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May the source be with you, but remember the KISS principle ;-)
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So, of course, are economists, even if the defunct economists are sometimes still alive. Martin Wolf |
| Speculation and gambling were always a part of Wall Street
but since the 1930’s they were just a side-show, now they are
the show. comment to Matt Taibbi article |
In Bailout Nation (Chapter 19) Barry Ritholtz tried to rank major players that led country into the current abyss:
1. Federal Reserve Chairman Alan Greenspan
2. The Federal Reserve (in its role of setting monetary policy)
3. Senator Phil Gramm
4-6. Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings (rating agencies)
7. The Securities and Exchange Commission (SEC)
8-9. Mortgage originators and lending banks
10. Congress
11. The Federal Reserve again (in its role as bank regulator)
12. Borrowers and home buyers
13-17. The five biggest Wall Street firms (Bear Stearns, Lehman Brothers, Merrill Lynch,Morgan Stanley, and Goldman Sachs) and their CEOs
18. President George W. Bush
19. President Bill Clinton
20. President Ronald Reagan
21-22. Treasury Secretary Henry Paulson
23-24. Treasury Secretaries Robert Rubin and Lawrence Summers
25. FOMC Chief Ben Bernanke
26. Mortgage brokers
27. Appraisers (the dishonest ones)
28. Collateralized debt obligation (CDO) managers (who produced the junk)
29. Institutional investors (pensions, insurance firms, banks, etc.) for
buying the junk
30-31. Office of the Comptroller of the Currency (OCC); Office of Thrift
Supervision (OTS)
32. State regulatory agencies
33. Structured investment vehicles (SIVs)/hedge funds for buying the junk
As Kevin Phillips noted "In the United States, political correctness, religious fundamentalism, and other inhibitions sometimes dumb down national debate" but the country now face pretty difficult choices... In a way it became one giant Enron. As money that is made from value addition in the form of manufacturing fades in significance to the volume of the money that is made from shuffling money around: Wall Street's locked USA in the situation from which there is no easy exit. Whether you shift private debt to public to increase confidence or not it's a huge debt. It can only be compared to the debt bubble of 1933. The liquidation of Bear Sterns and Lehman is only a start of consolidation of finances and we need to find something that replace financial sector dominance in the national economy. For now the only obvious choice is government but "Change we can believe in" administration does not intend to change the structural imbalances that were created and create jobs directly. It would be nice is some technological breakthrough happened which would lift the country out of this hole.
Deregulation epoch of the US capitalism with the dominant ideological doctrine of Market Fundamentalism (Reaganomics) if often known under the nickname of "Casino Capitalism." It lasted more then a quarter of a century. Sometimes it was called financial capitalism as opposite to industrial capitalism. Addiction of the societies to disastrous politico-economical doctrines are similar to addictions to alcohol and drugs in individuals. It is not easy to recover and it takes a long, long time and a lot of misery.
The term Casino Capitalism was coined by Susan Strange who used it as a title of her book Casino Capitalism published in 1986. She was one of the first who realized that
According to Susan Strange transformation of industrial capitalism into casino capitalism involved five trends all of which increased the systemic instability of the system and the level of political corruption:
The key to understanding of Casino Capitalism is that it was a series of government decisions (or rather non-decisions) that brought on the present state of financial instability and economic disorder. In other words casino capitalism has distinct "Made in the USA" and "Government property" marks. It was the USA elite, which refused to act responsibly in the face of changing economic conditions resulting from its own actions, and instead chose to try to perpetuate, by whatever means it had at its disposal, the institutional advantages that it had vis-a-vis its main economic rivals, stemming from the role of dollar as international reserve currency.
Self-reinforcing ‘positive’ feedback loops prevalent in Casino Capitalism trigger an accelerating creation of various debt instruments, interest of which at some point overwhelm systemic carrying capacity. Ability to lend against good collateral is quickly exhausted. At some point apparently there is no good collateral against which lending freely was possible, even at high rates. This means that the next stage of financial innovation involves scam and fraud, on increasing scale. Gradually Ponzi economy is replaced with Madoff economy.
This means that "society at large" does not have effective brakes to the assent of financial kleptocracy (or financial oligarchy), save the laws of physics—gravity and thermodynamics. In a way this was a silent coup. I would add to this the computer revolution and internet that made many financial transaction qualitatively different and often dramatically cheaper that in previous history. Computers also enabled creation of new financial players like hedge funds, exchange-traded funds (ETFs), as well as high-frequency trading and derivatives.
For Strange the speed at which computerized financial markets work combined with new much larger size and their now, near-universal pervasiveness is an important qualitative change. One of the side effects of this change is that volatility extends globally. Approximately $1.5 trillion dollars are invested daily as foreign transactions. It is estimated that 98 per cent of these transactions are speculative. In comparison with this casino Las Vegas looks like a aborigine village in comparison with Manhattan.
Note:
Susan Strange (June 9, 1923 - October 25, 1998) was a British academic who was influential in the field of international political economy. Her most important publications include Casino Capitalism, Mad Money, States and Markets and The retreat of the State : The Diffusion of Power in the World Economy.
For a quarter of a century, Susan Strange was the most influential figure in British international studies. She held a number of key academic posts in Britain, Italy and Japan. From 1978 to 1988, she was Montague Burton Professor of International Relations at the London School of Economics and Political Science (LSE), the first woman to hold this chair and a professorial position in international relations at the LSE. She was a major figure in the professional associations of both Britain and the US: she was an instrumental founding member and first Treasurer of the British International Studies Association (BISA) [1] and the first female President of the International Studies Association (ISA) in 1995.
It was predominantly as a creative scholar and a forceful personality that she exercised her influence. She was almost single-handedly responsible for creating ‘international political economy’ and turning it into one of the two or three central fields within international studies in Britain, and she defended her creation with such robustness, and made such strong claims on its behalf, that her influence was felt—albeit not always welcomed—in most other areas of the discipline. She was one of the earliest and most influential campaigners for the closer integration of the study of international politics and international economics in the English language scholarship.
In the later period of her career, alongside the financial analyses offered in Casino Capitalism (the analysis in which she felt was vindicated by the South-East Asian financial crisis) and Mad Money, Strange's contributions to the field include her characterisation of the four different areas (production, security, finance and knowledge) through which power might be exercised in International Relations. This understanding of what she termed "structural power", formed the basis of her argument against the theory of American Hegemonic Decline in the early eighties.
Her analysis particularly in States and Markets focused on what she called the ‘market-authority nexus’, the see-saw of power between the market and political authority. The overall argument of her work suggested that the global market had gained significant power relative to states since the 1970s. This led her to dub the Westphalia system Westfailure. She argued that a ‘dangerous gap’ was emerging between territorially-bound nation states and weak or partial intergovernmental cooperation in which markets had a free hand which could be constructive or destructive.
This idea of "casino capitalism" as a driver of financial instability was developed further in the book The Crisis of Global Capitalism by George Soros (1998), who highlights the potential for disequilibrium in the financial system, and the inability of non-market sectors to regulate markets.
Although the insights of the Soros critique of global capitalism are scarcely new, they are rarely articulated with such candor and accuracy by those who have so mastered its ways for personal gain. The following is a sampling of Soros' insights.Bank lending also contributes to the instability, because the price of real and financial assets is set in part by their collateral value. The higher their market price rises the larger the loans banks are willing to make to their buyers to bid up prices. When the bubble bursts, the value of the assets plummets below the amount of the money borrowed against them. This forces banks to call their loans and cut back on the lending, which depresses asset prices and dries up the money supply. The economy then tanks-until credit worthiness is restored and a new boom phase begins.
When I bought shares in Lockheed and Northrop after the managements were indicted for bribery, I helped sustain the price of their stocks. When I sold sterling short in 1992, the Bank of England was on the other side of my transactions, and I was in effect taking money out of the pockets of British taxpayers. But if I had tried to take social consequences into account, it would have thrown off my risk-reward calculation, and my profits would have been reduced.
Soros argues that if he had not bought Lockheed and Northrop, then
somebody else would have, and Britain would have devalued sterling no
matter what he did. "Bringing my social conscience into the decision-making
process would make no difference in the real world; but it may adversely
affect my own results." One can challenge the Soros claim that such
behavior is amoral rather than immoral, but his basic argument is accurate.
His understanding that it is futile to look to individual morality as
the solution to the excesses of financial markets is all too accurate.
Publicly owned companies are single-purpose organizations-their purpose is to make money. The tougher the competition, the less they can afford to deviate. Those in charge may be well-intentioned and upright citizens, but their room for maneuver is strictly circumscribed by the position they occupy. They are duty-bound to uphold the interests of the company. If they think that cigarettes are unhealthy or that fostering civil war to obtain mining concessions is unconscionable, they ought to quit their jobs. Their place will be taken by people who are willing to carry on.
Though not specifically mentioned by Soros, this is why corporations
are properly excluded from the political processes by which societies
define their goals and the rules of the marketplace. They are incapable
of distinguishing between private corporate interests and broader public
interests.
"Foreign ownership of capital deprives peripheral countries of autonomy and often hinders the development of democratic institutions. The international flow of capital is subject to catastrophic interruptions."
In times of uncertainty financial capital tends to return to its country of origin, thus depriving countries at the periphery of the financial liquidity necessary to the function of monetized economies. "The center's most important feature is that it controls its own economic policies and holds in its hands the economic destinies of periphery countries."
Monetary values have usurped the role of intrinsic values, and markets have come to dominate spheres of existence where they do not properly belong. Law and medicine, politics, education, science, the arts, even personal relations-achievements or qualities that ought to be valued for their own sake are converted into monetary terms; they are judged by the money they fetch rather than their intrinsic value."
Because financial "capital is free to go where most rewarded, countries vie to attract and retain capital, and if they are to succeed they must give precedence to the requirements of international capital over other social objectives.
From the historical view Reaganomics also can be considered to be the US flavor of Lysenkoism with economics instead of genetics as a target. Like it was the case in Bolshevism the ideology was developed and forced upon the society by a small group of players. The key ideas of Casino Capitalism were formulated and implemented by Reagan administration with some contribution by Nixon (the role of rednecks aka "moral majority", "silent majority" as an important part of republican political base, which can be attracted to detrimental to its economic position policies by the smoke screen of false "moral" promises).
It was supported by each president after Reagan (paradoxically with Clinton having the most accomplished record -- he was the best Republican President in a very perverted way). Like in case of Lysenkoism opponents were purged and economic departments of the country were captured by principless careerists ready to tow the party line for personal enrichment. Like in case of Bolshevism. many of those special breed of careerists rotated from Republican Party into Fed and other government structures. Classic example of compulsive careerists that were used by finance sector to promote its interests was Alan Greenspan.
Among early critiques of casino capitalism was John K. Galbraith. He promoted a pretty novel idea that the major economic function of Governments is to strengthen countervailing powers to achieve some kind of balance between capital and labor. While unions are far from being perfect and his prediction did not materialize in view of sliding to corporatism it may well be that the renewed support of unions right efforts to organize could make a big contribution to a revised, post subprime/derivatives/shadow_banking crisis of capitalism.
One of the key ideas of Reaganomics was the rejection of the sound approach that there can be a balance between too much government regulation and too little and that government role is important for smooth functioning of the market. In this area Reagan and its followers can be called Anarchists and their idea of 'free market" is a misnomer that masks the idea of "anarchic market" (corporate welfare to be exact -- as it was implemented). Emergence of corporate welfare Queens such as GS, Citi, AIG, are quite natural consequence of Reaganomics.
There might be some geo-strategically motives as well as the US elite in late 80th perceived that competitiveness is slipping out of the USA and the danger of deindustrialization is real. Many accuse Reagan with the desire to ride dollar status as a world reserve currency (exorbitant privilege) until the horse is dead. That's what real cowboys do in Hollywood movies...
| Reaganomics was a kind of the US flavor of Lysenkoism with economics instead of generics as a target... It can and should be called Economic Lysenkoism. |
The most interesting part of Reaganomics was the power of this ideology which conditioned "working class" and middle class to act against their own economic interests and permitted stagnation of wages during the whole 25 years period. This makes it in many ways very similar to Bolshevism as a whole, not just Lysenkoism (extremes meet or in less flattering way: "history repeats, first as a tragedy, then as farce).
Along with the term Reaganimics which implicitly stresses the deregulation, the other close term "market fundamentalism" is often used. Here is how market fundamentalism is defined (Longview Institute):
Market Fundamentalism is the exaggerated faith that when markets are left to operate on their own, they can solve all economic and social problems. Market Fundamentalism has dominated public policy debates in the United States since the 1980's, serving to justify huge Federal tax cuts, dramatic reductions in government regulatory activity, and continued efforts to downsize the government’s civilian programs.
It was serviced by pseudo-scientific theories of Milton Freedman as well as supply side economics. Those two can be called as two pillars, two cornerstones of Economic Lysenkoism.
