financial system reform

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Health Care Reform: Finance Next?

There is not much I can possibly add to the outpouring of analysis and pseudo-analysis in the media this morning. So I will restrict myself to a few comments:

It is about time.

For the richest country on earth to consign so many of its people to ill health or bankruptcy because it wants to cling to an outworn and increasingly dysfunctional system for healthcare delivery is just stunning. The notion that Americans do not like large government programs is false on the evidence: every time Social Security or Medicare come under fire, voters react quickly and strongly to preserve them. The Republicans, who still smart from their defeat seventy years ago over the New Deal, have learned that lesson well. Which is why they always package their attempts to eliminate entitlements in ways to hide the true intent. Plus they always kick up dust over the cost of the programs – they never offer cost control reforms, they simply cry that we must destroy the programs. This seems to be either an abject pessimism over their inability to reform, or an expression of some inner Leninist tendency where they need to destroy something in order to save it. I find it offensive either way.

This visceral opposition to anything vaguely social resonates with the public’s false image of itself as being, and wanting to be, free of government intervention. As if the middle class tax subsidy on home ownership – that infamous tax credit for mortgage interest paid – is not a government hand out. The fact is that our middle class is propped up by a web of government programs designed to limit the cost of key aspects of everyday life: Social security reduces the need to save as much for retirement; Medicare means we do not have to set aside savings to cover end of life health care; and things like the mortgage welfare program reduce the true cost of home ownership. Kick away just these three programs and the middle class is instantly reduced: most of it would shrink its standard of living in order to save to cover these expenses. Failing that,; many more would have to go without those benefits all together.

So the ongoing right wing opposition to social programs has a dark side to it that is never made explicit: our middle class only exists because of the government’s ability to shelter it from the volatility and cost of the free for all of the wider market place.

We have empirical evidence of this: all we need do is to look back in time. Before these programs were put in place our society was much more divided, with the middle being much less evident. The disparity between top and bottom was much more extreme.

We have yet more evidence: as the right wing ideology retook the policy heights, and free market deregulation gathered steam, we saw a marked return to the same deeply divided social structure of yore.

That most people do not reflect on this I attribute to complacency. As we lost touch with the generations who experienced the deprivation of the Great Depression, and the poverty that preceded it, we also lost touch with the reasons for placing well defined and strongly policed boundaries around the ‘free market’. We laughed at Hobbes because we had the benefit of Locke, Hume, and Smith. We derided those who reminded us that what we have is a veneer, and came to believe that we all were part of the American Dream.

One of the telling observations about Americans is their ongoing optimism. This sometimes prevents them understanding reality. When asked in surveys Americans routinely over-estimate their own status: 20% of the population thinks it is the top 1% of income earners. This inflated sense of accomplishment presents a massive obstacle to supporting socially provided benefits. To someone so evidently at the top, those programs appear not just unnecessary, but a burden also. They see costs, red tape, and bureaucracy, they do not see the platform those programs provide. Perhaps they would be more supportive if they realized the precarious nature of their own financial and social status. But the program’s success hides the precipice just enough for us to pretend it doesn’t exist.

Until a huge economic crisis reveals the truth.

One of the great consequences of the crisis we are living through – it is far from over – is the slowly accumulating disillusionment that it implies. The longer the crisis lingers, the worse this disillusionment will become.

The bitterness of the opposition to health care reform finds its roots in this disillusionment. The crisis has opened up or aggravated fissures in the socio-economic structure of society. For instance, the sub-group hit hardest by unemployment has been white males. Other groups still fare worse, but white males have seen the most change in fortune. The near complete collapse in the construction industry alone has accounted for nearly 1.5 million of the total 8.5 million lost jobs. Add this sudden shift to the decades long steady loss of traditional blue collar employment in manufacturing, and the potential for a volatile alienation from society as a whole is easily accounted for. Perhaps this explains the fervor and extremism of the Tea Party opponents of health care reform: they are not reacting to HCR, they are reacting to the long term erosion of their social status.

This extreme group emerged as the motor driving the entire Republican strategy. The result being that the GOP found itself marooned on an island with a variety of incoherent, yet very angry, fellow travelers. The loss being the centrists who often brought a softer touch to the GOP efforts to eliminate social programs.

