrill had misled Congress as to when the payments would be made. But for my money, the juiciest bit came at the end in the New York Times story:

Mr. Cuomo claimed that Merrill traders had mismarked their books as of early December in an effort to get higher bonuses.

"It appears that some of these losses may have been booked by Merrill employees who marked down their portfolios only after their 2008 bonuses were set," the attorney general wrote in the filing. "Despite the gargantuan unexpected losses, Merrill did not reconsider its bonus awards" and Bank of America did not request or demand that Merrill reduce its bonus pool, he wrote.

This is a particularly strong and damaging claim. I've read repeatedly of people who worked with traders saying that they would engage in strategies (not clearly described) that would lead them to show high profits though year end that they would wind up giving back (and often more) early in the next year. The idea was that they'd make so much on their trumped up performance that it didn't matter if they were fired next year. But a lot of types of behavior could produce this result, so it's hard to know what sort of trader chicanery was afoot. And without names, or descriptions of the nefarious deeds, its too vague to treat as substantiated.

But here, if Cuomo is correct, we have what amounts to fraud, and brazen to boot. And the exaggerated profits would also seem to be a books and records violation for senior management.

This could get very interesting. The investigations are finally getting to where the rubber hits the road.

Selelcted comments

Anonymous said...
We used to catch traders booking 'hedge' deals with variable spreads to take advantage of subtle distortions they had entered in market data.

When the market data was corrected (often something obscure like a 3D vol surface skew or SABR parameter) the P/L on their books would disappear like tax money in the hands of Hank Paulson.

Ken Lewis should be fired for getting snookered by one of the oldest tricks in the books.

sk said...
This provides dramatic evidence for that research piece on the looting type of behavior that occurs in these circumstances - by Akerlof and Romer that you've highlighted in your blog a few times.
Anonymous said...
"I've read repeatedly of people who worked with traders saying that they would engage in strategies (not clearly described) that would lead them to show high profits though year end that they would wind up giving back (and often more) early in the next year. The idea was that they'd make so much on their trumped up performance that it didn't matter if they were fired next year."

Frank Partnoy ex trader and now a law professor at the University of San Diego had these very tactics in his book FIASCO (1999). As a trader, he helped to put together "securities" that would book quick profits for Japanese fund managers but would blow up later on. All the managers cared about was the year end bonuses, knowing they would be moving on probably to other jobs in the next year.

FIASCO illustrated many of the Wall Street abuses that led to this Crash and Burn. But we kill the Canaries rather than listen to them.

Boat52 said...
We can only hope that Cuomo is cleaner than clean and that the dark force doesn't try to unseat him before victory.

Never before in history have so few taken so much from so many in such a short period of time.

Anonymous said...
This is Cuomo as Claude Raines in Casablanca - shocked to find traders mismarking their positions. Such reliable features of human nature are the reason internal control procedures were established.
The clear target here should be Ken Lewis - he struck a bad deal that failed to protect his shareholders at the time, as well as his future shareholders the American taxpayer.
By all means fire the traders for being dirtbags, and strip them of their illegitimate bonuses. But however wrong individual positions may have been, the failure to focus on the relevant details of an M&A deal that was done on the fly over a weekend is the true criminal act here.

[Mar 11, 2009] Tax Cuts and Work Effort across Income Levels

A revenue neutral change that makes taxes more progressive increases work effort. That is, when taxes on the middle class go down by a dollar and taxes on the wealthy go up by a dollar, the increase in work effort by middle class workers more than offsets and fall in work effort by the wealthy:

So, based on my research, if a need to raise some revenue means tax rates have to be increased for someone, raising them on the wealthiest will result in a smaller reduction in work effort than raising tax rates on the middle class.

That's Julie Hotchkiss reporting on her research in macroblog. There is a catch:

An additional relevant question remains: What is the implication of changing work effort for GDP growth? The relationship between work effort and value of output is not necessarily the same across income levels. In other words, one hour of high-income (higher education) labor is expected to yield a higher value of output in the economy than one hour of labor from a middle-income (lower education) worker. A complete analysis of the aggregate impact of the administration's tax plan would have to also take this into account.

However, the effect on growth is only one metric by which to judge this policy, e.g. the benefits to the household that come from one more hour of work may also differ across income levels, particularly if the additional money is used to buy necessities in one case, and luxuries in the other.

Posted by Mark Thoma on Wednesday, March 11, 2009 at 10:08 AM

Greenspan: The Fed Didn't Do It

Alan Greenspan takes on John Taylor's claim that the Fed caused the housing bubble, and he warns against "micromanagement by government" regulators. Greenspan says the Fed couldn't have caused the housing bubble because it lost control over long-term interest rates once financial markets became globalized, and those were the rates that caused the problem:

The Fed Didn't Cause the Housing Bubble, by Alan Greenspan, Commentary, WSJ: ...The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier...

[T]he presumptive cause of the world-wide decline in long-term rates was the ... surge in growth in China and a large number of other emerging market economies that led to an excess of global ... savings... That ... propelled global long-term interest rates progressively lower between early 2000 and 2005.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of ... the global housing price bubble. ... I would have thought that ... such evidence would lead to wide support for ... a global explanation of the current crisis.

However, starting in mid-2007, history began to be rewritten, in large part by ... John Taylor... Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust." This notion has ... taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical ... analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover,... the "Taylor Rule" ... parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight. Given the decoupling of monetary policy from long-term mortgage rates,... the Fed ... could not have "prevented" the housing bubble. ...

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

However, the appropriate policy response is not ... heavy regulation. That would stifle important advances in finance that enhance standards of living. ... The solutions for the financial-market failures ... are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities. ... Adequate capital and collateral requirements ... will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management..., while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

We seem to have a disagreement on the scope of regulation. Ben Bernanke:

Bernanke Calls for Broader Regulations, WSJ: Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets... Among his recommendations were tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily. ...

The recommendations were largely consistent with measures being pushed by House Financial Services Committee Chairman Barney Frank (D., Mass.), who is expected to be a key architect of the new financial regulation. ...

Mr. Bernanke ... also pushed for much tougher policies over ... big companies. "Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management and financial condition, and be held to high capital and liquidity standards," Mr. Bernanke said. ...

I'm in agreement with Greenspan's response to Taylor to the extent that following the Taylor rule wouldn't have stopped the crisis, but I think the low interest rate policy pursued by the Fed is part of the story and served to magnify other factors. As for regulation, relying mainly upon enhanced capital requirements as Greenspan proposes isn't enough, so I'm at least where Bernanke with respect to close supervisory oversight of firms who pose a systemic risk. But I'd go even further and - to the extent possible - break up the firms into smaller entities and sever their interconnections until they no longer posed a threat to begin with. This is harder than it sounds, or so I'm told, but I'd still pursue the option.

Selected Comments
Anonymous said...
Obama will dally,
Obama will dither,
As the gullible submit plans,
While their bank accounts wither ...

When are all the marks living in la la land going to wake up and realize that tendering remedial plans to a disingenuous non responsive government that has been hijacked by the wealthy elite golden collar crowd is a waste of precious time.

Who do you think is listening? These wasted efforts are beginning to look like the ignored baby tantrum - just crying and whining in the crib.

The 'rule of law' in scamerica is a selectively enforced farce that is owned and controlled by the gangsters that bought it from the crooked politicians.

It is the middle class bubble that is intentionally being popped right now as we speak. And there are other rationales for this intentionally created crisis, and darker forces at work, that need investigative attention.

Stop crying and start roaring! Start planning the demonstrations, protests and the new banker-less America that will return money to its basic utility function and provide a level competitive playing field. Shun the corrupt system and its sell out twits that got us all here. Be more skeptical!

Deception is the most powerful political force on the planet.

i on the ball patriot

[Mar 11, 2009] Banks Counted on Looting America's Coffers By DAVID LEONHARDT

The economists were George Akerlof, who would later win a Nobel Prize, and Paul Romer, the renowned expert on economic growth. In the paper, they argued that several financial crises in the 1980s, like the Texas real estate bust, had been the result of private investors taking advantage of the government. The investors had borrowed huge amounts of money, made big profits when times were good and then left the government holding the bag for their eventual (and predictable) losses.

In a word, the investors looted. Someone trying to make an honest profit, Professors Akerlof and Romer said, would have operated in a completely different manner. The investors displayed a "total disregard for even the most basic principles of lending," failing to verify standard information about their borrowers or, in some cases, even to ask for that information.

The investors "acted as if future losses were somebody else's problem," the economists wrote. "They were right."

On Tuesday morning in Washington, Ben Bernanke, the Federal Reserve chairman, gave a speech that read like a sad coda to the "Looting" paper. Because the government is unwilling to let big, interconnected financial firms fail - and because people at those firms knew it - they engaged in what Mr. Bernanke called "excessive risk-taking." To prevent such problems in the future, he called for tougher regulation.

Now, it would have been nice if the Fed had shown some of this regulatory zeal before the worst financial crisis since the Great Depression. But that day has passed. So people are rightly starting to think about building a new, less vulnerable financial system.

And "Looting" provides a really useful framework. The paper's message is that the promise of government bailouts isn't merely one aspect of the problem. It is the core problem.

Promised bailouts mean that anyone lending money to Wall Street - ranging from small-time savers like you and me to the Chinese government - doesn't have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today's crisis look tame.

But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters - savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade - can then act as if their future losses are indeed somebody else's problem.

Do you remember the mea culpa that Alan Greenspan, Mr. Bernanke's predecessor, delivered on Capitol Hill last fall? He said that he was "in a state of shocked disbelief" that "the self-interest" of Wall Street bankers hadn't prevented this mess.

He shouldn't have been. The looting theory explains why his laissez-faire theory didn't hold up. The bankers were acting in their self-interest, after all.

The term that's used to describe this general problem, of course, is moral hazard. When people are protected from the consequences of risky behavior, they behave in a pretty risky fashion. Bankers can make long-shot investments, knowing that they will keep the profits if they succeed, while the taxpayers will cover the losses.

This form of moral hazard - when profits are privatized and losses are socialized - certainly played a role in creating the current mess. But when I spoke with Mr. Romer on Tuesday, he was careful to make a distinction between classic moral hazard and looting. It's an important distinction.

With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government's involvement is crucial to the whole enterprise.

Think about the so-called liars' loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has reported, Merrill Lynch's losses from the last two years wiped out its profits from the previous decade.

What happened? Banks borrowed money from lenders around the world. The bankers then kept a big chunk of that money for themselves, calling it "management fees" or "performance bonuses." Once the investments were exposed as hopeless, the lenders - ordinary savers, foreign countries, other banks, you name it - were repaid with government bailouts.

In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.

I understand this chain of events sounds a bit like a conspiracy. And in some cases, it surely was. Some A.I.G. employees, to take one example, had to have understood what their credit derivative division in London was doing. But more innocent optimism probably played a role, too. The human mind has a tremendous ability to rationalize, and the possibility of making millions of dollars invites some hard-core rationalization.

Either way, the bottom line is the same: given an incentive to loot, Wall Street did so. "If you think of the financial system as a whole," Mr. Romer said, "it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury."

Unfortunately, we can't very well stop the flow of that money now. The bankers have already walked away with their profits (though many more of them deserve a subpoena to a Congressional hearing room). Allowing A.I.G. to collapse, out of spite, could cause a financial shock bigger than the one that followed the collapse of Lehman Brothers. Modern economies can't function without credit, which means the financial system needs to be bailed out.

But the future also requires the kind of overhaul that Mr. Bernanke has begun to sketch out. Firms will have to be monitored much more seriously than they were during the Greenspan era. They can't be allowed to shop around for the regulatory agency that least understands what they're doing. The biggest Wall Street paydays should be held in escrow until it's clear they weren't based on fictional profits.

Above all, as Mr. Romer says, the federal government needs the power and the will to take over a firm as soon as its potential losses exceed its assets. Anything short of that is an invitation to loot.

Mr. Bernanke actually took a step in this direction on Tuesday. He said the government "needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm." In layman's terms, he was asking for a clearer legal path to nationalization.

At a time like this, when trust in financial markets is so scant, it may be hard to imagine that looting will ever be a problem again. But it will be. If we don't get rid of the incentive to loot, the only question is what form the next round of looting will take.

Mr. Akerlof and Mr. Romer finished writing their paper in the early 1990s, when the economy was still suffering a hangover from the excesses of the 1980s. But Mr. Akerlof told Mr. Romer - a skeptical Mr. Romer, as he acknowledged with a laugh on Tuesday - that the next candidate for looting already seemed to be taking shape.

It was an obscure little market called credit derivatives.

[Mar 10, 2009] Willem Buiter Strikes Again, Calls for Over-Regulation of Banks

In case readers haven't figured it out, I am a big Willem Buiter fan. Even when he is wrong, he is at least forthright and colorful. He does have an appetite for showing off his formidable intellect. Nevertheless, his best qualities are his willingness to take on orthodoxies and authorities, and his vivid, trenchant style. It was Buiter who at the last Jackson Hole conference accused the Fed of "cognitive regulatory capture," eliciting a firestorm of criticism.

Today Buiter takes up one of my favorite causes: the need to leash and collar bankers. He dismisses the canard so often trotted out in the US, that too many restraints might inhibit financial innovation. Paul Volcker deemed the most important financial innovation in the last 30 years to be the ATM machine. Nassim Nicolas Taleb has dismissed the supposed advantages conferred by the development of the Black-Scholes option pricing model.

Given the considerable costs gambling innovation hath wrought, the calls to shackle bankers seem completely warranted. If any other class had done this much damage, they'd almost certainly be in jail.

Note the timing of this post. This is pre the G-20, where the Euro crowd is pushing for more financial regulation, particularly with new international mechanisms, while the US is arguing for more coordinated fiscal stimulus. The US does not want to (and won't as long as the dollar holds as reserve currency) cede control over its institutions. But a good deal more "harmonisation" and coordination is in order.

Buiter provides a long list of reform ideas. I've extracted the ones I found most interesting, and I encourage readers to look at the full roster. Be sure to read his comments on self regulation.

From VoxEU:

Financial regulation is a now-or-never proposition as the sector's lobbying power is greatly diminished. This column argues that we should embrace robust regulation now, risking over-regulation. Correcting mistakes later would be better than risking another era of "self-" or "soft-touch" regulation.

Over-regulate now

It is necessary, for political economy reasons, to rush new comprehensive regulation of the financial sector. While it would be better, holding constant the likelihood of the measures being adopted and implemented, not to act in haste, there is now a unique window of opportunity – a period of extraordinary politics, in the words of Balcerowicz – to actually get the thorough regulatory reform we need. The reason is that the private financial sector is on its uppers – down and out – and will not be able to put together much of a fight, let alone its usual boom-time massive lobbying effort to veto radical measures. It is better to over-regulate now and subsequently correct the mistakes than to risk another era of self-regulation and soft-touch under-regulation of financial markets, instruments and institutions.

Macro-prudential regulation
The objective of macro-prudential regulation is systemic financial stability. This has a number of dimensions:
Preventing or mitigating asset market and credit booms, bubbles and busts
Preventing or mitigating market illiquidity in systemically important markets
Preventing or mitigating funding illiquidity for systemically important financial institutions
Preventing or managing insolvencies of systemically important financial institutions

Other micro-prudential considerations (abuse of monopoly power; consumer protection; micro-manifestations of asymmetric information) should be left to the micro-prudential regulator(s).

Comprehensive regulation
Regulation will have to be comprehensive across instruments, institutions, markets and countries. Specifically, we must:

egulate all systemically important highly leveraged financial enterprises, whatever they call themselves: commercial bank, investment bank, universal bank, hedge fund, SIV, CDO, private equity fund or bicycle repair shop.
Regulate all markets for systemically important financial instruments.
Regulate all systemically important financial infrastructure or plumbing: payment, clearing, settlement systems, mechanisms and platforms, and the associated provision of custodial services.
Do it all on a cross-border basis.


Self-regulation is to regulation as self-importance is to importance. The notion that markets, including financial markets could be self-regulating, by properly incentivising CEOs and Boards of Directors and through market-discipline, is prima facie suspect. We decide to regulate markets because of market failure. Then we let the market regulate the market. This is an invisible hand too far. The concept of self-regulation is especially ludicrous for financial markets. Finance is trade in promises expressed in units of abstract purchasing power (money). It scales up and down ferociously quickly. If Airbus or Boeing wishes to double the size of its operations, it takes 4 or 5 years to put in place another set of assembly lines. If a bank wishes to scale its balance sheet and operations ten-fold, all it has to do is to add a zero in the right places. Given enough optimism, trust, confidence and self-confidence, financial activity can, through leverage, be scaled up alarmingly quickly. Once optimism, trust, confidence and self-confidence disappear and are replaced by pessimism, mistrust, lack of confidence and fear/panic, the scaling down of bank activities can occur even faster. Such an industry cannot be left to its own devices.

The importance of public information

Regulation can only take place on the basis of independently verifiable (public) information. Regulators cannot rely on information that is private to the regulated entity. This means that the capital adequacy of the first pillar of Basel II has to be overhauled radically, as its risk-weighting of assets relies in part on internal bank models that are private to the banks...

Regulation financial innovation

Financial innovation in products and institutions is potentially beneficial and potentially harmful. There is a need to regulate financial innovation. I propose the model used in the US by the Food and Drug Administration for pharmaceutical and medical products.

First, there is a positive list of financial instruments and institutions. Anything that is not explicitly allowed is forbidden.
To get a new instrument or new institution approved, there will have to be testing, scrutiny by regulators, supervisors, academic specialists and other interested parties, and pilot projects. It is possible that, once a new instrument or institution has been approved, it is only available 'with a prescription'. For instance, only professional counterparties rather than the general public could be permitted.....

Clearly, this approach to financial innovation would slow down financial innovation. It may even kill off certain innovations that would have been socially useful. So be it. The dangers of unbridled financial innovation are too manifest.

Yves here. The FDA has recently come under a lot of criticism (deservedly) but that is due in large measure to a lack of commitment to its mandate from deregulation-minded Administrations, budget cuts, and its conflicted position (40%+ of its budget comes from fees paid by the industry for new drug applications, an arrangement created during the Bush Senior presidency. Too high a turndown rate would deter applications. The problems with the FDA are due to a significant degree to nearly 20 years of efforts to undermine its role. And that is not my just my view; I've heard this sort of thing from FDA lawyers and former FDA commissioners). Back to Buiter:
Narrow banking vs. investment banking

The distinction between public utility banking/narrow banking vs. investment banking; (the rest) has to be re-introduced. I advocate a form of Glass-Steagall on steroids, with a heavily regulated and closely supervised narrow banking sector, engaged in commercial banking (taking deposits and making loans) and benefiting from lender of last resort and market maker of last resort support. The investment bank sector will also be regulated and supervised, but more lightly, and according to the same principles as other systemically important highly leveraged non-narrow bank institutions.

Universal banking has few if any efficiency advantages and many disadvantages. Economies of scale and scope in banking are soon exhausted. They tend to be fat to fail, have a lack of focus, and suffer from span-of-control negative synergies etc. Universal banks or financial supermarkets use their size to exploit market power and try to shelter their risky, non-narrow banking activities under the LLR and MMLR umbrella of the narrow bank that's hiding somewhere inside the universal bank....

Mixed public-private ownership

Given the manifest failure of the efficient market hypothesis, it is not at all obvious that systemically important financial institutions should be allowed to be listed companies. Financial institutions' stock market valuations have been notorious will-o'-the wisps and have, through stock options and other stock-market valuation-related executive remuneration components, contributed to the excessive risk taking during the recent boom. Partnerships, mutual ownership, cooperative ownership, and various forms of public and mixed public-private ownership may be more appropriate for financial institutions. Perhaps we should even consider removing limited liability for investment banks!

[Mar 9, 2009] Wolfgang Munchau Abandon All Hope.....

naked capitalism
OT, but super cool stuff:
The World According to Brooksley Born

Less than six months after she became the seventh Chairperson of the Commodity Futures Trading Commission, Brooksley Born discovered that a number of powerful congressmen wanted to dramatically limit her power to regulate the futures markets. The most controversial aspect of the new legislation sponsored by Senator Richard Lugar and others-and supported by the Chicago exchanges-is a proposal that would allow the exchanges to create "professional markets" that would be free of federal regulation.... great stuff!

This is so good and so off topic, but has to be shared as much as possible:

In 1997, Brooksley Born warned in congressional testimony that unregulated trading in derivatives could "threaten our regulated markets or, indeed, our economy without any federal agency knowing about it. " Born called for greater transparency--disclosure of trades and reserves as a buffer against losses.

Instead of heeding this oracle's warnings, Greenspan, Rubin & Summers rushed to silence her. As the Times story reveals, Born's wise warnings "incited fierce opposition" from Greenspan and Rubin who "concluded that merely discussing new rules threatened the derivatives market. " Greenspan deployed condescension and told Born she didn't know what she doing and she'd cause a financial crisis. (A senior Commission director who worked with Born suggests that Greenspan and the guys didn't like her independence. " Brooksley was this woman who was not playing tennis with these guys and not having lunch with these guys. There was a little bit of the feeling that this woman was not of Wall Street. ")

In early 1998, according to the Times story, one of the guys, Larry Summers, called Born to "chastise her for taking steps he said would lead to a financial crisis. But Born kept at it, unwilling to let arrogant men undermine her good judgment. But it got tougher out there. In June 1998, Greenspan, Rubin and the then head of the SEC, Arthur Levitt, Jr. , called on Congress "to prevent Ms. Born from acting until more senior regulators developed their own recommendations. " (Levitt now says he regrets that decision. ) Months later, the huge hedge fund Long Term Capital Management nearly collapsed--confirming some of Born's warnings. (Bets on derivatives were a key reason. )

"Despite that event," the Times reports, " Congress (apparently as a result of Greenspan & Summer's urging, influence-peddling and pressure) "froze" Born's Commissions' regulatory authority. The next year, Born left as head of the Commission. Born did not talk to the Times for their article.

What emerges is a story of reckless, willful and arrogant action and behaviour designed to undermine a wise woman's good judgment. The three marketeers' disdain for modest regulation of new and risky financial instruments reveals a faith-based fundamentalist approach to the management of markets and risk. If there is any accountability left in our system, Greenspan, Rubin and Summers should not be telling anyone how to run anything. Instead, Barack Obama might do well to bring back Brooksley Born and promote to his team economists who haven't contributed to the ugly mess we're in.

[Mar 7, 2009] Dahlem_Report_EconCrisis021809

The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession's insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.


The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession. Over the past three decades, economists have largely developed and come to rely on models that disregard key factors-including heterogeneity of decision rules, revisions of forecasting strategies, and changes in the social context-that drive outcomes in asset and other markets. It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, "systemic crisis" appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon.2 In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession.

The implicit view behind standard models is that markets and economies are inherently stable and that they only temporarily get off track. The majority of economists thus failed to warn policy makers about the threatening system crisis and ignored the work of those who did. Ironically, as the crisis has unfolded, economists have had no choice but to abandon their standard models and to produce hand-waving common-sense remedies. Common-sense advice, although useful, is a poor substitute for an underlying model that can provide much-needed guidance for developing policy and regulation. It is not enough to put the existing model to one side, observing that one needs, "exceptional measures for exceptional times". What we need are models capable of envisaging such "exceptional times".

... ... ...

There are a number of possible explanations for this failure to warn the public. One is a "lack of understanding" explanation--the researchers did not know the models were fragile. We find this explanation highly unlikely; financial engineers are extremely bright, and it is almost inconceivable that such bright individuals did not understand the limitations of the models. A second, more likely explanation, is that they did not consider it their job to warn the public. If that is the cause of their failure, we believe that it involves a misunderstanding of the role of the economist, and involves an ethical breakdown. In our view, economists, as with all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. Currently, there is no ethical code for professional economic scientists. There should be one.

Insolvent Insurer

The Big Picture

This part of AIG was nothing more than a giant structured finance hedge fund. Despite the fact this hedge fund had no rating, no supervision or oversight, it managed to trade off of the Triple AAA rating of the regulated half of the firm. Somehow, it was treated as if it was Triple AAA, regulated and guaranteed by the government.

It was exempt from any form of regulation or supervision, thanks to the Commodities Futures Modernization Act. This ruinous piece of legislation was sponsored by former Senator Phil Gramm (R), supported by Alan Greenspan (R), former Treasury Secretary (and Citibank board member) Robert Rubin (D), and current presidential advisor Larry Summers (D). It was signed into law by President Clinton (D). It was the single most disastrous piece of bipartisan legislation ever signed into law.

Selected comments

[Mar 3, 2009] Willem Buiter's Maverecon The unfortunate uselessness of most 'state of the art' academic monetary economics

March 3, 2009 |

The unfortunate uselessness of most 'state of the art' academic monetary economics

The Monetary Policy Committee of the Bank of England I was privileged to be a 'founder' external member of during the years 1997-2000 contained, like its successor vintages of external and executive members, quite a strong representation of academic economists and other professional economists with serious technical training and backgrounds. This turned out to be a severe handicap when the central bank had to switch gears and change from being an inflation-targeting central bank under conditions of orderly financial markets to a financial stability-oriented central bank under conditions of widespread market illiquidity and funding illiquidity. Indeed, the typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so, may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding. It was a privately and socially costly waste of time and other resources.

Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck.

Complete markets

The most influential New Classical and New Keynesian theorists all worked in what economists call a 'complete markets paradigm'. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity - both funding illiquidity and market illiquidity - are also impossible, unless the guilt-ridden economic theorist imposes some unnatural (given the structure of the models he is working with), arbitrary friction(s), that made something called 'money' more liquid than everything else, but for no good reason. The irony of modeling liquidity by imposing money as a constraint on trade was lost on the profession.

Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered. They did not allow such questions to be asked.

It is clear that, when searching for an appropriate simplification to address the intractable mess of modern market economies, the starting point of 'no markets', that is, autarky or no trade, is a much better one than that of 'complete markets'. Goods and services that are potentially tradable are indexed by time, place and state of nature or state of the world. Time is a continuous variable, meaning that for complete markets along the time dimension alone, there would have to be rather more markets for future delivery (infinitely many in any time interval, no matter how small) than you can shake a stick at. Location likewise is a continuous variable in a 3-dimensional space. Again rather too many markets. Add uncertainty (states of nature or states of the world), never mind private or asymmetric information, and 'too many potential markets', if I may ruin the wonderful quote from Amadeus attributed to Emperor Joseph II, comes to mind. If any market takes a finite amount of resources (however small) to function, complete markets would exhaust the resources of the universe.

Beyond this simple 'impossibility of complete markets' proposition, there is the deeper point, that the assumption of complete markets in most of the New Classical and New Keynesian macroeconomics assumes away the problem of contract enforcement. This problem is especially acute in trade over time or intertemporal trade, where the net value to each party to a contract of fulfilling the terms of the contract varies over time and can change sign. In a world with selfish, rational, opportunistic agents, able and willing to lie and deceive, only a small set of voluntary transactions will ever be observed, relative to the universe of all potentially feasible transactions.

