regulation

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Break Up The Banks. Please.

How do I say this delicately?

The banking system, and in particular the biggest banks, were central players in the development of the crisis; they then played a major role in spreading contagion around the world; they then collapsed due to mismanagement, poor regulation, and endemic greed; this required that they be propped up beyond their normal subsidy by the taxpayer; the cost of propping them up transformed a private debt catastrophe into a sovereign debt catastrophe; this undermined national budget across the globe; which, in turn, induced a wave of austerity-driven debt reduction by governments; which has now ensured that the crisis has become a depression.

Well done banks.

Break up the banks.

So what began as an orgy of private debt growth has ended up becoming a national and governmental debt crisis. The human cost is scarcely calculable. As governments desperately try to carve back their debt levels – rightly or wrongly – they slash at programs that generally benefit the poor, the elderly, or the sick. So those that most need protection get less. Whereas the banks, sitting at the supposed center of our primal capitalist system, get coddled, protected, propped up, and generally avoid any consequence of the competitive struggle that is supposed to be that system’s hallmark feature and source of strength.

The self described paragons of capitalist virtue, those big bad bullies of cut throat trading and macho creative destruction, turn out to be mommy’s boys who cry at the slightest scratch, slink off pathetically to whimper in corners when criticized even slightly, and require a gossamer weight touch rather than a heavy hand so as to avoid their tender egos being undermined.

What wimps.

Meanwhile, it turns out, they’ve been cheating, conniving, and variously being rotten throughout. Indeed they represent the very apotheosis of the capitalism they espouse. Were it not for rigging, creating cabals, hiding in dark corners of murky pools, drawing a veil over their shady dealings, and corrupting public officials with floods of money, they would not have survived this long.

Our banking system is rotten to the core. It is toxic. It fails in its social purpose at every turn. It misallocates capital. Worse: it syphons off capital for its own use and thus starves the real economy. It imposes huge costs on the rest of us by way of absurd fees, poor service, and constant error in risk management. It needs perpetual attention and subsidy. In short it is a great big expensive spoiled brat.

And by big, I mean big. As in massively over-sized, flabby, gorged, and mortiferously obese.

And that’s the good news.

Phew.

Please recall that, at the onset of crisis, I was one of those who argued for nationalization rather than bail out. I also called for enforced downsizing so that the banking system could be rendered into something vaguely resembling a competitive capitalist style system freed of constant public subsidy. I didn’t get very far. Such things were all too radical.

Yet here we are after years of discussion, so-called reform, and botched regulation and we are still uncovering evidence of just how deviant our banks are. To say they behave in anti-social ways is to do massive injustice to that concept. They are the very poster children of anti-social behavior.

It was inevitable.

When the American banking system was deregulated few of us predicted the current outcome. Some of that early deregulation made sense. Getting rid of the McFadden Act was sensible. Allowing banks to set up branches across state lines eliminated a very artificial and unnecessary barrier to banking business. After all the bank’s customers are not thus limited.

But getting rid of Glass-Steagall turns out to have been a big mistake.

At the time some of us were concerned about mixing trading, investment, and commercial banking under one roof. That’s a volatile mix. The prevailing theory was that the brew would be positive not negative and that the income flowing in from investment banking and trading would augment the commercial banks to keep them afloat. Recall that the big concern back then was that straightforward commercial banking was becoming increasingly unprofitable as chunk after chunk of its usual business, and thus sources of profit, were being allowed to drop outside the usual boundaries of banking. I can remember management discussions as we fretted over the damage that the boom in commercial paper issuance by AAA rated companies was doing. As more and more companies were able to raise cash outside of the then ‘normal’ channels of commercial lending the commercial banks found themselves being squeezed. They were being forced to rely on small business and individual lending, both of which were fragmented, higher risk, and lower profit.

How innocent those concerns now appear in light of the subsequent tsunami of error and failure that engulfed banking.

So the commercial banks, we were one of them, lobbied hard to be allowed to diversify. They saw trading and investment banking as alternative profit sources.

What none of us foresaw was the enormous cultural impact that the shift would have. It was assumed, as much by the regulators as by the commercial banks themselves, that the consolidation of banking would benefit the commercial banks. By size they dominated the overall industry. They would, it was thought, remain predominantly commercial, but that they would add other activities.

