Economic Dreams - Economic Nightmares

US Oligarchs and their Minions

Simon Johnson, former chief economist for the International Monetary Fund and co-author of The Baseline Scenario takes American oligarchs to task in The Quiet Coup, Atlantic Monthly, May 2009. Johnson believes, going forward, that we should seek smaller, better-regulated banking/finance houses incapable of doing systemic damage, and overseen by a different set of oligarchs (Wiki link). Maybe? Or maybe we'll find a way to regulate bigger entities effectively? Or maybe we'll just set the stage for the next big mess? Who knows?

In any case we certainly need to find something to hope for. Burning existing oligarchs at the stake is likely out. So maybe just replacing them, rewriting regulatory rules, and starting over is the best we can hope for. Somehow I think that is where Team Obama will ultimately attempt to take us. In any case, read Simon's thought provoking, controversial article. Here is a somewhat-lengthy excerpt:

Becoming a Banana Republic
In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn't be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn't roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there's a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a "buck stops somewhere else" sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for "safety and soundness" were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector's profits—such as Brooksley Born's now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful. The boom began with the Reagan years, and it only gained strength with the deregulatory policies of the Clinton and George W. Bush administrations. Several other factors helped fuel the financial industry's ascent. Paul Volcker's monetary policy in the 1980s, and the increased volatility in interest rates that accompanied it, made bond trading much more lucrative. The invention of securitization, interest-rate swaps, and credit-default swaps greatly increased the volume of transactions that bankers could make money on. And an aging and increasingly wealthy population invested more and more money in securities, helped by the invention of the IRA and the 401(k) plan. Together, these developments vastly increased the profit opportunities in financial services.

Not surprisingly, Wall Street ran with these opportunities. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man). In that period, the banking panic of 1907 could be stopped only by coordination among private-sector bankers: no government entity was able to offer an effective response. But that first age of banking oligarchs came to an end with the passage of significant banking regulation in response to the Great Depression; the reemergence of an American financial oligarchy is quite recent.

Financial Regulation – Principles

This morning I am watching CSPAN's coverage of US Treasury Secretary Geithner at a House Committee on Financial Services hearing on financial regulation and systemic risk. Watch Geithner's opening statment here (via Yahoo! News).

Yesterday, over at Mother Jones Kevin Drum laid out some principles to guide new financial regulation. Drum suggested three and asked readers for more:

- Firmer Regulation Over Leverage, wherever and however it occurs. [To increase] capital adequacy ratios, … lead to similar oversight of hedge funds; ̷ overhaul how capital and assets are calculated; [regulate] effective leverage embedded in complex derivatives; [add] rules about off-balance-sheet vehicles; and so forth.

- Stronger Commitment to Act Countercyclically. …to force the Fed to keep an eye on asset inflation as well as goods inflation; a dedication to limiting credit expansion as well as credit destruction; capital adequacy rules that weren't merely stronger, but that tightened during expansions and loosened during contractions; and stronger down payment requirements for mortgage loans.

- A recognition that the global financial system could stand to have a little more sand in its gears. Something to slow it down just a little bit, … like a small transaction tax [Iverson here: e.g. a Tobin Tax (Wiki link) -- that could act in part as an insurance premium to tax payers against the risk that the tax payer will be required to bail them out]; exchange trading for credit derivatives; and stronger transparency rules.

Here is a combined "Eight Regulatory Principles" list, edited slightly:

• Firmer Regulation Over Leverage, (wherever and however it occurs, e.g. higher capital and margin (leverage) requirements that might be even higher for very large firms/entities that pose potential systemic risk)
• Stronger Commitment to Act Countercyclically (to lean against the wind during both "irrational exuberance" and "irrational pessimism", including adding "asset bubbles to diagostic toolkit)
• Better Control of Cross-border Capital Flows
• Better Firewalls Between Financial Businesses
• Holding Credit Rating Agencies and Auditors Accountable for their Judgments
• Making Financial Transactions as Transparent as Possible (like making them exchange traded, or having adequate clearing houses outside exchanges)
• Better Means to Discourage Speculative-runs-to-ruin (on corporations that show signs of relative weakness during market breakdowns)
• Reformed Incentives for Financial Executives, large in-house traders, etc. (e.g. require some bonuses to be paid in restricted stock that can only be liquidated in say 10 years.)
  