The huge boost of Casino Capitalism was given by the collapse of the USSR in 1991. That gave a second life to Reagan era. New Deal regulations were systematically destroyed. Dumped down variants of Nietzsche philosophy like bastardtized variant promoted by Russian emigrant Ann Rand became fashionable. A lot of chest thumping of the status of America as a hyper power and "end of history" where capitalism was supposed to reign supreme followed. But in 2000 the moment to pay the piper arrives. It was postponed by Iraq war and housing bubble but reappeared in much more menacing form in 2007. It looks like in 2009 the USA arrived to the a classic Minsky moment with high unemployment rate and economy suppressed by (and taken hostage) by Ponzi finance institutions which threaten the very survival of our system and way of life.
Some level of government coercion (explicit or implicit ) is necessary for proper labeling of any pseudo-scientific theory with the term Lysenkoism. This holds true for both Market Fundamentalism (after all Reagan revolution was "revolution from above" and hired guns from academia just do what powers that be expected) and, especially, supply side economic. In this sense the Repulican Party plaiyed the role very similar to the Communist Party of the USSR.
For example supply side economics was too bizarre and would never survive without explicit government support. This notion is supported by many influential observers. For example, in the following comment for Krugman article (Was the Great Depression a monetary phenomenon):
Market fundamentalism (neoclassical counter-revolution — to be more academic) was more of a political construct than based on sound economic theory. However, it would take a while before its toxic legacy is purged from the economics departments. Indeed, in some universities this might never happen.
Extreme deregulation and extreme regulation (Brezhnev socialism) logically meets and both represent a variant of extremely corrupt society that cannot be sustained for long (using bayonets as in the case of USSR or using reserve currency and increasing leverage as is the case of the USA). In both cases the societies were economically and ideologically bankrupt at the end.
Actually, elements of market fundamentalism looks more like religious doctrine than political philosophy — and that bonds its even closer to Lysenkoism. In both cases critics were silenced with the help of the state. It is interesting to note that Reaganomics was wiped into frenzy after the dissolution of the USSR, the country which gave birth to the term of Lysenkoism. In a way the last act of the USSR was to stick a knife in the back of the USA. As a side note I would like to stress that contrary to critics the USSR was more of a neo-feudal society with elements of slavery under Stalin. Gulag population were essentially state slaves; paradoxically a somewhat similar status is typical for illegal immigrants in industrialized countries. From this point of view this category of "state slaves" is generally more numerous that gulag inmates. Prison population also can be counted along those lines.
It look like either implicitly or explicitly Reagan's bet was on restoration of gilded Age with its dominance of financial oligarchy, an attempt to convert the USA into new Switzerland on the "exorbitant privilege" of dollar status as the global fiat currency.
Casino Capitalism is characterized by political dominance of FIRE industries (finance, insurance, and real estate) and diminished role of other and first of all manufacturing industries. It was also accompanied by the drastic growth of inequality (New Gilded Age). Its defining feature is "the triumph of the trader in assets over the long-term producer" in Martin Wolf's words.
The other problem with Reagan counter-revolution is that it restored the power of financial oligarchy typical for Gilded Age. In the influential Atlantic Monthly article The Quiet Coup Simon Johnson argues that this power now needs to be broken:
The second problem the U.S. faces—the power of the oligarchy—is just as important as the immediate crisis of lending. And the advice from the IMF on this front would again be simple: break the oligarchy.
Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.
Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical—since we’ll want to sell the banks quickly—they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.
This may seem like a crude and arbitrary step, but it is the best way to limit the power of individual institutions in a sector that is essential to the economy as a whole. Of course, some people will complain about the “efficiency costs” of a more fragmented banking system, and these costs are real. But so are the costs when a bank that is too big to fail—a financial weapon of mass self-destruction—explodes. Anything that is too big to fail is too big to exist.
To ensure systematic bank breakup, and to prevent the eventual reemergence of dangerous behemoths, we also need to overhaul our antitrust legislation. Laws put in place more than 100years ago to combat industrial monopolies were not designed to address the problem we now face. The problem in the financial sector today is not that a given firm might have enough market share to influence prices; it is that one firm or a small set of interconnected firms, by failing, can bring down the economy. The Obama administration’s fiscal stimulus evokes FDR, but what we need to imitate here is Teddy Roosevelt’s trust-busting.
Caps on executive compensation, while redolent of populism, might help restore the political balance of power and deter the emergence of a new oligarchy. Wall Street’s main attraction—to the people who work there and to the government officials who were only too happy to bask in its reflected glory—has been the astounding amount of money that could be made. Limiting that money would reduce the allure of the financial sector and make it more like any other industry.
Still, outright pay caps are clumsy, especially in the long run. And most money is now made in largely unregulated private hedge funds and private-equity firms, so lowering pay would be complicated. Regulation and taxation should be part of the solution. Over time, though, the largest part may involve more transparency and competition, which would bring financial-industry fees down. To those who say this would drive financial activities to other countries, we can now safely say: fine.
Two PathsTo paraphrase Joseph Schumpeter, the early-20th-century economist, everyone has elites; the important thing is to change them from time to time. If the U.S. were just another country, coming to the IMF with hat in hand, I might be fairly optimistic about its future. Most of the emerging-market crises that I’ve mentioned ended relatively quickly, and gave way, for the most part, to relatively strong recoveries. But this, alas, brings us to the limit of the analogy between the U.S. and emerging markets.
Emerging-market countries have only a precarious hold on wealth, and are weaklings globally. When they get into trouble, they quite literally run out of money—or at least out of foreign currency, without which they cannot survive. They must make difficult decisions; ultimately, aggressive action is baked into the cake. But the U.S., of course, is the world’s most powerful nation, rich beyond measure, and blessed with the exorbitant privilege of paying its foreign debts in its own currency, which it can print. As a result, it could very well stumble along for years—as Japan did during its lost decade—never summoning the courage to do what it needs to do, and never really recovering. A clean break with the past—involving the takeover and cleanup of major banks—hardly looks like a sure thing right now. Certainly no one at the IMF can force it.
In my view, the U.S. faces two plausible scenarios. The first involves complicated bank-by-bank deals and a continual drumbeat of (repeated) bailouts, like the ones we saw in February with Citigroup and AIG. The administration will try to muddle through, and confusion will reign.
Boris Fyodorov, the late finance minister of Russia, struggled for much of the past 20 years against oligarchs, corruption, and abuse of authority in all its forms. He liked to say that confusion and chaos were very much in the interests of the powerful—letting them take things, legally and illegally, with impunity. When inflation is high, who can say what a piece of property is really worth? When the credit system is supported by byzantine government arrangements and backroom deals, how do you know that you aren’t being fleeced?
Our future could be one in which continued tumult feeds the looting of the financial system, and we talk more and more about exactly how our oligarchs became bandits and how the economy just can’t seem to get into gear.
The second scenario begins more bleakly, and might end that way too. But it does provide at least some hope that we’ll be shaken out of our torpor. It goes like this: the global economy continues to deteriorate, the banking system in east-central Europe collapses, and—because eastern Europe’s banks are mostly owned by western European banks—justifiable fears of government insolvency spread throughout the Continent. Creditors take further hits and confidence falls further. The Asian economies that export manufactured goods are devastated, and the commodity producers in Latin America and Africa are not much better off. A dramatic worsening of the global environment forces the U.S. economy, already staggering, down onto both knees. The baseline growth rates used in the administration’s current budget are increasingly seen as unrealistic, and the rosy “stress scenario” that the U.S. Treasury is currently using to evaluate banks’ balance sheets becomes a source of great embarrassment.
Under this kind of pressure, and faced with the prospect of a national and global collapse, minds may become more concentrated.
The conventional wisdom among the elite is still that the current slump “cannot be as bad as the Great Depression.” This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances. If our leadership wakes up to the potential consequences, we may yet see dramatic action on the banking system and a breaking of the old elite. Let us hope it is not then too late.
Hyman Minsky argued that a key mechanism that pushes an economy towards a crisis is the accumulation of debt. He identified 3 types of borrowers that contribute to the accumulation of insolvent debt: Hedge Borrowers; Speculative Borrowers; and Ponzi Borrowers. That corresponds to three stages of Casino Capitalism of increasing fragility:
A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market clearing asset prices and a sharp drop in market liquidity.[1]
After that there is a long a painful deleveraging period. The US will most likely face a long period of stagnation: the digestion of excessive debt of the private sector will take several years (FT.com Willem Buiter's Maverecon After the Crisis Macro Imbalance, Credibility and Reserve-Currency):
Since the excess of debt is relative to income and GDP, the lower the rate of growth, the longer the required period of digestion. This explains for the paradox of trying to stimulate consumption when the economy faces a monumental crisis provoked exactly by excessive debt and excessive consumption. A cartoon line best captured the spirit of it: “country addicted to speculative bubbles desperately searches a new bubble to invest in. ”
... ... ..
The roots of the crisis are major international macroeconomic imbalances. Despite the fact that the excesses of the financial system were instrumental to lead these imbalances further than otherwise possible, insufficient regulation should not be viewed as the main factor behind the crisis. The expenditure of central countries, spinned by all sort of financial innovations created by a globalized financial system, was the engine of world growth. When debt became clearly excessive in central countries and the debt-financed expenditure cycle came to an end, the ensuing crisis paralyzed the world economy. With the lesson of 1929 well assimilated, American monetary policy became aggressively expansionist. The Fed inundated the economy with money and credit, in the attempt to avoid a deep depression. Even if successful, the economies of the US and the other central countries, given the burden of excessive debt, are likely to remain stagnant under the threat of deflation for the coming years. The assumption of troubled assets by the public sector, in order to avoid the collapse of the financial system, might succeed, but at the cost of a major increase in public debt. Fiscal policy is not efficient to restart the economy when the private sector remains paralyzed by excessive debt. Even if a coordinated effort to increase public expenditure is successful, the central economies will remain stagnant for as long as the excessive indebtedness of the private sector persists. The period of digestion of excess debt will be longer than the usual recessive cycle. Since imports represent a drain in the effort to reanimate domestic demand through public expenditure, while exports, on the contrary, contribute to the recovery of internal demand, the temptation to central economies to also adopt a protectionist stance will be strong.
The instability and volatility of active markets can devalue the economic base of real lives, or in more macro-scenarios can lead to the collapse of national and regional economies. In a very interesting and grotesque way it also incorporates the key element of Brezhnev Socialism in everyday life: huge manipulation of reality by mass media to the extend that Pravda and the USSR First TV Channel look pretty objective in comparison with Fox news and Fox controlled newspapers. Complete poisoning of public discourse and relying on the most ignorant part of the population as the political base (pretty much reminiscent of how Bolsheviks played "Working Class Dictatorship" anti-intellectualism card; it can be called "Rednecks Dictatorship").
Over a period of fifteen years (from 1991 till 2007 -- the epoch after collapse of the USSR) casino capitalism evolved from a financial structure dominated by hedge financing to Ponzi financing. The shift toward speculative positions occurs as a logical, objective development because of the way in which success in a boom enhances expectations. The shift from speculative toward Ponzi finance was speed up by increased corruption of major players.
“As Minsky observed, capitalism is inherently unstable. As each crisis is successfully contained, it encourages greater speculation and risk taking in borrowing and lending. Financial innovation makes it easier to finance various schemes. To a large extent, borrowers and lenders operate on the basis of trial and error. If a behavior is rewarded, it will be repeated. Thus stable periods naturally lead to optimism, to booms, and to increasing fragility.A financial crisis can lead to asset price deflation and repudiation of debt. A debt deflation, once started, is very difficult to stop. It may not end until balance sheets are largely purged of bad debts, at great loss in financial wealth to the creditors as well as the economy at large.”
Erosion of manufacturing base and the level of dominance of FIRE industries cluster reached in the USA quite dramatic proportions. For example Chicago which was a manufacturing center since 1969 lost approximately 400K manufacturing jobs which were replaced mainly by FIRE-related jobs, In 1995 over 22% of those employed by FIRE industries (66K people) were working in executive and managerial positions. Another 17% are in marketing, sales and processional specialty occupations (computer system analysts, PR specialists, writer and editors).
According to the Center for Responsive Politics, the FIRE sector was and is the biggest contributor to federal candidates in Washington. Companies cannot give directly, so they leave it to bundlers to solicit maximum contributions from employees and families. They might have been brought down to earth this year, but they’ve given like gods: Goldman Sachs, $4.8 million; Citigroup, $3.7 million; J.P. Morgan Chase & Co., $3.6 million; Merrill Lynch, $2.3 million; Lehman Brothers, $2.1 million; Bank of America, $2.1 million. Some think the long-term effect of such contributions to individual candidates was clear in the roll-call votes for the bailout.
Take the controversial first House vote on bailout of major banks on Sept. 29, 2008. According to CRP, the “ayes” had received 53 percent more contributions from FIRE since 1989 than those who voted against the bill, which ultimately failed 228 to 205. The 140 House Democrats who voted for the bill got an average of $188,572 in this election cycle, while the 65 Republicans backing it got an average of $185,461 from FIRE—about 23 percent more than the bill’s opponents received. A tinkered bill was passed four days later, 263 to 171.