It didn’t work out that way. Not at all.

Because trading and investment banking produces gaudy returns on capital and because banks are rated on their ability to produce a return on capital, boards of directors, shareholders, rating agencies, analysts, and pretty much anyone involved in the development of the industry suddenly shifted their attitudes. Investment bankers producing huge profits emerged as front runners to manage the merged business. Commercial bankers, whose businesses tended to produce lower returns, fell by the wayside. Anyone with ambition went into the investment or trading side of the newly merged banks. Power went with them. The center of gravity shifted. From the late 1980’s through to today old time commercial bankers struggled to rise to the top of the industry. The top jobs invariably went to their investment banker competitors. The industry was changed beyond recognition. The older values went out the window. They were replaced by the values we are so appalled by today.

In retrospect it makes sense. In an industry obsessed by ROC, those who can claim to produce higher ROC’s win the big jobs.

Further, deregulation set off a merger mania.

When I first entered banking the bank I worked for had $2.3 billion in assets and was ranked in the top twenty-five banks in the country. JP Morgan Chase has just lost that much in one quarter on one set of trades. Those smaller banks were losing ground to non-bank competition. This meant that the regulatory system, designed to protect old time banking and thus the flow of capital into business, was becoming anachronistic. The investment banks and their ‘innovation’ were destroying the status quo. In the face of an out-of-date regulatory system the banks needed to fight back. One way – before the elimination of Glass-Steagall – was simply to create bigger commercial banks. Customers were supposed to benefit. Indeed, had this been the only trend, they probably would have. The last great innovation in banking is generally argued to have been the ATM, but I think we ought give that nod to the general ‘digitization’ of the payment system which has made electronic funds transfer, payment, and access to money more convenient and, despite those fees, cost effective.

The problem with banking is that it is incredibly difficult to assess the true cost of a specific service. Banks are great big bundles of cross subsidized activities, so disentangling the exact cost of service makes charging sensible prices very difficult. I have always characterized banks as mammoth bookkeeping services attached to great big lending machines. As those bookkeeping services were shifted to electronics and away from paper, the industry plunged into IT. Banks we’re amongst the first big customers for mainframe computers. They were among the first to use new database technologies. And they embraced the internet earlier than others. Banking is transactional – think withdrawing cash from an ATM of paying a bill by check. And computers lower the cost of transactions.

The problem is that in order to keep up with the ROC produced by trading, the people managing the bookkeeping functions like the branches and the payment system, and those running the lower return services like credit cards and small business lending were forced to ratchet up their fees. So the benefits of lower costs were eclipsed by rising fees. Instead of passing on the benefits to customers in the form of loser fees, the banks perversely raise fees in order to match the higher ROC targets now imposed on the industry.

The industry was thus slowly transformed, not so much in its activities, but in the perception of its ‘natural’ or sustainable return. What was once an acceptable return was no longer considered acceptable. So activities that failed to meet the newer and rising levels of desired return were de-emphasized, under invested in, or simply ignored. Capital was increasingly allocated to those activities capable of meeting the higher returns that analysts, shareholders, and even regulators were calling for as measures of competent performance. This meant trading and investment banking eclipsed old-time banking. The capture of the banking system by traders was underway.

I lived through this. Indeed I can recall conversations with our then chief financial officer as we planned to upcoming year. He was always calling for higher returns, his external advisors and our shareholder were pressing for them. I, along with others, argued that this meant taking greater and unacceptable risk. It implied getting into areas of banking that were both riskier than we were used to, and which were beyond our recent experience. We went for return. We blew the bank up.

So I have observed toxic banking firsthand, and I can recall how much of the toxicity stems from a commitment to meet unsustainable and unrealistic profit goals. Commercial and investment banking are different endeavors that need to be measured, managed, and regulated in different ways.

But that’s not the industry we have.