The first set of voluntary exchange-based transactions we are likely to see are self-enforcing contracts - those based on long-term relationships, repeated interactions and trust. There are some of those, but not too many. The second are those voluntarily-entered-into contracts that are not self-enforcing (say because interactions between the same sets of agents are infrequent and market participants have a degree of anonymity that prevents the use of reputation as a self-enforcement mechanism) but are instead enforced by some external agent or third party, often the state, sometimes the Mafia (sometimes it's hard to tell who is who). Third party enforcement of contracts is again often complex and costly, which is why it covers relatively few contracts. It requires that the terms of the contract and the contingencies it contains be third-party observable and verifiable. Again, only a limited set of exchanges can be supported this way.

The conclusion, boys and girls, should be that trade - voluntary exchange - is the exception rather than the rule and that markets are inherently and hopelessly incomplete. Live with it and start from that fact. The benchmark is no trade - pre-Friday Robinson Crusoe autarky. For every good, service or financial instrument that plays a role in your 'model of the world', you should explain why a market for it exists - why it is traded at all. Perhaps we shall get somewhere this time.

The Auctioneer at the end of time

In both the New Classical and New Keynesian approaches to monetary theory (and to aggregative macroeconomics in general), the strongest version of the efficient markets hypothesis (EMH) was maintained. This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation. Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many key asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. eduction. But most of the profession continued to swallow the EMH hook, line and sinker, although there were influential advocates of reason throughout, including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, Joseph Stiglitz and behaviourist approaches to finance. The influence of the heterodox approaches from within macroeconomics and from other fields of economics on mainstream macroeconomics - the New Classical and New Keynesian approaches - was, however, strictly limited.

In financial markets, and in asset markets, real and financial, in general, today's asset price depends on the view market participants take of the likely future behaviour of asset prices. If today's asset price depends on today's anticipation of tomorrow's price, and tomorrow's price likewise depends on tomorrow's expectation of the price the day after tomorrow, etc. ad nauseam, it is clear that today's asset price depends in part on today's anticipation of asset prices arbitralily far into the future. Since there is no obvious finite terminal date for the universe (few macroeconomists study cosmology in their spare time), most economic models with rational asset pricing imply that today's price depend in part on today's anticipation of the asset price in the infinitely remote future.

What can we say about the terminal behaviour of asset price expectations? The tools and techniques of dynamic mathematical optimisation imply that, when a mathematical programmer computes an optimal programme for some constrained dynamic optimisation problem he is trying to solve, it is a requirement of optimality that the influence of the infinitely distant future on the programmer's criterion function today be zero.

And then a small miracle happens. An optimality criterion from a mathematical dynamic optimisation approach is transplanted, lock, stock and barrel to the behaviour of long-term price expectations in a decentralised market economy. In the mathematical programming exercise it is clear where the terminal boundary condition in question comes from. The terminal boundary condition that the influence of the infinitely distant future on asset prices today vanishes, is a 'transversality condition' that is part of the necessary and sufficient conditions for an optimum. But in a decentralised market economy there is no mathematical programmer imposing the terminal boundary conditions to make sure everything will be all right.

The common practice of solving a dynamic general equilibrium model of a(n) (often competitive) market economy by solving an associated programming problem, that is, an optimisation problem, is evidence of the fatal confusion in the minds of much of the economics profession between shadow prices and market prices and between transversality conditions that are an integral part of the solution to an optimisation problem and the long-term expectations that characterise the behaviour of decentralised asset markets. The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time - a God-like father figure - who makes sure that nothing untoward happens with long-term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.

What this shows, not for the first time, is that models of the economy that incorporate the EMH - and this includes the complete markets core of the New Classical and New Keynesian macroeconomics - are not models of decentralised market economies, but models of a centrally planned economy.

The friendly auctioneer at the end of time, who ensures that the right terminal boundary conditions are imposed to preclude, for instance, rational speculative bubbles, is none other than the omniscient, omnipotent and benevolent central planner. No wonder modern macroeconomics is in such bad shape. The EMH is surely the most notable empirical fatality of the financial crisis. By implication, the complete markets macroeconomics of Lucas, Woodford et. al. is the most prominent theoretical fatality. The future surely belongs to behavioural approaches relying on empirical studies on how market participants learn, form views about the future and change these views in response to changes in their environment, peer group effects etc. Confusing the equilibrium of a decentralised market economy, competitive or otherwise, with the outcome of a mathematical programming exercise should no longer be acceptable.

So, no Oikomenia, there is no pot of gold at the end of the rainbow, and no Auctioneer at the end of time.

Linearize and trivialize

If one were to hold one's nose and agree to play with the New Classical or New Keynesian complete markets toolkit, it would soon become clear that any potentially policy-relevant model would be highly non-linear, and that the interaction of these non-linearities and uncertainty makes for deep conceptual and technical problems. Macroeconomists are brave, but not that brave. So they took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved. This was achieved by completely stripping the model of its non-linearities and by achieving the transsubstantiation of complex convolutions of random variables and non-linear mappings into well-behaved additive stochastic disturbances.

Those of us who have marvelled at the non-linear feedback loops between asset prices in illiquid markets and the funding illiquidity of financial institutions exposed to these asset prices through mark-to-market accounting, margin requirements, calls for additional collateral etc. will appreciate what is lost by this castration of the macroeconomic models. Threshold effects, critical mass, tipping points, non-linear accelerators - they are all out of the window. Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads at the insistence of the mainline models that all uncertainty is exogenous and additive.

Technically, the non-linear stochastic dynamic models were linearised (often log-linearised) at a deterministic (non-stochastic) steady state. The analysis was further restricted by only considering forms of randomness that would become trivially small in the neigbourhood of the deterministic steady state. Linear models with additive random shocks we can handle - almost !

Even this was not quite enough to get going, however. As pointed out earlier, models with forward-looking (rational) expectations of asset prices will be driven not just by conventional, engineering-type dynamic processes where the past drives the present and the future, but also in part by past and present anticipations of the future. When you linearize a model, and shock it with additive random disturbances, an unfortunate by-product is that the resulting linearised model behaves either in a very strongly stabilising fashion or in a relentlessly explosive manner. There is no 'bounded instability' in such models. The dynamic stochastic general equilibrium (DSGE) crowd saw that the economy had not exploded without bound in the past, and concluded from this that it made sense to rule out, in the linearized model, the explosive solution trajectories. What they were left with was something that, following an exogenous random disturbance, would return to the deterministic steady state pretty smartly. No L-shaped recessions. No processes of cumulative causation and bounded but persistent decline or expansion. Just nice V-shaped recessions.

There actually are approaches to economics that treat non-linearities seriously. Much of this work is numerical - analytical results of a policy-relevant nature are few and far between - but at least it attempts to address the problems as they are, rather than as we would like them lest we be asked to venture outside the range of issued we can address with the existing toolkit.

The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models that were then let loose on actual numerical policy analysis, was a major step backwards. I trust it has been relegated to the dustbin of history by now in those central banks that matter.


Charles Goodhart, who was fortunate enough not to encounter complete markets macroeconomics and monetary economics during his impressionable, formative years, but only after he had acquired some intellectual immunity, once said of the Dynamic Stochastic General Equilibrium approach which for a while was the staple of central banks' internal modelling: "It excludes everything I am interested in". He was right. It excludes everything relevant to the pursuit of financial stability.

The Bank of England in 2007 faced the onset of the credit crunch with too much Robert Lucas, Michael Woodford and Robert Merton in its intellectual cupboard. A drastic but chaotic re-education took place and is continuing.

I believe that the Bank has by now shed the conventional wisdom of the typical macroeconomics training of the past few decades. In its place is an intellectual potpourri of factoids, partial theories, empirical regulaties without firm theoretical foundations, hunches, intuitions and half-developed insights. It is not much, but knowing that you know nothing is the beginning of wisdom.

March 3, 2009 1:37pm in Culture, Economics, Financial Markets, Monetary Policy, Politics, Religion | 12 comments

Selected Comments

Don the libertarian Democrat

"The future surely belongs to behavioural approaches relying on empirical studies on how market participants learn, form views about the future and change these views in response to changes in their environment, peer group effects etc. Confusing the equilibrium of a decentralised market economy, competitive or otherwise, with the outcome of a mathematical programming exercise should no longer be acceptable."

I agree, and I'm reminded of a quote from my favorite philosopher, J.L. Austin:

"...our common stock of words embodies all the distinctions men have found worth drawing, and the connections they have found worth marking, in the lifetime of many generations: these surely are likely to be more numerous, more sound, since they have stood up to the long test of survival of the fittest, and more subtle, at least in all ordinary and reasonable practical matters, than any that you or I are likely to think up in our armchair of an afternoon – the most favorite alternative method."

I think that a Wittgensteinian/Austinian anlysis of the presuppositions and assumptions of Economic Models would be a worthwhile endeavor. Many of the models seem to presuppose a crude Behaviorism, although it's hard to tell, since it's not clear that they're claiming to be anything more than modelers.

I can't help but wonder if the desire to be scientific and professional has led to a sterile pursuit of clearly limited problems, much as it has in philosophy.


Congratulations! The admission to oneself of an error is the first step to a better understanding: a public admission also helps other people to that end.

It would take too long to answer this fully (even though I shall omit my own errors which are irrelevant) but I should like to make a few comments.

Firstly EMH is not empirical: it is an academic hypothesis invented by some American academics to reduce the complexity of markets by a few orders of magnitude so that they could develop some theories (a few of which are actually useful) called Modern Portfolio Theory. I was pointing out, while you were still at Yale, that EMH does not correspond to reality because it ignores DEATH and taxes (it also ignores frictional costs (not all of which are taxes), investment fashion, herd instinct and, now relevant but then insignificant, short selling). I have demonstrated from empirical data on more than one occasion that EMH is false (as have others - I make no claim to be Newton or Kepler). I have never seen any empirical data to support it (I have seen reports that in most years the average - NOT the good - actively-managed fund underperforms the index but since ALL index funds underperform the index EVERY year, this merely tells us that custodian's and auditors' charges are non-zero and nothing about the validity or otherwise of EMH).

EMH does not rely on "an Auctioneer at the End of Time" because it assumes a positive real return on investment so the value at the end of time becomes vanishingly small: please remember that EMH was invented by a bunch of American academics, not the MPC of the BoE under a Labour government. EMH does not handle the concept of a continuing negative real long-term return on investment because in that context there are no rational retail investors and (in the USA) no stock market.

I believe that an "Inefficient Markets" hypothesis comes far closer to reality that either EMH or a "No Markets" hypothesis: of course this will be hated by academics because it makes it horrendously difficult to produce any numbers to illustrate or support their theories (hence the invention of EMH).

Thirdly most contracts are small and belong in the category that you call "self-enforcing" but as a natural English speaker (so less grammatical with poorer syntax) I regard as those supported by rational/ enlightened self-interest . Most people belong to a network of small communities and so choose to deal fairly, or to appear to do so, with members of intersecting communities as well as their core community.

Fourthly, computers do not and cannot think: they merely calculate. I think that reintroducing the stocks might do more to improve the quality of macroeconomic economic advice that reliance on the most sophisticated computer programmes. It is possible to solve by algebra and analysis some problems that cannot be handled by computers

In Light of Nihilism

"I can't help but wonder if the desire to be scientific and professional has led to a sterile pursuit of clearly limited problems, much as it has in philosophy."

Academia is a sterile beast. Most academics begin to smell like old farts by their late 20's. Several fields of thought are finished. Such as logistics, psychology, sociology etc.

As for modern philosophy, I wouldn't worry. I know of no great philosopher thats actually received formal philisophical training. If there is one, I'm sure he thought it was the garbage.

I'm happy if mankind produces one great philosopher every 100 years.

Be Happy,


Gary Marshall

Hello Mr. Buiter,

When you write these long tracts, I find it is because you want to send as much of a confused message as possible. Congratulations, you have succeeded again.

The reason that monetary policies or academic monetary economics do not work is because they are founded on an absurdity: That a nation's central bank controls or greatly influences interest rates.

Not one monetarist has ever shown me how these secretive institutions perform such miracles even after being hounded. You have yet to comply with my requests made numerous times. I guess the above is finally a hint in the right direction; that monetary economics is an impotent and bizarre little fellow.

[Mar 1, 2009] US to Convert Preferred Shares in Citi to Common at 32% Premium to Market Price

naked capitalism
Anonymous said...
Majorajam said; "Hemant makes a great point. What is very much undersppreciated here are the foreign policy considerations, and their implications for this crisis."

What is really under appreciated here are the foreign policy considerations that intentionally created this crisis;


"Given this storied history and two years of congressional testimony on oil trading skullduggery, one would expect to find volumes of current information available about this oil trading juggernaut. Instead, this company's activities are so secret that its web site ( is a one page affair and lists only the addresses, phone and fax numbers of its offices in the U.S., London, Geneva, and Singapore. No officers' names, no bios, no history, no press releases. And while the Wall Street firms of Goldman Sachs and Morgan Stanley have been fingered by Congressman Bart Stupak (D-Mich) for gaming the system, Phibro has completely escaped scrutiny during a seven year period when crude oil has risen an astonishing 697%.

Phibro is the old Philipp Brothers trading firm that has resided secretly and quietly on Nyala Farms Road in Westport, Connecticut as a subsidiary of the banking/brokerage behemoth, Citigroup, since the merger of Traveler's Group and Citicorp (parent of Citibank) in 1998. Traveler's Group owned Phibro at the time of the merger. Despite the fact that Phibro has provided Citigroup with $2 billion in revenue over the past three years, the 205-page annual report for Citigroup in 2007 carries only the following one-sentence footnote on commodity income that acknowledges the existence of this company. "Primarily includes the results of Phibro Inc., which trades crude oil, refined oil products, natural gas, and other commodities."

Combing through government archives, the first noteworthy appearance of Phibro occurs on April 6, 2001, when the Wall Street law firm of Sullivan & Cromwell sent a letter to the Commodity Futures Trading Commission (CFTC), the Federal regulator of oil and other commodity trading, acknowledging that it was representing "the Energy Group." The letter was noteworthy because it delineated just who had teamed up to grease the oil rigging in Washington: namely, two investment banks (Goldman Sachs and Morgan Stanley); a house of cards that would later collapse (Enron); a proprietary trading firm inside a Frankenbank (Phibro inside Citigroup); and two real energy firms (BP Amoco and Koch Industries).

What the Energy Group had long lobbied for and finally received from its Federal regulator was the breathtaking ability to trade oil contracts and oil derivatives secretly in the over- the-counter (OTC) market, thus avoiding the scrutiny of regulated commodity exchanges, their CFTC regulator, and Congress. The April 6, 2001 letter was essentially to say thanks and interpret the new rules as favorably as possible for the Energy Group.

The change in the law occurred via the Commodity Futures Modernization Act of 2000 (CFMA) and is called the Enron Loophole. (Since Enron's trading room went belly up along with the company, and Phibro is still trading oil secretly all over the world, it should perhaps now be called the Phibro Loophole.)

What the CFTC also granted the big Wall Street trading firms was a license to sneak under the radar by using computer terminals located in the U.S. while trading oil on foreign exchanges like the Intercontinental Exchange (ICE) located in London but owned by an Atlanta, Georgia outfit that was funded and launched by Wall Street firms and big oil.

On June 3 of this year, Dr. Mark Cooper, Director of Research for the Consumer Federation of America, correctly outlined the problem to the Senate Committee on Commerce, Science and Transportation:

"The speculative bubble in petroleum markets has cost the economy well over half a trillion dollars in the two years since the Senate hearings first called attention to this problem…Public policies have made these markets the playgrounds of the idle rich, while consumers suffer the burden of rising prices for the necessities of daily life. We have made it so easy to play in the financial markets that investment in productive long term assets are unattractive…

The most blatant mistake occurred when Congress allowed the Commodity Futures Trading Commission to forego regulation of over the counter trading in energy futures…
Because there is no regulation of this huge swatch of activity, regulators have little insight into what is going on in energy commodity markets…
Large traders who trade in commodities in the U.S. ought to be required to register and report their entire positions in those commodities here in the U.S. and abroad…
If traders are unwilling to report all their positions, they should not be allowed to trade in U.S. markets. If they violate this provision, they should go to jail. Fines are not enough to dissuade abuse in these commodity markets because there is just too much money to be made."

The only correction I would make to the otherwise flawless argument above is that Wall Street is far from the playground of the "idle" rich. Wall Street executives spend every waking minute (and I've heard even dream about) how they can separate us from our money, our homes and a voice in Washington. How appropriate that Citigroup's slogan is "the Citi never sleeps."

Let's say the CFTC was not a compromised regulator, was not an audition stage and revolving door for million dollar jobs in the industry it regulates. Let's say it genuinely wanted to report back to Congress on just how big a player Citigroup is in the oil markets. According to a February 22, 2008 filing with the Securities and Exchange Commission (SEC), Citigroup has over 2,000 principal subsidiaries (meaning it really has more but it's not naming them). Of these, a significant number are secret offshore entities where records are unavailable to regulators. (For a mind boggling look at this sprawling octopus click here: )

So the CFTC can't get its hands on all records and even in jurisdictions where it can, it first has to know under what names, out of a possible 2,000, Citigroup is trading oil and then aggregate the positions.

On May 6 of this year, Tyson Slocum, Director of the Energy Program at the nonprofit watchdog, Public Citizen, testified before Congress on yet another roadblock preventing a meaningful investigation of oil price manipulation:

"Thanks to the Commodity Futures Modernization Act, participants in these newly-deregulated energy trading markets are not required to file so-called Large Trader Reports…

These Large Trader Reports, together with the price and volume data, are the primary tools of the CFTC's regulatory regime…So the deregulation of OTC markets, by allowing traders to escape such basic information reporting, leave federal regulators with no tools to routinely determine whether market manipulation is occurring in energy trading markets…
The ability of federal regulators to investigate market manipulation allegations even on the lightly-regulated exchanges like NYMEX New York Mercantile Exchange is difficult, let alone the unregulated OTC market."

Next comes what can only be described as an act of insanity on the part of the Federal Reserve. After allowing for the repeal in 1999 of the depression era investor protection legislation known as the Glass-Steagall Act in order to let Citigroup house retail bank deposits, investment banking, insurance, stock brokerage and speculative proprietary trading under one roof (the perfect storm that intensified the Great Depression) the Federal Reserve decided on October 2, 2003 that Citi wasn't scary enough. It needed to allow this company that had already been named in hundreds of lawsuits for securities frauds and manipulations and could not remotely manage itself as a financial firm to ramp up its oil trading business by allowing it to take possession of crude oil on tankers because it would "reasonably be expected to produce benefits to the public." Here are excerpts from the Fed's release suggesting the expansive plans Citi had in the oil storage and transport business:

"…Citigroup has indicated that it will adopt additional standards for Commodity Trading Activities that involve environmentally sensitive products, such as oil or natural gas. For example, Citigroup will require that the owner of every vessel that carries oil on behalf of Citigroup be a member of a protection and indemnity club and carry the maximum insurance for oil pollution available from the club. Citigroup also will require every such vessel to carry substantial amounts of additional oil pollution insurance from creditworthy insurance companies. Furthermore, Citigroup will place age limitations on vessels and will require vessels to be approved by a major international oil company and have appropriate oil spill response plans and equipment. Moreover, Citigroup will have a comprehensive backup plan in the event any vessel owner fails to respond adequately to an oil spill and will hire inspectors to monitor the loading and discharging of vessels. Citigroup also has represented that it will have in place specific policies and procedures for the storage of oil… The Board believes that Citigroup has the managerial expertise and internal control framework to manage the risks of taking and making delivery of physical commodities… For these reasons, and based on Citigroup's policies and procedures for monitoring and controlling the risks of Commodity Trading Activities, the Board concludes that consummation of the proposal does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally and can reasonably be expected to produce benefits to the public that outweigh any potential adverse effects."

Voting in favor of this unprecedented action was then Federal Reserve Chairman Alan Greenspan as well as current Chairman, Ben Bernanke."

Link, more;

Deception is the strongest political force on the planet.

i on the ball patriot

[Feb 23, 2009] Michael Hudson The Language of Looting by Michael Hudson

February 23, 2009
What "Nationalize the Banks" and the "Free Market" Really Mean in Today's Looking-Glass World

"Banking shares began to plunge Friday morning after Senator Dodd, the Connecticut Democrat who is chairman of the banking committee, said in an interview with Bloomberg Television that he was concerned the government might end up nationalizing some lenders "at least for a short time." Several other prominent policy makers – including Alan Greenspan, the former chairman of the Federal Reserve, and Senator Lindsey Graham of South Carolina – have echoed that view recently."

--Eric Dash, "Growing Worry on Rescue Takes a Toll on Banks," The New York Times, February 20, 2009

How is it that Alan Greenspan, free-market lobbyist for Wall Street, recently announced that he favored nationalization of America's banks – and indeed, mainly the biggest and most powerful? Has the old disciple of Ayn Rand gone Red in the night? Surely not.

The answer is that the rhetoric of "free markets," "nationalization" and even "socialism" (as in "socializing the losses") has been turned into the language of deception to help the financial sector mobilize government power to support its own special privileges. Having undermined the economy at large, Wall Street's public relations think tanks are now dismantling the language itself.

Exactly what does "a free market" mean? Is it what the classical economists advocated – a market free from monopoly power, business fraud, political insider dealing and special privileges for vested interests – a market protected by the rise in public regulation from the Sherman Anti-Trust law of 1890 to the Glass-Steagall Act and other New Deal legislation? Or is it a market free for predators to exploit victims without public regulation or economic policemen – the kind of free-for-all market that the Federal Reserve and Security and Exchange Commission (SEC) have created over the past decade or so? It seems incredible that people should accept today's neoliberal idea of "market freedom" in the sense of neutering government watchdogs, Alan Greenspan-style, letting Angelo Mozilo at Countrywide, Hank Greenberg at AIG, Bernie Madoff, Citibank, Bear Stearns and Lehman Brothers loot without hindrance or sanction, plunge the economy into crisis and then use Treasury bailout money to pay the highest salaries and bonuses in U.S. history.

Terms that are the antithesis of "free market" also are being turned into the opposite of what they historically have meant. Take today's discussions about nationalizing the banks. For over a century nationalization has meant public takeover of monopolies or other sectors to operate them in the public interest rather than leaving them so special interests. But when neoliberals use the word "nationalization" they mean a bailout, a government giveaway to the financial interests.

Doublethink and doubletalk with regard to "nationalizing" or "socializing" the banks and other sectors is a travesty of political and economic discussion from the 17th through mid-20th centuries. Society's basic grammar of thought, the vocabulary to discuss political and economic topics, is being turned inside-out in an effort to ward off discussion of the policy solutions posed by the classical economists and political philosophers that made Western civilization "Western."

Today's clash of civilization is not really with the Orient; it is with our own past, with the Enlightenment itself and its evolution into classical political economy and Progressive Era social reforms aimed at freeing society from the surviving trammels of European feudalism. What we are seeing is propaganda designed to deceive, to distract attention from economic reality so as to promote the property and financial interests from whose predatory grasp classical economists set out to free the world. What is being attempted is nothing less than an attempt to destroy the intellectual and moral edifice of what took Western civilization eight centuries to develop, from the 12th century Schoolmen discussing Just Price through 19th and 20th century classical economic value theory.

Any idea of "socialism from above," in the sense of "socializing the risk," is old-fashioned oligarchy – kleptocratic statism from above. Real nationalization occurs when governments act in the public interest to take over private property. The 19th-century program to nationalize the land (it was the first plank of the Communist Manifesto) did not mean anything remotely like the government taking over estates, paying off their mortgages at public expense and then giving it back to the former landlords free and clear of encumbrances and taxes. It meant taking the land and its rental income into the public domain, and leasing it out at a user fee ranging from actual operating cost to a subsidized rate or even freely as in the case of streets and roads.

Nationalizing the banks along these lines would mean that the government would supply the nation's credit needs. The Treasury would become the source of new money, replacing commercial bank credit. Presumably this credit would be lent out for economically and socially productive purposes, not merely to inflate asset prices while loading down households and business with debt as has occurred under today's commercial bank lending policies.

How neoliberals falsify the West's political history

The fact that today's neoliberals claim to be the intellectual descendants of Adam Smith make it necessary to restore a more accurate historical perspective. Their concept of "free markets" is the antithesis of Smith's. It is the opposite of that of the classical political economists down through John Stuart Mill, Karl Marx and the Progressive Era reforms that sought to create markets free of extractive rentier claims by special interests whose institutional power can be traced back to medieval Europe and its age of military conquest.

Economic writers from the 16th through 20th centuries recognized that free markets required government oversight to prevent monopoly pricing and other charges levied by special privilege. By contrast, today's neoliberal ideologues are public relations advocates for vested interests to depict a "free market" is one free of government regulation, "free" of anti-trust protection, and even of protection against fraud, as evidenced by the SEC's refusal to move against Madoff, Enron, Citibank et al.). The neoliberal ideal of free markets is thus basically that of a bank robber or embezzler, wishing for a world without police so as to be sufficiently free to siphon off other peoples' money without constraint.

The Chicago Boys in Chile realized that markets free for predatory finance and insider privatization could only be imposed at gunpoint. These free-marketers closed down every economics department in Chile, every social science department outside of the Catholic University where the Chicago Boys held sway. Operation Condor arrested, exiled or murdered tens of thousands of academics, intellectuals, labor leaders and artists. Only by totalitarian control over the academic curriculum and public media backed by an active secret police and army could "free markets" neoliberal style be imposed. The resulting privatization at gunpoint became an exercise in what Marx called "primitive accumulation" – seizure of the public domain by political elites backed by force. It is a free market William-the-Conqueror or Yeltsin-kleptocrat style, with property parceled out to the companions of the political or military leader.

All this was just the opposite of the kind of free markets that Adam Smith had in mind when he warned that businessmen rarely get together but to plot ways to fix markets to their advantage. This is not a problem that troubled Mr. Greenspan or the editorial writers of the New York Times and Washington Post. There really is no kinship between their neoliberal ideals and those of the Enlightenment political philosophers. For them to promote an idea of free markets as ones "free" for political insiders to pry away the public domain for themselves is to lower an intellectual Iron Curtain on the history of economic thought.

The classical economists and American Progressives envisioned markets free of economic rent and interest – free of rentier overhead charges and monopoly price gouging, free of land-rent, interest paid to bankers and wealthy financial institutions, and free of taxes to support an oligarchy. Governments were to base their tax systems on collecting the "free lunch" of economic rent, headed by that of favorable locations supplied by nature and given market value by public investment in transportation and other infrastructure, not by the efforts of landlords themselves.