According to the article Fire Sale from the American Conservative Magazine half of Obama’s top ten contributors, together giving him nearly $2.2 million, are FIREmen. The $13 million contributed by FIRE executives to Obama campaign is probably an undercount. Democratic committee leaders are also dependent of FIRE contributions. The list includes Sen. Dodd ( please look at Senator Dodd's top donors for 2007-8 on openSecrets.org ) and Sen. Chuck Schumer ($12 million from FIRE since 1989), Rep. Barney Frank ($2.5 million), and Rep. Charlie Rangel ($4 million, the top recipient in the House). All of them have been accused of taking truckloads of contributions while failing to act on the looming mortgage crisis. Dodd finally pushed mortgage reform last year but by then as his hometown paper, The Hartford Courant stated, “the damage was done.”
The Ponzi scheme stage of the current FIRE development started with the subprime mortgages scam which served as a catalyst for unfolding of a unprecedented derivatives mess. The latter was created by systematic deregulation and proliferation of purely speculative market players as exemplified by hedge funds.
There is no question that Reagan and most of his followers (Greeenspan, Rubin, Donaldson, Phil Gramm, etc) were rabid radicals blinded by ideology. But they were radicals of quite different color then FDR. They were close to what can be called financial terrorists inflicting huge damage to the nation and I wonder if RICO can be use to prosecute at least some of them.
While the essence of Reagonomics was financial deregulation, the other important element was restoring the Gilded Age status of financial oligarchy which influence was mortally wounded by FDR reforms. In this sense we can say that Reagan revolution was essentially a counter-revolution: an attempt to reverse the New Deal restrictions on financial sector and restore its dominance in the society. Like NYT times noted about Phil Gram (The Reckoning - Phil Gramm, Unswayed Champion of Deregulation - Series - NYTimes.com):
“Phil Gramm was the great spokesman and leader of the view that market forces should drive the economy without regulation,” said James D. Cox, a corporate law scholar at Duke University. “the movement he helped to lead contributed mightily to our problems.”
... ... ...
Once again, he succeeded in putting off consideration of lending restrictions. His opposition infuriated consumer advocates. “He wouldn’t listen to reason,” said Margot Saunders of the National Consumer Law Center. “He would not allow himself to be persuaded that the free market would not be working.”Speaking at a bankers’ conference that month, Mr. Gramm said the problem of predatory loans was not of the banks’ making. Instead, he faulted “predatory borrowers.” The American Banker, a trade publication, later reported that he was greeted “like a conquering hero.”
Here is how Reaganomics is defined in Wikipedia
Reaganomics (a portmanteau of "Reagan" and "economics") refers to the economic policies promoted by United States President Ronald Reagan. The four pillars of Reagan's economic policy were to:[1]
- reduce the growth of government spending,
- reduce marginal tax rates on income from labor and capital,
- reduce government regulation of the economy,
- control the money supply to reduce inflation.
In attempting to cut back on domestic spending while lowering taxes, Reagan's approach was a departure from his immediate predecessors.
Reagan became president during a period of high inflation and unemployment (commonly referred to as stagflation), which had largely abated by the time he left office.
The Number 1 idea ("reduce government spending") was essentially a scam, a smoke screen designed to attract Rednecks as a powerful voting block. In a way this was a trick similar to one played by Bolsheviks in Russia with its "worker and peasants rule" smokescreen which covered brutal dictatorship. In reality all administrations which preached Reagonomics (including Clinton's) expanded the role of state and government spending.
It is pretty interesting to see how people carefully filter information to fit their biases. For example, the key facts about repeal of Glass-Steagall law are (BTW Joe Biden voted for it):
Glass-Steagall had been weakened under Reagan, under the recommendation of Alan Greenspan who was essentially a Wall Street mole in Fed (see below the concept introduced by Willem Buiter of ‘cognitive regulatory capture’ of the Fed by Wall Street.)
Clinton administration and Congress supported the repeal but it was Phil Gramm who made it happened. Not only he was the main cheerleader for the repeal. Gramm essentially wrote the bill. As NYT noted:
The measure, which Mr. Gramm helped write and move through the Senate, also split up oversight of conglomerates among government agencies. The Securities and Exchange Commission, for example, would oversee the brokerage arm of a company. Bank regulators would supervise its banking operation. State insurance commissioners would examine the insurance business. But no single agency would have authority over the entire company.
“There was no attention given to how these regulators would interact with one another,” said Professor Cox of Duke. “Nobody was looking at the holes of the regulatory structure.”
The arrangement was a compromise required to get the law adopted. When the law was signed in November 1999, he proudly declared it “a deregulatory bill,” and added, “We have learned government is not the answer.”
Support was bipartisan which tells something about Clinton Congress:
REPUBLICANS FOR (52): Abraham, Allard, Ashcroft, Bennett, Brownback, Bond, Bunning, Burns, Campbell, Chafee, Cochran, Collins, Coverdell, Craig, Crapo, DeWine, Domenici, Enzi, Frist, Gorton, Gramm (Tex.), Grams (Minn.), Grassley, Gregg, Hegel, Hatch, Helms, Hutchinson (Ark.), Hutchison (Tex.), Inhofe, Jeffords, Kyl, Lott, Lugar, Mack, McConnell, Murkowski, Nickles, Roberts, Roth, Santorum, Sessions, Smith (N.H.), Smith (Ore.), Snowe, Specter, Stevens, Thomas, Thompson, Thurmond, Voinovich and Warner.
DEMOCRATS FOR (38): Akaka, Baucus, Bayh, Biden, Bingaman, Breaux, Byrd, Cleland, Conrad, Daschle, Dodd, Durbin, Edwards, Feinstein, Graham (Fla.), Hollings, Inouye, Johnson, Kennedy, Kerrey (Neb.), Kerry (Mass.), Kohl, Landrieu, Lautenberg, Leahy, Levin, Lieberman, Lincoln, Moynihan, Murray, Reed (R.L), Reid (Nev.), Robb, Rockefeller, Sarbanes, Schumer, Torricelli and Wyden.
During the Greenspan years there was what Willem Buiter call ‘cognitive regulatory capture’ of the Fed by Wall Street.
This regulatory capture has resulted in an excess sensitivity of the Fed to financial market and financial sector concerns and fears and in an overestimation of the strength of the link between financial market turmoil and financial sector deleveraging and capital losses on the one hand, and the stability and prosperity of the wider economy on the other hand. The paper gives five examples of recent behaviour by the Fed that are most readily rationalised with the assumption of regulatory capture. The abstract of the paper follows next. The latest version of the entire enchilada can be found here. Future revisions will also be found there.
Commodity Futures Trading Commission — under the leadership of Mr. Gramm’s wife, Wendy — had approved rules in 1989 and 1993 exempting some swaps and derivatives from regulation. In December 2000, the Commodity Futures Modernization Act was passed as part of a larger bill by unanimous consent after Mr. Gramm dominated the Senate debate...
“He was the architect, advocate and the most knowledgeable person in Congress on these topics,” Mr. Donovan said. “To me, Phil Gramm is the single most important reason for the current financial crisis.”
“The virtually unregulated over-the-counter market in credit-default swaps has played a significant role in the credit crisis, including the now $167 billion taxpayer rescue of A.I.G.,” Christopher Cox, the chairman of the S.E.C. and a former congressman, said Friday.
But you will never find discussion of flaws and adverse consequences Phil Gram (or Greenspan for a change) initiatives in Heritage Foundation and other right-wing think tanks publications.
No. 1: Reagan Fires Fed Chairman Volcker and Replaces Him With Greenspan in 1987:
Volcker also understood that financial markets need to be regulated. Reagan wanted someone who did not believe any such thing, and he found him in a devotee of the objectivist philosopher and free-market zealot Ayn Rand.
snip
If you appoint an anti-regulator as your enforcer, you know what kind of enforcement you’ll get. A flood of liquidity combined with the failed levees of regulation proved disastrous.
Greenspan presided over not one but two financial bubbles.
I had opposed repeal of Glass-Steagall. The proponents said, in effect, Trust us: we will create Chinese walls to make sure that the problems of the past do not recur. As an economist, I certainly possessed a healthy degree of trust, trust in the power of economic incentives to bend human behavior toward self-interest—toward short-term self-interest, at any rate, rather than Tocqueville’s "self interest rightly understood."
Stiglitz also refers to a 2004 decision by the SEC "to allow big investment banks to increase their debt-to-capital ratio (from 12:1 to 30:1, or higher) so that they could buy more mortgage-backed securities, inflating the housing bubble in the process."
Once more, it was deregulation run amuck, and few even noticed.
The Bush administration was providing an open invitation to excessive borrowing and lending—not that American consumers needed any more encouragement.
Here he refers to bad accounting, the failure to address problems with stock options, and the incentive structures of ratings agencies like Moodys that led them to give high ratings to toxic assets.
Valuable time was wasted as Paulson pushed his own plan, "cash for trash," buying up the bad assets and putting the risk onto American taxpayers. When he finally abandoned it, providing banks with money they needed, he did it in a way that not only cheated America’s taxpayers but failed to ensure that the banks would use the money to re-start lending. He even allowed the banks to pour out money to their shareholders as taxpayers were pouring money into the banks.
Stiglitz concludes:
The truth is most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal. Looking back at that belief during hearings this fall on Capitol Hill, Alan Greenspan said out loud, "I have found a flaw." Congressman Henry Waxman pushed him, responding, "In other words, you found that your view of the world, your ideology, was not right; it was not working." "Absolutely, precisely," Greenspan said. The embrace by America—and much of the rest of the world—of this flawed economic philosophy made it inevitable that we would eventually arrive at the place we are today.
The flawed economic philosophy brought by Reagan, and embraced by so many, brought us to this day. Ideas have consequences, especially when we stop empirically testing them. Republican economics have created great pain to America and harmed our national interest.
The flaw that Greenspan found was always there. Self regulation does not work. As Stiglitz said:
As an economist, I certainly possessed a healthy degree of trust, trust in the power of economic incentives to bend human behavior toward self-interest—toward short-term self-interest
Yes, for all their claims to science, the premise conflicts with tendencies of people.
This is the real legacy of Ronald Reagan and Alan Greenspan:
The whole scheme was kick-started under Ronald Reagan. Between his tax cuts for the rich and the Greenspan Commission’s orchestrated Social Security heist, working Americans lost out in a generational wealth transfer shift now exceeding $1 trillion annually from 90 million working class households to for-profit corporations and the richest 1% of the population. It created an unprecedented wealth disparity that continues to grow, shames the nation and is destroying the bedrock middle class without which democracy can’t survive.
Greenspan helped orchestrate it with economist Ravi Batra calling his economics "Greenomics" in his 2005 book "Greenspan’s Fraud." It "turns out to be Greedomics" advocating anti-trust laws, regulations and social services be ended so "nothing....interfere(s) with business greed and the pursuit of profits."
Attempts of theoretical justification of Reaganomics are called voodoo economics. They fall into two major categories:
In Orwell's Animal Farm all animals are equal - except that some are more equal than others. All in the spirit of law, order and the proper functioning of society, of course. Fittingly, the animals that have chosen this role by themselves and for themselves, are the pigs.
Cut to US financial markets today. After years of swinish behavior more reminiscent of Animal House than anything else, the pigs are threatening to destroy the entire farm. As if it wasn't enough that they devoured all the "free market" food available and inundated the world with their excreta, they now wish to be put on the public trough. Truly, some businessmen believe they are more equal than others.
But do not blame the pigs; they are expected to act as swine nature dictates. The fault lies entirely with the farmers, those authorities entrusted by the people to oversee the farm because they supposedly knew better. While the pigs were rampaging and tearing the place apart, they were assuring us all that farms function best when animals are free to do as they please, guided solely by invisible hooves. No regulation, no oversight, no common sense. Oh yes, and pigs fly..
So what is to be done now? Two things:
In other words, the focus from now on should be on adding value by means of work and savings (capital formation), instead of inflating assets and borrowing.
Furthermore, we should realize that in a world already inhabited by close to 7 billion people and beset by resource depletion and environmental degradation, defending growth for growth's sake is a losing proposition. The wheels are already wobbling on the Permagrowth model; pumping harder on the accelerator is not going to make it go any faster and will likely result in a fatal crash.
Debt, and finance in general, should be left to re-size downwards to a level that better reflects the carrying capacity of our world. The Fed's current actions are shortsighted and "conservative" in the worst interpretation of the words: they are designed to artificially maintain debt at levels that myopically projects growth as far as the eye can see.
What level of resizing may be necessary? I hope not as much as at Bear Stearns, which got itself bought by Morgan at buzz-saw prices: $2 per share represents a 98% discount from its $84 book value. What scares me, though, is the statement by Morgan's CFO, who said the price reflected the risk the firm was taking, even though he was comfortable with the valuation of assets in Bear's books. It "...gives us the flexibility and margin of error that's appropriate given the speed at which the transaction came together", he said.
If it takes a 98% discount and the explicit guarantee of the Fed for a large portion of assets to buy one of the largest investment banks in the world, where should all other financial firms be trading at? ....Hello? Anyone? Is that a great big silence I hear, or the sound of credit imploding into a vacuum?
March 11, 2010 | Senator for Delaware Newsroom - Floor Statement
Introduction: Where the Burden of Proof Lies
Financial regulatory reform is perhaps the most important legislation that the Congress will address for many years to come. Because if we don't get it right, the consequences of another financial meltdown could truly be devastating.