We have a commercial banking system with a cancerous investment banking system grafted on top. Worse, the commercial system is now subject to an investment banking style management. The cancer feeds off of and subjugates the rest. The industry is run, not for its customers, but for its executive management. And they are traders not bankers. The cultural incompatibility is stark. The banks have destabilized what was once stable. They have done this, first in response to outside nonbank competition, and then as a result of ill-advised merging of two incompatible businesses.

First they grew to offset the loss of traditional business. Then, when that failed to stem the loss, they grew by merging with investment banks. The result is manifestly a failure. An anti-social failure.

Their growth has not produced a more stable industry. Nor has it stemmed the growth of non-bank competition. All it has done is to produce organizations that sprawl across finance; are a morass of poorly fitting activities; are too big to manage; too big to fail; and too big to be useful. They simply exist in their own universe to feed themselves and to extract profit from the economy in order to justify their continued growth and existence.

We don’t need them.

They need us.

But we don’t need them.

Their size produces no value. On the contrary it destroys value. Especially in view of the cheating, market rigging, and other abuses of social propriety that they indulge in to feed the maw of their bonus cultures. They have grown to excess. They are excessive. We cannot afford them any longer.

They should go.

We need to revert back both to smaller banks and to an industry divided. So breaking up the banks ought address the misguided imposition of investment banking culture in commercial banking; and it ought to make the new banks small enough that management actually knows what it is managing, and if it doesn’t then the new banks need to be small enough to blow up without taking the economy down with them.

One last thing.

Possibly the greatest advantage of breaking up the banks will be to reduce their ability to corrupt politics. The age of deregulation has been the age of corruption. Our politics is poisoned by the cash that flows not just from the banks but from the oligarchs beyond. The Supreme Court conflated, to its eternal shame, cash with freedom of speech. This was not the beginning of corruption, but simply the affirmation of it. It was a final cynical act in the steady erosion of the balance between wealthy oligarchs and democracy. It brought clarity to the subversion of the pre-existing order by wealth, and to the clear and present danger represented by the oligarchic class to our basic freedoms. Bankers played a key and early role in this subversion. The takeover of banking by traders and their desire to prop up their ability to reap excess rewards, now, in retrospect, seems best explained as the capture of an entire industry for the personal gain of a few. A few, who once ensconced in charge, then used the profits of that industry to entrench their privilege.

So liberating banking from the traders who now run it will reduce the corruption of our politics.

Break up the banks. Break them before they break us … again.

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Business Taxes, Or the Lack Thereof

There is an alternative universe somewhere in which America’s biggest businesses actually pay taxes. I know, I know, I am being idealistic. Well some of them do, even here on earth – blessed be Monsanto! Last year anyway. But many don’t. Indeed many seem to be able to collect refunds of grotesque proportions.

Ask most anyone in Washington policy circles and you will be told that American companies face a major global disadvantage: our corporate tax rate is one of the highest around. This, supposedly, is a huge burden on the poor dears, and is just one more reason why these put-upon patriots are groaning rather than beaming. Listen to their apologists and you begin to wonder how they survive at all in this intense anti-business, hostile, and undeserving nation of big business haters. That no company worth its salt actually pays anything close to the tax rate is never mentioned in polite circles.

It is uncouth to mention reality when big business wants to make its case.

And I am realistic: this is an imperfect world, soany tax paid by big corporations is simply passed along to consumers ultimately, just as any cost of business is.

Nonetheless, if we have a corporate tax we ought to try to collect some corporate taxes. Our current effort is embarrassing in its ineffectiveness.

The Citizens for Tax Justice and the Institute on Taxation and Economic Policy have just issued a joint report documenting just how far we are from even that minimal goal. According to their report, corporate taxes covered over 25% of federal expenditure during the first two post-war decades. Then big business started to attack through their lobbying efforts. They managed to buy off enough of our legislature that by the 1990’s that percentage had fallen to around 11%. Not content, they pressed on. So by 2010 corporate taxes covered a mere 6% of federal outlays.

That is an epic lobbying success story. Or corruption on a grand scale.