The argument between Progressive Era reformers, socialists, anarchists and individualists thus turned on the political strategy of how best to free markets from debt and rent. Where they differed was on the best political means to achieve it, above all the role of the state. There was broad agreement that the state was controlled by vested interests inherited from feudal Europe's military conquests and the world that was colonized by European military force. The political question at the turn of the 20th century was whether peaceful democratic reform could overcome the political and even military resistance wielded by the Old Regime using violence to retain its "rights." The ensuing political revolutions were grounded in the Enlightenment, in the legal philosophy of men such as John Locke, political economists such as Adam Smith, John Stuart Mill and Marx. Power was to be used to free markets from the predatory property and financial systems inherited from feudalism. Markets were to be free of privilege and free lunches, so that people would obtain income and wealth only by their own labor and enterprise. This was the essence of the labor theory of value and its complement, the concept of economic rent as the excess of market price over socially necessary cost-value.

Although we now know that markets and prices, rent and interest, contractual formalities and nearly all the elements of economic enterprise originated in the "mixed economies" of Mesopotamia in the fourth millennium BC and continued throughout the mixed public/private economies of classical antiquity, the discussion was so politically polarized that the idea of a mixed economy with checks and balances received scant attention a century ago.

Individualists believed that all that shrinking central governments would shrink the control mechanism by which the vested interests extracted wealth without work or enterprise of their own. Socialists saw that a strong government was needed to protect society from the attempts of property and finance to use their gains to monopolize economic and political power. Both ends of the political spectrum aimed at the same objective – to bring prices down to actual costs of production. The common aim was to maximize economic efficiency so as to pass on the fruits of the Industrial and Agricultural Revolutions to the population at large. This required blocking the rentier class of interlopers from grabbing the public domain and controlling the allocation of resources. Socialists did not believe this could be done without taking the state's political and legal power into their own hands. Marxists believed that a revolution was necessary to reclaim property rent for the public domain, and to enable governments to create their own credit rather than borrow at interest from commercial bankers and wealthy bondholders. The aim was not to create a bureaucracy but to free society from the surviving absentee ownership power of the vested property and financial interests.

All this history of economic thought has been as thoroughly expunged from today's academic curriculum as it has from popular discussion. Few people remember the great debate at the turn of the 20th century: Would the world progress fairly quickly from Progressive Era reforms to outright socialism – public ownership of basic economic infrastructure, natural monopolies (including the banking system) and the land itself (and to Marxists, of industrial capital as well)? Or, could the liberal reformers of the day – individualists, land taxers, classical economists in the tradition of Mill, and American institutionalists such as Simon Patten – retain capitalism's basic structure and private property ownership? If they could do so, they recognized that it would have to be in the context of regulating markets and introducing progressive taxation of wealth and income. This was the alternative to outright "state" ownership. Today's extreme "free market" idea is a dumbed-down caricature of this position.

All sides viewed the government as society's "brain," its forward planning organ. Given the complexity of modern technology, humanity would shape its own evolution. Instead of evolution occurring by "primitive accumulation," it could be planned deliberately. Individualists countered that no human planner was sufficiently imaginative to manage the complexity of markets, but endorsed the need to strip away all forms of unearned income – economic rent and the rise in land prices that Mill called the "unearned increment." This involved government regulation to shape markets. A "free market" was an active political creation and required regulatory vigilance.

As public relations advocates for the vested interests and special rentier privilege, today's "neoliberal" advocates of "free" markets seek to maximize economic rent – the free lunch of price in excess of cost-value, not to free markets from rentier charges. So misleading a pedigree only could be achieved by outright suppression of knowledge of what Locke, Smith and Mill really wrote. Attempts to regulate "free markets" and limit monopoly pricing and privilege are conflated with "socialism," even with Soviet-style bureaucracy. The aim is to deter the analysis of what a "free market" really is: a market free of unnecessary costs: monopoly rents, property rents and financial charges for credit that governments can create freely.

Political reform to bring market prices in line with socially necessary cost-value was the great economic issue of the 19th century. The labor theory of intrinsic cost-value found its counterpart in the theory of economic rent: land rent, monopoly price gouging, interest and other returns to special privilege that increased market prices purely by institutional property claims. The discussion goes all the way back to the medieval churchmen defining Just Price. The doctrine originally was applied to the proper fees that bankers could charge, and later was extended to land rent, then to the monopolies that governments created and sold off to creditors in an attempt to extricate themselves from debt.

Reformists and more radical socialists alike sought to free capitalism of its egregious inequities, above all its legacy from Europe's Dark Age of military conquest when invading warlords seized lands and imposed an absentee landlord class to receive the rental income, which was used to finance wars of further land acquisition. As matters turned out, hopes that industrial capitalism could reform itself along progressive lines to purge itself of its legacy from feudalism have come crashing down. World War I hit the global economy like a comet, pushing it into a new trajectory and catalyzing its evolution into an unanticipated form of finance capitalism.

It was unanticipated largely because most reformers spent so much effort advocating progressive policies that they neglected what Thorstein Veblen called the vested interests. Their Counter-Enlightenment is creating a world that would have been deemed a dystopia a century ago – something so pessimistic that no futurist dared depict a world run by venal and corrupt bankers, protecting as their prime customers the monopolies, real estate speculators and hedge funds whose economic rent, financial gambling and asset-price inflation is turned into a flow of interest in today's rentier economy. Instead of industrial capitalism increasing capital formation we are seeing finance capitalism strip capital, and instead of the promised world of leisure we are being drawn into one of debt peonage.

The financial travesty of democracy

The financial sector has redefined democracy by claiming claims that the Federal Reserve must be "independent" from democratically elected representatives, in order to act as the bank lobbyist in Washington. This makes the financial sector exempt from the democratic political process, despite the fact that today's economic planning is now centralized in the banking system. The result is a regime of insider dealings and oligarchy – rule by the wealthy few.

The economic fallacy at work is that bank credit is a veritable factor of production, an almost Physiocratic source of fertility without which growth could not occur. The reality is that the monopoly right to create interest-bearing bank credit is a free transfer from society to a privileged elite. The moral is that when we see a "factor of production" that has no actual labor-cost of production, it is simply an institutional privilege.

So this brings us to the most recent debate about "nationalizing" or "socializing" the banks. The Troubled Asset Relief Program (TARP) so far has been used for the following uses that I think can be truly deemed anti-social, not "socialist" in any form.

By the end of last year, $20 billion was used to pay bonuses and salaries to financial mismanagers, despite the plunge of their banks into negative equity. And to protect their interests, these banks continued to pay lobbying fees to persuade legislators to give them yet more special privileges.

While Citibank and other major institutions threatened to bring the financial system crashing down by being "too big to fail," over $100 billion of TARP funds was used to make them even bigger. Already teetering banks bought affiliates that had grown by making irresponsible and outright fraudulent loans. Bank of America bought Angelo Mozilo's Countrywide Financial and Merrill Lynch, while JP Morgan Chase bought Bear Stearns and other big banks bought WaMu and Wachovia.

Today's policy is to "rescue" these giant bank conglomerates by enabling them to "earn" their way out of debt – by selling yet more debt to an already over-indebted U.S. economy. The hope is to re-inflate real estate and other asset prices. But do we really want to let banks "pay back taxpayers" by engaging in yet more predatory financial practices vis-à-vis the economy at large? It threatens to maximize the margin of market price over direct costs of production, by building in higher financial charges. This is just the opposite policy from trying to bring prices for housing and infrastructure in line with technologically necessary costs. It certainly is not a policy to make the U.S. economy more globally competitive.

The Treasury's plan to "socialize" the banks, insurance companies and other financial institutions is simply to step in and take bad loans off their books, shifting the loss onto the public sector. This is the antithesis of true nationalization or "socialization" of the financial system. The banks and insurance companies quickly got over their initial knee-jerk fear that a government bailout would occur on terms that would wipe out their bad management, along with the stockholders and bondholders who backed this bad management. The Treasury has assured these mismanagers that "socialism" for them is a free gift. The primacy of finance over the rest of the economy will be affirmed, leaving management in place and giving stockholders a chance to recover by earning more from the economy at large, with yet more tax favoritism. (This means yet heavier taxes shifted onto consumers, raising their living costs accordingly.)

The bulk of wealth under capitalism – as under feudalism –always has come primarily from the public domain, headed by the land and formerly public utilities, capped most recently by the Treasury's debt-creating power. In effect, the Treasury creates a new asset ($11 trillion of new Treasury bonds and guarantees, e.g. the $5.2 trillion to Fannie and Freddie). Interest on these bonds is to be paid by new levies on labor, not on property. This is what is supposed to re-inflate housing, stock and bond prices – the money freed from property and corporate taxes will be available to be capitalized into yet new loans.

So the revenue hitherto paid as business taxes will still be paid – in the form of interest – while the former taxes will still be collected, but from labor. The fiscal-financial burden thus will be doubled. This is not a program to make the economy more competitive or raise living standards for most people. It is a program to polarize the U.S. economy even further between finance, insurance and real estate (FIRE) at the top and labor at the bottom.

Neoliberal denunciations of public regulation and taxation as "socialism" is really an attack on classical political economy – the "original" liberalism whose ideal was to free society from the parasitic legacy of feudalism. A truly socialized Treasury policy would be for banks to lend for productive purposes that contribute to real economic growth, not merely to increase overhead and inflate asset prices by enough to extract interest charges. Fiscal policy would aim to minimize rather than maximizing the price of home ownership and doing business, by basing the tax system on collecting the rent that is now being paid out as interest. Shifting the tax burden off wages and profits onto rent and interest was the core of classical political economy in the 18th and 19th centuries, as well as the Progressive Era and Social Democratic reform movements in the United States and Europe prior to World War I. But this doctrine and its reform program has been buried by the rhetorical smokescreen organized by financial lobbyists seeking to muddy the ideological waters sufficiently to mute popular opposition to today's power grab by finance capital and monopoly capital. Their alternative to true nationalization and socialization of finance is debt peonage, oligarchy and neo-feudalism. They have called this program "free markets."

Michael Hudson is a former Wall Street economist. A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002) He can be reached via his website,

"The Myth of Simple Market Solutions"

Macroeconomics gets the headlines, especially lately, but there's a lot more to economics than the study of abstract aggregates used as barometers of economic performance. Robert Stavins follows up on his post arguing that market failure is common in the environmental domain with an explanation of why simple solutions to these problems are often inadequate:

The Myth of Simple Market Solutions, by Robert Stavins: I introduced my previous post by noting that there are several prevalent myths regarding how economists think about the environment, and I addressed the "myth of the universal market" ­– the notion that economists believe that the market solves all problems. In response, I noted that economists recognize that in the environmental domain, perfectly functioning markets are the exception, not the rule. Governments can try to correct such market failures, for example by restricting pollutant emissions. It is to these government interventions that I turn this time.

A second common myth is that economists always recommend simple market solutions for market problems. Indeed, in a variety of contexts, economists tend to search for instruments of public policy that can fix one market by introducing another. If pollution imposes large external costs, the government can establish a market for rights to emit a limited amount of that pollutant under a so-called cap-and-trade system. Such a market for tradable allowances can be expected to work well if there are many buyers and sellers, all are well informed, and the other conditions I discussed in my last posting are met.

The government's role is then to enforce the rights and responsibilities of permit ownership, so that each unit of emissions is matched by the ownership of one permit. Equivalently, producers can be required to pay a tax on their emissions. Either way, the result - in theory - will be cost-effective pollution abatement, that is, overall abatement achieved at minimum aggregate cost.

The cap-and-trade approach has much to recommend it, and can be just the right solution in some cases, but it is still a market. Therefore the outcome will be efficient only if certain conditions are met. Sometimes these conditions are met, and sometimes they are not. Could the sale of permits be monopolized by a small number of buyers or sellers? Do problems arise from inadequate information or significant transactions costs? Will the government find it too costly to measure emissions? If the answer to any of these questions is yes, then the permit market may work less than optimally. The environmental goal may still be met, but at more than minimum cost. In other words, cost effectiveness will not be achieved.

To reduce acid rain in the United States, the Clean Air Act Amendments of 1990 require electricity generators to hold a permit for each ton of sulfur dioxide (SO2) they emit. A robust permit market exists, in which well-defined prices are broadly known to many potential buyers and sellers. Through continuous emissions monitoring, the government tracks emissions from each plant. Equally important, penalties are significantly greater than incremental abatement costs, and hence are sufficient to ensure compliance. Overall, this market works very well; acid rain is being cut by 50 percent, and at a savings of about $1 billion per year in abatement costs, compared with a conventional approach.

A permit market achieves this cost effectiveness through trades because any company with high abatement costs can buy permits from another with low abatement costs, thus reducing the total cost of reducing pollution. These trades also switch the source of the pollution from one company to another, which is not important when any emissions equally affect the whole trading area. This "uniform mixing" assumption is certainly valid for global problems such as greenhouse gases or the effect of chlorofluorocarbons on the stratospheric ozone layer. It may also work reasonably well for a regional problem such as acid rain, because acid deposition in downwind states of New England is about equally affected by sulfur dioxide emissions traded among upwind sources in Ohio, Indiana, and Illinois. But it does not work perfectly, since acid rain in New England may increase if a plant there sells permits to a plant in the mid-west, for example.

At the other extreme, some environmental problems might not be addressed appropriately by a simple, unconstrained cap-and-trade system. A hazardous air pollutant such as benzene that does not mix in the airshed can cause localized "hot spots." Because a company can buy permits and increase local emissions, permit trading does not ensure that each location will meet a specific standard. Moreover, the damages caused by local concentrations may increase nonlinearly. If so, then even a permit system that reduces total emissions might allow trades that move those emissions to a high-impact location and thus increase total damages. An appropriately constrained permit trading system can address the hot-spot problem, for example by combining emissions trading with a parallel system of non-tradable ambient standards.

The bottom line is that no particular form of government intervention, no individual policy instrument – whether market-based or conventional – is appropriate for all environmental problems. There is no simple policy panacea. The simplest market instruments do not always provide the best solutions, and sometimes not even satisfactory ones. If a cost-effective policy instrument is used to achieve an inefficient environmental target - one that does not make the world better off, that is, one which fails a benefit-cost test – then we have succeeded only in "designing a fast train to the wrong station." Nevertheless, market-based instruments are now part of the available environmental policy portfolio, and ultimately that is good news both for environmental protection and economic well-being.

Posted by Mark Thoma on Tuesday, February 24, 2009 at 12:33 AM in Economics, Environment, Market Failure, Policy

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Lafayette says...
MT: Macroeconomics gets the headlines, especially lately, but there's a lot more to economics than the study of abstract aggregates used as barometers of economic performance.

Thank you, MT, for the above cited remark. Nothing could be more true today, I suggest, in the realm of economic studies.

Macroeconomics has always been the love-child of economists, whilst microeconomics was left, somewhat, to languish. Even if the latter has come up with some highly interesting academic work.

I would hope that its link, as seen in some studies being carried out at prestigious institutions, to other disciplines (particularly sociology and psychology) will expand its interests to students.

The devil is in the details and we need to understand that devil in order to comprehend his mischief. Especially about markets, which makes your remark all the more appropriate in this thread.

Posted by: Lafayette | Link to comment | February 24, 2009 at 12:42 AM

Lafayette says...

Needed rehabilitation

Stavins: The bottom line is that no particular form of government intervention, no individual policy instrument – whether market-based or conventional – is appropriate for all environmental problems.

Given Stavins' academic focus, explained by clicking through to his article, it is perhaps appropriate that he should be thinking about environmental challenges.

He presumes that the government tweaks markets by setting up markets to resolve certain market aberrations. He gives as an example the establishment of the market for greenhouse emissions permits. There are a number of such market devices, as reviewed here. In Europe, where many such market devices are in place (or being established) they seem to work.

I would also like to see the established for other markets, namely in the Public Services sector. And, I am thinking of Health Care. There is no way we are going to seriously reduce the cost of American HC without reducing its costs. Yes, it is overburdened with mindless paperwork. But, that will not totally solve the problem. I doubt electronic paperwork, even if all our records become electronic based, will solve the real problem. [Besides, such efforts in the UK and France have proved to be dismal failures for the moment, due to the arch complexity of transferring records from paper to electronic format.]

We need, I suggest, a separate, parallel agency, based upon more modest Civil Service pay-scales, that provide HC-services. In order to staff such an agency, we must provide free tuition to young adults willing to undergo the grueling route to mastery of their specialty, whether it be GP, nursing, or myriad other medical specialties. In counterpart, they would provide a minimum service (measured in years) to this agency, at Civil Service pay-scales.

If we employ the above device to build a first-class professional Army, why not a first-class professional, alternative Public Universal Health Care Service?

Besides, why ever do we presume that a university education must depend upon costly private institutions? We have a large state-university system that could be expanded to bring in more of those, in the lower classes, who want an education.

Some questions: Why must students go to private funding sources to pay for their tuition fees? Why must families begin saving at birth for their child's university education -- which automatically leaves the poor incarcerated in an economic condition from which they will never escape? (And feeds the maw of delinquency and criminal activity.)

Education/training is the only escalator out of poverty. It needs rehabilitation to do the job correctly.

Posted by: Lafayette | Link to comment | February 24, 2009 at 01:08 AM

Real Person from the Real World says...

Lafayette: "Some questions: Why must students go to private funding sources to pay for their tuition fees? Why must families begin saving at birth for their child's university education -- which automatically leaves the poor incarcerated in an economic condition from which they will never escape?"

Why? BRANDING - where everything is always assigned to a value scale. Sony vs Samsung, Harvard vs Brown, Ivy league vs private university, private university vs state university. It seems to be a *law* of biz today, that schools are cost centers, and just like some CEO's are worth bigger obscene salaries then others, the grads from Harvard worth more than state U.

Posted by: Real Person from the Real World | Link to comment | February 24, 2009 at 03:52 AM

bakho says...

Interesting POV. Imposing regulated markets is just another means of regulation.

There are some technological fixes that will never happen without government intervention because the private sector is not large enough or the returns would be too difficult to capture or the returns are not as great as investment elsewhere.

Posted by: bakho | Link to comment | February 24, 2009 at 04:17 AM

paine says...

"economists tend to search for instruments of public policy that can fix one market by introducing another"
nice line
too bad he didn't have one that
quips as well on the limits of mechanism design

sometimes one mechanism deserves another
or at least some "sector wide rules of the game "
as here:

"An appropriately constrained permit trading system can address the hot-spot problem, for example by combining emissions trading with a parallel system of non-tradable ambient standards."

cap and trade plus regs
not a case of belt and suspenders

Posted by: paine | Link to comment | February 24, 2009 at 04:50 AM

ken melvin says...

Pooh. Set the rules under which they are to operate. There's your market.

Posted by: ken melvin | Link to comment | February 24, 2009 at 05:26 AM

Not Mark T says...

Noteworthy by its omission is any discussion of the intractable valuation of the environmental and public health benefits that do not trade in markets.

Posted by: Not Mark T | Link to comment | February 24, 2009 at 07:19 AM

Anonymous says...

Stavins spends very little time on the simplest solution of all, energy and pollution taxes. A tax allows the government to step in and correct the costs to reflect damage to others and society, removing the externality.

No need to try to set up and make efficient some complicated cap-and-trade market. Removing subsidies on mining, farming, lumber, and other polluting industries and adding substantial taxes on energy and pollution is a simpler and easier solution. It is not a solution to all problems, but it solves many.

Posted by: Anonymous | Link to comment | February 24, 2009 at 08:15 AM

Bruce Wilder says...

Unfortunately, anonymous, it isn't clear what the tax should be, or how it should vary over time and changing circumstance.

The advantage of cap-and-trade is that it is a mechanism for dynamic adjustment.

Posted by: Bruce Wilder | Link to comment | February 24, 2009 at 09:23 AM

Anonymous says...

Thanks, Bruce, for the comment, but I believe cap-and-trade has the same issue. The market price will be determined by scarcity -- the "cap" in cap-and-trade -- and it is not clear where to set that cap.

The problem of setting the tax or cap is simplified if we do not treat this as an optimization problem where we are attempting to find the exact amount of the tax or cap that matches match the externality. Rather, we can treat this as policy.

Viewed as policy, energy and pollution taxes are a shift from our current practice of subsidizing polluting industries to penalizing polluting industries. The level of the tax that is appropriate depends on the policy goals. The underlying justification for the tax, whatever level it is set at, is partially or completely eliminating the externality polluting industries impose on the public.

Posted by: Anonymous | Link to comment | February 24, 2009 at 10:07 AM

Lafayette says...

Lady Luck

RP: ... and just like some CEO's are worth bigger obscene salaries then others, the grads from Harvard worth more than state U.

I remember a study, which I came across quite by accident some time ago, that analyzed "brand name" university diploma for correlation with income level. The correlation, as I recall, of Ivy League schools with future income was not significantly better than that of ordinary State Universities, within the population examined. The study was done some time in the 1960s.

Try as I may, I cannot, however, find that study on the Net. Wish I could ...

Furthermore, as regards the possible correlation between income and IQ, this from WikiP (here) is interesting:

One reason why some studies claim that IQ only accounts for a sixth of the variation in income is because many studies are based on young adults (many of whom have not yet completed their education). On pg 568 of "The g Factor", Arthur Jensen claims that although the correlation between IQ and income averages a moderate 0.4 (one sixth or 16% of the variance), the relationship increases with age, and peaks at middle age when people have reached their maximum career potential. In the book, A Question of Intelligence, Daniel Seligman cites an IQ income correlation of 0.5 (25% of the variance).

That correlation is not quite as tight as I would have expected. I suspect, therefore, that IQ has very little to do with a predilection for a business career. One can easily have a high IQ and no desire whatsoever for a business career.

Nonetheless, the long-term unemployment rate of those with a postsecondary education does remain fairly stable at about half that of those without. That alone should indicate a sense to national priorities in terms of funding Secondary and Tertiary Public Education/Training -- free, gratis and for nothing.

What's the trade-off? Is there a link between class (read income) and criminality? If people cannot or do not get an education, are they more or less prone to criminality/delinquency? Some think so.

Consider this rather elaborate (read academic) conclusion from a UK study on crime:

For the case of income, education increases the returns to legitimate work, raising the opportunity costs of illegal behaviour. Consequently, subsidies that encourage investments in human capital reduce crime indirectly by raising future wage rates

Education raises the "opportunity costs of illegal behaviour". Never thought of it that way, but, what they hey ...

Posted by: Lafayette | Link to comment | February 24, 2009 at 10:13 AM

Patricia Shannon says...

Someone with a really high IQ is less likely to fall for the fallacies that richer is happier or better or more moral.

Posted by: Patricia Shannon | Link to comment | February 24, 2009 at 12:50 PM

Lafayette says...

A Lost Generation?

PS: Someone with a really high IQ is less likely to fall for the fallacies that richer is happier or better or more moral.

That sounds like Common Sense to me, but it has been so Uncommon lately that one wonders if we've not taken leave of our senses.

I think our behaviour the past fifteen years has been deplorably amoral. We've justified our behaviour of self-indulgence by thinking that if we don't then someone else will. Therefore, we "lose".

It is indicative of a collapse of moral values by the seduction of material temptation. Aka hedonism.

Hedonism: the ethical theory that pleasure (in the sense of the satisfaction of one's desires) is the highest good and proper aim of human life

Posted by: Lafayette | Link to comment | February 24, 2009 at 01:20 PM

Lucian Bebchuk Says the Stimulus Bill's Restrictions Disconnects Executive Performance From Compensation Incentives By LUCIAN BEBCHUK

In a last-minute addition to the stimulus bill passed Friday, Congress imposed tight restrictions on pay arrangements in all financial firms that have or will receive funds from the federal government's Troubled Asset Relief Program (TARP).

While I have long been a critic of corporate compensation practices, these restrictions leave me concerned. They weaken executives' incentives to deliver the long-term performance that is needed to benefit banks, the economy, and taxpayers who have injected vast amounts of capital into these institutions.

While the new restrictions seem to have been motivated by a desire to limit total pay, it is the pay structure that they tightly regulate. The Obama administration's proposals focused on constraining pay unrelated to performance. The stimulus bill takes the opposite approach -- constraining incentive compensation, limiting it to one-third of total pay.

To be sure, incentive compensation in many public companies has been flawed. Some incentive compensation has been so in name only, and some of it has provided perverse incentives to focus on short-term results to the detriment of long-term performance.

But these problems require tightening the link between pay and long-term performance -- not giving up on it altogether. Mandating that at least two-thirds of an executive's total pay be decoupled from performance, as the stimulus bill does, is a step in the wrong direction.

Another wrong step is the bill's categorical prohibition on using any form of incentive compensation other than restricted stock. In the first place, some executives covered by the bill (up to 25 in some firms) run limited parts of the company's operations. Their incentive pay might be best tied to the performance of their unit's particular results, not to that of the whole company.

But even for top executives, the banks' special circumstances may make exclusive use of restricted stock contrary to taxpayer interests. In many banks, the shareholders' equity, which is junior to the government's investments in preferred shares and the claims of bondholders, now represents a small fraction of the bank's capital. Indeed, the value of some banks' common shares might largely represent an "out-of-the-money option," expected to deliver value only if things considerably improve.

In such circumstances, restricted stock may provide incentives for executives to take excessive risks with the bank's survival. Consider the case where an infusion of additional capital would greatly dilute the value of common shares but would be best for the bank, while failing to get that capital would put the bank's future at risk. In such circumstances, compensation in restricted common shares would provide executives with an incentive to avoid raising capital (which would wipe out their shares' value) and gamble on survival without additional capital.

The compensation restrictions have another adverse effect on incentives. Executives can sidestep them by returning TARP funds and avoiding them in the future. Some observers argue that such actions would be unlikely because they would be costly to the bank. This overlooks the divergence between the interests of the bank and its executives. The bill provides executives with counterproductive and unnecessary private incentives to terminate or avoid TARP funding, even when doing so would not be in the bank's best interest.

The stimulus bill's adverse incentives deserve special attention because of the government's current approach to the banking sector. While infusing large amounts of capital into banks, the government has chosen to leave their management largely to the discretion of bank executives. This makes executive incentives of paramount importance.

Compensation structures with distorted incentives may have already imposed large losses on investors and the economy. Public officials should be wary of introducing new distortions and perverse incentives. With so much hanging in the balance, ensuring that those running the country's banks have the right incentives is as important as ever.

Mr. Bebchuk, director of the Harvard Law School program on corporate governance, is co-author of "Pay without Performance: The Unfulfilled Promise of Executive Compensation" (Harvard University Press, 2004).