In the Senate, as we continue to move closer to consideration of a landmark bill, however, we are still far short of addressing some of the fundamental problems – particularly that of “too big to fail” – that caused the last crisis and already have planted the seeds for the next one. And this is happening after months of careful deliberation and negotiations, and just a year and a half after the virtual meltdown of our entire financial system.
Following the Great Depression, the Congress built a legal and regulatory edifice that endured for decades. One of the cornerstones of that edifice was the Glass-Steagall Act, which established a firewall between commercial and investment banking activities. Another was a federally guaranteed insurance fund to back up bank deposits. Other rules were imposed on investors to tamp down rampant speculation, like margin requirements and the uptick rule on short selling.
That edifice worked well to ensure financial stability for decades. But in the past thirty years, the financial industry, like so many others, went through a process of deregulation. Bit by bit, many of the protections and standards put in place by the New Deal were methodically removed. And while the seminal moment came in 1999 with the repeal of Glass-Steagall, that formal rollback was primarily the confirmation of a lengthy process already underway.
Indeed, after 1999, the process only accelerated. Financial conglomerates that combined commercial and investment banking consolidated, becoming more leveraged and interconnected through ever more complex transactions and structures, all of which made our financial system more vulnerable to collapse. A shadow banking industry grew to larger proportions than even the banking industry itself, virtually unshackled by any regulation. By lifting basic restraints on financial markets and institutions, and more importantly, failing to put in place new rules as complex innovations arose and became widespread, this deregulatory philosophy unleashed the forces that would cause our financial crisis.
I start by asking a simple question: Given that deregulation caused the crisis, why don’t we go back to the statutory and regulatory frameworks of the past that were proven successes in ensuring financial stability?
And what response do I hear when I raise this rather obvious question? That we have moved beyond the old frameworks, that the eggs are too scrambled, that the financial industry has become too sophisticated and modernized and that it was not this or that piece of deregulation that caused the crisis in the first place.
Mind you, this is a financial crisis that necessitated a $2.5 trillion bailout. And that amount includes neither the many trillions of dollars more that were committed as guarantees for toxic debt nor the de facto bailout that banks received through the Federal Reserve’s easing of monetary policy. The crisis triggered a Great Recession that has thrown millions out of work, caused millions to lose their homes, and caused everyone to suffer in an American economy that has been knocked off its stride for more than two years.
Given the high costs of our policy and regulatory failures, as well as the reckless behavior on Wall Street, why should those of us who propose going back to the proven statutory and regulatory ideas of the past bear the burden of proof? The burden of proof should be upon those who would only tinker at the edges of our current system of financial regulation. After a crisis of this magnitude, it amazes me that some of our reform proposals effectively maintain the status quo in so many critical areas, whether it is allowing multi-trillion-dollar financial conglomerates that house traditional banking and speculative activities to continue to exist and pose threats to our financial system, permitting banks to continue to determine their own capital standards, or allowing a significant portion of the derivatives market to remain opaque and lightly regulated.
To address these problems, Congress needs to draw hard lines that provide fundamental systemic reforms, the very kind of protections we had under Glass-Steagall. We need to rebuild the wall between the government-guaranteed part of the financial system and those financial entities that remain free to take on greater risk. We need limits on the size of systemically significant non-bank players. And we need to regulate effectively the derivatives market that caused so much widespread financial ruin. It is my sincere hope that we don’t enact compromise measures that give only the illusion of change and a false sense of accomplishment. If we do, then we will only have set in place the prelude to the next financial crisis.
The Steady Removal of Glass-Steagall Protections
First, however, let us examine the origins – both obscure and well-known – of the Great Recession of 2008. As I have already noted, the regulators began tearing down the walls between commercial banking and investment banking long before the repeal of Glass-Steagall. Through a series of decisions in the 1980s and 1990s, the Federal Reserve liberalized prudential limitations placed upon commercial banks, allowing them to engage in securities underwriting and trading activities, which had traditionally been the particular province of investment banks. One fateful decision in 1987 to relax Glass-Steagall restrictions passed over the objections of then Federal Reserve Chairman Paul Volcker, the man who is today leading the charge to restrict government-backed banks from engaging in proprietary trading and other speculative activities.
With the steady erosion of these protections by the Federal Reserve, the repeal of Glass-Steagall had become a fait accompli even before the passage of the Gramm Leach Bliley Act (GLBA) in 1999. In effect, by passing GLBA, Congress was acknowledging the reality in the marketplace that commercial banks were already engaging in investment banking. As the business of finance moved from bank loans to bonds and other forms of capital provided by investors, commercial banks pushed the Federal Reserve to relax Glass-Steagall standards to allow them to underwrite bonds and make markets in new products like derivatives. Even before GLBA was passed, J.P. Morgan, Citigroup, Bank of America and their predecessor organizations had all become leaders in those businesses.
After Glass-Steagall’s Repeal: The Opening of the Floodgates
If the changes in the financial marketplace that led to the repeal of Glass-Steagall took place over many years, the market’s transformation after 1999 was swift and profound.
The Emergence of Mega Banks
First, there was frenzied merger activity in the banking sector, as financial supermarkets that had bank and nonbank franchises under the umbrella of a single holding company bought out smaller rivals to gain an ever-increasing national and international footprint. While the Riegle-Neal Banking of Act of 1994, which established a 10% cap nationally on any particular bank’s share of federally-insured deposits, should have been a barrier for at least some of these mergers, regulatory forbearance permitted them to go through anyway. In fact, then Citicorp’s proposed merger with Travelers Insurance was actually a major rationale behind the Glass-Steagall Act. Most of the largest banks are products of serial mergers. For example, J.P. Morgan Chase is a product of J.P. Morgan, Chase Bank, Chemical Bank, Manufacturers Hanover, Banc One, Bear Stearns, and Washington Mutual. Meanwhile, Bank of America is an amalgam of that predecessor bank, Nation’s Bank, Barnett Banks, Continental Illinois, MBNA, Fleet Bank, and finally Merrill Lynch.
Financial Disintermediation and the Rise of Shadow Banking
Second, the business of finance was changing. Disintermediation, the process by which investors directly fund businesses and individuals through securities markets, was already in full bloom by the time of the repeal of Glass-Steagall. This was demonstrated by the dramatic growth in money market fund and mutual fund assets and by the fact that corporate bonds actually exceeded non-mortgage bank loans by the middle of the 1990s.
The subsequent boom in structured finance took this process to ever greater heights. Securitization, whereby pools of illiquid loans and other assets are structured, converted and marketed into asset-backed securities (ABS), is in principle a valuable process that facilitates the flow of credit and the dispersion of risk beyond the banking system. Regulatory neglect, however, permitted a good model to mutate and grow into a sad farce.
On one end of the securitization supply chain, regulators allowed underwriting standards to erode precipitously without strengthening mortgage origination regulations or sounding the alarm bells on harmful nonbank actors (not even those within bank holding companies over which the regulators had jurisdiction). On the other, securities backed by risky loans were transformed into securities deemed “hi-grade” by credit rating agencies, only after a dizzying array of steps where securities were packaged and repackaged into many layers of senior tranches, which had high claims to interest and principal payments, and subordinate tranches.
The non-banking actors – investment banks, hedge funds, money market funds, off-balance-sheet investment funds – that powered structured finance came to be known as the shadow banking market. Of course, the shadow banking market could only have grown to surpass by trillions of dollars the actual banking market with the consent of regulators.
In fact, one of the primary purposes behind the securitization market was to arbitrage bank capital standards. Banks that could show regulators that they could offload risks through asset securitizations or through guarantees on their assets in the form of derivatives called credit default swaps (CDS) received more favorable regulatory capital treatment, allowing them to build their balance sheets to more and more stratospheric levels.
With the completion of the Basel II Capital Accord, determinations on capital adequacy became dependent on the judgments of rating agencies and, increasingly, the banks’ own internal models. While this was a recipe for disaster, it reflected in part the extent to which the size and complexity of this new era of quantitative finance exceeded the regulators’ own comprehension.
When Basel II was effectively applied to investment banks like Lehman Brothers and Goldman Sachs, which had far more precarious and potentially explosive business models that utilized overnight funding to finance illiquid inventories of assets, the results were even worse. The SEC, which had no track record to speak of with respect to ensuring the safety and soundness of financial institutions, allowed these investment banks to leverage a small base of capital over 40 times into asset holdings that, in some cases, exceeded $1 trillion.OTC Derivatives
Third, little more than a year after repealing Glass-Steagall, Congress passed legislation – the Commodity Futures Modernization Act of 2000 (CFMA) – to allow over-the-counter (OTC) derivatives to essentially remain unregulated. Following the collapse of the hedge fund Long Term Capital Management (LTCM) in 1998, then Commodities Futures Trading Commission (CFTC) Chairwoman Brooksley Born began to warn of problems in this market. Unfortunately, her calls for stronger regulation of the derivatives market clashed with the uncompromising free-market philosophies of Federal Reserve Chairman Alan Greenspan, then Treasury Secretary Robert Rubin and later Treasury Secretary Larry Summers. To head off any attempt by the CFTC or another agency from regulating this market, they successfully convinced Congress to pass the CFMA.
The explosive growth of the OTC derivatives market following the passage of the CFMA was stunning – the size of the OTC derivatives market grew from just over $95 trillion at the end of 2000 to over $600 trillion in 2009. This growth had profound implications for the overall risk profile of the financial system. While derivatives can be used as a valuable tool to mitigate or hedge risk, they can also be used as an inexpensive way to take on leverage and risk. As I noted before, certain OTC derivatives called credit default swaps were crucial in allowing banks to evade their regulatory capital requirements. In other contexts, CDS contracts have been used to speculate on the credit worthiness of a particular company or asset.
But they pose other problems as well. Since derivatives represent contingent liabilities or assets, the risks associated with them are imperfectly accounted for on company balance sheets. And they have concentrated risk in the banking sector, since even before the repeal of Glass-Steagall, large commercial banks like J.P. Morgan were major derivatives dealers. Finally, the proliferation of derivatives has significantly increased the interdependence of financial actors while also overwhelming their back-office infrastructure. Hence, while the growth of derivatives greatly increased counterparty credit risks between financial institutions — the risk, that is, that the other party will default at some point during the life of the derivative contract — those entities had little ability to quantify those risks, let alone manage them.
Therefore, on the eve of what was arguably the biggest economic crisis since the Great Depression, which was caused in large part by the confluence of all the forces and trends that I have just described, the financial industry was larger, more concentrated, more complex, more leveraged and more interconnected than ever before. Once the sub-prime crisis hit, it spread like a contagion, causing a collapse in confidence throughout virtually the entire financial industry. And without clear walls between those institutions the government insures and those that are free to take on excessive leverage and risk, the American taxpayer was called upon to step forward into the breach.The Crisis and the Response: Expanding the Safety Net
Unfortunately, the government’s response to the financial meltdown has only made the industry bigger, more concentrated and more complex. As the entire financial system was imploding following the bankruptcy filing by Lehman Brothers, the Treasury and the Federal Reserve hastily arranged mergers between commercial banks (which had a stable source of funding in insured deposits) and investment banks (whose business model depended on market confidence to roll over short-term debt).
Before the Lehman bankruptcy, Bear Stearns had been merged into J.P. Morgan. After the Lehman collapse, one of the biggest mergers to occur was between Bank of America and Merrill Lynch. And Ken Lewis, the CEO of Bank of America at the time, alleges that it was consummated only following pressure he received from Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke.
As merger plans for the remaining two investment banks, Goldman Sachs and Morgan Stanley, faltered, another plan was hatched. Both Goldman Sachs and Morgan Stanley – neither of which had anything even close to traditional banking franchises – were both given special dispensations from the Federal Reserve to become bank holding companies. This provided them with permanent borrowing privileges at the Federal Reserve’s discount window – without having to dispose of risky assets. In a sense, it was an official confirmation that they were covered by the government safety net because they were literally “too big to fail.”
Following the crisis, the U.S. mega banks left standing have even more dominant positions. Take the multi-trillion-dollar market for OTC derivatives. The five largest banks control 95 percent of that market. With such strong pricing power, these firms could afford to expand dramatically their margins. The Federal Reserve estimated that those five banks made $35 billion from trading in the first half of 2009 alone. Of course, they used these outsized profits from trading activities in derivatives and other securities not only to replenish their capital, but also to pay billions of dollars in bonuses.
The New Financial Order
Large and complex institutions like Citigroup dominate our financial industry and our economy. MIT professor Simon Johnson and James Kwak, a researcher at Yale Law School, estimate that the six largest U.S. banks now have total assets in excess of 63 percent of our overall GDP. Only 15 years ago, the six largest U.S. banks had assets equal to 17 percent of GDP. We haven’t seen such concentration of financial power since the days of Morgan, Rockefeller and Carnegie.
As I stated at the outset, I am extremely concerned that our reform efforts to date do little, if anything, to address this most serious of problems. By expanding the safety net — as we did in response to the last crisis — to cover ever larger and more complex institutions heavily engaged in speculative activities, I fear that we may be sowing the seeds for an even bigger crisis in only a few years or a decade.
Unfortunately, the current reform proposals focus more on reorganizing and consolidating our regulatory infrastructure, which does nothing to address the most basic issue in the banking industry: that we still have gigantic banks capable of causing the very financial shocks that they themselves cannot withstand.