This is, of course, a byline in the long pro-business deregulatory narrative of the last three decades. At each step along the way big business bleated away complaining of its unfair burden. It coupled this with threats of imminent collapse, outsourcing, offshoring, and all sorts of dire threats. As true patriots these companies wanted – they told us – to continue to employ people here, but these taxes were breaking their backs. Our tax rate of 35% is simply the last straw. No wonder we are not competitive anymore. It was able to purchase protection and subsidy. It showed its gratitude by pouring cash into politicians pockets. By way of free speech naturally. Companies are people too, as Mitt Romney blurted out last month.

That none of this conforms with the facts should surprise no one who listens to either modern politics or economics. Most all of economic theory has nothing to do with actual economies and the facts found within them. And no element of reality stands between our policy makers and their craven efforts to pander to those who pay for their election.

A few facts from the report:

  • Verizon: reported a profit of about $12 billion in 2010. It didn’t pay any taxes. No. It received a refund of $703 million.
  • General Electric – whose CEO is playing a role for Obama as jobs czar – earned $10.4 billion in profit in 2010. It managed to scam a refund of $4.7 billion. If I were the Verizon CEO I would be firing my army of lawyers and accountants and hiring GE’s.
  • Pepco, a power company in DC, hit the jackpot. It scammed a refund of $508 million on profits of $882 million.
  • 37 of America’s largest companies pay no taxes at all. None. That is to say that you or I pay more than DuPont, Wells Fargo, Boeing, and the aforesaid Verizon and GE added together. I bet that makes you feel good. Patriots all.
  • The 56% of all tax subsidies and tax breaks went to four industries: finance, utilities, telecom, and oil/gas/pipelines.
  • The list of companies getting the biggest subsidies includes the poverty stricken: Wells Fargo, AT&T, Goldman Sachs, Exxon, IBM, Boeing, Verizon, GE, Proctor and Gamble, and PNC Financial.

Clearly it pays to hire that army of lawyers and accountants: Federal Express scammed sufficiently to get its tax rate down to 0.9% averaged over the last three years. UPS, in the same business and a direct competitor, paid 24.1% If you are a UPS shareholder its time to join the line complaining.

The report is worth your while reading. It is an endless indictment of our tax code. It will make you annoyed, angry or outright murderous.

And it will have no impact.

This is because, as the report writers point out, the prevailing wisdom in Washington is that our top companies need help. If there was ever a more direct example of how corrupt American politics has become it is this. These companies are on the public dole, and yet they want more. Those corporate jets are getting a tad old after all. And those CEO’s all need shiny new cufflinks – and I include the new female CEO of IBM in that category after having checked out what she was wearing in her PR campaign after her recent promotion.

As I said: the realist in me knows that fixing the loopholes that create this mess will merely pass the higher taxes along to customers. None of these companies are known to swallow such costs in the name of competition. And most, as you will have noticed, are in heavily subsidized and protected industries. They are not typically under entrepreneurial cost or competitive pressure. They are used to twisting Washington around, and fleecing customers at the same time.

Ultimately knowing all this will simply annoy us rather than lead to change. For all the storm being kicked up about tax reform, we all know that big business will be able to buy enough votes to protect its turf. Reform will go nowhere other than to continue to shift the tax burden onto the little people who have no representation in Congress. Taxation without representation – now that’s a rallying cry worth using. I wish somebody had thought of that.

Perhaps we should save ourselves the trouble and just surrender to the plutocrats. Let’s abolish corporate taxes altogether. That way they can fire all those tax lawyers and accountants and make even more profit. After all they need more profits. It’s not like corporate profits are at a seventy year high or anything.

Oh. Wait. Yes they are.

Now that makes me even more upset.

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All Change In Real Estate?

Lost amid the euphoric scenes coming to us from the Egypt was today’s release by the government of its suggestions for change in the structure of US housing policy. It seems that big changes lie ahead for the US housing market, with many of the results of those changes very uncertain.

The primary basic thrust is to reduce the roll of government in the market while beefing up regulation and setting standards for securitization, foreclosure, and underwriting to limit future recurrences of the recent debacle. The headline in all this is the the government is proposing to eliminate the twin towers of the old regime: Fannie Mae, and Freddie Mac are to go. These two organizations are now massive players in the market for mortgages so their reduction and then elimination will have to play out over a decade or more. Nonetheless the goal is to privatize the mortgage market. Depending on which of the three options proposed in the report that market will be almost entirely handed over to private capital, with only the original low income support function of the FHA remaining intact.