The Bad Bank Assets Proposal- Even Worse Than You Imagined

naked capitalism

The Obama Administration, if the Washington Post's latest report is accurate, is about to embark on a hugely expensive "save the banking industry at all costs" experiment that:

1. Has nothing substantive in common with any of the "deemed as successful" financial crisis programs

2. Has key elements that studies of financial crises have recommended against

3. Consumes considerable resources, thus competing with other, in many cases better, uses of fiscal firepower.

The Obama Administration is as obviously and fully hostage to the interests of the financial services industry as the Bush crowd was. We have no new thinking, no willingness to take measures that are completely defensible (in fact not doing them takes some creative positioning) like wiping out shareholders at obviously dud banks (Citi is top of the list), forcing bondholder haircuts and/or equity swaps, replacing management, writing off and/or restructuring bad loans, and deciding whether and how to reorganize and restructure the company. Instead, the banks are now getting the AIG treatment: every demand is being met, no tough questions asked, no probing of the accounts (or more important, the accounting).

[Feb 3, 2009] Davos under fire By Gustavo Capdevila

One of the few indicators on the rise at this time of economic and financial crisis is the level of repudiation expressed about those responsible for the disaster, and about the institutions sponsoring them.

This became apparent at the Swiss tourist resort of Davos, the venue for the annual sessions of the World Economic Forum (WEF), one of the arenas that has supported the deregulation policies blamed for causing the present global economic and financial crisis.

Socialist Swiss lawmaker Susanne Leutenegger was outspoken in linking the WEF with the crisis. The Davos Forum has been one of the ideological agencies behind these policies, as finance, industry and politics mingled at the forum sessions, which started 39 years ago, she said.

This was the place where contacts and informal networks were established, while politicians sat "below the salt" and the media were fascinated by the rich and powerful global elite, she said. The forum was "a fly-by-night lobby operation for the bankrupt neo-liberal (free market) business model".

Leutenegger was speaking at the awards ceremony of the Public Eye on Davos, organized by Swiss non-governmental organizations The Bern Declaration and Greenpeace Switzerland, where "dubious distinctions" are conferred on companies that have shamefully violated ethical and environmental principles.

As a result of these awards and the political content of the prize-giving ceremonies, the Public Eye has been, since 2000, one of the most critical observers of the Davos Forum.

Back then, the media were in such a frenzy about Davos that they stifled voices of critical dissent calling for a more socially responsible economy with sustainable policies, Leutenegger said.

The global Public Eye award went this year to US mining company Newmont, the world's largest gold producer, for its "scandalous" practices in Ghana, where it has destroyed unique natural habitats, carried out forced resettlement of local people and polluted soil and rivers, according to the jury.

The "prize" for Swiss companies was awarded to BKW FMB Energy, for building a coal-fired thermoelectric plant in Germany. Coal is the most polluting of all fuels, the organizers said.

In contrast, the Public Eye awarded a Positive Prize, in recognition of the efforts of Colombian trade union leaders Jairo Quiroz and Freddy Lozano and their union Sintracarbon to reverse the decision of a transnational coal mining company that had displaced 800 Afro-descendant families to expand their operations in El Cerrejon, in northeastern Colombia.

In fact, the negative awards target two companies that epitomize the social and environmental abuses committed by all the members of the WEF and by large corporations that are the true image of profit motivated globalization, the organizers of the Public Eye said.

The Bern Declaration and Greenpeace sent a letter to US President Barack Obama on Thursday, asking him to introduce corporate regulation.

So far, efforts to impose mandatory international corporate accountability rules on transnational corporations have failed because of opposition from the United States, they said.

The message to Obama requests that in the future, all transnational company projects respect the rights of local communities in their area of operations. It also asks for an end to impunity for companies that violate the rules.

The two organizations want the Public Eye to become a rallying point for all critics of the Davos Forum, said Oliver Classen of The Bern Declaration.

The Swiss authorities also came in for criticism for their financial support for the WEF. The forum is a private meeting, but the Swiss government subsidizes it to the tune of eight million Swiss francs (US$7 million), mostly for security services, Leutenegger said.

She estimated that total spending by the Swiss state on the Davos Forum amounted to some 20 million Swiss francs.

Police from several Swiss cantons and some 5,000 army soldiers are deployed during the week of WEF sessions, while the national air force, in conjunction with that of Austria, secures the air space over Davos.

Leutenegger said that street protests against the Davos Forum are for the most part prohibited. The rights to free speech and free association are practically suspended throughout the country during the WEF, she said.

A demonstration against the Davos Forum, convened by left-wing political and social organizations for Saturday in Geneva, was banned by the authorities.

Leutenegger remarked that the neo-liberal revolution appears to have failed dismally worldwide, and now its "shameless promoters" want to get free money from the state.

However, the Davos Forum, a successful instigator of that economic model, is doing very well, the lawmaker said. According to her estimates, the world's top 1,000 companies, members of the WEF, contribute some 40 million Swiss francs annually to the forum.

In total, including the special contributions from financial companies and the fees paid by forum participants, the WEF, which operates in Switzerland as a charitable foundation, has an annual income of about 100 million Swiss francs.

Leutenegger also rebuked the left and trade unions for failing to apply the necessary pressure to contain the forces that precipitated the crisis.

Fundamental discussion is needed, especially among the left, trade unions and social movements, about building a post-capitalist system and putting it into practice, she concluded.

(Inter Press Service)

Op-Ed Columnist - Disgorge, Wall Street Fat Cats -

The president's disgust at Wall Street looters was good. But we need more. We need disgorgement.

Disgorgement is when courts force wrongdoers to repay ill-gotten gains. And I'm ill at the gains gotten by scummy executives acting all Gordon Gekko while they're getting bailed out by us.

With the equally laconic Tim Geithner beside him, Mr. Obama called it "shameful" and "the height of irresponsibility" for Wall Street bankers to give themselves $18.4 billion worth of bonuses for last year.

They should know better, he coolly chided. But big shots - even Mr. Obama's - seem impervious to knowing better. (Following fast on Geithner's tax lacunae, Tom Daschle's nomination hit a pothole when he had to pay $140,000 in back taxes he owed mostly for three years' use of a car and a driver provided by a private equity firm.)

At least the old robber barons made great products. When you make money out of money, unmoored from morality and regulators, it must unhinge you. How else to explain corporate welfare queens partridge hunting in England, buying French jets and shopping for Lamborghinis?

Mr. Obama was less bracing than during the campaign, when A.I.G. executives were caught going to posh retreats after taking an $85 billion bailout. He called for them to be fired and to reimburse the federal Treasury. Now that he has the power to act, Mr. Obama spoke, as his spokesman Robert Gibbs put it, "like that disappointed parent that doesn't embarrass you in the mall, but you feel like you've let somebody down."

That's not enough, not with the president and Geithner continuing to dole out what may end up being a trillion dollars to these "malefactors of great wealth," as Teddy Roosevelt put it.

USA Today wrote about "the A.I.G. effect:" executives finding ways to spend more discreetly, choosing lesser-known luxury hotels and $110 pinot noir instead of the $175 variety.

More than a disappointed parent, they need a special prosecutor or three. Spare the rod, spoil the jackal. Anyone who gave bonuses after accepting federal aid should be fired, and that money should be disgorged to the Treasury.

Claire McCaskill popped out a bill to limit the pay of anyone at firms taking federal money to no more than the president makes - $400,000.

"These people are idiots," she said on the Senate floor. "You can't use taxpayer money to pay out $18 billion in bonuses. ... Right now they're on the hook to us. And they owe us something other than a fancy wastebasket and $50 million jet."

One Obama official said her idea is catchy, but it won't work "because no one would come to Treasury to participate, and that means our economy would continue to stumble downward."

Senator Chuck Grassley urged the administration to snatch back the bonuses. "They ought to give 'em back or we should go get 'em," the Republican told me. "If this were Japan and a corporate executive did what is being done on Wall Street, they'd either go out and commit suicide or go before the board of directors and the country and take a very deep bow and apologize."

He was shocked to learn that the Office of Management and Budget, insistent on following the Paperwork Reduction Act, was dragging down a special inspector general's investigation of what banks are doing with taxpayer money. (After complaints, the O.M.B. yielded on Friday.)

"Once in a while, some C.E.O. comes and talks to me and I wonder if they're laughing under their breath at having to talk to someone who makes 1 percent of what they make," he said.

Treasury officials and Barney Frank are dubious about recouping bonuses. "Paulson let the cat out of the bag," Frank said of Henry Paulson, Geithner's predecessor, "and it can't be gotten back."

But aren't taxpayers shareholders in these corporations now, and can't shareholders sue or scream "You misspent my money!" like Judy Holliday?

"In 'The Solid Gold Cadillac,' " said Frank, who knows the movie.

"We got some preferred shares," he mused, "but I don't think we could sue on that basis."

Rudy Giuliani resurfaced Friday to defend corporate bonuses, telling CNN that cutting them would mean less spending in restaurants and stores.

Stupid. Even without bonuses, these gazillionaires can still eat out. It's like Rudy's trickle-up Make Work Program: Make Leisure.

Some Obama policy makers still buy into the notion that if they're too strict, these economic royalists, to use F.D.R.'s epithet, might balk at the bailout, preferring perks over the prospect of their banks going belly-up.

The president needs to think like Andrew Cuomo. " 'Performance bonus' for many of the C.E.O.'s is an oxymoron," he said. "I would tell them, a) you don't deserve a bonus, b) where are you going to go? and c) if you want to go, go."

[Feb 1, 2008] Asia Who served the cheap booze? By Hossein Askari and Noureddine Krichene

The end of the George W Bush era at noon on January 20, 2009, was unflatteringly prefaced on January 5 by Senate majority leader Harry Reid (Democrat, Nevada): "I really do believe President Bush is the worst president we've ever had." The current economic and financial turmoil cannot contradict this opinion.

After inheriting a stable and prosperous economy from president Bill Clinton, with a budget surplus of more than US$200 billion, Bush has bequeathed President Barack Obama a record-shattering $1,200 billion projected deficit for 2009, an unemployment rate exceeding 7.2% of the labor force and expected to rise rapidly possibly into the double-digit range, rapidly declining real incomes, a contracting real gross domestic product (GDP), and a government debt that has more than doubled to exceed 90% of GDP.

Bush said, "Wall Street got drunk and left us with the hangover." The Wall Street Journal, January 19, 2009, in an article titled the "Bush Economy" replied, "Who does Mr Bush think was serving the liquor?"

This free-flowing booze is the consequence of the cheapest monetary policy in US history (frequently referred to as Greenspan's put, after the policy of former Federal Reserve chairman Alan Greenspan), underlined by a fully deregulated financial system following the repeal of the Glass-Steagall Act in 1999. The Bush administration has caused the most spectacular housing bubble in US history, accompanied by an unprecedented commodity speculative bubble, a record depreciation of the US dollar, capped by pushing interest rates to the zero bound in December 2008. The dire consequences for the real economy are only beginning to emerge and have a long way to go before we should expect a significant turnaround.

The financial calamity that has followed the bursting of these bubbles has caused the worst financial crisis in the US since the Great Depression, with fallouts across the Atlantic to European banks exposed to the US subprime markets. Historic bailouts by governments in the US and Europe have had to be undertaken, socializing losses from Ponzi schemes and preserving private speculative gains. Many financial institutions have fallen into bankruptcy, and all of the accumulated gains in financial wealth in over a decade has been wiped out overnight as illustrated by the collapse of stock indices.

With the nationalization of major financial institutions and the highly subsidized credit policy, many conservatives now accuse Bush of being a "socialist".

In spite of a monumental bailouts, financial institutions continue to suffer huge losses and to shed jobs. With writedowns of about $1 trillion (and growing), nonperforming portfolios are afflicting most major banks. Bank of America recorded its worst losses ever in 2008 and announced plans to shed 4,000 jobs. It required a government capital injection of $20 billion and a liquidity injection of $138 billion. Citigroup, even after suffering huge losses and receiving $45 billion injection and $306 billion in guarantees from the government, has decided to split itself into a banking institution and a brokerage institution. The Royal Bank of Scotland reported a loss of $41.3 billion in 2008 - the biggest loss in British corporate history, prompting the UK government to announce a second bank rescue plan. Still, there is no end in sight.

While the Bush administration has ended, Bush appointee Ben . Bernanke, who as the chief of the Council of Economic Advisers (CEA) and then as the chairman of the Federal Reserve, has been in charge of Bush financial policies, will remain a most powerful decision-maker under the Obama administration.

Bernanke, as a historian of the Great Depression, has been a staunch supporter of ultra-expansionary policies under Greenspan, serving up the cheap booze to Wall Street. By conviction, he continues to run the most expansionary policy in the US history. Despite the ravages that this policy has already caused the US and the world economy, Bernanke and his supporters have all along promised a quick turnaround through magic reductions in interest rates. Their motto is that the economic crisis would have been far worse if interest rates had not been cut to the zero bound.

How much worse could it be? They have no answer to this question. While the banking sector, as illustrated above, has kept on collapsing and the economy deteriorating, in spite of record low interest rates, they strongly believe that unlimited money expansion will eventually bolster the health of the banking system and bring about economic recovery!

In a speech at the London School of Economics (LSE), on January 13 [1], Bernanke stated that, "In the near term, the highest priority is to promote a global economic recovery. The Federal Reserve retains powerful policy tools and will use them aggressively to help achieve this objective ... The virtue of these policies in the current context is that they allow the Federal Reserve to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound ... Fiscal policy can stimulate economic activity, but a sustained recovery will also require a comprehensive plan to stabilize the financial system and restore normal flows of credit."

More explicitly, Bernanke, following the program in Sweden in the 1990s, called for setting up a bank at the US Treasury that would buy all bad assets, redeem all write downs, and provide guarantees against defaulting loans or securities. Being aware of the controversy over the Troubled Assets Relief Program, Bernanke admonished policymakers to be responsible: "Responsible policymakers must therefore do what they can to communicate to their constituencies why financial stabilization is essential for economic recovery and is therefore in the broader public interest."

There were disappointing omissions in the Fed chairman's address. Specifically, he attributed the financial crisis to a bursting credit boom. He ignored altogether the role of record-low interest rate policy adopted by the Greenspan Fed, which he supported as a chairman of the Council of Economic Advisors, in creating the credit boom and multiplying Ponzi finance in which investors rely solely on appreciation of their assets to service their debt.

In spite of repeated calls, notably by Fed governor Edward Gramlich, for arresting housing speculation, the Fed and the Bush administration simply ignored these calls. Dramatically low interest rates squeezed bank incomes, pushed loans to sub-prime markets and caused over leveraging through securitization and credit derivatives (such as credit default swaps). Finally, they precipitated the collapse of banking institutions, including those considered "too big to fail".

Bernanke went on ignoring the evils of extremely low interest rates that he persistently implemented since August 2007 saying that the Federal Open Market Committee "maintained the view that the rapid rise in commodity prices in 2008 primarily reflected sharply increased demand for raw materials in emerging market economies, in combination with constraints on the supply of these materials, rather than general inflationary pressures".

But who pushed the dollar to record lows and the gold to record highs in 2008? Certainly not the emerging countries. If Bernanke's claim was true, why did all commodity prices fall simultaneously and rapidly while emerging countries were still growing in 2008? Assuming Bernanke was right, then the sharp demand for commodities by emerging countries was primarily ignited by record low US interest rates and the record US external current account deficit. It is unfortunate that. Bernanke ignores the Fed's responsibility in igniting commodity inflation since 2003 through speculation and in intensifying it in 2007-2008 until it finally depressed real growth and real spending.

Bernanke was not clear regarding his objectives: whether he wanted again to stimulate aggregate demand through free money to consumers, or he had a nostalgia for another credit boom, or he wanted a banking system that was sound and could support traditional and safe banking business. If Bernanke was after one of the first two objectives, then certainly banks are still awakening from a hangover and will not be willing to get drunk again no matter how much free booze Bernanke will serve them. The Fed's overleveraging of its balance sheet and extensive liquidity injection have only led banks to buy government papers or build excess reserves.

If Bernanke wants the US financial system to be like the financial system in many other developed countries, essentially guided toward traditional banking and less toward speculation, then that goal is without a doubt within reach.

Warren Buffet showed how it could be done when he extended a loan to GE at 10%. With Bernanke pushing interest rates to zero bounds and short-cutting banks through direct lending to finance companies and private companies, banks will be stifled and cannot survive under such a monetary policy. In spite of the abnormal squeeze on their incomes, banks have continued to extend loans to safe and traditional business.

The Fed data [2] clearly shows the absence of any credit crunch whatsoever for safe business in all sectors of the economy. The types of credit that have been impaired are essentially the subprime sectors that suffered large defaults, namely subprime housing and consumer loans. It is quite understandable that banks cannot not extend such highly risky loans at insignificant interest rates.

Bernanke has expressed the view that President Barack Obama's $1 trillion stimulus package may not work unless the government sets up an institution at the Treasury that would buy all bad assets, redeem all writedowns and provide guarantees for loans and securities. As in the case of TARP, Bernanke's plan has found large supporters in the banking sector and in the media. Such a plan would call on Congress to sign a blank check for an indefinite period for bailouts. Is it equitable to socialize speculative losses and preserve private speculative gains? In other words, is it legitimate for the homeless to pay for the fat salaries of the financiers? Is it legitimate to deny American children education in order to refund Ponzi losses?

As Obama's stimulus package is projected to push the fiscal deficit to over $2 trillion, or about 16% of GDP, by how much would Bernanke's additional TARP plan expand this deficit? How could such monumental deficits be financed? We are asked to take at face value his warning that our survival hinges on his plan, and therefore it matters less how much sacrifice we have to make for repairing Fed's errors.

Besides socializing speculative losses, Bernanke wanted the government to prevent foreclosures, implying the Treasury should pay the mortgage of every homeowner. That would be indeed the ultimate socialist society, where citizens are secured money for free spending and free houses. While it is a laudable policy to keep people in their houses, it should be done in a way that the housing bubble is allowed to burst while lenders and borrowers incur the losses.

It is unfortunate that US policymakers have not yet grasped the heavy toll of a decade of expansionary policy in terms of fiscal cost, financial anarchy, crumbling economy and collapsing banking institutions. By blowing up the US external deficits, cheap money policy has increased dramatically US imports; it has ultimately benefited the exports of other countries and weakened US industries. It appears that the Obama administration is embarking on a fast track of expansionary fiscal and monetary policies. Such policies could only prolong the economic agony and could trigger the highest inflation in US history.

Would Bernanke's zero interest rates and unlimited cheap money achieve the objective of a quick turn around? Since August 2007, such a policy has brought only a succession of economic and financial setbacks. This is the clear result. Continuing with the same policy would deplete real savings and consequently capital accumulation. It is a guarantee for a continuation of the financial crisis. If banks replay the Bernanke-Greenspan credit boom, then the consequences are obvious. If the monetary brake is re-applied with vigor, then interest rates will overshoot and, as in the 1980s, a debt crisis would be inevitable.

Very clear warnings were expressed by a number of prominent people, including Edward Gramlich, Joseph Stiglitz, Maurice Allais and George Soros, regarding the dangers of a cheap money policy. These warnings were totally ignored.

A top priority for the new administration should be to stabilize monetary policy and bring the Fed back to the realm of traditional central banking, that is mainly in managing liquidity and safeguarding the soundness of the financial system. The new administration should strictly arrest bailouts. The problems of banks have to be resolved within the banking sector. Ailing banks have to recapitalize on their own or simply face bankruptcies. Disappearance of insolvent banks, or any loss-making business, has never meant in any country or at any time, disappearance of financial or economic activity.

The slogan according to which we bailout banks or we die is fallacious and should be abandoned. Isn't it time to cut off the umbilical cord from the Bush administration's costly policies, or are we doomed to continue to be tied them? If the Obama administration does not cut the ties, history may indeed judge President Obama even more harshly than it already has president Bush.

1. Speech by Bernanke at the Stamp Lecture, London School of Economics, London, England, January 13, 2009. Click here.
2. Release dated January 23, 2009. Click here.

Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist at the International Monetary Fund and a former advisor, Islamic Development Bank, Jeddah.

(Copyright 2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)

[Jan 31, 2009] Wall Street Quakes at Threat of $400,000 Pay Cap

Populist backlash is clearly evident. Banksers probably start trembling like they were in 1930th. It's funny that there is a very fine line between banksers and bank robbers: the difference is mainly in tools and the size of the damage, not the net results.

Today, Senator Claire McCaskill of Missouri introduced legislation that would limit salary, bonus, and stock options for executives as financial firm recipients of bailout funds be limited to the President's level of pay, currently $400,000.

McCaskill's proposal is likely to go all of nowhere. She is not a member of the Finance or Appropriations committee, so her proposal is more a shot across the bow than a serious initiative. And given that "executive" is generally defined as the five most highly paid corporate officers, the ones whose remuneration is listed in the proxy statement, it covers only a trivial number of employees.

But her bill is getting a lot of media coverage, which means it could serve as a starting point for negotiations. It has become a benchmark as far as the public is concerned.

So how reasonable is it? The problem is that too few people in the industry have any memory of what bad times were like, and the last few years were so grotesquely rich (in terms of pay, not risk adjusted performance) as to have distorted industry participants' sense of reality. The pretext for the largess was that the really good people would decamp to hedge funds, so pay had to be ratcheted up to those levels (John Whitehead, former co-chairman of Goldman, dismissed that idea when the bubble was at its peak).

Bear in mind: the bonuses paid in 2008 in New York, when all the big domestic players and most of the large foreign firms (who constitute the bulk of employment) were on government life support, were the roughly the same as in 2004, which was a good but not stellar year. I'm not certain of the headcount differences then versus now; with the loss of Bear, Lehman, and a lot of headcount cuts industry-wide, I doubt that employment is much above 2004 levels.

Since people are generally not too open about pay (and tend to exaggerate to boot), I have only a couple of datapoints, but I think they are germane. Anyone with relevant info from the last downturn is encouraged to speak up.

The dot bomb bust was bad on Wall Street. To give an idea: I went to see a friend in the search business in 2002 to get his insights about a company he knew. He had two neat stacks of unopened letters on a credenza behind his desk, each roughly 2 feet high. I asked about them. He explained he was getting an enormous amount of letters from job-seekers (and mind you, his was a very small firm). He didn't bother opening them, since he knew or could find plenty of good people and employers preferred to hire the employed over the unemployed. The letters were from unknown quantities and there was no reason for him to try to weed through them.

So why did he keep them? In case someone connected called him to ask him if he had received the resume of his good buddy. Then he would dig through the pile and give it a (usually obligatory) look.

One of the hard hit businesses was mergers and acquisitions. Keep in mind that M&A is a fee business; the professionals do have overhead (salaries, travel, secretarial, computers and software, access to databases) but they don't use capital and they require less infrastructure than trading operations (which have trading stations, data feeds, lots of software and valuation modes, risk management, sales forces, back office). Now admittedly, in boom cycles (the late 1980s and the last few years) Wall Street messes up this nice model and decides to try to gain a leg up in M&A by risking its balance sheet (committing to lend to fund deals). That always leads to ruin. But that gets reined in during bad times, so let's think of the traditional, high wits, low overhead version of the business.

I'd welcome any other inputs, but the people I knew in M&A (senior MDs running what had been high profit industry groups, so the top of the food chain in that business) were cut back to $400,000. And they were unhappy but not disappointed, if you can appreciate the distinction. They of course hated that they had to keep trying to do business when there was no business to be had. Tilling a field during a drought is not pleasant. But they were grateful to still have a job, to not have been demoted, and knew intellectually that their pay was fair in light of current conditions.

Assume 3% inflation. Compound $400,000 forward to 2009. You get roughly $500,000.

M&A is a talent business. You need pretty highly developed skills to master the technical aspects and be credible with CEOs. The top people can and do set up or join boutiques (although some recent ones overlarded with talent, like Perella Weinberg, haven't done as well as the older boutiques, like Greenhill & Company).

Traders will argue that level is too low, that if they make $30 million for someone, they deserve a bigger cut.

No dice, Unless you are willing to pay back your share of losses, I don't accept the logic that you are entitled to a asymmetrical pay deal. You may have been lucky enough to extract that, but what you can get in good times (or from chumps) and what you deserve in a more abstract sense are two different things. You are playing with other people's money, and that carries with it substantial responsibilities (or at least it should, but management heretofore has been complicit in pretending that it doesn't).

Warren Buffet, in his reinsurance business, had a simple formula: his execs got a pool of 15% of the profits on deals written 5 years earlier, ex any losses on the same pool. Five years was long enough for the vast majority of deals to prove themselves out.

I could see a variant of that formula for traders. Say you do make $30 million in profits in year one. You get a salary and only 1/10 of your cut that year in cash. The rest is deferred. Any losses in years 2-5 get deducted (the deferred portion can be invested in a high or low risk manner at the choosing of the trader, so there would be some income on the deferred amount) Any remainder is paid out.

Now that would take some tweaking (t creates an incentive for a trader having a super year to change firms, for instance), and there may be better ways to achieve the same end, but you get the drift: you can't have people who take serious risks with capital enjoying "head's I win, tails you lose" arrangements. Either they rewards have to be reined in substantially so they have less reason to take big gambles, or they need to share more in the downside.

The threat to contain pay is serious enough that Wall Street may have to find a way to deny its reflexes and exercise restraint. This is going to make for some interesting theater.

Babe's Ghost said...
GDP? Are you joking? Wall Street is supposed to be a facilitator, but it's grown so big that it's become a tax on the real economy.

I think (hope) that the systemic changes are going to limit the amount of risk (leverage) that people are going to be able to take on. This will depress earnings (winnings?) and bring bonuses back to earth.

That said, I'm all for McCaskill's proposal. In fact, I sent her an email promising a campaign contribution if it gets done.

Everyone knows things are going to get much worse as the slow down builds and ripples through the real economy. I'm not sure that scapegoating a few individual fraudsters like Madoff are going to satisfy some who lost their job, their house and their 401k, then watched $18bn in bonuses distributed to people who lost $2 or 3 trillion dollars. If I were an ambitious AG with jurisdiction I might try something even more punitive with an eye on a possible primary challenge to Bam.
Watch me drop the F-bomb on them
"Fnationalization! Fbankruptcy! Ftaxes! Funemployment!"

hat-tip bg

January 31, 2009 3:42 AM
Viv said...
Forget pay caps, these people should be in prison. If a milk company or a toy company sold you substandard, toxic products they would be shut down and prosecuted for negligence. When that happens on wall street, the government bails them out with the taxpayers money and pays their salaries.

I don't give a damn whether some trader made 30 million in a year, if it weren't for taxpayer support he would be out and unemployed. Putin was right when he said in Davos that the Investment Banks have lost more in one year than they made in the previous 25.