The Need for Fundamental Reform
Rather than pass the buck to a reshuffled regulatory deck, which will still be forced to oversee banks that former FDIC Chairman Bill Isaac describes as “too big to manage, and too big to regulate,” we must draw hard statutory lines between banks and investment houses.
We must eliminate the problem of “too big to fail” by reinstituting the spirit of Glass-Steagall, a modern version that separates commercial from investment banking activities and imposes strict size and leverage limits on financial institutions.
We must also establish clear and enforceable rules of the road for our securities markets in the interest of making them less fragmented, opaque and prone to collapse. The over-the-counter derivatives market must be tightly regulated, as originally proposed by Brooksley Born – and rejected by Congress – in the late 1990s.
Finally, I believe the myriad conflicts of interest on Wall Street must be addressed through greater protection and empowerment of individual investors. Our anti-fraud provisions, as represented for example by Rule 10(b)5, under the 1934 Securities Act, need to be strengthened.
Eliminating “Too Big to Fail”
The Insufficiency of Resolution Authority
One key reform that has been proposed to address the “too big to fail” problem is resolution authority. The existing mechanism whereby the FDIC resolves failing depository institutions has, by and large, worked well. After the experiences of Bear Stearns and Lehman Brothers in 2008, it is clear that a similar process should be applied to entire bank holding companies and large nonbank institutions.
While no doubt necessary, this is no panacea. No matter how well Congress crafts a resolution mechanism, there can never be an orderly wind-down, particularly during periods of serious stress, of a $2-trillion institution like Citigroup that had hundreds of billions of off-balance-sheet assets, relies heavily on wholesale funding, and has more than a toehold in over 100 countries.
There is no cross-border resolution authority now, nor will there be for the foreseeable future. In the days and weeks following the collapse of Lehman Brothers, there was an intense and disruptive dispute between regulators in the U.S. and U.K. regarding how to handle customer claims and liabilities more generally. Yet experts in the private sector and governments agree – national interests make any viable international agreement on how financial failures are resolved difficult to achieve. A resolution authority based on U.S. law will do precisely nothing to address this issue.
While some believe market discipline would be reimposed by refining the bankruptcy process, Lehman Brothers demonstrates that the very concept of market discipline is illusory with institutions like investment banks, which used funds that they borrowed in the repo market to finance their own inventories of securities, as well as their own book of repurchase agreements, which they provided to hedge funds through their prime brokerage business.
Investment banks, the fulcrum of these institutional arrangements, found themselves in a classic squeeze. On one side, their hedge fund clients and counterparties withdrew funds and securities in their prime brokerage accounts, drew down credit lines and closed out derivative positions, all of which caused a massive cash drain on the bank. On the other side, the repo lenders, concerned about the value of their collateral as well as the effect of the cash drain on the banks’ credit worthiness, refused to roll over their loans without the posting of substantial additional collateral. These circumstances quickly prompted a vicious cycle of deleveraging that brought our financial system to the brink. With such large, complex and combustible institutions like these, there can be no orderly process of winding them down. The rush to the exits happens much too quickly.
That is why we need to directly address the size, the structure and the concentration of our financial system.
The Volcker Rule: A Good Beginning
The Volcker Rule, which would prohibit commercial banks from owning or sponsoring “hedge funds, private equity funds, and purely proprietary trading in securities, derivatives or commodity markets,” is a great start, and I applaud Chairman Volcker for proposing that purely speculative activities should be moved out of banks. That is why I joined yesterday with Senators Jeff Merkeley (D-OR) and Carl Levin (D-MI) to introduce a strong version of the Volcker Rule. But I think we must go further still. Massive institutions that combine traditional commercial banking and investment banking are rife with conflicts and are too large and complex to be effectively managed.
Glass-Steagall for the 21st Century
We can address these problems by reimposing the kind of protections we had under Glass-Steagall. To those who say "repealing Glass-Steagall did not cause the crisis, that it began at Bear Stearns, Lehman Brothers and AIG," I say that the large commercial banks were engaged in exactly the same behavior as Bear Stearns, Lehman and AIG – and would have collapsed had the federal government not stepped in and taken extraordinary measures. Moreover, in response to the last crisis, we increased the safety net that covers these behemoth institutions. The result: they will continue to grow unchecked, using insured deposits for speculative activities without running any real risk of failure on account of their size.
We need to reinstate Glass-Steagall – in an updated form – to prevent or at least severely moderate the next crisis.
By statutorily splitting apart massive financial institutions that house both banking and securities operations, we will both cut these firms down to more reasonable and manageable sizes and rightfully limit the safety net only to traditional banks. President of the Federal Reserve Bank of Dallas Richard Fisher recently stated: “I think the disagreeable but sound thing to do regarding institutions that are [‘too big to fail’] is to dismantle them over time into institutions that can be prudently managed and regulated across borders. And this should be done before the next financial crisis, because it surely cannot be done in the middle of a crisis.”
A growing number of people are calling for this change. They include former FDIC Chairman Bill Isaac, former Citigroup Chairman John Reed, famed investor George Soros, Nobel-Prize-winning-economist Joseph Stiglitz, President of the Federal Reserve Bank of Kansas City Thomas Hoenig, and Bank of England Governor Mervyn King, among others. A chastened Alan Greenspan also adds to that chorus, noting: “If they’re too big to fail, they’re too big. In 1911 we broke up Standard Oil -- so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”
Size and Leverage Constraints: Cutting the Mega Banks and Shadow Banking System Down to Size
But even this extraordinary step of splitting these institutions apart is not sufficient. Cleaving investment banking from traditional commercial banking will still leave us with massive investment banks, some with balance sheets that exceed $1 trillion in assets.
For that reason, Glass-Steagall would need to be supplemented with strict size and leverage constraints. The size limit should focus on constraining the amount of non-deposit liabilities at large investment banks, which rely heavily on short-term financing like repos and commercial paper.
The growth of those funding markets in the run-up to the crisis was staggering. One report by researchers at the Bank of International Settlements estimated that the size of the overall repo market in the U.S., Euro region and the U.K. totaled approximately $11 trillion at the end of 2007. Incredibly, the size was more than $5 trillion more than the total value of domestic bank deposits at that time, which was less than $7 trillion.
The overreliance on such wholesale financing made the entire financial system vulnerable to a classic bank run, the type that we had before we instituted a system of deposit insurance and strong bank supervision. Remarkably, while there is a prudential cap on the amount of deposits a bank can have (even though deposits are already federally insured), there is no limit of any kind on liabilities like repos that need to be rolled over every day. With a sensible limit on these liabilities at each financial institution (for example, as a percentage of GDP), we can ensure that never again will the so-called shadow banking system eclipse the real banking system.
In addition, institutions that rely upon market confidence every day to finance their balance sheet and market prices to determine the worth of their assets should not be leveraged to stratospheric levels. To ensure that regulatory forbearance does not permit another Lehman Brothers, we should institute a simple statutory leverage requirement, that is, a limit on how much firms can borrow relative to how much their shareholders have on the line. As I have said in a previous speech, a statutory leverage requirement that is based upon banks’ core capital — i.e. their common stock plus retained earnings — could supplement regulators’ more highly-calibrated risk-based assessments, providing a sorely-needed gut check that ensures that regulators don’t miss the forest for the trees when assessing the capital adequacy of a financial institution.
This would push firms back towards the levels of effective capital they had in the “pre-bailout” days – like in the post World War II period when our financial system generally functioned well. To be sure, this would move our core banks from being predominantly debt financed to being substantially capitalized by equity. But other parts of our financial system already operate well on this basis – with venture capital being the most notable example. The return on equity relative to debt would need to rise to accommodate this change, but – as long as we preserve a credible monetary policy – this is consistent with low interest rates in real terms.
I would also stress that a leverage limit without breaking up the biggest banks will have little effect. Because of their implicit guarantee, “too big to fail” banks enjoy a major funding advantage – and leverage caps by themselves do not address that. Our biggest banks and financial institutions have to become significantly smaller if we are to make any progress at all.
Reforming Our Financial Markets
Turning now to derivatives reform, I have already noted how large dealer banks completely dominate the OTC marketplace for derivatives, an opaque market where these banks exert enormous pricing power. For over two decades, this market has existed with virtually no regulation whatsoever.
Amazingly, it is a market where the dealers themselves actually set the rules for the amount of collateral and margin that needs to be posted by different counterparties on trades. Dealers never post collateral, while the rules they set for their counterparties are both lax and pro-cyclical, meaning that margin requirements tend to increase during periods of market turmoil when liquidity is at a premium. The complete lack of oversight of these markets has almost brought our financial system to its knees twice in ten years, first with the failure of LTCM in 1998, and then with the failure of Lehman Brothers in 2008. We have known about these problems for over a decade – yet we have so far done nothing to make this market better regulated.
That is why I applaud CFTC Chairman Gary Gensler’s efforts in pushing for centralized clearing and regulated electronic execution of standardized OTC derivatives contracts as well as more robust collateral and margin requirements. Clearinghouses have strong policies and procedures in place for managing both counterparty credit and operational risks. Chairman Gensler underscores that this would get directly at the problem of “too big to fail” by stating: “Central clearing would greatly reduce both the size of dealers as well as the interconnectedness between Wall Street banks, their customers and the economy.” Moreover, increased clearing and regulated electronic trading will make the market more transparent, which will ultimately give investors better pricing.A strong clearing requirement, however, should not be swallowed by large exemptions that circumvent the rules. While I am sympathetic to concerns about increased costs raised by non-financial corporations that use interest rate and currency swaps for hedging purposes, any exemption of this sort should be narrowly crafted. For example, it might be limited to transactions where non-financial corporations use OTC derivatives in a way that qualifies for GAAP hedge accounting treatment. In any case, we should recognize more explicitly that when such derivatives contracts are provided by too big to fail banks, the end users are in effect splitting the hidden taxpayer subsidy with the big banks. And remember that this subsidy is not only hidden – it is also dangerous, because it is central to the incentives to become bigger and to take more risk once any financial firm is large.
Given that one of the key objectives behind increased clearing is to reduce counterparty credit risk, it also seems reasonable that derivatives legislation place meaningful constraints on the ownership of clearinghouses by large dealer banks.
Addressing Conflicts of Interest
Finally, we need to address the fundamental conflicts of interest on Wall Street. While separating commercial banking from investment banking is a critical step, there are still inherent conflicts within the modern investment banking model.
Better Addressing Securities Fraud
Let’s take the example of auction rate securities. Brokers at UBS and other firms marketed these products, which were issued by municipalities and not-for-profit entities, as “safe, liquid cash alternatives” to retail investors even though they were really long-term debt instruments whose interest rates would reset periodically based upon the results of Dutch auctions. In other words, these unsuspecting investors would be unable to sell their securities if new buyers didn’t enter the market, which is exactly what happened. As credit concerns by insurers who guaranteed these securities drained liquidity from the market, bankers continued to sell these securities to retail clients as safe, liquid investments. There was a blatant conflict of interest where the banks served as broker to their retail customers while also underwriting the securities and conducting the auctions.
There is an open issue of why such transactions did not constitute securities fraud, for example under Rule 10(b)5 – which prohibits the nondisclosure of material information. Civil actions are still in progress and perhaps we will learn more from the outcomes of particular cases. But no matter how these specific cases are resolved, we should move to strengthen the legal framework that enables both private parties and the SEC (both civil and criminal sides) to bring successful enforcement actions.
Individuals at Enron, Merrill Lynch, and Arthur Anderson were called to account for their participation in fraudulent activities – and at least one executive from Merrill went to prison for signing off on a deal that would help manipulate Enron’s earnings. But it is quite possible that no one will be held to account, either in terms of criminal or civil penalties, due to the deception and misrepresentation manifest in our most recent credit cycle. We must work hard to remove all the loopholes that helped create this unfair and unreasonable set of outcomes.
Strengthening Investor Protection
We can begin by strengthening investor protection. Currently, brokers are not subject to a fiduciary standard as financial advisors are, but only subject to a “suitability” requirement when selling securities products to investors. Hence, brokers don’t have to be guided by their customers’ best interest when recommending investment product offerings – they might instead be focused on increasing their compensation by pushing proprietary financial products. By harmonizing the standards that brokers and financial advisors face and by better disclosing broker compensation, retail investors will be able to make better, more informed investment decisions. Even Lloyd Blankfein, the CEO of Goldman Sachs, has stated that he “support[s] the extension of a fiduciary standard to broker/dealer registered representatives who provide advice to retail investors. The fiduciary standard puts the interests of the client first. The advice-giving functions of brokers who work with investors have become similar to that of investment advisers.”
It has also become known that some firms underwrite securities – promoting them to investors – and then short these same securities within a week and without disclosing this fact, which any reasonable investor would regard as adverse material information. In the structured finance arena, investment banks sold pieces of collateralized debt obligations — which were packages of different asset-backed securities divided into different risk classes — to their clients and then took proceeded to take short positions in those securities by purchasing credit default swaps. Some banks went further by shorting mortgage indexes tied to securities they were selling to clients and by shorting their counterparties in the CDS market. This is how a firm like Goldman Sachs could claim that they were effectively hedged to an AIG collapse.