I think this outcome of HCR is the most enduring. The Republicans have given themselves a very sharp, and clearly minority, definition. They have been flushed out as being unreconstructed in their opposition to social programs, not in a fiscally responsible way, but in a visceral, almost unthinking, way. They offer no alternative except opposition to whatever is going on. They are so hell bent on opposition that they have forgotten to supply policies of their own. Their claim that they will undo HCR is an odd one given the extreme unlikelihood that they will, any time soon, have sufficient Senate and White House control, at the same time, to followthrough on the threat. By then HCR will be embedded and its benefits manifest, and the GOP will be faced with yet another program to chip away at despite its popularity.

We should all recall the dire consequences that previous generations of right wingers have made about each step along the American development of its safety net: Reagan famously predicted the end of the American way of life, and the destruction of the economy, were Medicare to be enacted.

There are just so many times a party can cry wolf. If these programs are as devastating to the American way of life as the Republicans portray them, sooner or later, we should see the economy implode or the voters rise up in rebellion. Instead we see neither. On the contrary we see the opposite.

When we experience implosion, as in the current crisis, what we find is that social programs perform their task admirably and soften the disaster for a vast number of people. The programs gain in popularity. And the implosion is caused, not by the burden of the safety net, but by the elimination of the boundaries set on the free market.

So HCR exposes a contradiction in the American soul. One side of which espouses individuality and rugged independence from central government, even while the other craves the safety net and its ability to soften the blow of the vicissitudes of the free market. America’s ability to manage this contradiction depends upon the largesse its economy creates. In the good times we favor individuality since the harshness of the wild frontier appears remote. When reality intrudes we retreat towards a more communal and comfortable world in which we see a need for government help.

The transition from one era to the next is bound to be riven with infighting as different groups cling to the one or the other position.

We are living through such a transition.

The Reagan era ended with the Bush tax cuts as its apogee. The split in society was opened wide as one small part benefitted, not just in terms of the tax reduction which was far less serious than many on the left imagine, but it terms of its ability to rise free from control and establish a set of rules that syphoned off wealth in disproportionate ways. The emergence of this new Gilded Class is established fact. The nastiness and the emnity in our politics exists only below this class. The name calling is by one disadvantaged group towards another. The criticism in the media – Investors Daily – that HCR is a huge welfare give away to minorities is an example of the ‘debate’. A significant thread running through the opposition to HCR was the extension of coverage to millions of currently deprived people. The word ‘socialist’ was thrown around carelessly, often by people who have no clue what it means.

Yet this fighting all took place within that part of American society most damaged by the economic crisis. The fighting as so intense because it appears to be a ‘zero-sum’ game at that level.

The people who caused the crisis, the oligarchs who run our banks, and who benefit from their ability to rig the financial markets in their favor, are unscathed. Their coverage was never in doubt. They were never touched by the insurance industry’s quirky and anti-social activities. Their wealth mitigated the effects of the steady decline everyone else experienced. Indeed they actually engineered and benefitted from that decline. They are ideologically agnostic: they talk free markets, yet cling to oligarchic industry structures, they advocate individualism, yet clamor for the rewards that tight school and business kinship garner. They move with the tide and ride free on the backs of the struggle that goes on below them. They have a deep rooted interest in the failure of resolution in that struggle. As long as the energies of the disadvantaged are spent on infighting, as long as the Tea Party types carry their water, they remain able to rent seek on society. They stay safe.

For now.

With HCR done, maybe we can turn our attention towards getting our economy back, and out of the grasp of the financiers whose greed and incompetence ruined it for us all.

To me this is the big fight.

HCR was a necessary completion of the safety net for the middle class. It was a marker that American society was concerned about its own, and that no one should be outside the great flow of riches that its capitalist machine generates. But the true frontier is yet to be tackled. We have yet to rein in the excesses of the beast that caused the crisis. Financial reform is the focus of that fight.

