Banking Reform: The Game Heats Up

I think we are all getting tired of these long drawn out reform discussions. Health care reform lasted decades it seems, and now financial system reform threatens to linger on through the summer. Nothing, it seems, can be done quickly.

I realize that haste is probably not conducive to wise legislation, but we have been talking about bank reform for ages. Since the onset of the crisis at least. Acres of space have been devoted to the topic. Entire bookshelves – mine anyway – are now filled with histories of the crisis, suggested cures, tell-all exposes of the culprits, and general chatter about the dire consequences if we don’t restrain the big banks in future. I assume that responsible legislators have read at least some of this stuff. So why the long, slow, and tedious, process?

And why the errors?

Here’s the thing: the longer this all goes the less likely we are to end up with a satisfactory solution. Plus, learning from the health care non-debate there appears to be not sensible purpose served by trying to reach a bi-partisan end point. The Republicans are apparently just as ideologically opposed to reforming banking as they were about reforming health care. The only good news on the bi-partisan score is that this time one or two GOP senators seem genuine about trying to help. Of course we saw such an attitude from Senator Snow on health care before she followed the strict party line at crunch time.

For those of you whose eyes don’t glaze over at the very words ‘bank reform’ the next few weeks will be filled with action. For those of you who are bored by the topic: shame on you! Bank reform is vital to the enduring health of the economy, without it the odds are that we will be facing a bank crisis within a few years. Don’t take my word for it: Jamie Dimon, CEO of JP Morgan Chase, is so convinced of the likelihood of renewed crises that he says we should all just get used to them.

Well, Jamie, no.

No we should not get used to financial crises.

Dimon is using history very selectively. During the 1800’s and up until the 1930’s bank panics and other financial crises were, indeed, regular features of the American economic landscape. And in more recent times there have been international crises on a fairly regular basis – Mexico, Argentina, various South-East Asian countries, Scandinavia, and Russia have all experienced major crises during the past few decades.

But by referring to this list as if it makes crises inevitable, Dimon cunningly mixes and matches for his own convenience. He mixes American domestic crises before the 1930’s with more recent foreign crises. What he carefully avoids is that America itself has faced few domestic crises since the 1930’s, and those we have seen have all occurred after the hugely mistaken deregulation of the 1980’s and 1990’s.

So from the 1930’s through the late 1970’s there were no big domestic bank crises in America.

There have been several since Reagan.

Why?

Banking is inherently unstable.

It involves deliberate risk taking. As with all risk taking, sometimes the risks blow up and losses occur. Those losses can cascade through the economy because it implies lost deposits or loans, which come from investor pockets and thus impair the ability to continue normal business outside of banking.

As I have said before, banking is the oil in the economic engine. If it is drained the engine seizes up – even a good engine is not immune.

So getting the banking system right is essential. In fact it is the most essential aspect of economic policy, because without good banks nothing else works.

Which is why the deregulation started by Reagan was so stupid. And I mean stupid in all the several meanings of that word. As America fell under the narcotic effect of ‘market magic’ legislators felt emboldened to slash away at the various bulwarks put in place during the Depression – bulwarks that had worked for decades to keep banking under control. Instead they sought to revert to the pre-Depression era of laissez-faire. In particular they preached that the ‘market’, that magical land of reason and omniscience, would ‘cure’ any flaws in the system and ‘purge’ the economy of errors. They believed in the wonders of the palliative and efficacious liquor of deregulation.

Well that worked really well.

We now have over 8.5 extra unemployed people exactly because of the total inanity of the market magic theory. It is sad to see how completely that false doctrine gripped everyone – from right wing legislators, through Clinton officials, on through bureaucrats, and out into the wider public, the market magic disease spread its contagion sparing few. Those of us who argued for something else were simply dismissed as backward and out of touch with the modern world.

Well, call me old fashioned, but I don’t think it takes too much to realize that the theoretical basis upon which the market magic folks built their dream world was vapor of the most pernicious kind: it sounds really great until you ask questions. Then it crumbles to nothing.

The challenge now is to rebuild the banking system on something a little more solid. Something that isn’t riven through with starry eyed utopian economic fallacies.

Let’s start with economics itself.

Markets are fatally flawed. Period. Anything you read in a textbook that suggests markets can ever be ‘perfect’ should be expunged from your memory. Now. Markets sometimes work. That’s the best we can ever say. Most often they don’t work well at all. Why? Because there are people in them. And people make mistakes; do nasty things like cheat; tend to want to hoard rather than share; and don’t always act rationally. Since markets can only work flawlessly when they are populated by omniscient, uber-rational, emotionless, and unchanging ‘agents’ imbued with herculean calculating capacity, the very notion of a market working is such a manner is simple nonsense. The people who invented and believe that stuff are ideological dreamers intent on imposing their social experiment upon the rest of us.