Unfortunately, the use of products like CDS in this way allows the banks to become empty creditors who stand to make more money if people and companies default on their debts than if they actually paid them. These and other problematic practices that place financial firms’ interests against those of their clients need to be restricted. They also completely violate the spirit of our seminal legislation from the 1930s, which insisted – for the first time – that the sellers and underwriters of securities disclose all material information. This is nothing less than a return to the unregulated days of the 1920s; to be sure, those days were heady and exciting, but only for a while – such practices always end in a major crash, with the losses disproportionately incurred by small and unsuspecting investors.
Investors should also have greater recourse through our judicial system. For example, auditors, accountants, bankers and other professionals that are complicit in corporate fraud should be held accountable. That is why I worked on a bill with Senators Specter and Reed to allow for private civil actions against individuals who knowingly or recklessly aid or abet a violation of securities laws.
Conclusion: Hard Lines, Not Regulator Discretion
Admittedly, this is not an exhaustive list of financial reforms. I also believe we need to reconstitute our system of consumer financial protection, which was a major failure before our last crisis. We must have an independent Consumer Financial Protection Agency (CFPA) that has strong and autonomous rulemaking authority and the ability to enforce those rules at nonbanking entities like payday lenders and mortgage finance companies. Most importantly, the head of this agency must not be subject to the authority of any regulator responsible for the “safety and soundness” of the financial institutions. The CFPA must look out for the interests of consumers and for consumers alone.
Unfortunately, like the public option in healthcare, the CFPA issue has become something of a “shiny object” – though certainly an important one – that has distracted the focus of debate away from the core issues of “too big to fail.”
Beginning with the solutions for “too big to fail,” each of these challenges represents a crucial step along the way towards fixing a regulatory system that has permitted both large and small failures. Each is an important piece to the puzzle.
I know there are those who will disagree with some, and perhaps all of these proposals. They sincerely advocate a path of incrementalism, of achieving small reforms over time. They say that problems as complex as these need to be solved by the regulators, not by Congress. After all, they are the ones with the expertise.
I respectfully disagree.
Giving more authority to the regulators is not a complete solution. While I support having a systemic risk council and a consolidated bank regulator, these are necessary but not sufficient reforms – the President’s Working Group on Financial Markets has actually played a role in the past similar to that of the proposed council, but to no discernible effect. I do not see how these proposals alone will address the key issue of “too big to fail.”
In the brief history I outlined earlier, the regulators sat idly by as our financial institutions bulked up on short-term debt to finance large inventories of collateralized debt obligations backed by subprime loans and leveraged loans that financed speculative buyouts in the corporate sector.
They could have sounded the alarm bells and restricted this behavior, but they did not. They could have raised capital requirements, but instead farmed out this function to credit rating agencies and the banks themselves. They could have imposed consumer-related protections sooner and to a greater degree, but they did not. The sad reality is that regulators had substantial powers, but chose to abdicate their responsibilities.
What is more, regulators are almost completely dependent on the information, analysis and evidence as presented to them by those with whom they are charged with regulating. Last year, former Federal Reserve Chairman Alan Greenspan, once the paragon of laissez faire capitalism, stated that “it is clear that the levels of complexity to which market practitioners, at the height of their euphoria, carried risk management techniques and risk-product design were too much for even the most sophisticated market players to handle properly and prudently.” I submit that if these institutions that employ such techniques are too complex to manage, then they are surely too complex to regulate.
That is why I believe that reorganizing the regulators and giving them additional powers and responsibilities isn’t the answer. We cannot simply hope that chastened regulators or newly appointed ones will do a better job in the future, even if they try their hardest. Putting our hopes in a resolution authority is an illusion. It is like the harbor master in Southampton adding more lifeboats to the Titanic, rather than urging the ship to steer clear of the icebergs. We need to break up these institutions before they fail, not stand by with a plan waiting to catch them when they do fail.
Without drawing hard lines that reduce size and complexity, large financial institutions will continue to speculate confidently, knowing that they will eventually be funded by the taxpayer if necessary. As long as we have “too big to fail” institutions, we will continue to go through what Professor Johnson and Peter Boone of the London School of Economics have termed “doomsday” cycles of booms, busts and bailouts, a so-called “doom loop” as Andrew Haldane, who is responsible for financial stability at the Bank of England, describes it.
The notion that the most recent crisis was a “once in a century” event is a fiction. Former Treasury Secretary Paulson, National Economic Council Chairman Larry Summers, and J.P. Morgan CEO Jamie Dimon all concede that financial crises occur every five years or so.
Without clear and enforceable rules that address the unintended consequences of unchecked financial innovation and which adequately protect investors, our markets will remain subverted.
These solutions are among the cornerstones of fundamental and structural financial reform. With them we can build a regulatory system that will endure for generations instead of one that will be laid bare by an even bigger crisis in perhaps just a few years or a decade’s time. We built a lasting regulatory edifice in the midst of the Great Depression, and it lasted for nearly half a century. I only hope we have both the fortitude and the foresight to do so again.
Jan 8, 2010 | Bloomberg
Sitting in his London office, Adair Turner is a study in gray eminence. A charcoal wool suit complements his silver fringe of hair, and he’s framed by a window that looks out to a leaden winter sky punctured by steely skyscrapers. The towers are home to Barclays Plc, HSBC Holdings Plc and other lenders Turner watches over as chairman of the U.K. Financial Services Authority, Britain’s financial regulator. The setting belies Turner’s growing reputation in the City, London’s financial district, as a troublemaker.
Turner, a former director general of the Confederation of British Industry, or CBI, the main U.K. business lobby, might have reasonably been expected to act as a bureaucratic booster for banks and investment firms reeling from the global recession.
Instead, since taking the job in September 2008, he’s used his time as regulator to scold the financial services industry for growing too large on the back of risky products that he says offer little value to society, Bloomberg Markets magazine reported in its February issue. To reduce the appetite for speculative risk, Turner is promoting a levy on financial transactions to divert money to the poor and support efforts to address climate change. The so-called Tobin tax is named after the late U.S. economist James Tobin, a Nobel laureate who proposed a surcharge on currency trading to deter speculation.
“I believe in markets; I believe in enterprise,” says Turner, who numbers Franklin D. Roosevelt and British economist John Maynard Keynes among his personal heroes. “But I have always believed that market economies will not of themselves combine that with environmental sustainability or with a reasonably just and good society. I believe that capitalism needs to be saved from itself.”
Pinstriped Provocateur
Turner -- a member of the British House of Lords and head of the country’s Committee on Climate Change -- seems to enjoy his role as a pinstriped provocateur, casually remarking that he also supports the decriminalization of drugs.
“I very strongly believe that society is best served by not having shibboleths, areas where we can’t go,” he says.
Turner’s public campaign has helped nudge British lawmakers into getting tough on banks. U.K. Prime Minister Gordon Brown told a Group of 20 nations meeting in November that he supported a global transaction tax. Then, on Dec. 9, Brown’s government imposed a temporary 50 percent levy on bank bonuses, which applies to awards over 25,000 pounds ($39,800) issued from that day to April 5. The charge will be paid by banks instead of employees.
‘Core Issue’
Turner is using his post and influence to ask that bankers consider what purpose they serve in society.
“To say that in Britain, in London, as head of the FSA, is really something one would not expect,” says Tommaso Padoa- Schioppa, European chairman of Promontory Financial Group, a regulatory advisory firm. “He addressed a core issue: that the size of finance may have grown beyond what is serving a useful purpose for the economy,” says Padoa-Schioppa, who was Italy’s finance minister from 2006 to 2008.
Turner is lambasting an industry still smarting from the credit crisis. Financial services accounted for 10.1 percent of the U.K.’s gross domestic product and 27.5 percent of corporate taxes in 2007, according to statistics from the U.K. government and PricewaterhouseCoopers LLP. More than 1 million Britons were employed in financial services that year, according to the U.K. Office for National Statistics. The London-based Centre for Economics and Business Research estimates that City firms have cut as many as 50,000 jobs since the beginning of 2008.
Covering Risk
In the wake of the global recession, Turner’s FSA is proposing that U.K. banks at least double the amount of capital they set aside to cover the risks of proprietary trading and bolster the level of shareholder equity available to absorb potential losses from activities such as lending. The FSA also wants to require big banks to draw up so-called living wills to guide regulators on how to wind up their operations the next time a disaster strikes.
Turner triggered controversy in August when he first floated the transaction tax idea and criticized the size of the U.K. financial sector in an interview in Prospect, a British journal. At a black-tie gathering of financial executives in London on Sept. 22, Turner said banks should move away from products, such as complex derivatives, that don’t benefit society.
“Some financial activities which proliferated over the last 10 years were socially useless, and some parts of the system were swollen beyond their optimal size,” he told the gathering.
‘Appalled, Disgusted, Ashamed’
Turner’s remarks have been condemned by executives who say it’s ridiculous to introduce a moral dimension to regulation.
“Quite honestly, I am appalled, disgusted, ashamed and hugely embarrassed,” wrote Howard Wheeldon, a senior strategist at BGC Partners LP, in an August note. “How dare he?” Wheeldon now says. “Markets will decide if something is too big or too small. It’s not for an individual, however powerful, to slam and damn nearly 1 million people.”
Michael Spencer, chief executive officer of London-based broker ICAP Plc, joined the chorus of critics in late November.
“I was genuinely offended,” Spencer said at an industry awards dinner in London. “Using his logic, I presume he would describe Porsche as socially useless for making cars that go twice the speed limit or Jimmy Choo for making shoes in dozens of different colors.”
Turner is mostly unrepentant. While his words may have been imperfect, he now says, he stands by the sentiments behind them.
“I wish I had said ‘economically useless’ rather than ‘socially useless,’ as it would have been more precise,” he says.
Global Influence
Now, Turner has a potentially more powerful forum for his ideas: the G-20. As a member of the global Financial Stability Board, he’s been asked by the G-20’s central bankers and finance ministers to propose ways in which governments should regulate international firms such as Deutsche Bank AG and Goldman Sachs Group Inc. His brief is to explore whether banks’ trading arms should be split from their deposit-taking units.
Turner has said he’s against such a divide and instead favors surcharges on riskier trades to make them less attractive. He has also proposed requiring lenders to set up separate regional subsidiaries so that bank failures can be contained, helping to prevent the market seizures that followed the 2008 collapse of Lehman Brothers Holdings Inc.
Power, Charisma
The son of a town planner, Jonathan Adair Turner has displayed a political suppleness throughout his public career. At the University of Cambridge, where he studied history and economics, he was chairman of the student Conservative Association, only to shift his allegiance to the now-defunct center-left Social Democratic Party in 1981. Though Turner was given a peerage in 2005 by the Labour government, he joined the House of Lords as a cross-bench, or unaffiliated, member.
“There are very few people out there who have his charisma,” Wheeldon says. “Power seems to ooze from his fingertips.”
After graduating with top honors from Cambridge in 1978, Turner worked as an economics tutor and joined McKinsey & Co. four years later, eventually opening the management consulting firm’s banking practice in Eastern Europe and Russia. It was at McKinsey that he met his Irish-born wife, Orna Ni-Chionna, with whom he has two daughters. In 1995, he became director general of the CBI at the age of 39.
‘Red Adair’
At the CBI, Turner built a relationship with Labour Party leader Tony Blair and was dubbed “Red Adair” by the British press, a play on the name of the late American oil-well firefighter. At the time, Labour officials regularly met with City executives to assure them that the party was friendly to business. Blair became prime minister following Labour’s landslide win in May 1997, ending four terms of Conservative rule that began with Margaret Thatcher’s election in 1979.
“The CBI in the old days was the bulwark of the Thatcher regime,” says Simon Gleeson, a regulatory lawyer at Clifford Chance LLP in London. “Adair was seen to be extending the CBI hand of friendship to the Blairites. For the mainstream CBI, this was just the most radical thing.”
As one of his first acts as chancellor of the Exchequer in Blair’s government, Brown created the FSA in 1997 and divided oversight for the financial system among it, the Bank of England and the Treasury. In 2002, Blair appointed Turner to head a government commission on the U.K.’s pension system.
Turner’s 2005 report recommended requiring all workers to enroll in a pension program and called for boosting the retirement age to 68 from 65. The proposals were initially rejected by Brown for being too costly. Today, both major parties endorse Turner’s plan to keep people working longer, following bank rescue deals that have cost U.K. taxpayers about 850 billion pounds.
Stage Double
Turner, named FSA chairman by now-Prime Minister Brown’s government in 2008, may lose his job after the next general election, which must be held by June. The opposition Conservatives have pledged to abolish the FSA and hand regulation back to the Bank of England.
Thanks in part to his public profile, Turner currently appears as a character in a David Hare play about the financial crisis called “The Power of Yes.” The drama, based on interviews with bankers and investors, reaches a climax with Turner’s character noting that following the recession, talented people may turn their backs on financial careers to battle climate change or drive medical research.
In real life, Turner is just as skeptical about the size of the industry he regulates.
“There is a confusion that blew up over the years that the FSA ought to be the cheerleader for London’s financial services industry,” he says. “It’s not the role of the regulator to make the industry as large as possible. I think some people get confused about that.”
After Turner’s yearlong campaign to challenge presumptions in the City, there’s little doubt that the days of uncritical oversight are over.