Without a solid resolution to financial reform, any gains elsewhere remain subject to destruction: the engine that supplies the wealth we allocate to various aspects of life needs overhaul. Its dysfunction cost us 8.5 million jobs, countless lost homes, and trillions in dollars of lost wealth. yet it still spewed out billions in wealth to the perpetrators of the collapse. Not only do we need to limit the damage these folks can do, but we need to cut back the banks so as to free up resources for the economy at large. And we need to eliminate – not curtail, but eliminate – the possibility that a single big bank could bring the entire economy to its knees.

So HCR is the first step. Financial reform is now even more vital to make it stick.

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Banking: Where’s The Anger?

Wow, banking lives a charmed life. Not eighteen months have past the gambling the big banks undertook in the mid 2000’s sank the economy, but there they all are getting ready to pay our fat bonuses. Don’t we all wish we could live like that? So even as the ‘real’ economy still sheds jobs, over 85,000 in November, the intrepid souls who gamble on Wall Street have recovered and are going to be paid their due.

Somewhere in the last Obama must have woken from the sloth that has characterized him so far this year: he ventured out long enough to knock the fat cats and to promise a ‘levy’ on the banks sufficient to pay back all that TARP money. Hurrah. I won’t hold my breath however because this administration has, in its very short life, made a specialty of using palliative words and then delivering nothing to back them up.

Robert Reich has an excellent column in today’s Financial Times in which he lays into the financial ‘reform’ being proposed as a fix for the problems that led to the crisis. I agree with his overall conclusion: nothing that is being proposed comes even close to solving the central problems. Once again we are being misled. Once again we are being given weak and uninspired leadership when we need strength and character. We are being treated to a charade and being told it is serious drama.

Those of you who have read my comments throughout the past year will know that I have lost all faith in our bankers to be trusted to perform banking with any skill or social responsibility. What goes in on Wall Street is not banking in the manner most of us imagine. Gone are the days of sobriety and conservative evaluation of risk. Gone is the value seen in a long term relationship with a customer. Gone is the fiduciary trustworthiness that fosters loyalty. And gone is the value placed on the memory of bankers who have seen recessions or crises before. All gone.

In their place are a set of post-modern ideas driven purely by greed, faulty economics, and an abiding need on the part of bank managers to make a personal buck at all costs – even if it means robbing their shareholders blind. The entire industry has slipped from being a respectable, if boring, source of predictable profits, to a glitzy, casino like, and seedy source of bonus pool cash for managers. From Park Avenue to Atlantic City boardwalk.

This has been a transition into lunacy that began a long time ago.

I wish I could say I was not part of it, but I distinctly recall conversations with financial employees – people like the CFO – of the bank I worked at where the topic was how to ring more return on equity from an old fashioned bank. You can’t without wrecking the bank. The implication is a very simple one: more return requires more risk. In good years bank managers fall prey to the notion that it was their skill forcing the return on equity up. In bad years they blame the economy. In good years they see vindication in the risks they took, and decide they are skilled enough to take more. In bad years they blame the risk managers they ignored the year before.

One way around taking more risk on the balance sheet is to bulk up on charges to customers that have no balance sheet impact: hence ATM charges, and all those other charges that bloat bank earnings but offer little no service in return. I understand banks need to cover the costs of all that infrastructure they build to service us – bank branches cost a bundle – but covering costs and price gouging so as to fatten bonus pools are two distinctly different exercises.

Now, of course, those monster fees the banks are charging are being used to cover the gaping holes created by the gamblers. So not only did we send the banks bail out money to keep the gamblers afloat, but we are now paying extra fees as well. Those gamblers must return a pretty penny sometime if they are worth all these serial bail outs.

It’s easy to sit here and vent frustration at the total lack of response in Washington. It’s entirely another thing to watch as the banks set off down the same disastrous road that led to the crisis. Unfortunately all the signs are that they headed exactly down that same path. The combination of low interest rates, lessened competition, and an expanded safety net has increased the bank’s appetite for bad banking. Their risk profiles are already increasing even though the last crisis is still being investigated.

That there is little public anger over this is astounding. I know that most folks are sick of the bonuses being paid out, but the problems in banking go far deeper and wider than that. Those bonuses are a symptom, not the sole cause of the problems. Yes, pay incentives need to be brought both back to reality and connected to long term profit. But that is just the start: those bonuses exist because the banks make way too much profit. At the height of the last lunacy bank profits accounted for 40% of all the profits made in the American economy. That is simply ridiculous. No one, except the bankers, think that four in every ten dollars of value in our economy comes from banking. Add in all the hangers-on like the accountants and attorneys who validate and execute securitized transactions and the amount of our wealth being sucked into what should be an intermediary business is staggering.