Another key goal of the changes is to limit the possibility of huge future taxpayer involvement in the mortgage market. The report makes clear that private capital should bear the brunt of any repeat of the recent crisis. Each of the three options has a different backstop roll for the government, but in all three there is a concerted effort to reduce the moral hazard embedded in the existing policy set up.

But perhaps the most radical change is the implicit shift in thinking: housing policy is no longer simply a question of encouraging maximum home ownership, the rental market needs sprucing up and support as well. Indeed the report devotes some space to the need to attract moire capital into multi-family rental housing to provide better options for the low income families who were teased into home ownership and who are most deeply affected by the shenanigans of the unscrupulous lenders behind the bubble. There’s even talk of getting rid of the mortgage interest tax credit to reduce the skew in national investment that long standing government support of home ownership has induced. This shift away from public support and encouragement of home ownership is a complete sea change in US policy and runs counter to the post war premiss that home ownership is the ultimate goal for the average family. Renting is now to be an equal partner.

What all this means is unclear. Plus there will no doubt be contentious debates ahead. Already some conservatives have waded in and called the report a fudge. They advocate, naturally, an even more restricted roll for government. Plus, given the ongoing fragility of the housing market no one wants to rush – except the libertarian wing of the GOP – but one thing is clear: the US housing market, the construction industry, the lenders, and its regulators are going to be put through a dramatic change.

My guess?

More expensive mortgages, especially for higher priced homes. Lower house prices, than otherwise, so gains from current levels will be limited. A shift towards renting rather than owning, or rather, a better mix of the two. Wall Street domination of the mortgage market. The abolition of the tax credit -which is really only welfare for the middle class. And more options for financing. Oh, and much, much, more fine print to wade through. That means higher legal and other transaction fees.

None of this is soon. But it’s on its way.

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It’s The Demand, Stupid

Things are not looking very good. When we have luminaries such as Greenspan and Rubin agreeing that the economy is weak, but that it will get through this minor lull in good shape, we have to worry. Neither of them has much credibility any more, so I take their unanimity on the positive outlook as a bad sign: the economy must be getting weaker.

In any case the data seems to suggest we have hit a tough patch. How tough is all we are debating.

The problem is that I don’t think there’s any way to tell exactly where this slide will end up. It is easy to make the case that GDP could continue to drop back into negative territory. It is also easy to argue that we will pull put of the dive before we hit the ground. My own view is that the evidence suggests a rocky second half with very low growth, but growth nonetheless. This is small comfort to the unemployed: it would be no surprise at all were unemployment to creep up as the swoon continues.

It is remarkable how quickly the discussion has turned to towards trying to size up the decline. Only a few months ago those of us who warned of a tough road ahead were being called unduly pessimistic. After all profits were rebounding, manufacturing was on the up, productivity was rising, and even housing had a semblance of life. Only profits remain healthy. Everything else has hit the proverbial bump in the road.

If you recall my view of 2010 was conditioned by the oddity or imbalance of the spurt in activity that generated all that hope. There was a genuine rebound from the depths of 2007/2008, especially later last and early this year. My issue was with the froth over and above that base rebound. A big inventory cycle reversal and the benefits of the stimulus, neither of which were permanent features of the ongoing economy, made it very difficult to determine just how robust the recovery was.

We are now finding out.

Which brings us to the question of what policy should be going forward.

The main line of attack should be supportive. Of that there is no doubt. Now is far too early to start any tightening. In fact, while I have argued against tightening throughout the past few months, that position is even more important now.

The Fed acknowledged as much yesterday with its begrudging approach to the money supply. As I predicted, the Fed basically avoided making any move in either direction, it stayed pat. It accomplished this by announcing that it would reinvest the proceeds of any maturities in its portfolio back into more investments. This means that it is not reducing its level of support for the economy. Nor is it adding anything.

Meanwhile the war amongst various policy camps rages on.

