Two Americas

There are ominous signs emerging within our nascent recovery: one part of America is seemingly well on the way to a prosperous 2010, while the other remains stuck in a fear filled, jobless, and decidedly unprosperous mess.

This week’s release of bank earnings highlights this divergence.

“it is reckless and extraordinarily bad public policy to be as oblivious to the rent seeking activities of Wall Street as the current administration appears willing to be.”

One one side we saw Goldman Sachs and JP Morgan Chase announce with all their usual swagger that they have earned record, or near record, profits last quarter. Their speculation and gambling goes on unabated and in what is now effective a government sustained oligopoly they have been able to make hay. This is less a testimony to their skill or financial acumen than it is to the inefficiency of the markets within which they gamble and the weakness of their counter-parties. Of course they still benefit from the no-cost insurance that we taxpayers offer them: they remain too big to fail and so can gamble their hearts away knowing that their risks are tacitly underwritten not by their own shareholders but by the US Treasury.

That this offensive free ride is still tolerated by the public baffles me.

Were Goldman to have to underwrite its own risks through the purchase of private insurance its profits would be severely diminished. There are few, if any, insurers with the balance sheet strength to cover the enormous and complicated risks that Goldman undertakes. Thus there is only one effective recourse: us. That Goldman uses our backstop with impunity for the private gain of its employees is a moral stain on every single employee of that institution. The hubris is astonishing.

More astonishing is the complete lack of will within the corridors of power to rein them in.

Nor only was Goldman – and I should add the others: JP Morgan Chase and Morgan Stanley – too big to fail last year, but it has now become ‘even-more-too-big-to-fail’. It is simply arrant nonsense to argue that the benefits of Goldman’s size is worth the massive burden we all bear.

Those benefits are supposed to be the efficient allocation of capital within the economy. Remember: the underlying social purpose of banking – the reason we provide it more protection than any other sector of activity – is that we need capital to be allocated for optimum use. This should ensure that the economy at large grows most effectively and thus we all benefit from the increase in wealth thus ensured.

That the banking system obviously and egregiously failed seems to have slipped past our leaders. Instead of steering capital into long term projects that increased our national competitiveness and raised productivity – the ultimate and most certain source of future wealth – the system poured trillions into specious real estate deals, totally irrelevant risk management derivative products, and securitization of things that no one had a clue as to the underlying value of. The entire process was focused exclusively on short term gains for the benefit of the managers and staff of the banks involved. they gained while the economy lost. Economists call this kind of anti-social behavior ‘rent seeking’: it is the exaction of above market ‘rents’ based upon a biased or asymmetrical distribution of power or information. Every single absurd bonus paid out within the financial sector represents an exaction or tax on the rest of the economy.

The shame is that this rent seeking goes on unabated. Why? Because the authorities are shamelessly abetting it. The big banks have stormed the halls of power and co-opted the regulatory process. In another country we would deride this activity as corruption. America has a long history of forcing regulatory reform on other countries who have experienced legislative capture in this way. The very often brutal policies enforced by the IMF and World Bank as part of the bail out of smaller nations – those policies are referred to as the “Washington Consensus” – are designed to rid those places of the corruption that allows personal rent seeking at the cost of public welfare.

Apparently the Washington Consensus is too tough for Washington.

So one America continues its happy rent seeking ways and its Guilded Age extravagance.

On the other side the second America flounders under the weight of the first.

The results of the two other big banks – Citicorp and Bank of America – highlight the difference.

I have no sympathy for either of these two behemoths. They too should be cut down in size. They were horribly mismanaged and followed extraordinarily stupid business practices not least within their evidently inept risk management departments. Nonetheless their portfolios of assets are a better reflection of what banking is supposed to be: less about gambling and more about making loans to business and individual borrowers.

That these two have now reported rising credit losses is a deep and disturbing commentary on where the economy stands. Main Street is plainly hurting. The rising tide of foreclosures and the persistent difficulties within business are creating a second wave of recession dependent loan losses. This is exactly as any analyst would have predicted: it is entirely normal for banks to suffer losses as the economy flounders. It happens in every recession. Loan losses rise as the economy sinks, and they continue to rise even after a recovery starts because it takes time for the banks to abandon hope of recovery on the loans. Later on, when the economy has returned to health, some of those loans will turn out to have been healthy and the banks typically benefit from a surge in reversals of the original losses. This is why bank profitability should always – absolutely always – be measured through an entire business cycle and not on a year to year basis.