What we have in this country is FASCISM. Plain and simple, when you socialize losses and privatize profits for corporations, that is FASCISM. And America has a history of liking fascists like Mussolini before WW2, Pinochet in Chile etc. But in America dissent is not crushed, it is merely ignored. Dissenters can shout all they want about TARP, Geithner, Ineffective Keynesian theories that were discredited in the 70's. It's just ignored.
What the elite want in America, they get. And so expect more deflation, no way would the top 0.1% of Americans want their cash holdings deflated away.

January 31, 2009 5:21 AM
Anonymous said...
Putin was right when he said in Davos that the Investment Banks have lost more in one year than they made in the previous 25.

I was just thinking about this the other day. If this bailout reaches a couple to three trillion, how many years of Wall Street profits is that? Is it 25 years of profits? 50 years?

There's this notion that saving Wall Street is worthwhile (presumably because Wall Street creates value), but what if the losses over the last few years have wiped out 50 years worth of profits? Is that a business model that we want to try and save? I would say no.

January 31, 2009 5:59 AM
Anonymous said...
The Obama administration is not likely to impose tougher restrictions on executive pay on most firms receiving aid under the government's $700 billion financial rescue program, the Washington Post reported on Saturday.

These two den of thieves need each other salary cuts ain't gonna happen.

January 31, 2009 6:17 AM
bg said...
"I don't see what's wrong with golden handcuffs. A lot of places have vesting schedules. A lot of Wall Street firms (and other places) would give a portion of comp in restricted stock."

For golden handcuffs to work they have to be percieved as being two way. I might be very good at my job, but the firm is likely to fire X% of the people this year, and Y% every year afterward (to keep up morale). Selling a long dated option with high volatility has to pay higher than a short dated option with the same volatility.

An insecure employee will not value defered comp nearly as much as a secure one.

January 31, 2009 6:25 AM
Anonymous said...
The level of demagougery over executive compensation is getting uncomfortable.

So the POTUS only makes $400,000 per year ( while in office) but there are sizable perks including a fashionable home, a 747 for a private jet and deferred compensation through book deals and speaking fees if the ex POTUS chooses to cash in.

While our politicians rant and rave
about the excesses on Wall St. maybe they should take a closer look at what goes on on K Street. Ask their wives and brothers in law
just what they do to earn their huge compensation packages and compare the unfunded liabilities of our government to those of the banking system.

This is not to excuse Wall St of its gross excesses merely to point out pots calling kettles black is no solution to the problem. If excessive compensation for minimal
economic value is the problem why not cast our nets wider.

How is it that on many an American university campus these days the most highly paid 'academic' is the football or basketball coach? His pay may exceed that of the entire engineering faculty!

What of the cosmetology school dropout turned real estate broker earning more than the chief of orthopedic surgery at the county hospital? The illiterate ghetto gang bangers who are blessed with the ability to run fast, jump high or catch a ball getting multi-million dollar signing bonus? My dog can do all of those things and does it for some basic rations and the occasional massage.

Compensation is a tricky thing often with no apparent rhyme nor reason to it. That cosmetology dropout turned real estate broker who earns a fabulous income selling
McMansions earns that money because she can do it better than others. The NCAA coach you see in the Orange Bowl makes his money doing a very difficult thing. He has to recruit teenage athletes and get them to win football games 90 plus percent of the time. Even the leaping ghetto gangbanger with a ball has to be better at his craft than a legion of others who would take his position in a heartbeat. It ain't easy staying on top, even on Wall St.

January 31, 2009 6:49 AM
Expat said...
@bg: generally, and talking specifically from experience, deferred bonus schemes are not lost if the trader is fired. If a bank pays you 25% upfront and then 25% a year for three years, it cannot fire you immediately without paying you out entirely.

The Heads-I-Win attitude is rampant in banking. I know a dozen traders who have run up positions, held them through the end of the year, collected huge bonuses then happily accepted getting fired when the position lost tens of millions once the trader stopped propping it up.

If a trader is good, he makes money year in and year out so being held to five year results is not unreasonable. Senior managers should be held to a minimum of five years and probably longer.

Many argue that banker X who made money should not be penalized because banker Y lost money. but in reality, the banking profits of the past ten years are all built on the bubble. The profits were illusory. Once the risk is reduced and the economy returns to reality, those profits won't exist.

And finally, if the trader or banker is so fantastic, then he SHOULD do it on his own or for a boutique shop or fund. Anyone working for a US bank today is now a public servant getting paid with MY tax dollars. I see no reason for them to get paid millions.

$400k is a lot of money. Too bad if Manhattan real estate "collapses" or Maserati dealers go out of business.

January 31, 2009 6:54 AM
Richard Kline said...
Regarding capping and deferring bonus income, as you know Yves I have been advocating much what you propose for a year (and before that but). I would further add that employees eligible for bonus pools need to have explicit language in their contracts that their firms can claw back any bonus income for bonus cycles in which deals signed off on by said receipient are demonstrated to have had inadequate due diligence or outright fraud or misrepresentation. In effect, that would make all of the top tier's bonus income recoverable at any time since they sign off on the entirety of what is traded/shunted under them. The language of what constitutes failure needs to be clear to protect the bonus receipients from punitive recoveries, but still.

You are responsible for the good and the ill that you do---unless you are a financier (or a neocon). For them, it's all jackpot, all the time; i.e. the game's rigged. Is it any wonder, then, that many don't care whether their deals are any good for _anyone_ at all? Why should they: there's no penalty for failure, and stupendous riches for the appearance of success.

As for all those insecure employees who find intolerable the risk of waiting for their pools to prove out and hence vest, they are invited to exit now, start their own shops, and raise their own cash throughput. You'll find that given that choice most of them will prove to have bigger mouths than ambitions. And as for the rest---good riddance: those are the boys who shut their eyes to risk or fake the numbers because they are Mr. Right Now all the time.

January 31, 2009 6:58 AM
JP said...
Two points, the smaller point first:

And given that "executive" is generally defined as the five most highly paid corporate officers, the ones whose remuneration is listed in the proxy statement, it covers only a trivial number of employees.

True, but setting a limit on their salaries will most likely have the intended effect of setting a limit down the chain, unless the execs are so generous to keep their underlings at far higher salaries.

The bigger point: The banks are no longer functioning businesses. The exist only because they are on the government dole. They are welfare queens. Driving far better than Cadillacs.

They are ex-banks. No longer of this world. Kicked the bucket. Sleeping with the angels.

If they think they're worth more than $100K/yr, then let them go to that job. There's plenty of qualified people now to backfill your place.

They are commodities, but are slow to realize it.

January 31, 2009 7:48 AM
ruetheday said...
"Traders will argue that level is too low, that if they make $30 million for someone, they deserve a bigger cut."

There are so many problems with that line of thought. What about the engineer making $90k/year who gets a patent and ends up making $100 million for his company? What about the EMT who responds to a car crash and saves a life (maybe that of the trader)? And the POTUS comparison is very apropos - this is a man who leads the free world and has the power to launch nukes at a moments' notices, he is a real master of the universe in some sense, unlike the ego-inflated impostors on Wall Street.

But perhaps the biggest problem is the fundamental asymmetry with regard to gains and losses. If that trader causes his firm to incur a big loss, he still gets a salary and simply forgoes a bonus (maybe loses his job if he really screws up). He incurs no personal loss of capital. If he thinks he is entitled to more than he gets now, perhaps he ought to strike off on his own and trade his own account and actually face real gains and losses.

January 31, 2009 7:52 AM
Anonymous said...
why not change the use of the term 'bailout' to 'welfare.' 'Bailout' doesn't evoke appropriate contrition, shame, or fear of retribution that 'corporate welfare' should.

Americans are still reluctant to think of hanging the bastards, so lets do something collectively before that day comes -like using politically correct language.


January 31, 2009 8:11 AM
Anonymous said...
as a wallstreet worker, please don't take away my bonus.

i have a drug habit, a hot piece of ass girlfriend who loves me for my money, a top of range condo, a sports car and a party lifestyle to fund.

i know i lose your hard earned tax money, but as you can see, it's for a good cause, your money funds my happiness. we all like happiness don't we? you wouldn't deny happiness would you?

do the right thing, pay your taxes, fund my happiness.

January 31, 2009 8:43 AM
Anonymous said...

why not change the use of the term 'bailout' to 'corporate welfare recipients.' ...use correct language, not 'politically correct language.'

Wall Street and the ideology of lawlessness led by Ayn Rand devotee Alan Greenspan (yes, it was and is a cult as insidious as any other with the power to appear benevolent but ultimately evil and deadly) have proven that 'free markets' work.

The ideology has led to failure and collapse.

Let it collapse. Let them collapse. There are honest people out there with integrity, talent and experience who could emerge and will emerge if we survive this.

All this chatter, as if these people and their system should be taken seriously let alone saved in their present form, is like discussing the idea that you can change doo doo back into filet mignon.

January 31, 2009 8:53 AM
Anonymous said...
Expat said-The Heads-I-Win attitude is rampant in banking. I know a dozen traders who have run up positions, held them through the end of the year, collected huge bonuses then happily accepted getting fired when the position lost tens of millions once the trader stopped propping it up.

Wow-legal theft-How do I get into this business?

January 31, 2009 8:54 AM
Anonymous said...
How about fraudster bank executives giving back all their 2008 bonuses in exchange of reduced prison term?
January 31, 2009 9:07 AM
Anonymous said...
Agree with Anonymous at 6:49 am...why is POTUS getting $400k...average american gets 1/10th of that with housing, car payments and grocery bill to boot...the egregious POTUS compensation and pension need to be cut with 100% of speaking/book fees going to the exchequer...
January 31, 2009 9:36 AM
Fomer PE guy said...
"M&A is a talent business. You need pretty highly developed skills to master the technical aspects"
I though you stopped drinking the kool-aid.

Wall Street, especially PE and hedge funds, is about one thing -Leverage. Without it they have been exposed as nothing more than speculators who can increase their returns in bubble times and then beg the taxpayers for a bailout when the leverage needs to be unwound.

January 31, 2009 9:39 AM
Anonymous said...
From the News Hour discussion of McCaskill's $400,000 cap:

JIM LEHRER: Is that a moral -- that's a moral issue?

DAVID BROOKS: Well, I do think it's a moral issue. I still think the McCaskill idea is just a terrible idea.


DAVID BROOKS: Because these are banks that depend on superstars. And there's not an ocean of superstars out there. And we may not like these people, but the fact is, to get a good CEO who can lead a company effectively, there are actually, if they can do it well, if they're Jack Welch or somebody, they're actually worth the money.

Now, that doesn't mean I'd buy into the hedge fund bonus structure, which was yielding $300 million bonuses. But, nevertheless, the reality is, to keep top talent from going overseas or wherever it would go, you've got to allow pay over $400,000 a year in New York City.

MARK SHIELDS: These are companies -- let's be very candid -- they are now taxpayer-subsidized. If they have these superstars, they probably haven't reached that point.

Now, last I heard there was a strain of thought in this whole mess called 'moral hazard'. Evidently, according to Brooks, we've got that notion entirely backwards. We've been thinking the hazard lies in rewarding irresponsibility through such things as privatize gain and socialize losses. Brooks, who has never met a rhetorical challenge against his thread bare republicanism that he cannot slickly meet, now comes to tell us that the hazard in all this lies in the morality of superstar celebrities who, if not paid according to, like totally free markets, man, will find other work. Even if the taxpayers must fund those 'totally free markets' from time to time, we risk immorality in not paying these superstars what the market says they are worth.

Got it?

January 31, 2009 9:51 AM
Independent Accountant said...
I have no sympathy for any Wall Street firm which got a bailout. People don't want to work for bailout recipients at $400,000 a year, $25 million a year traders included, leave. No entity that holds federally insured deposits should be in 80+% of the businesses Citibank is in anyway. They get cheap funding through FDIC insured deposits then pay it out in bonuses! What a scam. The WSJ writes today, "Many Wall Street employees work under employment contracts, that can't be unwound". The WSJ should stop shilling for Wall Street. Of course these contracts can be broken. That's one reason you file BANKRUPTCY! As a condition of getting federal bailout money all creditors and executory contract holders should have been told: you have 90 days to object to our tearing up your contracts. Not one dime goes into your firm until you waive objection. Don't like it, force the Wall Street house into bankruptcy. Do you think you'll get more in bankruptcy?
If the M&A guys are any good, their leaving won't hurt the Wall Street houses which employ them very much. Each is presumably being paid his marginal revenue product. It's the executives and traders who are wildly overpaid. What did a clown like Richard Fuld "earn" in the last five years? Not one cent in my book. The same goes for Robert Rubin, Lloyd Blankfein and who knows who else?
If the M&A guys want to stay, Citbank et. al. can rent them office space and let them use Citibank's telephone system. They don't even need to change physical offices.
January 31, 2009 9:51 AM
JP said...
ok if you want talent to fly overseas.
Hahahaha. Let them. Send them to the competition; Let them wreck other countries banking systems like they've wrecked ours.

They need to be replaced. If they go away of their own volition, so much the better.

January 31, 2009 10:31 AM
Anonymous said...
Failure is failure. Stop rewarding it. "Put. That coffee. Down. ... Coffee's for closers only."

Stop throwing money at these losers. Fire them. Let them go under. WATCH THEM BURN AND DANCE IN THE FIRELIGHT.

This is like the forest management idiots that won't let anything burn, even though it's healthy for the forest. You end up with a 20-year deferred powder keg that won't stop burning until the entire forest is destroyed. Or, it's like the "don't shoot the deer" morons who ban hunting and let deer populations grow until they're all too dumb and starved to keep the herd in good health.

Michael: "How bad do you think it's gonna be?"
Clemenza: "Pretty goddam bad. Probably all the other Families will line up against us. That's all right. These things gotta happen every five years or so, ten years. Helps to get rid of the bad blood. Been ten years since the last one. You know, you gotta stop them at the beginning. Like they should have stopped Hitler at Munich, they should never let him get away with that, they was just asking for trouble."

Burn these useless maggots out and make room for people that know what the hell they're doing. Stop rewarding failure. Stop propping up dysfunction. Most importantly, by the love of Christ stop insisting on doing it with OTHER PEOPLE'S MONEY. Specifically, mine.

January 31, 2009 10:32 AM
Anarchus said...
I'm all for the cap on pay for wall street idiots, though shouldn't there be a quid pro quo?

I'll gladly settle for a $400k limit on Wall Street pay IF the government will mandate immediate and totally public and transparent audits (with prison penalties for tax evasion enforced!) for all elected federal government officials and senior cabinet level appointments and their subordinates. I'm just saying, fair is fair, is it not?

January 31, 2009 10:41 AM
JP said...
I'm just saying, fair is fair, is it not?

Sure, we should limit the salaries of anyone requiring welfare checks.

Right now, it's the banks that require large sums of welfare money, so let's start there.

January 31, 2009 10:55 AM
Gentlemutt said...
David Brooks: "Because these are banks that depend on superstars. And there's not an ocean of superstars out there. And we may not like these people, but the fact is, to get a good CEO who can lead a company effectively, there are actually, if they can do it well, if they're Jack Welch or somebody, they're actually worth the money."

Mr. Brooks is often reasonably sensible, but this time his comment is just plain stupid. What is the economic value of any gambler in a zero-sum negative game? In the Panic of 2008 we have seen the aggregate value of all such gamblers.

A hard cap on income in any industry may not be smart, but income caps and penalties for any industry that brings the economy to its knees as Finance just did are by no means entirely unreasonable.

January 31, 2009 11:09 AM
cesqy said...
The board of directors (BOD) who oversee these companies are a major part of the overcompensation problem. They are in-bred cronies who take care of each other. I think making a law that allows them to serve on only one board at a time would constrain salary increases. BOD clawbacks are also important in the regulation scheme.
January 31, 2009 11:37 AM
doc holiday news service said...
US wealthy lose $20 trillion, says strategist

This illusion was worth $50 trillion at the market's peak in 2007, according to Grantham. In his quarterly review he writes: "How could we kid ourselves that we were suddenly rich and didn't need to save for our pensions when were sitting in the very same buildings we bought in 1974? We have not lost wealth, but just the illusion of wealth."
He says the situation has led to a run down in savings and a build up in debt: "Now the illusion of wealth has been lost with formidably negative effects on animal spirits." Advisers serving the lower reaches of the high net worth community could be facing quite a challenge: profits growth at the majority of private banks is tending to ebb away.
Grantham points out that personal wealth following write downs in equities, housing and commercial real estate now totals $30 trillion while debt remains stuck at $25 trillion.
Credit standards have tightened up but more illusory wealth needs to disappear before the US economy will start to recover: "To be successful we need to halve the level of debt. Somewhere between $10 trillion and $15 trillion will have to disappear."

>> I say, so the F what, life goes on and life will go on, Spring will come, Summer will come and this to shall pass; crap happens, just like when the Large Hadron Collider screwed up not long ago. In no time at all, that baby will be fired up again and things will get back to where they were, before the black hole as opened... and then, making money will be like making a pie or burger.

January 31, 2009 11:43 AM
Roylat said...
I have been trying to make some sense of the financial collapse and government responses. I started my own blog,, to help spread the wisdom I glean from blogs like this one. The more I learn, the dumber I seem to become. Perhaps others can help me.

*What is the problem with letting all of the failing investment firms fail, with the government guaranteeing all depositors of any size?
*Wasn't the FDIC set up to take over failing bank? Why not let it?
*Wouldn't it be a lot cheaper for the government to pay off bank depositors than to take over all of the nearly worthless toxic debt held by banks?
*Aren't there some banks that have avoided the pitfalls of the big investment banks and would be in a position to take over the business of the failed banks?
*Instead of a "bad bank," couldn't the government establish a "good bank," one that would lend to well-run, solvent banks with excess loan demand?
*Can some of the learned people that read these blogs provide some numbers on the amounts of bank deposits compared to loans at the big, failing banks, such as Citigroup and BofA?

I'm putting these questions up as a post at my blog,, under the title, "Some Dumb Questions About Dealing with Failing Banks," so you can post your answers there. I'd really appreciate some enlightenment. These questions seem akin to, Is the Emperor without clothes?" But, no one seems to be asking them.

January 31, 2009 12:18 PM
Anonymous said...
A simple self-executing solution to the toxic mortgage assets would be a fee based program of federal mortgage insurance. For a fee of 1% of the face value of the mortgage any existing mortgage would be able to be guaranteed up to 30%; if the mortgage holder wished to go to 40%, it would be required to reduce principal by 10%; if the mortgage holder wished to procure a 50% guarantee, it would be required to reduce the principal amount by 20% and 60% for a 30% reduction. This approach would provide a floor value for mortgage assets and perhaps a market for the mortgage backed assets. In order to qualify the lender would have to certify that the interest rate was market or adjust it to market. This approach would permit homeowners to stay in their homes. The lender would calculate the optimum guarantee/principal reduction formula to protect its interest thus limiting the government's potential exposure. This would stretch TARP dollars- insurance has more leverage [bad word] than buying assets. The principal reduction amounts might vary based on regional basis - e.g. Los Angeles 12.5%/ Cleveland- 10%, This would permit hundreds of thousands of people to avoid bankruptcy.
January 31, 2009 12:25 PM
florin said...
Actually I have a very simple solution for the traders' compensation (which seems to be the most controversial), and which also avoids the problems with deferrals.
Pay them a salary within the proposed limits (under 400,000), but also allow them, instead of a bonus, to invest a fixed percentage (chosen at the beginning of the year) of their own money alongside all the deals that they make for their employers. Some of the deals are short-term, some are long-term, some are profitable, some not. Traders who elected too high a percentage (such that they cannot pony up the necessary money) are not allowed to work on those too large deals.
January 31, 2009 12:45 PM
David said...
I have been dissapointed so far with Obama. The country is screaming for populist measures such as salary caps on employees of these firms. They want blood and they deserve blood. But Obama has been blind to it so far. He might talk "shameful" etc but he has not acted on it. He needs to bust some balls and reign in Wall Street but so far he has acted to protect the elite. He needs to listen more to Buffett and Volcker and less to Geitner, Bernanke, Summers and Rubin.
January 31, 2009 1:27 PM
donna said...
The reason they have the bonuses is because of the salary caps of the 80s after the last time we went through this. Short memories, I swear...
January 31, 2009 1:52 PM
Eric L. Prentis said...
Sen. Chuck Schumer the banking industry lackey, interviewed by Charlie Rose last night, said that letting US banks fail and then nationalizing them is unthinkable because government shouldn't be in the business of determining who should receive loans and deciding which companies/industries should succeed or fail. Unfortunately, Schumer doesn't recognize that Congress is doing the exact same thing by bailing out their crony, bankrupt, incompetent, overpaid with taxpayer bonuses, Wall Street welfare queen bankers who ride around in jets. Slimy-on-the-take politicians only posture and offer specious rationalizations of the positions already decided upon by their controlling corporate masters and then sold to the masses on corporate controlled TV.
January 31, 2009 1:53 PM
donna said...
And the whole reason for IRAs was because people didn't want to put their money into the market, so Saint Reagan gave us IRAs to keep the game going.

Hey, the last 30 years has really all been one big financial scam, and it finally busted. But we kept the party going as long as we could! Congratulations, America!

What stuns me is the entire Republican party (what's left of it) being in such deep denial that the jig is up and the game is over.

January 31, 2009 1:55 PM
Anonymous said...
McCaskill's speech was just a stunt, designed to get a popular reception, and therefore let off a little steam in the country at large. Quite frankly, I found it patronizing.

If DC wanted to take action, then they would simply do it.

At the same time Dodd was feigning outrage about bonuses, he supposedly was using his chairmanship to block consideration of a House bill that would have clawed back those bonuses.

For two years, Obama has committed to EFCA, a bill that should make it easier for unions to organize. In the current economic climate, passage of this bill would lead to a complete transformation of the American workplace overnight: unionization on a mass scale, across all industries. On Thursday, Obama waxed eloquently about unions being central to thriving middle class, and a thriving middle class being central to a thriving overall economy...then he signs three wholly inconsequential bills, and slips Biden's name onto the roster of committee. Meanwhile, Biden and others in the administration tell reporters that EFCA "probably won't happen this year...maybe next". And the event is billed as a great moment for American labor, whose leaders (in the room) applaud even as the shiv is fully inserted.

Look, the Dems could do just about whatever they wanted. They have large majorities in both houses, a president at the height of his popularity (which is very high), the country is in the midst of a major economic crisis, and their longstanding opponents (Wall Street) are exactly the ones in most dire trouble. Hell, you've even got a socialist running the IMF...I mean, to say "the rails are greased" would be an understatement.

But they won't do anything. It's because they simply don't want to. They like the system. Mainstream liberals have always liked the system; they just make minor changes to it, to ameliorate some of its most glaring defects. Loosely speaking, most of them seem to share the same cultural sensibilities as their counterparts on Wall Street.

So I just ignore McCaskills bill, Dodd's protestations, and Obama's "committment", because there is obviously nothing substantive to any of it.

January 31, 2009 2:10 PM
Waldo said...
"What stuns me is the entire Republican party (what's left of it) being in such deep denial that the jig is up and the game is over."

I watched the Kudlow show this week and all the "tax cut" crap is for saving the rich man his dough. Such sh*t. Kudlow is another example of economics " gone mad". He belongs with the Gary S. Beckers and Paul Wolfowitz thugs of this financially deteriating world.

I am a successful entrepreneur and tax cuts really to nothing for my business or my finanical behavior. But I can see capital gain tax cuts preserving the thieving by the Bush administration these past eight years.

Does anyone think for a minute about the $45 billion profit ExxonMobil generated in '08!!! Oil is a commodity isn't it! Our Presidencial institution has lead the thieving. We must punish this.

A bit of good news, I read last week that the WorldCom CEO (Ebbers) got 25 years in prison for his fraud. O.J. is in prison (finally).

Justice is what is needed for this cure.

January 31, 2009 2:11 PM
Anonymous said...
The primary cause of the financial disaster we are in is the ludicrous wall street pay system. The system has created an incentive to bankrupt the country, destroy their own companies, steal peoples pensions, jobs, and way of life and, at the end of the day, their own industry.

If we ever want deep, liquid, and transparent markets again, we must destroy the bonus system. Not only are these scum bags not worth a fraction of what they are paid they are more dangerous, and have done more harm, to the security of our country than any terrorist organization on earth.

January 31, 2009 3:04 PM
JP said...
And for comparison...
January 31, 2009 3:13 PM
Anonymous said...
"Teldar Paper, Mr. Cromwell, Teldar Paper has thirty-three different vice-presidents each earning over $200,000 a year. [some shareholders in the audience whistle in astonishment]" -- Gordon Gekko, condemning the greed of incompetent corporate executives during (ironically enough) his classic "greed is good" speech in Wall Street

Sure, there's been a spot of inflation since 1987, and these are mere industrial managers rather than financial industry masters of the universe, but still... it's astonishing to hop into the time machine and see what was considered an outrageous level of compensation in an earlier golden era of largesse. Are we on the cusp of the mother of all reversions to the mean?

January 31, 2009 3:55 PM
Anonymous said...
Bankers and banks only operate within the confines given. If they successfully lobbied Congress to redact existing law then who is to blame?

Sell or stop buying bank stocks, they'll get the memo eventually.

Best analogy is sports players being multi-millionaires. If people didn't like the game they wouldn't exist.

January 31, 2009 4:18 PM
rathernotsay said...
Some data points:

Bonuses (excl basic) in GBP (gross), London credit structuring team in the markets division at a top European bank:

2002 Graduate recruit 4k
2003 Analyst 35k
2004 Associate 130k
2005 Associate 310k
2006 VP 450k
2007 VP 300k (cut in line with peers)
2008 quit, but old colleagues say they expect to be down 80% on 2007

This is before 40% tax. 15% of bonuses from 2004 were allocated as 3-5y restricted equity, i.e. they are now worthless. On top of this, my basic rose from about GBP 35k to GBP 80k (gross).

I was rather naive about pay when I joined the bank, so even the 35k bonus for 2003 knocked my socks off at the time. As you can imagine, I am a very happy person now.

I always saw my earnings as a huge stroke of luck and a windfall. I quit in March 2008 because I had reached my target of making my family totally financially secure, and wanted to do something more meaningful with my life. I did not see the financial crisis coming and expected bonuses to go up again in 2008, so from that perspective my timing was very fortuitous.

I don't think any of the deals I worked on were inherently rotten and none that I know of has caused losses for my old employer (who was very strict on us about risk management). However I am sure that many of those deals will have been blown up by the crisis causing big losses for the investor clients that bought them.

Yes, I do think I and my colleagues were horrendously overpaid, and I actually never felt morally comfortable with the pay levels, which was a major reason for wanting to quit (I know this is easy to say now, but it is the honest truth as my ex-boss would testify). This was a fairly unique perspective and most colleagues had trouble understanding why I wanted to leave.