There are those who argue we should reduce or simply get rid of the stimulus since it has not achieved a total reversal of the crisis. This is, of course, nonsense. I agree that the stimulus failed to turn the unemployment situation around. But that was entirely predictable. It was too small to begin with. What the stimulus achieved was a far more limited goal: it stopped us falling into depression. So far anyway. The notion that we should look to investment activity and business to lead the way is totally without credibility. Yet this is the alternative being pressed by those who opposed the stimulus. Their line of attack is that we should reduce regulation and other ‘encumbrances’ on business. We should reduce the uncertainty in the business environment. We should subsidize investment. We should throw tax breaks to businesses. And, most of all, we should get rid of any silly notions of government interference in the ‘natural’ workings of the economy. Once this is all done, the sun will rise again, the birds will sing and we will emerge into a re-run of the good old days. Oh and there will be plenty of jobs in this rediscovered capitalist nirvana.

This sort of reasoning is the time honored approach adopted by all right of center thinkers. It can be summed up as: ‘get government out of the way and we’ll be fine’.

The problem I have with this is that all the evidence contradicts it.

Profits are strong. Companies have cash to spend. Interest rates are very low, which means that borrowing is cheap, and that even marginal investments will make a profit. Project hurdle rates are minimal. The economy is awash with cash – if it isn’t why are people concerned about the inflationary impact of the money supply?

Yet despite all this, business is still retrenching or standing still. The investment environment is strong. Why aren’t we seeing a surge of construction, development or expansion?

It’s the demand stupid!

Demand is weak.

That reduces the prospect for sales and so offsets the low cost of capital. This weak sales outlook cripples business expectations. And as any Keynesian will tell you: the most volatile component of the economy is business investment based upon those expectations. Until demand picks up even ridiculously low interest rates and the total elimination of regulation will not be sufficient to spur investment.

Which also undermines the parallel argument we hear from the same analysts that all that government debt implied by the stimulus soaks up the available savings and so ‘crowds out’ private investors from the credit markets. This is specious for the same reasoning. We are suffering from excess savings not insufficient savings. There has been a remarkable collapse in business investment. So there is no demand for capital coming from that quarter. In any case profits have recovered, so businesses are generating capital from internal cash flows. They don’t need, necessarily, to borrow. That represents a problem for the capital markets: where does the cash all go, if not into private investment? Into government. All that is happening at the moment is that the government is borrowing instead of the private sector, and spending, instead of the private sector, because the private sector has no intention of doing so.

Were the government deficits crowding out the private sector we should be seeing interest rates rising in response to the capital squeeze. But they are falling, not rising. If the prospect of government debt inundating the market was as awful as the deficit hawks tell us it is, those fears would be translated into higher rates, not lower rates.

The point is simple: all the signs are that the credit market fears continued decline more than it fears the bloating of government debt. This makes perfect sense when we look at the cost of lost wealth from recession/depression versus the cost of debt accumulation. The cost of carrying debt is far less than the cost of all that lost wealth from our failure to reignite the economy. The tradeoff is simple and the credit market is voting with its feet for more stimulus and more debt. Despite all the bleak words flowing from the denizens of the market. Plus, once we get GDP rising at reasonable rates we can run deficits for long periods and still lighten the debt load. This is because of basic math: as long as the increase in GDP outpaces the increase in debt, the debt load and its cost as a percentage of GDP goes down.

The goal has to be getting GDP going at decent rates. Not managing the debt downwards.

To put this in perspective: the rate on inflation proofed government five year bonds fell below zero this week. Think about that. There are sufficient investors, with enough cash, who are so concerned about the economy’s prospects that they will pay the government to keep their cash safe rather than look for an opportunity to invest it at higher rates. That’s what a negative rate implies.In other words business expectations are so bleak that the government could borrow almost endlessly at almost zero cost and still not absorb all the money looking for a safe home.

There is a savings glut.

We are in a liquidity trap.

The only exit is through more expansive government activity.

There is only one target for policy:

It’s the demand stupid!

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Meanness, Mediocrity, and Bank Reform

It takes a particularly virulent form of mean spiritedness for a nation to walk away from its most vulnerable citizens at a time of their greatest need. Yet that is what the US, and by implication you and I, has just done. The Senate was unable to muster enough votes to continue the extension of long term unemployment benefits. So they lapsed. The cost would have ben small in the context of our overall deficit. The impact would have been enormous for the thousands of families whose lives have been turned upside down by the corrosive effects of long term unemployment.