-- Editors: David Ellis, Gail Roche
To contact the reporters on this story: Caroline Binham in London at cbinham@bloomberg.net;
Taibblog - True-Slant
It has become conventional wisdom, perhaps even cliche, to pin the origins of the credit crisis on the big banks or, AIG or even the practice of financial modeling. Certainly, these actors have received the most play in the media, and have now endured the focus of populist ire for more than a year. We now think that the analysis leading commentators to focus blame on these entities is fatally flawed.
Over the Christmas holiday a nasty thing happened: Tim Geithner’s Treasury Department decided to lift the cap on aid to the Government-Sponsored Entities, Fannie Mae and Freddie Mac, apparently in response to Obama administration fears that the two agencies would become insolvent. The cap was raised from $200 billion on each and government backstopping of the mortgage market will apparently now extend into infinity for at least three years, through 2012.
The move has already inspired a mini-firestorm, with several outlets delving deeply into the recent history of the GSEs and uncovering some disturbing new facts. Chief among those were an analysis of the GSEs by a former chief credit officer of Fannie named Edward Pinto, who found that Fannie and Freddie routinely mismarked subprime or Alt-A (a sort of purgatory class of nonprime risky mortgage, resting between subprime and prime) mortgages as prime. The Wall Street Journal explains:
In general, a subprime mortgage refers to the credit of the borrower. A FICO score of less than 660 is the dividing line between prime and subprime, but Fannie and Freddie were reporting these mortgages as prime, according to Mr. Pinto. Fannie has admitted this in a third-quarter 10-Q report in 2008.
This is a damning fact and if true certainly supports the Journal claim that the GSE actions were a “principal cause of the financial crisis.” But having established this, the Journal then goes in this direction:
Market observers, rating agencies and investors were unaware of the number of subprime and Alt-A mortgages infecting the financial system in late 2006 and early 2007. Of the 26 million subprime and Alt-A loans outstanding in 2008, 10 million were held or guaranteed by Fannie and Freddie, 5.2 million by other government agencies, and 1.4 million were on the books of the four largest U.S. banks.
Sometimes I’m amazed at the speed with which highly provocative information like this GSE business can be converted into distracting propaganda in this country. In the right hands Pinto’s analysis of the GSEs — just like the revelations in the past few years about practices at AIG, Moody’s, Countrywide, Goldman Sachs, the Fed, and, hell, let’s add the offices of Senator Chris Dodd — would have been a starting point for a deeper investigation into a financial system that is clearly a complex and intimate symbiosis of state and private corruption.
For what we’ve learned in the last few years as one scandal after another spilled onto the front pages is that the bubble economies of the last two decades were not merely monstrous Ponzi schemes that destroyed trillions in wealth while making a small handful of people rich. They were also a profound expression of the fundamentally criminal nature of our political system, in which state power/largess and the private pursuit of (mostly short-term) profit were brilliantly fused in a kind of ongoing theft scheme that sought to instant-cannibalize all the wealth America had stored up during its postwar glory, in the process keeping politicians in office and bankers in beach homes while continually moving the increasingly inevitable disaster to the future.
That is a terrible story and it is also sort of a taboo story, since we don’t really have a system of media now that is willing or even able to digest that dark and complicated truth. Instead, our media — which has always been at best an inadvertent accomplice to these messes — is basically set up to take every revelation about the underlying truth and split it down the middle, feeding half to one side of the political spectrum and one half to the other, where the actual point is then burned up in the useless smoke of a blame game.
The essentially complicit nature of the two ruling political parties was in this way covered up for decades, as the crimes of the Democrats were greedily consumed as entertainment by the Limbaugh crowd while the crimes of the Bushies became hot-selling t-shirts and bumper stickers for the Air America listenership. The abiding mutual hatred the red/blue groups shared consistently prevented any kind of collective realization about the structure of the overall scheme.
What worries me is that we’re now reverting to the same old pattern with the financial crisis story. We’re starting to see fault lines develop, where one side blames the government while another side blames Wall Street for the messes of the last two decades. The side blaming the government tends to belong to the free-marketeer class and divines in safety-net purveyors like the GSEs and in the Fed’s money-printing fundamental corruptions of the capitalist ideal, while the side blaming the bankers tends to belong to the left-liberal tradition that focuses on greed and seeming absence of community conscience among the CEO class as primary corruptors of the social contract.
In the former view the government is to blame for punting on its oversight responsibilities and for corrupting the financial bloodstream with market-altering guarantees, while in the latter view the bankers are at fault for lobbying the politicians to make exactly the same moves. The antigovernment folks like to focus on the irresponsible (and typically low-income or minority) home-borrower and their political allies in Washington as chief villains, while the anti-banker crowd looks at the massive personal profits and outsized influence of the executive class and waves the Cui bono? stick in that direction.
Both sides are right and both sides are wrong. I know that sounds like pox-on-both-their-houses pundit sophistry. But the point is that if you focus on one side and not the other, you miss the entire point. That’s why I get freaked out when I see an important story like this GSE thing come out, and have it be immediately accompanied by arguments that “market observers, rating agencies and investors were unaware of the number of subprime and Alt-A mortgages infecting the financial system,” as though the irresponsibility of the government agency precluded similar (and, I might add, intimately related) abuses on the private side.
I mean, really — market observers were unaware of the number of subprime mortgages infecting the system? Are we to understand that nobody caught on when outstanding mortgage debt grew by $3.7 trillion between 2003 and 2005, nearly equaling the entire value of all American real estate in the year 1990? They didn’t notice when subprime mortgages went from 3% of all mortgage lending in 1997 to 20% of the market in 2003? They didn’t notice when the volume of Alt-A loans and home equity loans surged through the early part of last decade?
Now I know that that’s not what Peter Wallison of the Journal is saying here; he’s saying that even if the market saw that increase in subprime loans, even those numbers were understated thanks to Fannie and Freddie’s deceptions. But the inference that the market was hoodwinked by the GSEs is absurd. It was plain to most everyone in the financial services industry that there was a bubble going on last decade, that something deeply fucked up was going on with the mortgage markets — just as it was plain to everyone in the late nineties that something was wrong with the stock markets, when companies like Theglobe.com with annual sales under $5 million could have a $5 billion stock valuation.
Everyone was involved in the mortgage scam. At the lender level the deceptions were myriad; liar’s loans, fraudulent income documentation, negative amortization loans, HELOCs, etc. The rush to get as many loans written as possible and then get those hot potatoes moved to the next sucker in the line was furious and extended from coast to coast, sinking one lender after another in Ponzoid debt and indictments.
Then there were the countless deceptions that emerged from the securitization process, the bad math that allowed banks like Goldman to do $474 million mortgage deals where the average equity in the home was just 0.71 percent, and sell 93% of that deal as investment grade paper.
Are we really to believe that the people who did those deals didn’t know what total crap they were selling? That the people who used CDO-squareds to magically turn BBB investments into AAA investments didn’t know how nuts that was?
There were the ratings agencies, who accepted all that bad math and slapped AAA ratings on crap mortgage-backed securities in exchange for the continued largess of the banks upon whom they were financially dependent — the same ratings agencies that later sputtered and coughed up bullshit my-dog-ate-my-homework excuses for mismarking mortgages, with the Moody’s revelation that a computer error caused them to misapply AAA ratings to billions’ worth of MBS being the comic low point.
Then further along in the chain you had crooks like the folks at AIG, who took advantage of the basic nonexistence of derivatives regulation to issue billions in guarantees for these mortgage investments that they had never had any intention of paying off, to say nothing of actually having the ability to do so. And of course underwriting the entire enterprise was the implicit guarantee of Alan Greenspan’s Fed, which made it known time and time again that its modus operandi was to refuse to recognize the existence of bubbles until after they blew up, at which point it would rush in and clean up the mess, bailing out all the chief actors out with easy money.
Everyone had a hand in the bubble, from the congressmen who killed regulatory initiatives to the regulators who snoozed at the wheel to the GSEs to the Fed to the banks to the ratings agencies to the lenders. I don’t think it’s really controversial to say that, but it does seem like there’s an argument brewing about what that across-the-board complicity means.
My own personal feeling is that our recent bubbles weren’t much different than pyramid scams and lotteries; they’re the handiwork of an essentially regressive and deeply cynical political organization that systematically hoovers up taxes and investment money mainly from middle-class suckers, where it eventually gets eaten in short-term cashouts and mostly blown on sports cars and tropical vacations and eye jobs for the trophy wives of Wall Street executives. Crackonomics: take literally all the spare money from four square city blocks and turn it into one tricked-out Escalade.
For me the basic dynamic of the mortgage bubble is some Ivy League dickwad hawking a billion dollars of securitized subprime mortgages to a pension fund, and then Hobie-sailing off into the sunset with a bonus after they all blow up. Of course my seeing it that way might have a lot to do with my own personal psychological prejudices, and I get that some other person with different hangups might choose to focus on Barney Frank deciding to “roll the dice on home ownership” with the GSEs.
But what I don’t see is how anybody can say that all of this happened because Fannie and Freddie rigged the game to get Mexicans in homes, and then the banks and the ratings agencies just reacted organically to the corrupted market and helped the bubble along through no fault of their own. That’s just another (albeit more convincing) version of the early attempt to pin the disaster on the Community Reinvestment Act, which in turn is just another way of playing the red-blue blame game, which in turn is missing the point.
This GSE story is a big one, but if it gets used as a path back to a “The Market Reacted Rationally” version of history, we’re screwed. It has to be looked at as an important part of a diabolical whole, a symbiotic scheme in which the banks and the state were irreversibly intertwined in an enterprise that on both sides was never about market economics, but crime. Because otherwise… the diversionary notion that one side or the other is wholly to blame is part of what makes the whole scam possible.
p.s. Just to get this out of the way, I love Zero Hedge, and Marla Singer has been really nice to me personally. I just don’t completely agree with this particular thing. I don’t see any reason why focusing blame on the banks and the ratings agencies and AIG was “fundamentally flawed,” because, well, shit, they were to blame. The fact that Fannie and Freddie now get to jump in the pigpen with them doesn’t change that for me.
I think in the end what we’re going to find is that all the relevant actors had their own motivations for getting involved in the bubble. Two and now three presidential administrations let the Fed overheat the economy for political reasons that should be obvious. Alan Greenspan, hell, he did it because he loves seeing himself on magazine covers and wanted to keep getting invited to the right Manhattan parties. There were congressmen that converted the expansion of cheap credit into low-income votes. The bankers and lenders went along because the system of compensation on Wall Street is fucked and rewards short-term thinking while ignoring long-term consequences.
To me all of these people were equally guilty of making bad decisions to benefit themselves in the here and now at the expense of the whole in the future. When it comes to bubbles, It Takes a Village, and blaming the whole mess on the “socialist” aims of a pair of government agencies seems off base — particularly since the Randian protocapitalists running the banks benefited every bit as much from this socialism as actual homeowners, and perhaps even more, when one considers that homeowners get foreclosed upon, while bonuses are forever.
This gets to the heart of it:
“We’re starting to see fault lines develop, where one side blames the government while another side blames Wall Street for the messes of the last two decades”
I have to admit my first thought when reading your first paragraphs was a sort of “Oh shit, more ammunition for the right wingers claiming that all of the housing bubble was caused by “the government forcing poor people to buy homes they couldn’t afford” as they tend to put it.
“Don’t even go there” I was thinking, just because it’s so abused and misconstrued, as you acknowledge.
I do think the whole thing can certainly still be seen as a problem of regulation, but more in the sense of implementation than in the sense of passing the laws or regulations, it was a lack of enforcement and oversight more than anything else.
One fairly clear refutation of the “the bubble was all because of Fanny/Freddy loaning money to unworthy people” meme is that housing bubbles happened all over the world, and Fanny Mae and Freddie Mac don’t operate all over the world. There are similar programs in other countries, but no one is trying to blame the worldwide housing bubbles on them.
Or, in fact I maybe some people are. (I live in France, I should check here. Most likely the same accusations are being made, I would bet). But that just demonstrates even more clearly that it can’t possibly be the fault of “government agencies” all over the world, in some wild coincidence of making the same errors and engaging in the same malpractice at the same moment.
Anyway this I entirely agree with:
“This GSE story is a big one, but if it gets used as a path back to a “The Market Reacted Rationally” version of history, we’re screwed.”rbrander:
“Blame the Banks” ultimately also means, “Blame the Government” as well – only the blame is for insufficient regulation. You can’t blame the banks for doing lawful business.
The only thing that the bank-hating side of the argument can really blame them for is the achievement of “regulatory capture”, that is, controlling their own regulators through lobbying.
The government-hating side, of course, is really complaining about too MUCH regulation, the banks being “forced” to make bad loans to poor people.
I don’t think one needs to get into long economic proofs that this wasn’t so; you just need to look at how enthusiastically they sold and pushed those bad loans. If they were being forced to make them by idealist, lefty regulators, they would have made them with a maximum of reluctance, gritted teeth, and foot-dragging. And there would be unsuccessful lobbying efforts they could point to where they tried to escape the poisonous requirements.
I don’t disagree that blame is shared all around – you achieve regulatory capture with campaign donations and junkets, nobody held a gun to the government’s head. My point is that the mechanisms of the corruption all run through a choke-point on the government side, the regulators and the Fed.