There is a realistic alternative: Keynesian economics is built upon the notion that markets can be flawed. It recognizes that uncertainty abounds, and that people are not automaton calculators, but that they are human. Warts and all. This isn’t to say that Keynes doesn’t need adaptation or updating. His ideas are in sore need of modernization. The problem is that his project was sidelined for four long, and now painful, decades during which we suffered at the hands of ideologues like Milton Friedman and his followers at the University of Chicago.

Next up: regulation.

One strand of Keynesian economics, that articulated by the great Hyman Minsky, tells us that the financial world is inherently unstable. Perhaps Minsky is Jamie Dimon’s bedtime reading, although I doubt it.

Minsky’s ‘Financial Instability Hypothesis’ should be compulsory reading for anyone involved in bank regulation or legislation. Basically FIH argues that banking is prone to bouts of self-delusion based upon the short term success of lending during the early stages of an economic cycle. That self-delusion allows banks to over-extend themselves, and allows borrowers to over-borrow for the same reason. Later in a cycle, borrowers start to repay loans from new lending rather from cash flow and, inevitably, as the cycle reaches a mature and slower pace, that leads to defaults. The banks overreact to the loan losses that pile up, credit becomes scarce and the economy topples into recession. Eventually, after the write offs are all taken, the entire process begins again, with the memory of recent losses fading as profits accumulate from new loans.

Since such a cycle is a natural part of capitalism, the only way to mitigate the damage done by bank self-delusion is to limit them in as many ways as possible. That means regulation that errs on the heavy side.

It means separating the more risky aspects of banking from the less risky, payment system aspects. In other words keep investment and commercial banks apart so that the latter are not tainted by the yahoo activity of the former.

It means limiting the size of banks so that each individual bank cannot destroy the economy were it to fail.

It means limiting the ‘innovation’ within finance to socially acceptable activities.

It means protecting consumers from scads of fine print and arbitrary business practices.

It means re-inventing the old fashioned notion of fiduciary responsibility within banking, and eliminating the notion of retrun on equity as the sole measure of success.

It means enforcing capital ratio rules and forcing lower levels of leverage than the absurd, gravity defying nonsense that brought Lehman to earth.

It means making sure regulators regulate and don’t capitulate to bank pressure.

It means shutting the revolving career-building door between banking and regulating bodies.

It means more rules and less regulatory latitude – we cannot presume that future regulators will not be at the behest of the industry.

It means extending regulation into all the dark and murky corners of Wall Street, thereby bringing hedge funds and derivative markets under close scrutiny and control.

It means breaking a bank’s ability to choose which regulations it wants to be ruled by – domestically as well as internationally.

It means destroying the industry’s political clout.

And it means wiping the arrogant smile off the face of an industry that single handedly brought the entire world to its knees, saddled our kids with piles of debt, and sent countless of our fellow citizens to the unemployment line.

We must all recall the biggest single lesson we just learned: these people are fools. They are incompetent. Otherwise they would not have lost the mountains of our wealth that they burned through. They are not clever. They are not talented. They are ordinary. And they are yet to pay for the damage they wrought. This includes Jamie Dimon, who is probably the most dangerous person in America because he has been left relatively untainted and therefore is still listened to. But he is just as culpable because he fed at the same trough and never complained.

So as the game heats up we should all be vigilant. Bankers will try to maintain their status and ability to take risks at our expense. We should be dogged in resisting them. They perpetrated a great wrong on society. We owe it to ourselves not to be fooled again however seductive the smooth talk and the generous donations become.

And above all else we should remember Jamie Dimon’s comment. You see he is right. Financial crises are frequent events. We should all expect another one soon. The banks cannot help themselves, they are self-delusional by their very nature.

But that doesn’t mean we should be too.

We can make Dimon’s prediction incorrect.

We can re-regulate and we can put banking back in the box it escaped from under Reagan and Clinton.

Our economy depends upon our doing so.

Addendum:

Essential reading for those who want to stay informed:

Books: “Econned”, by Yves Smith; and “Thirteen Bankers”, by James Kwak and Simon Johnson.

Blogs: Rortybomb; Calcluated Risk; and Baseline Scenario.

All three blogs are linked to from this site.