Do we care?

No.

We have become a nation so narcissistic and incapable of community action that we simply don’t care.

I fear for the children of those families.

And I fear for the future of any country so implacably opposed to generosity during difficult times.

This was a supremely mean action. It will have practically no impact on the trajectory of our debt. It panders to the puritanism of the right wing who are relentless in their Victorian era desire to impose punishment on the poor, as if being poor or unemployed was driven only by moral incapacity. That horrible and nonsensical attitude still rears its ugly head in Anglo Saxon economies, and is embedded in the roots of modern economics as well. Orthodox economists believe – or at least they teach – that being unemployed is a choice. To them anyone without a job has chosen not to work. So providing benefits to the unemployed to mitigate the effects of unemployment is a distortion of the workings of the ‘free market’. Naturally the puritans love this nonsense and have latched onto it in order to provide themselves with an intellectual legitimacy for their mean spiritedness.

This nasty attitude reminds me of St Augustine who, as ever the fatalist, told the slaves of his era that they must have sinned badly in the eyes of god for him to have made them slaves. His advice was to grin and bear it. And to try to pray a lot.

When historically significant preachers set this kind of example for the elite to trample on the poor, it comes as no surprise to read of the Senate’s nasty attitude.

Moving on:

Today’s report that GDP grew only 2.7% in the first quarter has been treated both as a surprise and a disappointment by the financial markets who imagined things were going better than that. I say ‘imagined’ because the evidence has been accumulating for weeks now that we are experiencing an entirely mediocre upturn. One that continues to be very vulnerable to weakness. Much of the disappointment seems to stem form the fact that every time the government has issued a first quarter GDP report the numbers have been worse. Today’s release is the third and final estimate. The first estimate was for 3.2% growth. That was trimmed in the second estimate to 3.0%. We finally settled at the 2.7% announced today.

That is not a very good growth rate for only the second quarter of recovery. Typically the US economy goes through two or three quarters of rapid growth – well over 4.0% – before settling back down at its historic 3.0% level. That we haven’t had such an experience this time merely reinforces my opinion that the economy was much more damaged by the banking follies of earlier this decade than many others give it credit for. Allow me to repeat: recoveries following financially rooted crises are always – always – more difficult and prone to setbacks. This is an empirically supported observation. Unfortunately it is not well known in academic economic circles because it is the outcome of research by non-traditional economists. Since my more orthodox brethren don’t read heretical works, like those of Keynes or Minsky, they are blissfully unaware of the dangers we still are facing.

Having said that, even the orthodox folks at the Fed are now beginning to become concerned that growth is not what they imagined it would be. That’s a relief since it removes the prospect of a Fed tightening from the immediate agenda. Any rise in interest rates now would send us downward quite quickly. We are lucky that the gloom in today’s report is sufficient to knock some sense into even the thickest of fiscal hawks heads. Or at least I hope so.

Just to complete the survey of mediocrity I should give you the actual numbers from the GDP report:

Consumption was positive, adding 2.1% to GDP

Private investment was also positive, adding 1.8%.

Net exports [exports less imports] was negative, deducting 0.8% from the total.

Government spending was also negative, deducting 0.4% .

These numbers hide a few important points.

First: the consumption figure is decent, but not great. Usually as the economy bounces back consumption is a major driver as consumers spend more than normal in order to make up for the spending they didn’t do during the downturn.

Second: the private investment figure is misleading. All of the growth came form inventory changes and not from actual investment in things like construction or machinery. Those two sectors were flat, and construction looks to be mired in a long term slump.

Third, and final: the government spending number is very worrying. I have warned of this before. The positive impact of the Federal level deficit is being more than offset by the draconian austerity plans that the States are implementing. While these local actions may appear to make sense to local politicians and voters, they are making the economy much weaker. They are draining spending power from the national economy. In effect the States are hoping that someone else will get the economy moving. The irony is that many of those same politicians and voters then express opposition to Federal deficit spending which remains our best hope for stimulating recovery and allowing those local budgets to recover.