The solution is thus clear if difficult: regulatory capture must be undone and the Fed made responsive to the long-term needs of the larger public, not the short-term needs of Wall Street.
I’d start with a major staff turnover, something Congress could probably push for successfully if they had enough pressure put on them by their voters.Matt Taibbi:
Sure. Except that a lot of this had nothing to do with regulatory capture at all. A lot of this was private lenders making bad loans, then private banks securitizing them and, using mismarkings of private ratings agencies, selling them to institutional suckers.
I would argue that while the mortgage bubble involved quite a lot of state participation/guarantees, it wasn’t a whole lot different in its particulars from the equity bubble, which was basically private entities fleecing private investors. In both cases the regulators stood idly by and did nothing, but the operating dynamic was private capital turning fraudulent/bad investments into private profits. It seems to me that what made mortgages such a logical pick to reinflate the bubble was that with so much saved wealth destroyed in the previous scheme, the next bubble had to involve borrowed money, and government sponsorship of “home ownership” was an easy way to make that happen.
What I take issue with is the notion that the bubble was caused by some socialist/government scheme to give homes to poor people. In my mind the poor people were incidental to the larger scheme, the same way wrecked cars are incidental to insurance fraud.
Amen brother. The market reacted like a market: Huge, hungry, voracious even, and something that will consume whatever you let it until it’s way past time to stop. It’s like a animal in which all of the synapses or genes or nerve pathways that regulate when to stop eating have been surgically removed, so it will literally just eat and eat until it explodes, like Mr. Creosote.davidlosangeles:
Mr. Taibbi,
Everything you wrote is dead-nuts on, thank you. However, you have pointed out half of the problem. The flourishing of bubbles, scams, and Ponzi schemes over the last two decades is not the result of personality flaws or intellectual shortcomings of individuals on Wall Street or among the economic regulatory bodies. These men and women are not fools or stupid, they understand that these devices are only short term sources of profits, ones that are ultimately corrosive to the long term health of the US economy. The fundamental problem is that there is no alternative outlet for investors.
Imagine you have 100 million dollars to invest and you want the greatest return that is save and legal, where do you put your money. Legitimate, legal investments in the US pay hardly anything at all. Nancy Miller has two excellent posts on how poorly traditional investments have done.
http://trueslant.com/nancymiller/2009/12/31/splash-safe-landing-for-the-economy-but-too-much-was-lost/
http://trueslant.com/nancymiller/2009/12/20/the-00s-the-biggest-loser-of-all-for-stocks/
The WSJ reported that the first decade of the 21st century was the worst performing decade in two centuries of stock market history. Washington and Wall Street are only too aware that there is an investment crisis. This is main reason that they have been repealing regulatory safeguards and turning a blind eye to Wall Street shenanigans, this is the only way to create a profitable outlet for investors. I am sure that they are all thinking that these are just transitional allowances until some more substantive, longer term solution comes along. There is little doubt that the real estate bubble was a direct result of economic regulators trying to alternative investment opportunities following the “dot.com” bubble / bust.
How many communities in this country once had thriving industries but are now dependent on casinos and tourism? Wall Street has made the same transition, it was once a place where investors met manufacturers to build industry. Speculation and gambling were always a part of Wall Street but since the 1930’s they were just a side-show, now they are the show.
With the lose of our industrial base, where else can investors get a competitive profit except through bubbles, scams, and Ponzi schemes.Matt Taibbi:
Sure. Except they’re not making profits. They’re losing money, great masses of it in fact.
What you’re talking about is compensation. There is no way to make high short-term profits when there are no easy investment opportunities. But when you can take some homeless person, give him a mansion, then sell his debt to a pension fund for real money, there’s a profit for you! Not a real profit, mind you, but a real bonus comes out of it.
I get that there weren’t many obvious high-returning investment opportunities suitable for all that money. But there were some that panned out, and there were probably a lot more that were never discovered because too much energy was expended simply trying to steal the crumbs still lying around. What if all of that money had gone into alternative energy companies? Into education? Border security? Aerospace research? Biomed? We might be sitting on a pile of cancer cures and solar generators instead of worthless IOUs. 9/11 might not have happened. We might not be at war. Who knows?
This story was always about the changed priorities of the investor class. Instead of taking chances on the industry and imagination of the American people, they decided to just steal the stuff those Americans already have. That’s the difference between bubbles and forward-thinking economics. Hell, that’s why we supposedly pay bankers so much — it’s their jobs to take money and use it to create new businesses that haven’t even been developed yet. To let them off the hook because there was nothing to invest in but savings accounts… to met that’s more an reflection of their general incompetence to do their jobs correctly.taojonesing:
Matt,
I’m confused by something.
As I understand things, Fannie and Freddie play only in the secondary market for mortgages. That is, neither GSE originates any mortgage loan, they only buy mortgages AFTER somebody else has made the loan. See Barry Ritholtz’s “Bailout Nation” for further details.
From that perspective, the WSJ’s claim that the GSEs were primarily responsible for the financial crisis has no merit even if you accept Fannie’s 15-month old admission, which I’ll grant you. However Fannie/Freddie mischaracterized the mortgages they bought, they did not make the bad loans that helped spark the crisis and cannot be held responsible for doing so (NOTE: subprime was too small to cause the crisis; it was the securitization of subprime that inflated the size of the problem to a point where things could explode). The folks at ZH are smart enough to know this (and I’m sure they do), so they’re talking their book if they argue otherwise (and they tell all of us to assume that they are talking their book).
Nevertheless, something is still rotten in Denmark. Why did Fannie mischaracterize the loans it had purchased? Was it, perhaps, to nominally stay within guidelines it was supposed to follow when purchasing loans on the secondary market? Was Fannie already trying to bailout the banks through the back door?
That’s the real issue in the Xmas Eve Massacre: a backdoor bailout of Wall Street not subject to Congressional oversight. When you really look into it, I think you’ll agree.
In the meantime, I’d suggest spending more time at the Baseline Scenario, Calculated Risk, Barry’s the Big Picture, Yves’ Naked Capitalism, Jesse’s Cafe Americain, and Mish’s site (just to get a full spectrum of politics in there). ZH has a lot of provocative stuff, but it just isn’t a reliable starting point. You’re probably just smarter than I am, but I need the perspectives that these other bloggers bring to bear to understand whether ZH is spot-on or full of it.D.D. Cook:
Amen brother. The puppeteers had a field day with the rest of us fools. They lined their pockets and feathered their nests and got us to look the other way by creating the ultimate blame game that split us right down the middle.
The Baseline Scenario
Beth
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: http://tinyurl.com/y9d6mpu
Best Baseline Scenario for 2009:
http://economix.blogs.nytimes.com/2009/06/04/obamas-gorbachev-moment/
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:
http://thecaucus.blogs.nytimes.com/2009/12/23/an-odd-couple-take-aim-at-rahm-emanuel/
(for those who can’t remember last year), PUMA is ‘Party Unity My Ass’.Bayard
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.
Armin
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.
StatsGuy
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.redleg
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
Armin,
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.GoodOlMike
markets.aurelius
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.
Anonymous
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!tippygolden
I’ve revised one of my Baseline Fables, exercising a touch of artistic licence in James Kwak and Felix Salmon’s conversation on bloggingheads.tv
http://tippygolden.wordpress.com/freddy-mercury/Jya
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”
(http://www.randomhouse.com/catalog/display.pperl?isbn=9780307589927)
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.
NYTimes.com
dcc: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.
westwing71The Mobius Decade. The Vandal Years. Zip. The Null Set. Paradise Lies... and Lies... and Lies... and Lies.
MSWOver 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.
Charles: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 WestWonderfully 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.
JorgeBellflowe: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.
splashyIt'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.
donnoloMonterey: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.
DSDecember: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.
themunzsydney:"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 USAYes. 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, NJIt 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.
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)
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?
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-
ROBERT KUTTNER: Right.
BILL MOYERS: By a margin of some 30 points-
ROBERT KUTTNER: Right.
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.
- One is to say, well, the interest groups are so powerful that the only thing I can do is I can work with them and move the ball a few yards, get some incremental reform, hope it turns into something better.
- The other way you can do it is to try to rally the people against the special interests and play on the fact that the insurance industry, the drug industry, are not going to win any popularity contests with the American people.
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?
MATT TAIBBI: No.
BILL MOYERS: Bob?
ROBERT KUTTNER: Yes.
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.
- One is the inefficiency and the bureaucracy and the paperwork which it doesn't address at all. It doesn't standardize anything.
- The other is price, which has now fallen by the wayside because there's no going to be no public option that's going to drive down prices.
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.
MATT TAIBBI: Right.
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.
BILL MOYERS: Galling?
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--
ROBERT KUTTNER: Sure.
MATT TAIBBI: A tremendous problem.
BILL MOYERS: Ten or 12 years ago, right?
MATT TAIBBI: 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.
ROBERT KUTTNER: Right.
MATT TAIBBI: Right.
BILL MOYERS: And that's what you mean?
ROBERT KUTTNER: Yeah.
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.
MATT TAIBBI: Right.
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--
MATT TAIBBI: Volker--
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.
- One is that Obama was naïve, that he doesn't know a whole about the financial services industry, and he felt the need to rely upon people who'd been there before, people who've had these jobs before, and you know, who have this expertise.
- And there's another school of thought that look, he took more money from Wall Street than any other presidential candidate in history. Goldman Sachs was his number one private campaign contributor. And if you just look at the evidence, it's just really business as usual. This is what the Democratic Party has done since the mid-'80s. They've relied heavily on the financial services industry to fund their campaigns. And it's the quid pro quo. They gave a lot of money to help these guys run, and in return, they get the big jobs, you know, in the White House.
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.
ROBERT KUTTNER: Thanks, Bill.
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.
attempter:Vinny G.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.
d4winds says:Let them come to the US. It’s their kind of place.
Vinny
Skippy: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.
anonymousWhen 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 | 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?"
From Tim Duy: The Fed in a Corner
There is much more in the piece....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.
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?
http://seekingalpha.com/article/174179-10-reasons-to-believe-that-we-re-in-a-depression?source=article_sb_popularEffective 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:
John Huss said in reply to 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."bakho: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!!!
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.
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 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.
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)
March 29, 2009 | washingtonpost.com
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 CommmentsI 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:
- Unpopular and unnecessary war;
- Breach of trust in public and commercial institutions;
- Unrestricted populism and lost of sense of reality on all levels of society;
- Unlimited greed and accompanying all-reaching corruption;
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...
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:
- Paul Krugman is reasonably up-to-date on research in macroeconomics over the past quarter century (Levine);
- 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);
- Christina Romer played a significant role in the design of the ARRA (Lucas);
- there is certainly debate over whether "advancing the science" means what Ed Prescott thinks it means (Prescott);
- 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);
- 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
- I don't think "working in those fields means what Michele Boldrin thinks that it means (Boldrin).
And in case there is any doubt:
- 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);
- 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);
- 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);
- 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);
- 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);
- it is in fact rather easy to find academic papers supporting the idea of fiscal stimulus under appropriate conditions, if you look (Zingales); and
- 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...
REIJI YOSHIDA Staff writerEvery 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.
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.
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
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”.
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.”
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...
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!
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.
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.
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 | respondOnce 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.
"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.
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).
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.Yves here. The story fails to note this was almost assuredly the most bank friendly program possible. Back to the story:
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.....But in the 10 months since then, the government has in many ways embraced his blue-sky prescription....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:
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.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.Yves here. Revisionist history. See here and note the date of the speech. Back to the article:
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.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.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:
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....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.Yves here. Of course not. Rubin knew nothing about anything bad and was determined to keep it that way. Back to the piece:
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.
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.
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.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.
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.
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.
- Paulson, Bernanke and Geithner blow Lehman up and everybody panics.
- Merrill looks ready to blow up and take the system down with it.
- Bank of America steps in - or better yet, is coerced in - and pays $44 billion for Merrill.
- But, the market freefall continues, taking WaMu, AIG and Wachovia down with it. Merrill loses its shirt in this disaster.
- By December, Ken Lewis is ready to pull out of the deal, citing the MAC (material adverse change) clause as grounds.
- Paulson and Bernanke go ballistic (Geithner was prepping to be Treasury Secretary) and get Ken Lewis to do something he thinks is bad for shareholders
- By February, BofA needs to be bailed out again to the tune of tens of billions more government money from Tim Geithner. BofA's stock tanks - shareholders are looking at 90%+ losses.
- Now, the SEC is investigating.
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.
Failed EstablishmentThe 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
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 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 | 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.larry.pullin@sbcglobal.net - 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.number_6@rocketmail.com - 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.
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.
April 14, 2009 | FT.com
... 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, www.nber.org
FT.comUseless 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.
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Willem,
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. "
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- 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.
| April 13 06:42pm |- 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?
- | April 13 08:44pm | Report this comment
- 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?===
- 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.
| April 14 10:16pm | Report this comment
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.)
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23. Wasn’t going to post this, but felt obliged to add to Ming’s mirth.
| April 15 07:09am | Report this comment
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.
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 critiqu
(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
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.
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?
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.
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.
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.
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.