I spent the money on my family's well-being (mortgage, kids' nursery, pension, etc), not on a ferrari or a yacht. I know that some people will say I should donate my ill-gotten gains to charity, but I think that charity begins at home. Our lifestyle is standard middle-class, which is all I ever aspired too, but without all the debt worries.

January 31, 2009 4:30 PM
Yves Smith said...

On your point that setting a cap for the execs will lead to everyone being paid less, that is not a given.

In the days when Wall Street firms were private partnerships, non-hierarchical pay was the norm. The managing partner was understood to be less valuable than the top producers. But spans of control were also narrower (and the firms were smaller). For instance, the head of a product area would primarily be a producer, only secondarily a manager, which was possible if the business units weren't too large.

You had a few cases become public, for instance, Lauren Hilibrand, head of Salomon's bond arbitrage group, made $25 million one year, when managing partner John Gutfreund made less than $3 million. Mike Milken made $600 million in his peak year, vastly more than Drexel CEO Steve Joseph. I am not privy to what people at Goldman were paid, but I would be pretty confident that the head of M&A (Geoff Boisi) and the head of risk arb (Bob Rubin) were better paid than the co-chairmen John Weinberg and John Whitehead.

And in the bad old days, that tendency even began influencing commercial banks, which has had a very strong tradition of hierarchical pay. Mark Kessenich, head of Citi's money markets division in the 1980s, was better paid than anyone at Citi save CEO John Reid, even though hierarchically, he was much further down the food chain.

As for Donna's comment, re salary caps in the 1980s, with all due respect, I don't know what you are talking about. Do you means relative to dud S&Ls? There weren't any on Wall Street.

As for the "M&A is a talent business" point, I hate to tell you, it is true. There are a lot of mid level and junior practitioners who ride on the coattails of the top guys and are no doubt overpaid and overestimate their abilities. I am not talking about them. (And they do get premium pay by being associated with big producers, just as John Thain's driver, who made $230,000 last year, did by virtue of working for the Big Man). However, the very top people can and do leave, and often join or form boutiques and do very well with no big firm overhead or brand name behind them.

The business is a brokerage business. It does not depend on capital (look at the success of firms like Rothschild, Lazard, Greehill & Co, and Felix Rohaytn's boutique). The line at Lazard in the old days was that a banker should be able to make business from a phone booth with a roll of dimes (today it would be quarters, but you get the point). How many of you in ANY job could go rent office space and bring in enough to support yourself, your overhead, and the relevant support staff?

M&A does do better in the boom times due to leverage (it's a lot easier to do deals with borrowed money) and at cyclical peaks, the big firms with trading operations inevitably screw themselves up by competing in M&A by using their balance sheets. That inevitably leads to huge losses, but the industry has no institutional memory.

But the flip side in that M&A falls off even more dramatically in the bust times than other areas (save perhaps structured finance in this cycle, which is probably never coming back to anything remotely like its peak level). In the early 90s bust, 3/4 of the people in M$A lost their jobs.

So boutiques will rise again. Those who are in the non-capital dependent businesses (and really good, with established clients) will leave the big firms, the rest will stay.

January 31, 2009 5:15 PM
Independent Accountant said...
In his last year at Drexel Milken made $550 million, easily $1.1 billion today. How's this sound? I think Milken was underpaid at $550 million! Why? Unlike the trader clowns, Milken brought Drexel from being a small Philadelphia firm into the big leagues. He made that firm.
January 31, 2009 5:20 PM
Anonymous said...
anon of 6:17am said:

"The Obama administration is not likely to impose tougher restrictions on executive pay on most firms receiving aid under the government's $700 billion financial rescue program, the Washington Post reported on Saturday."

What a joke!!!!! Every single large bank from JPM, to C, GS, to MS, are insolvent. So they don't want to take the money for fear of losing their perq's?!? That's when Paul Volcker needs to come in and say:

'You guys are going to take the money, because we know you're insolvent. We're going to cap your pay, and if you don't like it, I will make a phone call, and you WILL lose your business to your competitors."

The gov has to know these banks are insolvent and need to be taken over. If they don't know, they needed to find out yesterday.

YVES ---

Deferred compensation, a la Warren Buffett's way, is pure brlliance. There's a reason why he's richer than anyone on Wall Street. Maybe we should listen to him!!!

January 31, 2009 5:25 PM
bg said...
"As for the "M&A is a talent business" point, I hate to tell you, it is true. "

I was part of a LBO with CD&R in the internet bubble era. Although I lost my shirt, I can tell you that the partners that I worked with there were brilliant. If M&A ceased to exists they would be able to create value in any number of roles in business. You can argue that too much talent went into the wrong field, but you cannot argue it attracted talent.

Now when it came time for the due diligence on the part of the banks placing the money, they sent around a small mob of zombies who asked boilerplate questions and then wrote down the correct answer before we could reply.

January 31, 2009 5:33 PM
Yves Smith said...
Independent Accountant,

I'm not saying Milken's pay was sound, merely that the perceived producers have in the past been much better paid than the top brass, and so a pay cap at the top would not necessarily constrain pay to those below.

Miken had negotiated that he'd get 15% of the profits. Fred Joseph was under pressure to cut it back, but of course, that went no where. What one thinks of Milken very much depends on what one thinks of his business practices. Frankly, some of them were Mafia-like (a member of the legal team at one of the big raiders of the 1980s has told me a real horror story). And I don't mean the prostitutes at his Predator's Ball, either.

Financial Armageddon When Giants Fall Has Arrived!

January 29, 2009

My latest book, When Giants Fall: An Economic Roadmap for the End of the American Era, has just been published by John Wiley & Sons. It is already on the shelves at Barnes & Noble, and will soon be in stock at, Borders, and many other booksellers around the country.

For a taste of what it's all about, here is the Introduction:

In late 2007, a Chinese submarine suddenly "popped up" in the middle of U.S. military exercises taking place in the Pacific Ocean. According to Matthew Hickley of the United Kingdom's Daily Mail, the 160-foot Song class diesel-electric attack submarine "sailed within viable range for launching torpedoes or missiles " at the USS Kitty Hawk, a 1,000-foot aircraft carrier with 4,500 personnel on board that was being guarded by a dozen warships and at least two submarines. The newspaper added-in a report that received scant U.S. media attention-that American military chiefs "were left dumbstruck." One North Atlantic Treaty Organization (NATO) official said that "the effect was 'as big a shock as the Russians launching Sputnik '-a reference to the Soviet Union's first orbiting satellite in 1957 which marked the start of the space age."

But it isn't only in the military arena where there are signs that the United States is not quite in a league of its own. An August 2007 New York Times editorial, "World's Best Medical Care?" highlighted two studies that revealed the U.S. health care system, contrary to popular belief, had fallen significantly behind those of other nations. The first, published by the World Health Organization seven years earlier, ranked the United States 37th out of 191 countries worldwide. The second, detailed in May by the well-regarded Commonwealth Fund, rated the United States "last or next-to-last compared with five other nations-Australia, Canada, Germany, New Zealand, and the United Kingdom-on most measures of performance, including quality of care and access to it."

For a nation that has long viewed itself as the leader of the pack, the results were curiously incongruent. Yet so is the gap between the apparent economic standing of the United States and its long-term financial health. Such could be seen in an eye-opening commentary published in the July/August 2006 issue of the Federal Reserve Bank of St. Louis Review. Written by Laurence J. Kotlikoff, a Boston University economics professor, the essay posed a provocative question: "Is the United States Bankrupt?" Citing a $ 65.9 "fiscal gap" stemming from unaccounted - for pension and health care benefits that 77 million baby boomers are expecting to receive in their golden years, Kotlikoff argued that "unless the United States moves quickly to fundamentally change and restrain its fiscal behavior, its bankruptcy will become a foregone conclusion."

Many, if not most, Americans believe that their country's place in the world is not much different than it was two decades ago, when the collapse of the Berlin Wall left the United States as the last superpower standing. Some memories go back even further, to a time when the United States was a beneficent bulwark, helping allies and rivals alike to recover from the ravages of World War II. Yet vignettes like those-along with other evidence-point to the fact that, as music legend Bob Dylan once wrote, "The times they are a-changin'." Indeed, not only is the United States losing its grip on the reins of global leadership, but other nations, including China, Russia, India, Iran, and Venezuela, are asserting their right to set the international agenda.

For those with some sense of history, the prospect of a new world order should not be all that surprising. Indeed, when it comes to the relative fortunes of countries and empires, the only thing you can be sure of is that tomorrow's winners will be different from today's. Advantages that might once have pushed a nation to the top of the heap can become untenable burdens. Technological advances can level the playing field, sometimes abruptly. Those who have lagged try harder, in the hope they can lead. Sometimes, people simply tire of the old and seek out the new. Whatever the reasons, the United States' loss of status and the prospect of intense jockeying for power by individuals, groups, and nations around the globe will have far-reaching consequences for economies and markets.

There's more to it, however. As unsettling as a seismic geopolitical shift might be, it is not the only major challenge the world will face in the years ahead. Developments that have played a role in fostering geopolitical upheaval will also heighten other strains. Among the most daunting is the issue of resource constraints. For any American who has experienced the painful consequences of sharply higher prices at the gas pump, it is apparent that circumstances are different than they were only a few years ago. The same holds true in regard to the price and availability of other important resources and the vast array of globally traded commodities. All of a sudden, the promise of a land of plenty has been found wanting.

Thanks to years of booming economic growth in countries around the globe, more people now have the opportunity-as well as the desire-to enjoy what Americans and others in economically advanced nations have long taken for granted. In places like China, for example, with its population of 1.3 billion people, there has been a clamor for automobiles, air conditioners and heating systems, and an agricultural product that many once viewed as a luxury item, served only on special occasions-that is, meat. Meanwhile, the rest of the world has not stood still. Hundreds of millions of people have bought homes, cars, flat-screen televisions, and computers; have increased the miles they drive and the vacations they take; and have kept on consuming as if the horn of plenty could only grow larger.

Coming Home to Roost

Now, though, circumstances are changing. The mistakes and excesses of the past are coming home to roost. It is much more costly and difficult, for example, to obtain the fuel needed to power the spending and consumption habits of an increasingly energy-dependent world. Burgeoning appetites for food have stressed the global ecosystem, undermining the availability of resources that mankind has depended on from time immemorial. Water supplies and sanitation facilities not only have failed to keep pace with the population growth of the past century, they have lagged behind the increases in developing-country per-capita consumption levels that have occurred during the past decade.

Around the world, these concerns have spawned restiveness, protests, and riots. Evidence suggests, however, that the roots of heightened social instability are broad-based. After years of pressure and propaganda from businesses and policy makers for greater integration, people are challenging the utopian promise of globalization and unfettered cross-border commerce. Emboldened by the self-confidence that comes with improving fortunes, the Chinese, the Indians, the Russians, and other up-and-comers are no longer willing to kowtow to the wishes of the West or to suppress the resentments of the past. Many are feeling the powerful tug of tribal roots. All of a sudden, there is much less impetus to keep primal urges under wraps.

The blistering economic successes of the emerging powers, aided by mercantilistic trading strategies, the luck of geography, and a powerful marriage of economics and politics, have also fostered other developments that will destabilize the economic and financial landscape ahead. Around the world, numerous imbalances have sprung up, many unprecedented. Export-driven powerhouses and commodity-rich nations like China, Japan, Russia, Brazil, and oil producers in the Middle East have accumulated outsized foreign currency reserves, with much of their holdings, until recently at least, kept in U.S. dollars. Large chunks have, in turn, been plowed into U.S. stocks, real estate, and bonds, especially government and agency-issued securities.

For a while, this recycling process seemed almost symbiotic, a kind of perpetual-motion machine. The United States-its government and its citizens-would spend more than it could afford on a wide range of goods and services produced elsewhere. Foreign vendors-or, more likely, their public-sector overseers-would redirect the proceeds back into U.S. assets, helping to keep liquidity abundant, market conditions stable, and the cost of borrowing low. This combination would foster the illusion of never-ending nirvana, encouraging everyone to continue carrying on as before. Spend. Borrow. Repeat. It was seemingly a golden age of peace and prosperity for all.

In the end, though, things didn't quite work out as many had hoped. U.S. public and private sector debt levels soared to all-time highs. Wages stagnated, domestic opportunities disappeared, and the costs of living suddenly rose beyond the reach of ordinary working-class Americans. The allure of buying cheap products from foreign-based manufacturers, together with the stampede by U.S. multinational corporations to move production to offshore locations where labor and other operating costs were low, allowed the nation's manufacturing prowess to wither on the vine, undermining future growth prospects. All the while, the circle of dependency helped chip away at support for what has long been the world's major reserve currency.

Gaining Advantage

To be sure, those who have been feeding the beast have suffered some indigestion themselves, as dollar-denominated holdings have fallen in value. Nevertheless, their steady accumulation of cross-border surpluses and other economic resources has given them potent weapons, allowing them to secure geopolitical advantage. Nations like China and Russia, for example, have been aggressively wielding their financial firepower in Africa, Asia, Europe, and South America. In resource-rich regions, they've negotiated trade deals and built production and logistical facilities; they've provided grants and loans and underwritten infrastructure projects; they've supplied arms and high-tech defensive capabilities-increasingly, the currency of choice in a troubled world-all in exchange for what everybody else now wants.

Geopolitical up-and-comers have taken an increasingly aggressive tack in their dealings with established powers. In recent years, for example, China has revealed plans to diversify its $ 1.8 trillion of official reserves, showing just who is in charge of the United States' economic future. The Asian nation has also warned its ostensibly more powerful rival away from any moves that might undermine its export strategy, asserting that, if need be, China would resort to the so-called nuclear option-dumping its holdings of U.S. assets all at once, regardless of the damage it might cause to its own interests. Russia, meanwhile, has not been shy about increasing its stranglehold over energy supplies for Europe, or throwing its weight around in Asia, Africa, and the Middle East.

Such machinations have helped to augment an already growing antipathy toward free trade and increasing cross-border cooperation, in the West and elsewhere. Spurred on by the fallout from a global financial crisis and a quickening economic downturn, protectionist sentiments have gained strength. Increasingly, the harsh realities of dislocations and distortions have overshadowed the lofty theories of economic liberalization-neoliberalism. Fractures have developed in collective political arrangements. Monetary unions and currency pegs agreed to when times were good are being called into question as conditions worsen. Around the world, multilateralism is being subverted by regionalism, bilateralism, and unilateralism.

Meanwhile, the altered dynamic of key resource markets has set the stage for a debilitating and increasingly divisive struggle for advantage. Financial Times commentator Martin Wolf has made reference to a "zero-sum world," where a shortage of productivity-enhancing energy might turn back the clock to a time when gains could be achieved only at others' expense. The prospect of a further disorderly unwinding of numerous global imbalances-apart from the extraordinary eruptions already seen-also signals serious trouble ahead. So does a reversal of the productivity gains of recent years, brought on by heightened geopolitical unrest, rapidly diminishing economies of scale, and adverse demographic trends.

Further undermining the outlook, of course, is the United States ' loss of standing-economically, politically, and militarily. Over the past several decades, booming global growth has had many forebears, though two, in particular, stand out. The first is the existence of the United States' protective umbrella, which has allowed vast resources to be channeled into productive peacetime activities. The second is a Western-fomented economic order, centered on the neoliberal-capitalist agenda. But with global stability in doubt, the rules and mechanisms of the established financial and trading system under assault, and the world's largest marketplace for goods and services becoming unhinged, advanced and developing countries alike will suffer the consequences.

It won't just be growth prospects that are affected. Economic shifts and shocks will destabilize other realms, too. Indeed, the schisms are already apparent. Growing wealth inequality and the scramble for key commodities have fostered tension and conflict between haves and have-nots. Long-distance, hydrocarbon-fueled global supply chains no longer offer the benefits they once did, lessening the attractiveness of increasing global connectedness. The fact that relatively few countries have managed to realize outsized gains under a trade regime ostensibly based on equality and fair dealings has raised suspicions about others ' intentions. Instead of drawing people together, the successes of the past are driving them apart.

Around the world, economically inspired nationalism has stirred up feelings of arrogance and animosity toward outsiders. An emphasis on diversity has fostered an acceptance of divisiveness. Large populations of illegal immigrants, tolerated when booming growth created a seemingly insatiable demand for low-cost labor, are suddenly the targets of an angry backlash. In places like South Africa, Italy, and the United States, among many others, there have been grassroots movements to punish, prey on, and drive out foreign nationals. Popular anxiety has also spurred growing calls for a dramatic political response. In the United States, meanwhile, weariness and resentment over the long - drawn-out military actions in Iraq and Afghanistan have allowed isolationist sentiments to broaden their hold.

Responding to the End of the American Era

Taken together, these various developments constitute a clear and present danger to the economic well-being of every American, especially those who have been conditioned to believe that life can only get better in future. Dramatically changing times will require new ways of dealing with everyday routines. People will need to factor in the likelihood that livelihoods will be continually at risk. Many will be forced to expend a great deal of time and energy figuring out new ways of getting around and getting by. Living arrangements and lifestyle choices that once seemed second nature will have to be completely rethought when efforts to acquire the basics-fuel, food, water-are much more time-consuming and difficult than before.

Those in the United States and elsewhere will have to pay better attention to where and how they live, who they depend on, and what their options are when things go wrong. They will also need to think about the steps they need to take now in anticipation of the upheavals that will occur in future. Health-and security-related concerns, for example, will have to be a key focus of attention when deteriorating public finances, widespread business failures, and crumbling infrastructure boost crime, disrupt safety nets, and leave critical services, including medical care, that much harder to come by. No doubt the world will also be a more perilous place when competition for scarce resources is intensifying and powerful interests at home and abroad are vying to gain the upper hand-in any way they can.

Most, if not all, businesses will quickly discover that existing models either are irretrievably broken or will have to be dramatically reworked to accommodate the risks and challenges associated with a more uncertain and unstable operating environment. Unlike during the era of globalization, bigger won't necessarily be better. In fact, large size will likely be a serious disadvantage when flexibility and fast response times are imperative. Growth for growth's sake will be the road to ruin when the costs and risks of boosting payrolls, increasing plant and equipment, and taking on hefty financial obligations more than outweigh the potential benefits.

Mounting logistical disruptions, tighter borders, heightened geopolitical instability, rising costs of key inputs like water and energy, and an assortment of dislocations will shoot holes in many of the old theories about how to improve efficiency and boost growth. For most firms, approaches that might once have increased the odds of success, including just-in-time inventory management, the development of long and intricate supply chains, and outsourcing of functions to other locales, will lead to their undoing. What is more, instead of focusing on aggressively pruning back operations to reduce costs, owners and managers will be forced to strike a tenuous balance between what they might be able do without and what they must have on hand to remain in business when disaster strikes.

Needless to say, investors will have a much more difficult time preserving and expanding wealth under these sorts of conditions. Not only will economic and financial circumstances create a far more treacherous trading environment than has been seen before in modern times, but even ostensibly correct decisions could prove calamitous when other, previously less likely developments intervene. Betting against the dollar, for example, makes sense on many levels. However, the risks stemming from investing in or moving funds into other currencies, markets, and economies during a time of turbulence and growing geopolitical conflict may well offset all of the potential rewards-and then some. Paradoxically, having what others really want might not necessarily be such a good idea in the new scheme of things. At a time when everything is suddenly up for grabs, some things are best left out of reach.

In the end, the road ahead will be fraught with myriad dangers that will be impossible for anyone to ignore or avoid, regardless of current circumstances. Even worse, developments that have brought us to this point make it clear that a new, far more challenging environment is not just a passing storm, poised to quickly blow over. Instead of looking forward to a return to the way things once were, Americans-and investors in particular-will have to get used to a "new normal, " where only those who are flexible, open-minded, resilient, and fully prepared for the worst will be able to survive, let alone come out on top. Those who refuse to take these threats seriously risk losing everything. Now more than ever, it is time to become attuned to an entirely unique roadmap.


Congratulations again....looking forward to reading your new book!

That second-to-last paragraph in the intro sample you posted above just about says it all. In particular:

"....but even ostensibly correct decisions could prove calamitous when other, previously less likely developments intervene."


"At a time when everything is suddenly up for grabs, some things are best left out of reach."

Posted by: dukeb | January 29, 2009 at 09:40 PM

Congratulations, Mr. Panzner.

I had pre-ordered the book at Amazon, so I look forward to its arrival.

Posted by: oblomov | January 30, 2009 at 12:43 AM

My personal thinking about so called democracy...

Posted by: Josef Boberg | January 30, 2009 at 07:46 AM

I look forward to reading it because I just read post-american world by Fareed Zakharia, which was excellent but he wrote it just before the economic meltdown so the whole premise of his book missed that huge aspect. In fact, he kept referring to the robust US economy and stock markets and clearly he wasn't saying it made sense. I hope your book will put add this factor into the mix

Posted by: Ellen | January 30, 2009 at 09:43 AM

Cogito ergo sum. The trouble is that too many people stopping thinking. The worse trouble is that we elected too many of them to make our decisions for us. Also, we have failed to ask basic questions. In the mayhem here in the UK, one question is whether the world any longer needs the City of London finance market in the shape it has been or will be. There is nobody facing up to that one, although we may need to get the right answers very quickly, or the supermarkets could start to empty.

Posted by: Tom Knott | January 30, 2009 at 10:31 AM

With all respect to your views, a bet against America is a Loser's Bet.

I invite you to read "King Dollar" which I wrote in July 2008, and published in August 2008. So one sided was the furor against the dollar, that the site publishing it withdrew it under pressure.

Yet events have demonstrated the view on the dollar to be quite timely.

What you fail to understand or apparently grasp, is that Reserve Curency Status is not determined by economic factors, but rather Geopolitical considerations.

While you have many facts that are indeed correct, the bottom line is that one Nation will lead in the World. Like or not, that is America, and nothing on the horizon can change that - most certainly not Russia or China.

Your fiscal math, like others is fatally flawed because is doesn't consider that the $ 1 Trillion we export now in the energy complex, will, using the timeless tools of American ingenuity and innovation, eventually be returned to our economy with a multiplier.

There alone is a treasure chest of Tens of Trillons - something not in the calculus of those, as you, who would have us believe it's the end of the line for America.

As I said, "read "King Dollar" - for a different view on how things are aligned and will play out in this Century.

You can find it at my site

Posted by: Carlos T. | January 30, 2009 at 10:40 AM

Differing views unwelcome here ?

Posted by: Carlos T. | January 30, 2009 at 10:47 AM

Don't worry, I won't bother to comment again - or visit your site.

The fact that you can't accept opposing views, speaks to both the depth and substance of your personal character as well as your views.

Posted by: Carlos T. | January 30, 2009 at 10:57 AM

The fact that your comments remain on my site is proof that alternative views are welcome here. I'm not exactly sure what you are on about?

Posted by: Michael Panzner | January 30, 2009 at 11:03 AM

I had observed that they were posted - then removed.

It has been my experience in recent times that there is an almost virulent anti-Dollar mentality - such that as with "King Dollar" was effctively censored.

And it has been my experience that various sites are not interested in opposing views on America and the Dollar.

So excuse my sensitivity in that regard.

Obviously, with regard to you, I was mistaken - and frankly, glad to be.

I've read your work and views for quite some time - though I have almost invariably been in disagreement with your conclusions.

The reason is simple: Intellectual Honesty.

My views cannot have validity without considering and pondering views to the contrary. That is the lifeblood of true Intellectual Honesty.

And whatever the true solutions to our problems, dialogue and discourse hold the keys to finding them.

In any event, I apologize.

Posted by: Carlos T. | January 30, 2009 at 11:14 AM


If there are 10's of trillions of dollars via the petro-dollar, they why are we so hopelessly in debt. Why are we in a mega-financial quake with 9 trillion put up by the FED and still no solution is apparant?

Ultimately, you will be proven wrong. Your mindset is, we are America and when we tap our heels the rest of the world kneels.

The USA is not in command of its own destiny and requires many billions daily from foreigners just to keep the lights on. These daily inputs are drying up as other world economies fail too.

I write this to you so you will not be blind-sided by the fact that the USD/USA will collapse in 2009.

Posted by: Joe M. | January 30, 2009 at 12:21 PM

My above post should be addressed to Carlos and not to Knott, sorry about that.


I have bookmarked your site and we shall indeed revisit and see who saw it right. BTW, I saw how all this was going to play out in 2004 and invested accordingly. My current ROI = +60%. Money has a way of talking and we know what the other stuff does.

Posted by: Joe M. | January 30, 2009 at 12:31 PM

The answer to your question is simple.

Debt is about control and wealth redistribution.

The game is transferring wealth from the hands of the many to the hands of the few.

That game has been played since the dawn of civilization, and always will be played. The facilitatators of this game change with the ages - but the game does not.

In our time, the facilitators are Central Banks and their minions.

In the time of the Romans or the Egyptians, etc., the fruits of the many were taken through force and violance.

Such was the way the game was played then.

In modern times, however, the game hasn't changed - only how it is played.

Now, Debt is used as the means, rather than overt force and violence. People agree to this confiscation of the fruits of their labor.

The result is the same however.

You say "mega-quake" - and I've heard infinite commentary to that end - but what has really changed ? Nothing.

The game in Markets is to "mark-up" a given instrument ( stocks, bonds, commodoties, etc., etc. )to its maximum point of inflation. Then it is sold all the way down, until the masses throw in the towel.

Then the stage is set for the next Inflation.

The whole public dialogue is part of that game.

Where you are going wrong is in believing American Power and these fiscal issues are synonomous - they are not.

These "Debt" and "Fiscal" issues are merely means by which the fruit of your labor - and millions of others - is voluntarily yielded, and redistributed as the few see fit.

I urge to read both "King Dollar" as well as the "Metrical Equilibruim of Housing" for an expansion on these matters.

Have you ever seen a Magic Act ? Do you believe it ?

The real "trick" is diversion. Understand that, and you understand what is going economically and politically.

Posted by: Carlos T. | January 30, 2009 at 12:48 PM

I appreciate your views Joe. Indeed time will tell.

I read dozens of books on Markets and Market History - and one day came along "Reminscenses of a Stock Operator".

It was the last book I ever bought on Markets.

I recommend you read it. It is the best investment you'll ever make.

Jesse so aptly said Markets never change because Human Nature never changes. Indeed.

The doom and gloom will continue and probably get worse - given the unwinding yet to occur.

By the time just about everyone has foresworn stocks - then the real bottom will have been reached, and the whole process will start over.

Nothing will have changed - only who has the Wealth.

Posted by: Carlos T. | January 30, 2009 at 01:12 PM

I'm a nobody but here is my two bits ps I don't sell books. The wealth of a Nation determines its position in the world.