The social value in banking is in moving capital around efficiently, and in allocating it to the most profitable, wealth creating activities. What seems to have happened is that the money was diverted into finance for finance’s own sake. The industry didn’t allocate capital, it simply accumulated it. Now this might well be an indictment of our non-banking managers who obviously cannot create enough value to justify receiving the capital themselves. It might also be an indictment of the economy at large because we have distortions that attract capital away from industry and throw it at asset bubbles like real estate – the American fixation with real estate is a proximate cause of the last crisis that also hasn’t gone away. But the larger social question we need to ask is: how did the banks run off with all that capital they were supposed to be channeling into productive and wealth producing stuff we all could benefit from?

It is that question we need to resolve. My guess is that we don’t want to hear the answer: they rigged the game and invented a slew of unnecessary ‘products’ like most of the derivatives and securitized assets of the past decade whose returns are inflated by the leverage banks added to their bets. Regular business would never take that amount of risk. Then again, regular business does not routinely and artificially inflate itself in order to look profitable.

In the end we all have to realize that the banks syphoned off our wealth for their own benefit. They pumped up their profit margins by taking stupid risks which enabled them to justify keeping the money for themselves. Those of us who were fixated on short term indicators like the stock market fell for the ruse and facilitated the cash flow in.

We were robbed.

Now we all know that: where’s the anger?

Obama we are waiting.

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Obama: A Year End Economic Report Card

This has all the appearance of a slow news week coming up. At least for the economy. On Thursday and Friday we will hear a little more about unemployment, consumer sentiment, and retail sales, but before then we will have nothing to do but watch the slow moving lunacy that is the health care ‘debate’.

And, yes, it justifies those quote marks.

Given this, I thought now would be a good time to reflect on the overall Obama economic agenda and start to hand out his year end grades. So here we go:

  • Growth, or lack thereof:

I begin here because everything else has to be placed in the context of the overall economy. As those of you who follow my comments closely will no doubt recall – how could you forget? I have shouted loudly enough! – I have been a regular critic of the administration’s luke warm efforts with regard to stimulus. I thought from the outset that they set the bar too low and failed to fight for the necessary injection of cash to guarantee an end to the recession.

This failure was based on two parallel lines of reasoning: first there was a shallow sense of political possibility – the administration deemed that in the aftermath of TARP Congress was not in the mood to spend enough to save the economy, and so it chose not to spend its capital on getting the right stimulus package together; and, second, there was a clear rift within the administration’s economic advisory wing between those who sought a larger stimulus and those who believed the forgoing about the political landscape. This internal conflict resulted in any discussion of a properly configured package being eliminated before the start of debate.

We began the discussion with one hand tied behind our backs.

Naturally the outcome was messy. Far too much of the stimulus was allocated to low effectiveness items – tax refunds being the classic example – and too little was allocated to big spending, and therefore big employment, capital projects. There was to be no second New Deal.

The political calculation was both cynical and misdirected. Opponents of government spending were not mollified or muzzled, and advocates were left doubting the administration’s political will. Both camps ended up with something to grouse about. The opponents were given ample leeway to complain about the failure of government intervention, while advocates – like yours truly – have been left to fret constantly about a missed opportunity. Either way the administration looks a little lame. But that seems to be a theme lately.

As we now know, with the Congressional Budget Office report last week, what stimulus there was had the predicted and desired effect. It put a considerable floor under the economy. Fewer jobs were lost, and growth has returned earlier than would have been possibly without such a stimulus.

The enduring problem is that the weakness of the original package echoes on through the economy’s current struggles. Because the stimulus fell way short of the amount needed to guarantee a return of solid self sustained growth within the private sector, we are faced with an ongoing worry that growth is so weak it could evaporate at the first sign of reversal. Plus, as we all know, unemployment has risen to a sadly high level, notwithstanding its slight decline last month. So while the CBO points to success, that success is sufficiently muted that many regular folks just don’t see it.