It is also why financial industry bonuses should be tied to a cycle length performance and not to short term profits.

That B. of A. and Citi are entering another round of losses is, therefore, not a surprise. It is annoying that they were so astoundingly stupid to get involved in the yahoo gambling – something they clearly did not have a clue about – during the last few years that they lost billions in that gambling and thus were not well capitalized ahead of this predictable storm. But at least it is reassuring that they still have bank assets that relate to capital allocation.

The frenzy of bank profit and loss reports this week adds a gloomy cast to our picture of the economy.

Not only is the economy barely sputtering to life, but the divergence of the recovery will almost assuredly add a major threat to the recovery’s sustainability. The weakness of the major Main Street oriented banks will restrict their willingness and ability to lend. Meanwhile the robust profitability of the Wall Street gamblers will allow them to syphon off capital to bolster their activities – money will always flow to the profits no matter how anti-social the activities that produce those profits are. So the rent seekers will enlarge their grip on the capital flows, they will continue to flood it into ever more obscure and irrelevant securitization packages and derivatives [ of derivatives, or derivatives, of … ], and thus stifle the flow of money to that part of America still digging out from underneath the pile of rubbish the gamblers foisted on it last year.

As you can tell I am more than a little frustrated at the administration’s total inability to fight for the second of these two Americas.

This lack of fight is inexcusable and dangerous.

Let me give you two simple examples of the apparent extent of the capture of the government by the gamblers.

First was the recent hiring by the SEC of a new Chief Operating Officer for one of its enforcement units. The newly hired COO is 29 years old, has minimal experience, but has the only reference one needs: four years at Goldman Sachs. I find it incredible that the SEC could not locate a better qualified and more seasoned person. This COO may well be a boy genius. I doubt it, even so the taint of Wall Street should have been sufficient to render him inappropriate. When so much public money has been plundered by Wall Street for its own private gain, and while we continue to provide no-cost insurance to its activities there is no way in hell an ex-Goldman employee should have been hired for a serious job. That he has virtually no experience – he has an analytical not operations background – makes the move suspicious. At the very least it screams out the extent to which Wall Street has invaded the fabric of the institutions we rely upon to monitor its activities.

The second example concerns Geithner. His telephone records were recently made public under a Freedom of Information Act request. The pattern and timing of his telephone calls is telling: he had more conversations with the CEO’s of Goldman and JP Morgan Chase than he had with his own boss. He very often got on the phone to his Wall Street friends immediately after chatting with Obama. The volume of calls to his Wall Street connections vastly outweighs that of his calls to colleagues within the administration or to outside experts and economists. It seems his most important flow of advice and information acme from within the industry he was engaged in both bailing out and in shaping the future regulation of. I do not ascribe particular nefarious motives to this obvious bias in Geithner’s network. I will leave that to you. My purpose here is simply to note that our most senior economic administration leader is, apparently, guided mostly by those we need to control. Indeed they are the very same leaders who screwed the country’s economy. Their incompetence is demonstrated and very public. Why their advice carries weight is beyond me. But it does – to Geithner at least.

I offer these two small examples as evidence: there is no way that the second of our two Americas is getting the same treatment, the same deferential hearing, and has the same influence as the first.

That the gamblers are back to their old ways – announcing massive bonuses even as unemployment rises for everyone else – is a bad omen. As the economist Hyman Minsky taught us, finance is inherently unstable and thus needs to be heavily restricted so as not to spread its contagion. That we have so quickly forgotten last year’s lessons, and that we are apparently treating the gamblers excesses with indifference, tells me that we will have to suffer the consequences of their anti-social activities again. Probably sooner rather than later.

We are all aware of the dictum that those who ignore history are destined to repeat it. It just seems a little silly to repeat it so soon.

I will go further: it is reckless and extraordinarily bad public policy to be as oblivious to the rent seeking activities of Wall Street as the current administration appears willing to be.