Leadership is a euphemism for domination & control. In its attempt to extract maximum wealth America is doing what other Empires have done, it is over extending itself. I'm 84 years old and I have never seen "established leadership" impose order successfully, Chaos as always been the norm.Being tuned in to
reality does not make you anti-anything, understanding that you never put your feet in the same river twice does not make you hate that river

Congressional Sound and Fury Over Wall Street Bonuses Sure to Signify Nothing

Jan 2009 | naked capitalism

A firestorm of criticism was unleashed from Washington at bonus-reaping-while-Wall-Street-burns bankers, with President Obama deigning to join in the fray. The tone was unusually heated:
President Barack Obama fed a swelling populist revolt against Wall Street bonuses, calling it "shameful" that banks doled out $18.4 billion as taxpayers bail out companies and the U.S. remains mired in a recession.

The bonuses are "the height of irresponsibility," Obama said today before meeting Treasury Secretary Timothy Geithner and Vice President Joe Biden at the White House. Firms need to "show some restraint and show some discipline," Obama said.

And the funniest, or most pathetic, depending on your point of view, was this:
The president joined politicians such as Senator Christopher Dodd, who today called for using "every possible legal means to get the money back." The bonus pool for 2008 by New York City financial companies was the sixth-largest ever amid record losses in the securities industry,...

"I'm going to be urging -- in fact not urging, demanding -- that the Treasury Department figures out some way to get the money back," Dodd said. "This is unacceptable."

Now this blogger is as irate about the payment of largely unwarranted bonuses as anyone. In any other industry, firms losing money on a survival-threatening scale would have eliminated them or targeted them far more selectively, well, save for the auto industry, which serves to prove the point.

However, the Congressional hyperventilating is a shameless diversionary tactic. Let us turn to philosopher Rodney Dangerfield:

If you steal $1000 from a convenience store, you go to jail for ten years. If you steal $100 million, you get called before Congress and called bad names for ten minutes.
The tongue lashing might go on a little longer this time, but the general observation holds.

If Congress wants to assign blame, it might start by looking in the mirror. It has made a ritual of occasionally getting exercised about executive pay, calling some hearings and trying to make high fliers squirm, and then proceeded to do nothing, That makes it abundantly clear that they intended to do nothing, giving the perps to continue as before.

For those who claim that big pay is needed to motivate and reward superior CEO performance, there is ample evidence to the contrary. Studies have found that companies with the highest paid CEOs tend to underperform (one theory is that the high pay is a symptom of weak corporate governance). Similarly, Jim Collins, in his book Good to Great, found that the companies that produce consistent, long-lived superior results were without exception lead by modest and not terribly well remunerated executives.

And trying to shift blame for the TARP-funding-bonuses fiasco solely to the admittedly badly behaved but completely predictable Wall Street firms is absurd. Congressmen signed off on comp restrictions that were known at the time to be toothless, mere window dressing, so they could say they had gotten concessions from Treasury on that point. As we remarked back in September, when Treasury had the temerity to have a private briefing for members of the Securities Industry and Financial Markets Association, and not the broader public:

The exec comp provisions sound like a joke, They DO NOT affect existing contracts, they affect only contracts entered into during the two years of the authority of this program and then affect only golden parachutes. More detail on that point, but I don't need more detail to get the drift of the gist.

And of course, the bill's provisions pertained only to top officers, not to the highly paid rank and file, who received the lion's share of the bonuses.

That rather basic point in missed by commentators. Back to the Bloomberg article:

Treasury has the authority under legislation that created the TARP to issue regulations that "claw back" excessive executive compensation, said Larry Hamermesh, a corporate law professor at Widener University in Wilmington, Delaware.

"It was pretty clear from TARP I that the secretary of the Treasury was supposed to establish a provision for executive clawback," Hamermesh said in a phone interview. "How the secretary has implemented that isn't clear."

The Treasury could require companies that request additional funds to repay excessive bonuses as a condition of the further financing, Hamermesh said.

Really? The TARP defines "executives" as "one of the top 5 executives of a public company, whose compensatoni is required to be disclosed pursuant to the Securites Exchange Act of 1934....and any non-public party counterparts." So it apples to a teeny fraction of the bonus recipients in the limelight.

And even then, the clawback had little reach:

a provision for the recovery by the fnancial institution of any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate
Mind you, this language originated inthe 110 page intermediate version of the TARP legislation, the one presented to the House in September in which Dodd played a major role.

No one has said that these firms misrpresented 2008 performance. They said they had dreadful years and paid bonuses anyhow.

And some of the high profile examples are beyond any reach. John Thain gave up his 2008 bonus already; his $15 some odd signing bonus was pre-TARP, so he does not appear to have gotten any TARP funds. Thain hired Thomas Kraus from Goldman to be global head of sales and trading with a guaranteed bonus of $39 million. Peter Kraus, another Goldman recruit, who joined as of September, had a clause triggered by the Bank of America acquisition that leads to a $25 million payout.

Lawyers and comp experts are welcome to chime in, but I do not know of a legal theory by which the bonuses could be clawed back. The only ones I can think of are embezzlement and fraudulent conveyance, neither of which applies (OK, maybe a very clever attorney could devise a theory that the entire bonus process 2006-2008 at big public investment banks was a conspiracy to embezzle, but it would take a ton of discovery and would be seen as striking at the heart of capitalism, such as it is, and so would go nowhere). Fraudulent conveyance in simple terms allows creditors of a bankrupt firm to challenge and recoup certain payments made shortly prior to bankruptcy. Since none of the TARP recipients are bankrupt (the whole point of TARP was to avoid bankruptcy filings) that's a non-starter.

The best the chumps powers that be can hope for is a few ritual disgorgements. For those who aspire to a life in the public eye, that might make sense. But Dick Grasso, whose pay by any standards was grotesque (as was his self importance, claiming responsibility for getting the NYSE running post 9/11 when firefighters and Verizon technicians, many of whom ruined their lungs, played a far bigger role) still won a pitched battle with Eliot Spitzer (who had a legal theory that I thought had considerable merit: that the comp was inconsistent with the NYSE's status as a not for profit). So if anyone decided to put up a battle, it is hard to see how they could be compelled to return the money.

Put it another way: if Congress is unwilling to find a way to intervene in securitization agreements to facilitate mortgage mods, a far more important problem, both politically and practically, they are most certainly not going to meddle here.

[Jan 28, 2009] The Bears Lair by Martin Hutchinson

January 26, 2009 | The Bears Lair

Those who have visited Michigan recently or the Mahoning Valley of Ohio in the 1980s can recognize the symptoms of a rust belt. A hitherto prosperous industry, paying high wages to its employees, has been overtaken by market changes and is forced into harsh downsizing or even bankruptcy. As a result, the lives of many inhabitants degenerate into alcoholism, home foreclosures and welfare.

This time around, the decaying industry is finance, and the rust belt cities are London and New York.

The parallels with the U.S. automobile industry are closer than they look. In the early years of the auto industry, it included both large companies and small specialty manufacturers, the latter being remembered now as producers of "vintage" cars of very high quality. Then the Great Depression wiped out most of the specialty producers, which could not compete with the mass producers' costs. For the next several decades, the business was dominated by a heavily-capitalized oligopoly with extremely highly paid employees, quite high profitability but deteriorating product quality. Finally, it became clear that the oligopoly was uncompetitive and the industry began to shed workers and close plants.

In finance, the early specialty producers were the London merchant banks; for Duisenberg, Packard and Stutz you can substitute Hambros, Warburgs and Hill Samuel. They, too, had superb product quality and are remembered with great fondness by their former customers, but were driven out of the business by heavily capitalized competitors, in this case running behemoth high-risk trading desks rather than mass production assembly-line factories. The employees of the well-capitalized behemoths were even better paid than the UAW work force in the 1950s. Then gradually product quality began to deteriorate, and bad practices such as "liar loan" securitized mortgages, accounting "mark-ups" of assets that had not been sold and self-deluding risk management crept in.

The main difference between the two cases is that the collapse of the finance sector has taken the form of a sudden Gotterdammerung rather than the steady but inexorable decline characteristic of the U.S. automobile industry. The bottom line is the same: Detroit needs to downsize radically, but so does Wall Street.

As I have written previously, in and after the 1980s, the central activity of the financial sector became not service but rent-seeking. Finance doubled its share of Gross Domestic Product (GDP) in the 30 years to 2006, but very little of the addition represented products and services that provided true value to the economy as a whole. Securitization was mostly a complex and expensive means of getting assets off banks' balance sheets. Derivatives helped manage risks, but only a tiny percentage of the multitrillion dollar outstandings in the derivatives markets represented risk amelioration; the rest was just trading noise or outright speculation. Hedge funds and private equity funds were mostly a means of multiplying excessively the fees charged for investment management; they almost drove out of business the true venture capital funds, which had a genuine economic value. Principal trading, the most exciting activity of all in the glory years for greedy investment bank partners, was simply a means of using large amounts of outside shareholders' capital to trade on insider information about the market's deal flow. All of these activities were legal; none of them added value to anybody but their immediate practitioners, while they represented additional costs and lower returns for everybody else. In other words, they fulfilled the dictionary definition of rent seeking.

Given the aggression, greed and high intelligence of the average investment banker, rent seeking can never be eliminated completely. Nevertheless, the conditions that made it flourish have already changed, and good policy will ensure that they do not recur in the future. In particular:

• Financial complexity is mostly an additional source of risk, and provides little or no added value to the economy as a whole. A Madoff-style Ponzi scheme could only grow to the monstrous size it did in an environment in which even institutional investors were ignorant and incurious about the way in which their investment returns were derived. • More than a decade of easy money after 1995 increased asset prices, thereby providing returns to those who bought assets on a leveraged basis, while making leverage itself very easy to obtain. • The move from thinly capitalized "Duisenberg" investment/merchant banks, providing advice to companies and arranging their financing to behemoth "General Motors" financial conglomerates taking principal positions in the securities of companies they advised produced an immense interconnecting web of conflicts of interest and insider trading opportunities. • Risk management methodologies, which achieved acceptance so great that under the Basel II regulations "sophisticated" banks were allowed to select their own, were fundamentally flawed. They rested on an academic theory of efficient markets that in practice is easily disprovable and represents a very poor approximation to reality. The prolonged period of easy money and bullish markets appeared to validate them; we now know better. • Remuneration practices in the industry became far more generous than their historical norms, more also than that necessary to attract staff of the right intellectual caliber and other qualities. This was a product of the almost uninterrupted bull market in bonds and stocks from 1982 to 2007, a large part of the returns from which was scooped off by financial sector employees who added far less value than they extracted.

If rent seeking is to a large extent eliminated, it is likely that the financial services sector will approximately halve in size, returning to around its 1970s share of GDP. Its usage of capital will decline only modestly, since the excessive leverage built up in the last decade will need to be corrected. Conversely, the sector's human resource usage needs to decline by much more than half – after all, we have a multitude of tools today that allow the relatively simple functions of traditional finance to be performed much more efficiently, and with less human input. In addition, with modern telecommunications technology, many of the routine tasks of finance (including almost all the non-mechanizable parts of the back office, but also much research and document preparation) can be performed by well-educated but lower-paid employees in India or elsewhere. Thus, while the sector's overall value added will halve, the portion of value added attributable to capital will significantly increase, that attributable to labor will decline.

For the financial practitioners of New York and London, the future is thus bleak. Rewards will be greatly reduced, as the market operates ferociously both on the income side and the employee costs side of their employers. Headcount will also be greatly reduced, as functions are eliminated, work is outsourced to the Third World and the weaker entities go bankrupt or are merged into competitors. The decline in practitioners' incomes might be as much as 80%, even after a modest market recovery, though the number of practitioners should reduce by only 50% to 60%.

That also promises a weak future for the local beneficiaries from financial services incomes in New York or London. Such losers would include local housing markets and those of the smarter resorts, together with the army of real estate agents, decorators, construction companies and lawyers that have benefited so egregiously during the bubble. It would also include local restaurants, clothing retailers, jewelers and other high-end products and services. The tourism business will find far fewer takers for the kind of "short break" luxury sybaritic packages in which it has recently specialized. Thus the short-term knock-on effect on the overall economy of poorer bankers will be severe, even though the long-term economic benefits of eliminating the dead-weight costs of the bloated banking community will be even greater.

The two centers most adversely affected by these changes will be London and New York. Asian financial centers will continue to benefit from the faster regional rates of overall economic growth, while as in the 1980s, the problems of Dubai will spread far beyond finance.

In New York, the "rust belt" effect will be severe but not overwhelming – it will be 1970s Cleveland rather than 1980s Youngstown. Many of the skyscrapers of the financial district and the luxury residential areas will become ghost buildings, as their predecessor buildings did in the 1930s, but they are unlikely to descend to the chain-round-the facility-guarded-by-a-Rottweiler-and-a-tattooed-thug state symptomatic of the worst industrial blight.

However, the resemblance to 1970s Cleveland (which defaulted in 1978) will probably be increased by a municipal bankruptcy. Mayor Michael Bloomberg has pursued the policy of former New York Mayor (1965-73) John Lindsay. He has increased municipal spending by 52% over six years while prices rose 20%, and has relied on hefty increases in property taxes to fund the increase. Those funding sources have disappeared, but we are still only at the stage of cosmetic cuts and financing gimmicks. As the downturn continues, New York's fiscal state will become rapidly worse, and default is inevitable in a year or two. Bloomberg has altered the rules to allow himself to run for mayor again this November; he would be mad to do so, since the fiscal deterioration would make his third term a very unpleasant experience.

London will be the Youngstown of this downturn, an excellent market for Rottweilers, wire mesh and tattooed thugs. Docklands in particular will revert to its 1970s squalor, albeit with some very expensive buildings scattered around. Few of the financial institutions that have prospered so lavishly in the London of the past couple of decades are British owned, and those that are were excessively involved in the British mortgage market – an even bigger disaster than the U.S. market because home values were even more outrageous at the peak. Given that the financial sector will be downsizing anyway, will top management in Frankfurt, New York or Tokyo want to keep its stable of expensive London whiz-kids, in order to continue participating in a market that was never central to their overall strategy and is now unprofitable? I doubt it. Even the Russian mafia may leave, though probably to Cyprus rather than Moscow. Whereas New York's downturn may produce municipal bankruptcy, London's downturn has a fair chance of producing national bankruptcy. Going forward, British youth will have to find a new way to make a living – single-malt Scotch and tourism cannot support a nation of 60 million people.

Inhabitants of London and New York have spent the last couple of decades sneering at their provincial cousins, particularly those involved in the grubby world of manufacturing. Now the Rust Belt has reached them also.

The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of "Great Conservatives" (

[Jan 28, 2009] Rewarded for Failure

This is just a manifestation of "socialism for the rich", is not it ?
Financial Armageddon

Although I disagree with economists about many things, I'm a big believer when it comes to incentive theories. Simply put, when people are rewarded in some way for doing one thing instead of another, they will tend to oblige.

That is one reason why, for example, Soviet factories were famous for producing large stockpiles of substandard goods that nobody really wanted. Instead of responding to market forces, workers and managers were being rewarded on the basis of how well they met state-mandated production targets.

In that vein, given that many of those who helped bring about the worst financial crisis since the Great Depression are still in charge -- read: being rewarded for earlier bad behavior -- as detailed in the following Associated Press report, "AP IMPACT: No Pink Slips for Bailed-Out Bank Execs," logic suggests they will carry on making the same mistakes as before.

They've been bailed out, but not kicked out.

At banks that are receiving federal bailout money nearly nine out of every 10 of the most senior executives from 2006 are still on the job, according to an Associated Press analysis of regulatory and company documents.

The AP's review reveals one of the ironies of the bank bailout: The same executives who were at the controls as the banking system nearly collapsed are the ones the government is counting on to help save it.

Even top executives whose banks made such risky loans they imperiled the economy have been largely spared any threat to their jobs, as Washington pumped billions in taxpayer money into the companies. Less fortunate are more than 100,000 bank employees laid off during a two-year stretch when industry unemployment nearly tripled, bank stocks plummeted and credit dried up.

[Jan 27, 2009] Online Death agony of Thatcher era by F William Engdahl

Jan 27, 2009 Asia Times

During the end of the 1970s into the 1980s, British Conservative prime minister Margaret Thatcher and the City of London financial interests who backed her introduced wholesale measures of privatization, state budget cuts, moves against labor and deregulation of the financial markets.

They did so in parallel with similar moves in the US initiated by advisers around Reagan. The claim was that hard medicine was needed to curb inflation and that the bloated state bureaucracy was a central problem.

For almost three decades, Anglo-American university economic faculties have turned to Thatcherite deregulation of financial markets as "the efficient way", in the process, undoing many of the hard-fought gains secured for personal social security, public health care and pension security of the population. Now the poster-child economy of the Thatcher revolution, Great Britain, is sinking like the proverbial Titanic, a testimony to the incompetence of what is generally called neo-liberalism or free-market ideology.

As the neo-liberal revolution began in the economies of the US and the UK, it should not be not surprising that the epi-center of catastrophe in the global crisis now unfolding also lies with the economies of the US and the UK, as well as a handful of economies, including Ireland, Canada, Australia, New Zealand and Iceland, all of which embraced the free market Thatcherite agenda most strongly in recent years.

Notably, the man who personally implemented Thatcherite financial market reforms and deregulation during the era of Tony Blair in Britain was Gordon Brown, then Treasury secretary.

A sample of most recent British developments is instructive. Britain's economy is about to suffer its most vicious slump since 1946, shrinking by a drastic 2.8% this year, according to the European Union's latest estimates. The UK is predicted to suffer the worst recession of any large European economy.

The consequences for the UK will include soaring unemployment, while the economy also teeters on the brink of full-blown deflation. Unemployment will rise by more than 900,000 people over the next 12 months, driving the jobless total to 2.55 million by the end of the year, or 8.2% of the workforce, from 5.3% at present.

In parallel, the currency, the pound, which is not part of the eurozone currencies, has fallen dramatically against the euro and even the US dollar in recent weeks over growing fears of the collapsing UK economy and banking system. Sterling has fallen below US$1.40 to its lowest point in seven-and-a-half years because of concerns about the depth of Britain's banking crisis and the government's rising debt levels. This coming year the UK government's borrowing levels may exceed ฃ118 billion, equal to 8% of GDP.

Britain will not be able to reap much benefit from a lower pound for exports because, as part of the Thatcher revolution, the national economy has out-sourced, de-industrialized and turned into a service economy where, as in the US, finance and banking became the motor of economic growth the past two decades. That motor has now broken.

Public debt soaring
Fueled by the cost of state bank bailouts, the UK's national debt is set to rise to ฃ1.06 trillion, or 72% of GDP, by 2010, a sharp rise of more than 70% from present levels.

Last week, the Brown government, only three months ago hailed as the institution that was taking effective action to control the global financial meltdown, was forced to introduce yet another new bank bailout package of measures designed to rescue the country's banking sector.

Brown refused to put any ceiling on the amount that he might ultimately need, creating great distrust in the Brussels and across the EU.

Combined, British banks have some US$4.4 trillion of foreign liabilities. That is twice the size of the British economy. UK foreign reserves are virtually nothing at $60.6 billion. Little wonder that savvy currency traders and hedge funds have decided the British pound can go only one way - down. Swap markets for CDS now price in an alarming 10% probability of Britain having to default on state debt obligations in the next few years as public debt explodes.

The last time England had a default on state debt was in the early 14th century, when King Edward III decided to declare default on his then huge debts to the large Italian banking house of Bardi & Peruzzi, taking the large bank down with it and spreading ruin across Europe.

Kiss of life to a corpse

Brown admits he does not know whether the second bank rescue package the government just launched will work, senior ministers admit. One minister is quoted anonymously in the British press, "The truth is that we can't be sure whether it will be effective. We have to look calm to try to instill some confidence in the system. But we don't know what will happen next. No one can be sure that this is the end of it. We are in completely uncharted waters. The position is changing all the time."

In brief, the authorities have lost control in the UK.

Brown and Treasury Secretary Alistair Darling claim the second bailout did not mean the first package they unveiled last October had failed. That deal, they insist, was about preventing banks from going bust; this one was about ensuring they had the confidence to lend to businesses and the public.

The government refuses to reveal how much it will cost taxpayers. Officials dismissed talk of a ฃ200 billion bailout, saying some measures had a low risk and figures were still being calculated. Labour Party backbenchers conceded it would be difficult to "sell" the rescue plan to an increasingly hostile public. Not surprisingly, polls have turned dramatically against Labour and Brown, now showing that were elections held today the Conservative Party would secure a win over Labour of 9% to 13%. An astonishing 49% of all Britons fear losing their job this year.

A major impediment to swift and consequent government action to contain the impact of the banking crisis has been the dominance of Thatcherite ideology as an almost religious dogma that permeates even Labour, where Brown's predecessor as prime minister, Blair, was portrayed as a Labour version of Thatcher. The ideological absurdity of the situation was underscored recently when the Conservative opposition offered broad support for measures, even though their concern over soaring borrowing led them to oppose the government's ฃ20 billion fiscal stimulus designed to keep the economy moving.

As well, it is clear, following the nationalization last year of the Northern Rock home-loan firm and the forced state share of 70% in the Royal Bank of Scotland, that a type of approach is being adopted similar to that used in the early 1990s' Swedish banking crisis, in which the state nationalized banks that were insolvent and unable to raise private capital.

Sweden then split the banks into "good banks" and "bad banks". In the good bank, the business of lending to the real economy continued unabated. The assets in the bad bank, largely illiquid Swedish real estate holdings, were held by the state until economic growth again allowed the government to sell the assets in a healthy market. The ultimate taxpayer cost of the "Securum" model were estimated to have been zero or even a tiny profit when all costs were factored.

The ideological Labour government is stubbornly refusing to admit the logic of the situation, and ends up cutting the dog's tail off by inches. As certain Labour MPs call for the full nationalization of the banks, the government says that is not its goal. Darling stated, "We have a clear view that British banks are best managed and owned commercially and not by the government. That remains our policy."

John McFall, Labour chairman of the Treasury Select Committee, who believes full nationalization of the banks is inevitable, asked Darling in a recent House of Commons debate if the government would take a 100% stake in the banks if the new package did not restart lending.

Vince Cable, who watches the Treasury for the Liberal Democrats, said, "The government increasingly resembles somebody who is trying to give the kiss of life to a corpse. The government now effectively controls one of the largest banks in the world. It will almost certainly have to put more money in; it may well acquire other banks." Cable had predicted the bursting of the house price and personal debt bubbles - and the nationalization of Northern Rock.

Royal Bank of Scotland next

The same day Brown's government announced the second bank bailout attempt, the Royal Bank of Scotland issued a statement revealing it expected losses of ฃ28 billion for 2008, far greater than anyone was expecting and triggering a further selloff in shares of all major British banks.

The huge losses announced at RBS were mainly the result of its acquisition of ABN Amro in 2007. RBS paid a high price for ABN and admitted last week that the business was worth around ฃ20 billion less than it had previously thought. This unexpected announcement resulted in a 67% fall in its shares.

Brown, in a pathetic attempt to deflect blame, has said that he was particularly "angry" at the record losses racked up by the Royal Bank of Scotland, and the large write-offs of foreign debt. Lloyds Bank is rumored to be the next bank in need of emergency help as the economy of Britain goes into free-fall, the tragic eulogy to Thatcherism.

Origins of the neo-liberal model

The so-called neo-liberal finance model espoused by the Thatcher government after 1979 had its origins in a decision by leading Anglo-American financial powers and their circle that it was time to begin a wholesale clawing back of the concessions they had granted under, as they saw it, duress, during the Great Depression of the 1930s and in the case of Britain the post-war economic difficulties.

The origins of the effort in the United States go back to a seminal little-known book by a scion of the vastly wealthy Rockefeller family, the late John D Rockefeller III, titled The Second American Revolution. There, amid soporific rhetoric about creation of a "humanistic capitalism", he called for a drastic reduction in the role and size of government in the economy. That theme was then propagated through the efficient propaganda apparatus of the Rockefeller imperium, aided by the economist guru of the Rockefellers' University of Chicago, Milton Friedman.

Amid the misnamed "stagflation" - sluggish growth, high inflation - era of the late 1970s into the 1980s, that propaganda machine blamed all ills on "big government", conveniently ignoring the pivotal role of the manipulated oil shocks, shocks manipulated and brought about by the same Rockefeller family, as I detail in A Century of War: Anglo-American Oil Politics. Rockefeller protege Paul Volcker of Chase Manhattan Bank was sent to president Jimmy Carter on orders of David Rockefeller to "wring inflation out of the system" in October 1979, the same general time Thatcher's Bank of England imposed its own form of economic "shock therapy".

The true economic causality was obscured and reams of press copy from the Friedmanite free-market camp during the Reagan and Thatcher era claimed that the "defeat of inflation" had been due to the ruthless discipline of Volcker and Thatcher. That was, we were told, again and again, the reason why the market should be unfettered from government regulation, freed to the devices of its own unbounded innovative genius.

The results of that unfettered "humanistic capitalism", or what now former Federal Reserve chairman Alan Greenspan approvingly called the "revolution in finance", is bringing both Meccas of neo-liberalism, the United States and Great Britain, to economic ruin. Somewhere between this and Joseph Stalin's Soviet central planning there lies a better way.

F William Engdahl is author of A Century of War: Anglo-American Oil Politics and the New World Order (Pluto Press) and Seeds of Destruction: The Hidden Agenda of Genetic Manipulation ( The present article is adapted from his forthcoming book, due in summer 2009, Power of Money: The Rise and Decline of the American Century. He may be contacted through his website,

(Copyright 2009 F William Engdahl.)

[Jan 26, 2009] Twenty-five people at the heart of the meltdown ... Business The Guardian

Alan Greenspan, chairman of US Federal Reserve 1987- 2006
Only a couple of years ago the long-serving chairman of the Fed, a committed free marketeer who had steered the US economy through crises ranging from the 1987 stockmarket collapse through to the aftermath of the 9/11 attacks, was lauded with star status, named the "oracle" and "the maestro". Now he is viewed as one of those most culpable for the crisis. He is blamed for allowing the housing bubble to develop as a result of his low interest rates and lack of regulation in mortgage lending. He backed sub-prime lending and urged homebuyers to swap fixed-rate mortgages for variable rate deals, which left borrowers unable to pay when interest rates rose.

For many years, Greenspan also defended the booming derivatives business, which barely existed when he took over the Fed, but which mushroomed from $100tn in 2002 to more than $500tn five years later.

Billionaires George Soros and Warren Buffett might have been extremely worried about these complex products - Soros avoided them because he didn't "really understand how they work" and Buffett famously described them as "financial weapons of mass destruction" - but Greenspan did all he could to protect the market from what he believed was unnecessary regulation. In 2003 he told the Senate banking committee: "Derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn't be taking it to those who are willing to and are capable of doing so".

In recent months, however, he has admitted at least some of his long-held beliefs have turned out to be incorrect - not least that free markets would handle the risks involved, that too much regulation would damage Wall Street and that, ultimately, banks would always put the protection of their shareholders first.