As a result, opponents of stimulus still rant about its failure and their complaints resonate well with a populace regularly spoon fed a diet of anti-government ideology over the past thirty years. The opposition has tapped into a populism deeply entrenched and steeped in suspicion of all things to do with government spending. So when the Federal budget is announced to be growing by leaps and bounds, opponents of stimulus find easy access to the media and have an equally easy time convincing voters that now is the time to reverse course and ‘balance the books’.

That these same folks were silent during the great debt surges under Reagan and Bush never seems to register with voters. As I have written here before nothing is more confounding of the stereotypical view of our political parties than the fact that, in its history, the US has had exactly two non-crisis surges in its national debt. Both were associated with Republicans – Reagan in the 1980’s, and Bush in the 2000’s – and yet neither gets the opprobrium it deserves. Let me repeat: national debt should go up in times of necessity. That’s what it’s for: to provide cash when the country faces a crisis. It should never go up when the economy is healthy.

Nonetheless, here we are, the stereotypes are being trotted out, the fiscal hawks are gaining strength, and the economy is still weak.

So what grade should we give? The economy is growing, for that we should allocate a B++. Growth could have been more robust so an A is not in order, but the odds are that we will grow modestly for a while. Unemployment is very high, that garners a C+. We could have attacked it with more energy and commitment, but much of the damage came on Bush’s watch. Most importantly, the political landscape is now strongly set against further intervention, even though the original stimulus was a success. This deserves a C. I can’t help but feel the political sands shifting against us – call it a lack of will, or call it a fine calculation, either way we have deliberately reduced our policy options at a critical moment in our economic development.

Overall grade? B or B- [with a plus trend] depending on how annoyed you are about the poor politics.

  • Financial Reform:

It would be easy to say ‘what financial reform’? given the slow dance going on in Congress, but this is a very important part of our economic agenda so we have to eschew giving an incomplete and grade what we know so far. Next year we will hand out the final grades.

I begin by repeating my comment about tepid leadership. Nothing speaks more to the administration’s style than its almost aloof handling of the financial crisis. Again we must be careful: this disaster festered and sprang to life under the auspices of the Bush regime so Obama is left to carry the bag. But that should be an opportunity to write history, not to wallow in bureaucracy. I am afraid the administration’s efforts so far are so way off target that they should not be dignified with the word ‘reform’. The current proposals have all the reformist thrust of a limp carrot. A wilted one to boot. It looks fine but has absolutely no crunch. The administration’s efforts have all the hallmarks of a bureaucrat’s small minded wish list: petty rule tweaks, minor adjustments, and lots of discussion about exactly where to staple the papers together. None about attacking the root causes of our problems. Which is a subject that might upset the bankers, so it gets shunted off to one side.

I see it as boiling down to this:

  1. Break up the big banks. They are too big for us to afford as a nation. Until they are cut down to size policy makers will live – understandably – in their thrall. This should have a nice patriotic and populist ring to it, bit instead is treated as a hair brained scheme thrown in from the fringe. Except that both Volcker and Greenspan have now endorsed it. That the administration doesn’t speaks volumes of its willpower.
  2. Cut the Federal Reserve Board down in size and scope. It failed. It failed as a systemic regulator. It failed as a monetary policy institution. And it failed as a protector of consumers. Of these three it should be allowed to keep the monetary policy portfolio alone. The others need to go elsewhere. Plus, and this is another populist measure that should be bringing Obama plaudits from Main Street, we need to open the Fed up. Currently the Fed is still an opaque gentlemanly bankers club. It is riven through with conflicts of interest and is overwhelmingly banker sympathetic. It needs to become a more balanced economic institution akin to central banks elsewhere. At the same time let’s reject the plainly silly notion that we can manage the economy without a Fed. Only extreme libertarians and neo-classical economists could think such a thing. And recent history has just dealt their worldview and nasty blow.
  3. Establish a true consumer finance regulator. This should be a no-brainer. And kudos to the administration for backing the idea. The Fed has been horrible as a protector of consumer interests. It fell hook line and sinker for the ‘let the markets decide’ version of regulation. It had a positively Ayn Randian perspective on the benefits of deregulation, so it should come as no surprise that consumer protection fell off its radar entirely. This needs to be fixed.
  4. Either abolish or regulate the derivatives markets. Properly speaking there are no centralized ‘markets’, which meant that the world of derivatives possessed all the sanity of the Wild West. No wonder it blew up. I fail to see the underlying economic or social purpose behind most of what goes on in the murky world of the derivatives business: it simply aggrandizes the players while we pick up the tab. Agricultural and commodity futures and their ilk I see a place for, but CDO’s and CDO ‘squared’ … not so much. If the game is to be continued put it out into the open. No more ‘dark pools’ and other testosterone polluted quagmires.
  5. Combine. Combine. Combine. Let’s have one financial regulator. No more regulatory arbitrage. Let’s have one national insurance overseer. And let’s get all the financial market regulation under one roof – preferably not the SEC’s given their record of pandering to business, but it will probably have to be there. Plus, and this won’t happen, let’s update Congress itself: one oversight committee and not the current mess.
  6. Lastly, ban corporate political contributions. Ban them. I know it won’t happen. But until it does our politics will remain corrupted by the flow of cash.