One of Drum's reader suggested three tactical moves. I'll add a fourth:

- Reinstate the Glass-Steagall Act in its final form (prior to repeal)
- Repeal the Gramm-Leach-Bliley Act
- Repeal Commodity Futures Modernization Act of 2000, which enabled unregulated market in credit default swaps, among other things
- Develop more flexibility in"Fair Value Accounting", mark-to-market accounting (e.g. to disallow entities to appear ever-more-wounded during bear raids)

From written testimony and verbal responses to questions, it looks to me like Geithner and Co. intend to cover most if not all the bases outlined in the principles above. But intentions must turn to action! We need to keep watch, as well as to add voice to make for better regulation, better action, and better oversight not only of government but of the private entities entrusted with our money.

PS. In March 23 WSJ online, George Soros offers insight into "Means to Discourage Speculative-runs-to-ruin" by regulating Credit Default Swaps.

------------------------
Update, 3/19/2011: Today, in Stop Killing Messengers, I added two more:

• Protecting Rewarding Whistleblowers
• Hiring High-power Talent

Finally, I'll add that I really don't support reinstating Glass-Steagall, but instead creating a modern version of it.

Why I Still Believe in Team Obama

For quite some time I have been giving Ben Bernanke and Tim Geithner passes, every bit as much as I did not give passes to Alan Greenspan. I believe that Team Obama—Larry Summers, Christina Romer, Ben Bernanke, Tim Geithner—see the error of their past ways, AND are savvy enough to guide us, in concert with others, however painfully into the next era of regulated finance.

I am not yet ready to declare capitalism dead. Still, I am very glad to see the gleeful "free market screech-monkey" chatter quieted.

But I just watch this stuff. I'm no expert. I glean advice and seek wisdom from post-Keynesian and other economists, from financial historians, and from those who dabble in complex system theory. I am first to recognize that what I hope to be true will likely not be—In this case trusting my (and your) fate to Team Obama.

If Paul Krugman is right, then I'm wrong to trust in Team Obama. If Jamie Galbraith is right, then I will be most certainly proven wrong if only for this reason:

…The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?

End Note on Free Market Fundamentalism: While looking for a good source on Free Market Fundamentalism, I found this note (5/23/2007) I dropped into Yves Smith's naked capitalism:

[W]e Americans have gravitated to a faith-based society/culture. And a big part of that "faith" transfers directly from religious fundamentalism to free-market fundamentalism (Wiki link): Government sucks, markets do it best/right.

If that thesis is correct, then American politicians (whether pandering to the religious right or themselves "true believers" in free-market fundamentalism) tend to shy away from redistributive policies/practices.

What will shake the faith, I don't know. I've been a believer for quite some time that we've got a hell of a problem here in the US with theological Millennium fever. Free-market fundamentalism is symptomatic of the bigger problem.

See also Market Fundamentalism v. Sustainable Development and my Economic Fundamentalism: Too Many False Prophets.

{Update, 3/24/07}: Better Still, read Steve Keen's recent Neoclassical Economics: Mad, Bad, and Dangerous to Know

Ten Trillion and Counting!

Tuesday, PBS Frontline will investigate what it means to add, in the next five years, 10 trillion dollars more debt to the American banking, political and social systems. See Ten Trillion and Counting. In the meantime we experience each day an ever-weakening US dollar, and ever-shrinking job/income picture for middle-class Americans, and an ever-more-anemic US consumption engine for the world economy.

What are to make of it?  One view, see Brad DeLong for example, paints this as a Keynesian economists dream.  DeLong see this as a chance to flood the world with money just in time to avert a total system collapse.  And then a chance to monitor the situation closely to ward off any hyperinflationary consequences that might accrue from the move. (Or maybe I'm putting words/ideas into DeLong's mouth?)

On the left, Paul Krugman sees the situation more darkly. Krugman believes that the Obama Administration, following the lead from the Fed (Ben Bernanke) and the Treasury (Tim Geithner)  continues to dither

…[I]f you think that the banks really, really have made lousy investments, this won't work at all; it will simply be a waste of taxpayer money. To keep the banks operating, you need to provide a real backstop — you need to guarantee their debts, and seize ownership of those banks that don’t have enough assets to cover their debts; that's the Swedish solution, it's what we eventually did with our own.