He has described the current financial crisis as "the type ... that comes along only once in a century" and last autumn said the fact that the banks had played fast and loose with shareholders' equity had left him "in a state of shocked disbelief".

Bill Clinton, former US president

Bill Clinton

Clinton shares at least some of the blame for the current financial chaos. He beefed up the 1977 Community Reinvestment Act to force mortgage lenders to relax their rules to allow more socially disadvantaged borrowers to qualify for home loans.

In 1999 Clinton repealed the Glass-Steagall Act, which ensured a complete separation between commercial banks, which accept deposits, and investment banks, which invest and take risks. The move prompted the era of the superbank and primed the sub-prime pump. The year before the repeal sub-prime loans were just 5% of all mortgage lending. By the time the credit crunch blew up it was approaching 30%.

George W Bush, former US president

George W Bush

Clinton might have started the sub-prime ball rolling, but the Bush administration certainly did little to put the brakes on the vast amount of mortgage cash being lent to "Ninja" (No income, no job applicants) borrowers who could not afford them. Neither did he rein back Wall Street with regulation (although the government did pass the Sarbanes-Oxley Act in the wake of the Enron scandal).

Senator Phil Gramm

Phil Gramm

Former US senator from Texas, free market advocate with a PhD in economics who fought long and hard for financial deregulation. His work, encouraged by Clinton's administration, allowed the explosive growth of derivatives, including credit swaps.

In 2001, he told a Senate debate: "Some people look at sub-prime lending and see evil. I look at sub-prime lending and I see the American dream in action."

According to the New York Times, federal records show that from 1989 to 2002 he was the top recipient of campaign contributions from commercial banks and in the top five for donations from Wall Street. At an April 2000 Senate hearing after a visit to New York, he said: "When I am on Wall Street and I realise that that's the very nerve centre of American capitalism and I realise what capitalism has done for the working people of America, to me that's a holy place."

He eventually left Capitol Hill to work for UBS as an investment banker.

Christopher Dodd, chairman, Senate banking committee (Democrat)

Christopher Dodd

Consistently resisted efforts to tighten regulation on the mortgage finance firms Fannie Mae and Freddie Mac. He pushed to broaden their role to dodgier mortgages in an effort to help home ownership for the poor. Received $165,000 in donations from Fannie and Freddie from 1989 to 2008, more than anyone else in Congress.

How We Were Ruined & What We Can Do - The New York Review of Books

But in the late 1970s, investment banks-Salomon Brothers in particular-discovered a profitable new source of business in these mortgage-backed securities and began packaging them in a way that made them more like conventional bonds, except that they paid higher interest. The most important breakthrough, says Morris, came in 1983, when an innovative banker at First Boston, Larry Fink, divided packages of mortgages into several different tiers of risk with appropriately graduated interest rates. These tiers are now called "tranches," the French word for "portion" or "slice." Fink's innovation attracted many more clients, including pension funds and major money market institutions, to invest in mortgage-backed securities, and eventually the private market accounted for substantially more such securities than did the government.

The first tier-or some 60 percent of all the investors in a mortgage-backed security-was to be paid interest and principal fully from the monthly cash flows of the mortgage holders and was therefore best protected. But these investors received the lowest interest rate. The more subordinate tiers were paid off after this senior tier received its payments, and thus earned higher interest because of the higher risk of nonpayment. The lowest tiers were the riskiest, the so-called toxic waste, which would get money last, and therefore lose money first if there were unanticipated defaults. But these investors were paid two to three percentage points more in interest to take the risk. This toxic waste was typically bought by hedge funds, the aggressive investment vehicles that took higher risks to earn higher returns for their investors, and often borrowed liberally to increase their returns on capital even further.

For the banks and mortgage brokers who wrote the mortgage loans, the financial advantage was significant. They could now sell the mortgages they wrote almost immediately to packagers, often investment banks, earning a quick and very handsome fee-one half to 1 percent of the value of the mortgage-in the process. By selling the mortgage loans, the banks did not have to maintain capital requirements for those loans, requirements that were imposed internationally by the Bank for International Settlements in the 1990s. The banks and mortgage brokers were then free to make still more loans with the cash they got back from selling the packaged mortgages and quickly to earn another round of fees.

Homeowners also benefited significantly from the securitization. In response to the demand for mortgages by pension funds, investment managers, banks, hedge funds, and others across the globe, mortgages were easily granted; banks and mortgage brokers lowered the interest rates on mortgages charged to home buyers in order to attract more customers. It was principally the investor appetite for the mortgage-based securities and the easy profits made by the banks and mortgage brokers that led to the mortgage-writing frenzy in the 2000s, not encouragement by the federal government to lend to low-income home buyers.

Securitization of mortgages was not all. In the 1990s, commercial and investment bankers expanded the market for new forms of insurance, called credit default swaps, which would supposedly guarantee holders of mortgage-backed securities against losses incurred by defaults. These were complex transactions involving derivatives-investment vehicles such as options or futures contracts based on traditional stocks, bonds, and averages or indices of stocks or bonds. Such insurance protection encouraged investors, including hedge funds and commercial and investment banks, to be still more bold in packaging and investing in mortgage-backed securities. Now that many of these mortgages have in fact defaulted, whether most of the insurance claims on them will be met is still an open question. AIG, the giant insurance company that was rescued by the federal government in September, for example, backed many of these insurance products and may not be able to meet its obligations.

By the late 1990s, America's credit system had changed radically. Enormous numbers of loans were held, not on the balance sheets of commercial banks or thrift institutions, which are regulated by the federal government, but in a rapidly growing "shadow" banking system of hedge funds and other unregulated investors in New York, London, and around the world. This shadow banking system in effect made the loans, but unlike commercial banks, which have reserve and capital requirements legally imposed upon them for activities on their balance sheets, and are also subject to Federal Reserve scrutiny, its capacity to borrow was by and large unrestricted. By the 1990s, securitizers, often investment banks and even commercial banks, were packaging not only residential mortgages but also equipment loans, commercial mortgages, credit card debt, and even student loans-known in general as collateralized debt obligations (CDOs)-and the shadow banking system was buying them. Morris writes that 80 percent of all lending by 2006 occurred in unregulated sectors of the economy, compared to only 25 percent in the mid-1980s.

The mortgages traveled such a long distance from institution to investor that no one was in personal touch with the actual mortgage holder any longer. Now, the likelihood of defaults was assessed not by someone who tracked a specific mortgage holder but by complex, computer-generated statistical models of the entire portfolio of mortgages. Like all such models, no matter how mathematically intricate, they required an estimate about the future based on the past-an estimate that was inherently incapable of adequately taking into account the consequences of a historically rare and therefore seemingly unlikely crash in housing prices.

In addition, the ratings agencies used these statistical models to award ratings to the mortgage-backed obligations sold to investors. The ratings agencies were paid by the commercial and investment banks, who sold the packages of mortgages according to their rating, and who invariably benefited more the higher the rating. The agencies now have much to answer for.

The recession of 2000 and the World Trade Center attacks of September 11 led the Federal Reserve under Alan Greenspan to cut its target interest rate, the federal funds rate, from 6.5 percent at the end of 2000 to 1 percent in 2003, the lowest since the 1960s. For major institutions borrowing was now almost free, but there was no commensurate increase in the federal scrutiny of the loans being made, a power the Federal Reserve had but that Greenspan foreswore. And investment banks, hedge funds, and even commercial banks through off-balance-sheet subsidiaries known as structured investment vehicles borrowed aggressively to invest in the mortgage-backed securities-sometimes their borrowings amounted to thirty or forty times capital. The structured investment vehicles, typically domiciled in the Cayman Islands, enabled the banks to avoid higher capital requirements placed on balance sheet loans and closer scrutiny by the Federal Reserve and other federal watchdogs.

Because the short-term interest rates most affected by the reduced federal funds rate were so low, investors, including commercial banks, borrowed money in the form of short-term commercial paper, and invested it in the longer-term mortgages, adopting exactly the highly dangerous strategy that led to savings and loan bankruptcies in the late 1980s. Commercial paper consists of loans businesses make to one another with their temporarily excess cash. If rates suddenly went up on the commercial paper, profit margins on the long-term investment, whose rates stayed the same, would disappear, and they did. Not to have taken account of this result was a crucial and unambiguous example of irresponsibility by executives at banks like Citigroup.

The new financial structure might have worked out nevertheless had the loans been as safe as widely believed. It turned out that they were not. The investors had failed to scrutinize them. By 2006, Zandi points out, more than $1.1 trillion of the $3 trillion in mortgages written were either subprime-mortgages to individuals with questionable ability to pay-or so-called Alt-A loans-made to people without verifying their income.

Most remarkable, perhaps, the frenzied subprime lending occurred after the housing market had already climbed to unthinkable heights. On average, the prices of homes had been rising since the early 1980s, but between 2000 and 2005, they leaped by 50 per-cent despite low inflation. Yale economist Robert Shiller estimated that it was the largest housing boom in American history. Of course, the easy mortgage availability and low rates fueled the rising market.

Some mortgage brokers claim that the subprime mortgage holders were simply irresponsible, buying houses they couldn't afford. In fact, bankers and mortgage brokers promoted enticing loans, the most important of which was the adjustable rate mortgage, or ARM, in order to lower mortgage payments temporarily to levels that might seem well within the means of lower-income buyers. The initial interest rate on an ARM was about 3 percent, or even lower, but it would be automatically reset higher in two years. Surveys showed that many mortgage holders did not understand the terms. Remarkably, Alan Greenspan publicly suggested that if borrowers failed to take advantage of the ARMs, they could lose "tens of thousands of dollars" on their mortgage payments.

But Zandi makes clear that the mortgage writers believed house prices would continue to rise, enabling the owners to refinance their mortgages at a value higher than the original mortgage and at more advantageous terms. A rapidly growing proportion of the subprime loans in this period were also made to speculative investors who bought several houses at a time and "flipped" them to profit from the rapidly rising prices.

The housing market at last began to falter in the spring of 2006. At first, home prices moved downward and then the rate of defaults by homeowners began to escalate. The following year, the rates on many ARMs were reset upward, adding an average of $350 to monthly payments, and doubling defaults to an annual rate of 1.6 million by the end of 2007. That year, as housing prices fell and defaults rose, the ratings agencies started downgrading some of the mortgage-backed holdings on the books of investment banks, hedge funds, and the subsidiaries of commercial banks. Their values began to fall in the market. In addition, other packages of debt obligations based on consumer debt or equipment purchases were looking less reliable.

As the mortgage-backed obligations began to look less sound, the commercial paper buyers demanded higher rates, squeezing profits, and forcing the investors to sell more of these obligations, pushing their values down further. Eventually, many of the commercial paper lenders refused to lend their short-term money to the investors at all.

What made matters worse is that when the values of these securities fall, the banks and other investors are obliged to write down the investment on their books -a widely practiced accounting rule, established by the Financial Accounting Standards Board and encouraged by regulators, known as mark-to-market. This produced losses that reduced capital and the ability to make new loans. Meantime, lenders to these investors also typically require that investors put up more money as the value of the investment falls-in order to meet what is known as the margin requirement. This, too, resulted in more selling.

When two hedge funds at Bear Stearns, with substantial investments in mortgage-backed securities, had to unload investments to meet their margin requirements in 2007, it generated such enormous losses that the old-line brokerage firm, in order to avoid outright bankruptcy, had to sell itself at fire sale prices to J.P. Morgan in early 2008, in a deal engineered by the Federal Reserve. The Bear Stearns losses in 2007 were the first concrete signs of looming catastrophe. Others were soon to come. Losses were being announced publicly at America's leading investment and commercial banks as well as foreign banks like the Royal Bank of Scotland and Switzerland's UBS.[1]

An excellent series this fall in The New York Times, called "The Reckoning," has provided fascinating insights into the reckless decision-making in some financial firms in the years just preceding the crisis. One of the reporters for the series, Gretchen Morgenson, describes how Merrill Lynch made twelve major acquisitions of mortgage and real estate companies between 2005 and early 2007 in order to take advantage of the boom, packaging the mortgages into mortgage-backed obligations themselves and selling them off or investing in them.

Merrill earned record profits in 2006 and set another record in the first quarter of 2007. But a common view outside the firm, Morgenson found, was that the Merrill executives did not understand the risks they were taking-or were perhaps deliberately looking the other way. Investors on all sides of these transactions were making a fortune. By the summer of 2007, with defaults rising and the value of the mortgage-backed obligations falling, the magic powder quickly turned to dust, and that October, Merrill reported a $2.3 billion loss. Stanley O'Neal, the chief executive, was forced to leave, as were other executives. But O'Neal took with him a $160 million severance package. Under O'Neal's successor, John Thain, former head of the New York Stock Exchange, Merrill sold itself to Bank of America in September 2008, during the same week in which the prestigious firm Lehman Brothers collapsed and AIG was bailed out by the federal government.

The Times series tells similar stories about the management of Citigroup, which tripled its issues of CDOs between 2003 and 2005, under the leadership of Charles Prince and, reportedly, the encouragement of Rubin. As late as the fall of 2007, reporters Eric Dash and Julie Creswell found, Prince was assured by the bond executives that the company would not suffer serious losses. Little attention was paid to risk taking. Less than a year later, total losses at Citigroup exceeded $65 billion and the bank was forced to seek federal help to stay in business. But Charles Prince, like Stanley O'Neal, walked away rich from Citigroup when he was replaced in 2007.

The Federal Reserve, which since 2006 has been led by Ben Bernanke, a former Princeton professor, only started cutting interest rates in the fall of 2007. In fairness to Bernanke, he was bold in light of the widespread opposition to such a cut. Many economists were worried at the time that rate cuts would reinforce an improbable resurgence of inflation.

One problem was that the Fed did not have adequate information about these markets because derivatives were not traded openly and the latest CDOs, including mortgage-backed obligations, were mostly on the books of the shadow banking system. It was a serious lapse of judgment, not to mention responsibility, on the part of the Federal Reserve under Greenspan and the Securities and Exchange Commission under Christopher Cox to fail to seek more comprehensive information far earlier about the surge of lending.

After the Federal Reserve stepped in to avoid a Bear Stearns bankruptcy in the spring of 2008, Treasury Secretary Henry Paulson continued to reassure the public that the mortgage crisis was contained. But only after Lehman was allowed to go bankrupt in mid- September, followed by the collapse of AIG and other financial institutions, did he at last demand the controversial $700 billion bailout fund from Con-gress and eventually proceed to supply capital to banks with part of it.

But even with the new capital, the banks were not lending appreciably more; nor, without specific stipulations guaranteeing their loans, should anyone have expected them to do so. The values of even more solid mortgage-backed obligations based on prime mortgages were falling and eating up the new capital.

Bernanke then cut the funds rate sharply again, lowering it in all to 1 percent from more than 5 percent in mid-2007, but with falling housing prices, credit largely unavailable, and declining consumer confidence, a serious recession was not to be averted. The Fed has taken other bold actions by buying or guaranteeing assets held by institutions. But as of this writing, defaults on mortgages are still running high, and all kinds of consumer and business loans are now under similar threat.

At the end of 2007, the administration and Congress pieced together a first stimulus plan composed of government spending and business tax breaks. It was not enough. The rebate checks eventually doled out to most American consumers were swallowed by the rapidly rising price of gasoline in the spring and summer of 2008. Congress talked about a second stimulus plan but it failed to act, partly because the administration offered no support. In 2008 job losses reached 2.6 million, and by December President-elect Obama was discussing an "economic recovery" package of more than three quarters of a trillion dollars, unthinkable only three months earlier.

The Obama team has not yet announced its thinking about how to reregulate the financial community once the economy is righted again. The team of economists headed by Lawrence Summers, the former Treasury secretary (1999–2001), were, after all, themselves supporters of financial deregulation in the 1990s when most of them were members of the Clinton administration. As the Times's series notes, Rubin, who preceded Summers as Treasury secretary (1995–1999), Summers, then his deputy, and Greenspan opposed regulating derivatives. In 1999, Rubin and Summers supported the repeal of the Glass-Steagall Act, the New Deal restriction separating investment and commercial banking.

In fact, with the blessings of the Clinton administration and Greenspan, commercial banks were already engaging in many of the more aggressive activities of investment banks; and investment banks, along with hedge funds, private equity firms, and other institutions, as we have seen, were making the loans once the province of commercial banks through purchases and packaging of mortgage-backed obligations. The Bush administration took deregulation further, essentially eliminating, for example, limits placed on borrowing by major investment banks.

One principle should dominate future regulation-the shadow banking system should be brought under the same regulatory oversight as commercial banking. In sum, these firms must maintain minimum capital requirements against the loans they make and mortgage-backed obligations and other CDOs they buy, just as commercial banks do. The structured investment vehicles commercial banks use to avoid such capital and other requirements should be disallowed. A federal agency, most desirably the Federal Reserve, should have the authority and obligation to examine the books of investment banks, hedge funds, and other participants in the shadow banking system to determine the quality of their investments and to set the standards by which capital is deemed adequate. Derivatives should be required to be listed on an exchange, where information about them and their prices is openly visible to market participants and federal authorities.

Rules are not enough, however. Greenspan had been given the authority to examine the quality of mortgage lending by Congress in the 1990s, but simply did not use it, pleading free-market principles. The SEC under Bush appointee Cox could have examined the books of investment banks, but again mostly did not bother. Congress will have to talk louder and exercise stronger authority.

Any regulation should also take account of the incentives for managers to take company risk for personal benefit. The ability to take immediate profits from fees on risky loans infected the financial industry and eventually the entire economy, and made possible disproportionately large annual bonuses. These incentives were among the main causes of the irresponsibility on Wall Street. The best way to prevent that from occurring is to base the bonuses and compensation of financial executives on the long-term profitability of the investment firms for which they work.

But the first order of business is to right the economy, and so far there has been only modest success at preventing matters from getting worse, for all the seeming activity by the Fed and Treasury. The number of lost jobs is rising sharply, consumption and manufacturing output are falling at record rates, house prices keep sliding, and large firms, like Linens 'n Things, have closed their doors. The major auto companies have only just won a reprieve with a loan from the federal government. What makes this recession more precarious than the steep 1982 recession is that a further fall in incomes will bring another round of intense credit contraction, as more home owners default, including prime borrowers. Now, many corporate borrowers are also one or two steps away from defaulting.

The broad outline of a rescue plan should be clear. It requires a two-pronged approach. First, the credit system must be unfrozen and loans must flow again, including mortgages. Second, demand for goods and services must be restored to slow the downward spiral of the economy, which is now well underway.

Restoring the health of the credit system, while some slight progress has been made, is not being managed well. The Treasury has given about half of the $700 billion bailout money approved by Congress to the banks as capital injections. But as noted, the banks largely have not used these funds to revive the credit markets. In fact, Paulson's original idea to buy some of the banks' assets that could not be sold or even priced, which was strongly criticized, was clumsy and expensive but was based on a sensible principle. If the banks are given capital, and it just falls down a hole because the banks' assets keep losing value, little good is done. The value of the assets have to be stabilized.

The recent bailout of Citigroup, which guarantees 90 percent of a portion of the bank's investments for a fee to be paid by the bank, was more practical if too generous to Citibank. A better proposal, offered by the Barnard College economist Perry Mehrling, is to have the federal government either insure or even buy the better assets of the banks, which have fallen irrationally in value along with the so-called toxic assets. At a reasonable cost, the federal government could then stop some of the bleeding and the capital could be put to work to make new loans, including writing new mortgages, and perhaps slow the fall in house prices.[2]

But if defaults continue at their current pace, the value of mortgage-debt obligations will remain under constant downward pressure, as will bank capital. The Bush Treasury has done little about this, leaving the task to modest measures taken by Fannie Mae and the Federal Deposit Insurance Corporation and purchases of assets by the Fed. There is no easy or cheap way to guarantee the bad loans, but ways must be found to slow the default rate. It is of some concern that as of this writing we have not heard more from the Obama transition team specifically on this issue.

Another necessary component for reviving the credit system involves the self-destructive accounting rules and loan covenants that are making the crisis worse than it need be. The losses required to be taken under mark-to-market accounting, and the consequent reduction in capital, reinforce the fall in asset values. Similarly, current ratings requirements force the financial institution to sell investments to raise capital. Federal authorities should imaginatively reassess these arrangements to adjust them, even if only temporarily, to minimize the crisis. International capital requirements should also quickly be relaxed.

The second major part of a rescue plan involves the so-called real economy. If fearful Americans start saving as much of their income as they did even in the early 1990s-a savings rate of 5 or 6 percent compared to nearly zero in 2007-the economy will lose $750 billion to $1 trillion in buying power. The stunning losses of stock market and housing wealth-which in the last year total well more than $10 trillion-could cause consumers to spend several hundred billion dollars less than was expected. Such a loss in demand will drive employment and profits way down. Moreover, with the federal funds rate already so low, the Federal Reserve's ability to stimulate the economy by lowering interest rates is now limited.[3] Thus, additional federal government spending of as much as $750 billion a year is by no means an exaggeration of what may be needed.

Here Obama has moved intelligently if cautiously in projecting a large spending package, probably amounting to as much as $800 billion over two years. He will invest part of the money in infrastructure and in clean energy, with emphasis on measures to protect against global warming. Such longer-term investment will create domestic jobs and is likely, if managed well, to stimulate higher productivity. The package will also include expanded unemployment benefits, aid to the states, and perhaps, to win political support, substantial tax cuts. Again, however, the hole in the economy may be still larger than Obama anticipates, and he may have to address the possibility of a further stimulus in six months or so.

This is, as many economists now concur, the worst economic crisis since the Great Depression. Financial market participants created a financial bubble of tragic proportions in pursuit of personal gain. But the deeper cause was a determination among people with political and economic power to minimize the use of government to oversee the financial markets and to guard against natural excess. If solutions are to be found, the nation requires robust and pragmatic use of government, free of laissez-faire cant and undue influence from the vested interests that have irresponsibly controlled the economy for too long.

[Jan 16, 2009] Obama Adviser Urges More Rigorous Global Financial Regulation -By Anthony Faiola

January 16, 2009 |

Paul Volcker was the lead author on a report calling for a restructuring of the global financial system. (By Mark Lennihan -- Associated Press) Washington Post Staff Writer Friday, ; Page D01

NEW YORK, Jan. 15 -- A top economic adviser to the incoming Obama administration unveiled a plan Thursday to radically rethink the global financial system, including measures that would dramatically expand government control over banking and investment in the United States. The report -- which recommends limiting the size of banks, monitoring executive pay and regulating hedge funds -- offers the first hint of the kind of change to the financial system that President-elect Barack Obama may push for in coming months.

Obama has pledged to present a package of reforms to prevent another round of the financial crisis that began in the United States, ahead of a summit of world leaders in London this April. Observers saw in Thursday's report potential building blocks of Obama's plan. Although issued by the Group of 30 -- an organization of international economists and financial policymakers -- its lead author is Paul Volcker, the chairman of the Federal Reserve during the Carter and Reagan administrations who will serve as a special adviser to the Obama White House. Part of Volcker's role is to help mastermind what could become the biggest overhaul of the U.S. financial system in decades.

"I think this is a clear sign that the new administration is going to push for a major overhaul, for major structural reforms of the regulatory system," said Steven Schrage, the Scholl Chair in International Business at the Center for Strategic and International Studies. "Having this highly esteemed group backing that proposal is going to put pressure to present those changes before [the] April summit."

The report's recommendations may find support among those in the United States and Europe who have called for tighter regulation over the financial system in the wake of the current economic crisis. But elements of the plan were already opposed Thursday by some in the financial industry, where some worry that the push for tighter government regulation may go too far.

The report offered 18 recommendations that would insert government regulators into the boardrooms of financial institutions as never before. The plan calls for vastly increased oversight of major banks, going as far as to recommend the end of an era of mega banks whose size makes their failure potentially catastrophic to the global financial system. To limit their size and scope, banks, the document states, should be prohibited from managing private-equity or hedge funds. And deposits should not be concentrated in the hands of too few banks.

"Keep them small, so that any failure won't have systematic importance," Volcker said at a news conference.

Money-market mutual funds that offer services similar to banks, including dollar-for-dollar withdrawal at any time, should be subjected to increased government oversight, the report said. Currently, most do not operate that way. But those bank-like mutual funds that want to avoid tighter regulation should sell relatively safe financial instruments and clearly state to customers that the value of their funds may or may not remain stable.

The proposal suggests that the U.S. government should clarify the status of mortgage giants Fannie Mae and Freddie Mac, either making them government agencies or regulating them as independent mortgage brokers. Credit-rating agencies would also be subjected to greater scrutiny.

Volcker said he would press the new administration to consider the measures, saying major changes are imperative because the financial system is "broken."

"It's a four-letter word," he said. "It's a mess."

Elements of the plan -- such as imposing regulation on hedge funds -- echo calls for closer supervision made by policymakers in the United States and abroad in past months. But Thursday's report was more specific and aggressive in imposing government restrictions on the financial system than a broad outline of changes agreed to by the Bush administration during a meeting of leaders representing the Group of 20 economic powers in Washington last November.

The Obama administration is expected to work closely with key congressional leaders including Rep. Barney Frank (D-Mass) on legislation that could restructure existing regulatory agencies and impose new guidelines on U.S. financial institutions. The scope of Volcker's proposal, analysts say, suggests that Obama's plan may contain highly ambitious reforms.

Although financial industry officials concede that more regulation is likely needed to prevent a repeat of the current crisis, they also said that some of the measures in the report appeared to go too far. For instance, they opposed the suggestion that banks limit their deposits and size.

"You want to apply the appropriate amount of regulation to address the concern that this kind of crisis never happens again," said Scott Talbott, senior vice president of government affairs for Financial Services Roundtable, which represents the largest financial institutions in the United States. "But at the same time, you don't want to stifle innovation, creativity or the allocation of resources to take appropriate risks."

Although the report calls for global reform, it acknowledged charges that flaws in the U.S. financial system were to blame for starting the current global economic crisis. Thusly, it noted that "several of the issues and recommendations have a direct U.S. focus."

The report renewed calls for greater international cooperation on regulation, and new laws to oversee exotic financial derivatives, made during the November summit in Washington. With cautious support by President Bush, plans are moving forward, for instance, to enhance international cooperation in overseeing major banks through the Financial Stability Forum in Switzerland. But European leaders have eagerly awaited a signal from Obama on his ideas for new rules for the global financial system.

It is unclear how many of the recommendations will make their way into Obama's final plan, but the report could lift the spirits of Europeans who have called for tighter government oversight on executives' pay and risk management in financial institutions -- an area where the Bush administration has offered tepid support. The report urges the government to enforce systematic board reviews of executive pay as well as new guidelines to measure the level of risk a firm is taking with exotic investments.


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