Well that’s my list. How does the administration stack up? C-, that’s how. They only score that well because the reform effort is still underway and Congress is adding in its own proposals to help stiffen the administration’s spine.

My problem with the administration and its attitude towards banking is predicated on what I perceive to be its over weighting towards the industry. Too many of its key players are closely aligned and sympathetic with industry positions. Geithner, Summers, and Bernanke are all schooled and experienced in the same way as the big industry insiders. They believe the same things. They differ only in degrees. Which is why the administration’s reform is redolent with tweaks and not bold action. They have bought the notion that a few nice nudges are all that is necessary to prevent another meltdown.

I couldn’t disagree more. That C- is under pressure already!

  • Health Care Reform:

I have never been more disappointed with Congress, the administration, and the entire structure of political discourse than I am over this issue. It has been a low point in American political life. This is an issue of supreme economic and social importance and the country has been treated to a spectacle worthy of a lower grade school bun fight. Pathetic dignifies it.

I give the administration enormous credit for getting the notion of health care reform on the agenda. That alone deserves an A+. It’s subsequent abject inability to shape the discussion is just appalling. It gets an F for that.

The entire process has been a long drawn out appeasement of a few senators. It has exposed the arcanity of the Senate process, which is designed to enforce compromise even on subjects as divisive as health care reform. Hence we watch people like Olympia Snowe being courted as if she is a world expert on health care, and have to listen to Joe Leiberman – painful at the best of times – twist and turn as he attempts to sink the public option.

As you know I love argument and debate. But this has been neither. It has been mudslinging and avoidance of fact. The name calling and hysteria over things like rationing has been demeaning to a nation that thinks of itself as a world leader. No one, seemingly, wants the public to hear what the central issues are. No one wants to inform.

This is the administration’s fault.

It has the soap box.

Nothing is more telling about the administration’s weakness as a source of leadership than this pseudo debate. Having put the ball in play the administration spent the entire summer avoiding getting entangled or even staking out a clear position on the choices. Even yesterday as he attempted to rally the Democratic caucus, Obama couldn’t bring himself to refer to the public option.

Let me not dither that way: we need reform. Said reform should expand coverage as much as possible. In the absence of a true single payer system – which is the least cost option – the system should highly regulate the insurance companies. We should all recognize that the health care coverage we get from employers is not ‘insurance’ it is a benefit. We need true insurance. But the economic nature of privately supplied insurance militates against widespread provision – private ‘for profit’ companies naturally want to cherry pick who they cover and what they pay for. Private companies ration health care via the prices they charge. Rightly so. The question before us is thus simple: do we agree that we should have limited, higher cost, and private insurance? or do we want more widely available, cheaper, but government provided insurance? They are the two central choices. Both are forms of rationing. All economic choices are a form of rationing. If we want cheap, we need the government’s size and indifference to profit to drive prices down. It is a scale argument. Plus: only the government will be willing to insure everyone. Even sick people.

And that’s what I thought a health system was for.

I don’t blame you if you have turned off from the ugliness that has passed for ‘debate’ this year.