On the right, Doug Noland sees this as hopelessly misguided as well:

…Washington fiscal and monetary policies are completely out of control.  Apparently, the overarching objective has evolved to one of rejuvenating the securities and asset markets and inciting quick economic recovery.  I believe the principal objective should be to avoid bankrupting the country … our policymakers and pundits are operating from flawed analytical frameworks … completely oblivious to the risks associated with the current course of policymaking.

There is indeed great hope policymakers will succeed in preserving the current economic structure.  On the back of massive stimulus and monetization, the expectation is that the financial system and asset prices will stabilize.  The economy will be, it is anticipated, not far behind.  And the seductive part of this view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom — perhaps enough even to appear to stabilize the system.  But seeming "stabilization" will be in response to massive Washington stimulus and market intervention — and will be dependent upon ongoing massive government stimulus and intervention.  It's called a debt trap.  …Hyman Minsky would view it as the ultimate "Ponzi Finance."

… [O]ur highly inflated and distorted system requires $2.0 TN or so of Credit creation to hold implosion at bay.  It is my belief that this will ONLY be possible with Trillion-plus annual growth in both Treasury debt and Federal Reserves liabilities.  Private sector Credit creation simply will not bounce back sufficiently to play much of a role.  Mortgage, consumer, and business Credit — in this post-Bubble environment — will not re-emerge as much of a force for getting total system Credit near this $2 TN bogey.  In this post-Bubble backdrop, only government finance has a sufficient inflationary bias to get Trillion-plus issuance.  But the day that policymakers try to extract themselves from massive stimulus and monetization will be the day they risk an immediate erosion of confidence and a run on both government and private Credit instruments.  Also as I've written, once the government "printing press" gets revved up it's very difficult to slow it down.  This week currency markets finally took this threat seriously.

I don't know.  For some strange reason, given what I've written here on this blog the last few years, I am still pinning my hopes on Bernanke and Geithner.  I hate the idea of $10 trillion more debt, but I hope that it serves as a systems stabilization mechanism while the longer-term deals are worked out to reset our financial systems (see Ken Rogoff interview noted below.)

For those who want a very good refresher as to why we got into this mess, see Joseph Stiglitz, 'Capitalist Fools', Vanity Fair, Jan 2009  Here is a timeline of events, drawn from Stiglitz that ought to be (hope springs eternal) the subject of an upcoming Congressional hearing:

• 1987 - Reagan administration decided to remove Paul Volcker as chairman of the Federal Reserve Board and appoint Alan Greenspan in his place … "Volcker … 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. … Greenspan presided over not one but two financial bubbles. After the high-tech bubble popped, in 2000–2001, he helped inflate the housing bubble."
• 1993 – "When I [Stiglitz] was chairman of the Council of Economic Advisers, during the Clinton administration, I served on a committee of all the major federal financial regulators, a group that included Greenspan and Treasury Secretary Robert Rubin. Even then, it was clear that derivatives [credit-default swaps, and so forth] posed a danger. We didn't put it as memorably as Warren Buffett —who saw derivatives as 'financial weapons of mass destruction'—but we took his point. And yet, for all the risk, the deregulators in charge of the financial system—at the Fed, at the Securities and Exchange Commission, and elsewhere—decided to do nothing, worried that any action might interfere with "innovation" in the financial system.
• 1998 - Brooksley Born, head of the Commodity Futures Trading Commission called for derivatives regulation—"a concern that took on urgency after the Fed, in that same year, engineered the bailout of Long-Term Capital Management, a hedge fund whose trillion-dollar-plus failure threatened global financial markets. But Secretary of the Treasury Robert Rubin, his deputy, Larry Summers, and Greenspan were adamant—and successful—in their opposition."
• 1999 (November) - Congress repealed the Glass-Steagall Act. "Glass-Steagall had long separated commercial banks (which lend money) and investment banks (which organize the sale of bonds and equities); it had been enacted in the aftermath of the Great Depression and was meant to curb the excesses of that era, including grave conflicts of interest."
  … "The most important consequence of the repeal of Glass-Steagall was indirect—it lay in the way repeal changed an entire culture. Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively. It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money—people who can take bigger risks in order to get bigger returns. When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risktaking."
• 2001 (June) - "[W]ith a follow-on installment two years later, [President bush] and his advisers seemed to believe that tax cuts, especially for upper-income Americans and corporations, were a cure-all for any economic disease—the modern-day equivalent of leeches."
  … "The cut in the tax rate on capital gains contributed to the crisis in another way. It was a decision that turned on values: those who speculated (read: gambled) and won were taxed more lightly than wage earners who simply worked hard. But more than that, the decision encouraged leveraging, because interest was tax-deductible. If, for instance, you borrowed a million to buy a home or took a $100,000 home-equity loan to buy stock, the interest would be fully deductible every year. Any capital gains you made were taxed lightly—and at some possibly remote day in the future. The Bush administration was providing an open invitation to excessive borrowing and lending—not that American consumers needed any more encouragement."
• 2002 (July 30) - "[I]n the wake of a series of major scandals—notably the collapse of WorldCom and Enron—Congress passed the Sarbanes-Oxley Act. … "[I]n the negotiations over what became Sarbanes-Oxley a decision was made not to deal with what many, including the respected former head of the S.E.C. Arthur Levitt, believed to be a fundamental underlying problem: stock options. Stock options have been defended as providing healthy incentives toward good management, but in fact they are 'incentive pay' in name only. If a company does well, the C.E.O. gets great rewards in the form of stock options; if a company does poorly, the compensation is almost as substantial but is bestowed in other ways. This is bad enough. But a collateral problem with stock options is that they provide incentives for bad accounting: top management has every incentive to provide distorted information in order to pump up share prices.
  "The incentive structure of the rating agencies also proved perverse. Agencies such as Moody's and Standard & Poor's are paid by the very people they are supposed to grade. As a result, they’ve had every reason to give companies high ratings, in a financial version of what college professors know as grade inflation. The rating agencies, like the investment banks that were paying them, believed in financial alchemy—that F-rated toxic mortgages could be converted into products that were safe enough to be held by commercial banks and pension funds."
• 2004 (April) - the Securities and Exchange Commission "allowed 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."
• 2008 (October 3) - The Bush administration's response to the crisis itself. "Both the administration and the Fed had long been driven by wishful thinking, hoping that the bad news was just a blip, and that a return to growth was just around the corner. As America's banks faced collapse, the administration veered from one course of action to another. Some institutions (Bear Stearns, A.I.G., Fannie Mae, Freddie Mac) were bailed out. Lehman Brothers was not. Some shareholders got something back. Others did not. The original proposal by Treasury Secretary Henry Paulson, a three-page document that would have provided $700 billion for the secretary to spend at his sole discretion, without oversight or judicial review, was an act of extraordinary arrogance. He sold the program as necessary to restore confidence. But it didn’t address the underlying reasons for the loss of confidence. The banks had made too many bad loans. There were big holes in their balance sheets. No one knew what was truth and what was fiction. The bailout package was like a massive transfusion to a patient suffering from internal bleeding—and nothing was being done about the source of the problem, namely all those foreclosures. 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.
  "The other problem not addressed involved the looming weaknesses in the economy. The economy had been sustained by excessive borrowing. That game was up."

If such a Congressional hearing were to happen, I'd like to see some name-economists, Administration supporters and detractors from left and right, as well as US government officials past and present, asked at each point along the timeline:What were you thinking? Why were you thinking it? And how would you now rethink it?

For perhaps the best insights as to where this may go, see the Ken Rogoff video interview on PBS NOW, Mar 14 (23 min)

Obama's Big Gambles

Last week's financial news was once-again grim. The Dow sits at 12-year lows, having fallen nearly 2500 points since the beginning of the year. Worse, the index has fallen over 50% in one year, making its worst performance since the Great Depression. Obama and Co. are just beginning the biggest Keynesian stimulus ever seen, that many believe will ultimately run in the three to five trillion dollar range. One BIG gamble! Another gamble will be to see if this and subsequent Administrations and the US Congress can then claw back enough money — new taxes — to cover the near-term push.