Overall I have to admit that the economy is moving along a track that I see as both very predictable and susceptible to risk. We should expect more mediocrity for the rest of this year.

Let me add my voice to those calling for more support to the economy. I have railed against austerity enough. I believe it to be blindly stupid. Those who want to shift the focus to the long term issues, and in particular our budget problems, are missing the point entirely. Without fixing the short term the long term is irrelevant. This was the driver behind Keynes famous dictum that ‘in the long term we are all dead’. His main point being that dealing with long term, far away, issues is always easier than dealing with immediate and more intractable issues. In his view this ease draws the attention of policy makers and economists away from the difficult and often messy problems of today, while allowing them to present a virtuous facade to the public.

In this case the mediocrity is of leadership and intellect. We suffer from a bureaucratic mindset that frames everything in terms of checklists and rules. So all the solutions on offer are tweaks to existing rules or the addition of new rules. As someone once said: if the only tool at hand is a hammer, all problems look like nails.

Maybe we need new tools.

Finally today, and to add to the mediocrity, we must mention bank reform.

After all the fuss and hand wringing Congress has managed to cobble together a reconciled financial reform bill. Presumably it will get to Obama’s desk before long. The timing of agreement was driven more by political considerations than by the need for reform: Obama is off to attend the latest G20 meeting and wanted to have legislation in hand so the US can dictate the nature of worldwide reform.

The simplest question to ask about the reform is: does it prevent future crises?

No.

What is does is to paper over a lot of the medium sized holes in the system and close down some of the more egregious consumer oriented activities of the banks. It doesn’t have enough strength to stop future melt downs. And it doesn’t prevent the need for future bail outs.

The better parts of the reform focus on the consumer. A new consumer protection agency is created but buried at the Fed. This is a typically lame response to the exploitation of consumers that has characterized banking for years. Remember though that the Fed had oversight for mortgage pricing regulation before the bubble. It did nothing to stop the activities of the worst offenders. Since the Fed remains staffed to the rafters with mathematically inclined economists rather than socially minded attorneys, I doubt this new agency will have the bite that some think it may.

Meanwhile the reform does tighten up the derivatives market somewhat although I suspect that the banks and their armies of overpriced lawyers will gut the intent of the new law within weeks. The ‘Volcker’ rule survived in muted form to reduce bank speculation, and the ‘Lincoln’ initiative also made it through to force banks to offload their speculative book of derivatives into non-Federally insured subsidiaries. Quite what this achieves I am not sure. The simple question we need to ask is: will the regulators allow Citibank to go belly up because its non-insured book of derivatives goes bust and threatens the mother ship? No I don’t think so. Thus the Lincoln plan is window dressing. The Volcker rule has more merit because it simply bans certain activities, specifically the use of low cost Federally insured deposits as a funding source for non-client based speculation. The problem is that the ban is not tight or comprehensive enough. The boys still have plenty of matches to play with.

Other aspects of reform are also humdrum. The big banks will have to cough up some cash to create a bail out fund, so that future bail outs will not come from the taxpayers. This raises the interesting question: why do we need this provision if the reform ‘stabilizes’ the financial system, which is Geithner’s claim? The obvious answer is that no one really thinks we will avoid future bail outs. Nor is the amount anywhere near enough in the context of the behemoth banks that now populate our system.

Finally the much ballyhooed liquidation process for big banks, while it sounds great, will immediately run afoul of international complications. Unless there is a uniform world wide and coordinated approach to bank bankruptcy procedure no amount of huffing and puffing here in the US means much. It certainly does nothing to end too big to fail.

And that is, in my mind, the really big issue. This reform does not eliminate banks that are too big to fail. All it does is to provide some nice rules for future bankruptcy procedures and to mitigate some, but not all, the causes of the past crisis. Our legislators are intent on, and content with, planning to fight the last war. That makes them feel good, but does not solve our central financial problem. While the dinosaurs still roam and dominate finance we are destined to endure more crises and suffer through an oligopolistic market where competition is stifled by the lumbering bureaucracies we call the big banks.

Oh well. I suppose some other president can solve that problem. The current incumbent wants to punt.

Mediocrity indeed.

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