Two other gambles are in play. First, US President Barack Obama seeks to do what has proven impossible for many other Administrations: to reform the US health care system, and simultaneously to reform and green-up US energy policy. Second, Obama seeks to end Bush's Iraq war, which Tomas Ricks believes history will record as "the biggest mistake in the history of American foreign policy". Obama also seeks to do something positive relative to the rest of the Middle East, especially focused on Afghanistan and Pakistan. We will leave the latter two gambles for later posts and will today focus on the stimulus gamble. Some stage-setting:

Borrow and Spend

Not many years ago Republicans railed against a Democrat-dominated US Congress for what they believed to be highly wasteful and dangerous Tax and Spend Liberalism. That day is gone. Now we fear Borrow and Spend tactics from both sides of the political aisle. This borrow and spend era began in earnest with Ronald Reagan. It was revisited, mimicked really, with George W. Bush's three trillion adventure into Iraq (See, e.g. Stiglitz and Bilmes, Washington Post, Mar 9, 2008) and the beginning salvos of a bailout in the wake of our recent financial meltdown. (For more see Wikipedia, Public Debt).

Now Barrack Obama intends to lead us further down the Borrow and Spend road into a massive Keynesian Fiscal Stimulus that could cost up to to 5 trillion dollars. (Wikipedia, Keynesian Economics).

The end of capitalism or just the end of Laissez-faire capitalism?

The Obama Administration claims they are doing only what is needed. Maybe. I don't know. My biggest fear is that no matter what "stimulus" is thrown at the problem, we simply can't create enough high paying jobs fast enough to innovate our way out of this crisis. When you listen to pundits telling us how we are going to grow our way out of this crisis — more jobs, more wealth — remember what is happening around us with computerized robotics and networked information systems. And the threat isn't just "manufacturing", but "professional practices" in medicine, law, accounting, and so on. Remember too, that the latest-greatest fad, new jobs in financial engineering just failed too.

The winds of Joseph Schumpeter's creative destruction (Wiki link) might this time blow away capitalism as we've known it. You tell me where the jobs are going to come from. I know that prediction is always flawed, and that historically we've "creatively" come up with jobs whenever our capitalist systems were threatened. But I keep hearing echoes from all the great economists, fearing an end to capitalism. Is it near? In any case I just can't see what these new jobs are going to be shaped from. Likely I'm just being short-sighted and frightened. Amidst it all, the Republican right howls about Obama and socialism (put those two word into Google and see what pops up).

If indeed the end of capitalism is not near then I side with the majority of economists that this rediscovered Keynesian is the way forward. If capitalism is indeed dead, we will have given a gift to the banking community that is largely resposible for getting us once again into this mess. And, maybe set a stage for hyperinflation. Scary thought! In either case, I remain angry about the fact that we really didn't have to get into this mess again. The lessons from the 1920s and 1930s should have kept us from allowing the massive bubbles to form this time around. But prevailing Friedmanite economic ideology (Wiki Link) that has only recently been debunked — for how long? — pretty much silenced dissenting voices and reasoning that might have prevented all. That is, prevented politicians, CEOs, brokers, "quants", lenders, borrowers, from drinking the Kool Aid this time around. Serious students of Keynes know that not only do you have to stimulate big economies sometimes, but you also have to "stabilize" by cooling over-heated economies. On that front, we all need to read more Minsky as Financial Times' Martin Wolf recently noted.

This transition, no matter where it takes us will be difficult and many people are going to be hurt, distressed, disgusted, and so on. Doug Noland says

… Today's Post-Bubble Facts of Life [Feb 12] create a serious policymaking dilemma. Unimaginable wealth was shifted to "Wall Street" and their client base during the boom, while millions of regular folk were saddled with unmanageable debt and, now, negative net worth. Those on the right side of the inflationary boom accumulated historic wealth, while millions on the wrong side destroyed their financial health. The runaway boom inflated expectations — and now comes the depressing phase of disappointment and growing despair. Of course the populace is ticked off, spurring politicians to vilify and seek amends and wealth redistribution. In this regard, there are no surprises today to those of us that have studied the post-1929 landscape. …

At minimum, historians are going to have a field day with this moment. For the rest of us, we have to hope that somehow we can find a reasonable path forward.