I do blame the administration for not having provided a more muscular leadership to keep us focused on the big issues. Instead we were left to muddle through.

And what a muddle it is. Even now, right at the end of the process, it is hard to tell what will emerge.

So somewhere between an A+ and an F? Pending the outcome I give the administration a C+/Incomplete

There you have it. The year end report:

Economy: B

Financial Reform: C-

Health Care Reform: C+/Incomplete

And a lot of ‘must try harder’!

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Moral Hazard and Banking

What an odd day. Clearly all our statisticians are at the beach because there is no data release of any kind today. So we can all take a break from the stress of trying to figure out what the entrails mean and relax a little.

But wait.

The immediate danger of depression is behind us, and the recession is ending – it may already have ended – so now is a good time to begin the inquest and strategize over how to avoid a repeat of the ‘Great Recession’.

Let me begin by saying that I doubt we will avoid recessions. They are an inevitable part of the exuberance of capitalism. The Keynes/Minsky vision seems to be correct: confidence builds as growth is sustained; people inevitably become greedy and over-extend; eventually this over-extension leads to implosion and a cathartic cleansing of illusory wealth. Only for the cycle to begin again. This cyclicality matches up well with what Schumpeter saw as ‘gales of destruction’ being immanent within the capitalist system.

One of the illusions we have just had dispelled was that of academic economists. They thought their orthodox theory had developed such refinement that we could moderate and avoid severe cycles. And I know of very few mainstream economists who imagines otherwise: there was a general sense of self-satisfaction within the profession that we had the theories and tools to fend off major bumps in growth. The evidence of the past thirty years seemed to back that notion up. All that was needed, the orthodox argued, was to clean up the details.

Some details.

“The best way to contain the evils of moral hazard is to make it personal.”

It now turns out that Keynes and his followers were exactly correct: markets are inherently fallible. This fallibility stems from the natural, residual, uncertainty that is a permanent property of our world. There is nothing we can do to eliminate it. All we can hope for is to box it in and translate it into manageable risks.

And on the front lines of uncertainty we find the banks.

So as we set out to rebuild the dykes we must focus on the banking system.

Lost in all the hubbub over health care is the fact that we are facing a large scale overhaul of the way in which we regulate banking. In many ways this is the most important reform being discussed in Washington – failure to reform the banks will accelerate our momentum towards the next recession.

We all now know far too much about banking: the headlines of late 2008 were replete with bank failures and collapses, bail-outs and bonus scandals. A certain banking fatigue set in and it was with a sigh of relief that the big banks seemed to have survived and then passed the stress tests organized by the Treasury earlier this year.

Not so fast.

Those self-same banks are right back at it. Even a cursory look at recent bank activities suggests that their behavior is little changed. Yes leverage [the ration of total assets to capital] is way down from the ridiculous and unsustainable levels that brought about the implosion, but there is absolutely no evidence that they would not pump themselves back up once the economy gets under way.

The biggest obstacle to getting a sound banking system is moral hazard. This is the idea that someone – a bank in this case – can undertake an otherwise excessively risky course of action because they are aware, a priori, that they will be saved from the consequences of that action.

Banking is rife with moral hazard. In fact it is the poster child for the concept.

As long as regulators, the government, and ultimately the taxpayer are viewed as a credible back-stop to the reckless speculation, gambling, trading of the big banks they have no incentive to rein in the yahoos who inhabit their trading desks.

And the problem is that these folks are really clever yahoos.

They have figured out that they can undertake inordinate risks without compunction because they will never have to face the consequences. The individual traders have every reason to go beyond the limits of reason because their bonus structure pays them on short term profits not long term profits. So a gain of $1 million today produces a nice bonus which is not subject to reduction when that gain turns into a $100 million loss a year from now. The traders and bankers keep their bonuses whatever the future reversal of fortune may be.

This is why the crisis did not produce many bankruptcies amongst the banker elite: their cash was already stashed away when the bottom fell out of their scams trades.

You and I were not so fortunate.

Nor are the shareholders driven to avoid the same risks. Stock prices are intensely related to short term profits. So a shareholder can sell a holding once the stock has run up in price, no matter how illusory the profits are upon which that price is based.

Then, when the collapse comes, the shareholders simply turn to the taxpayer and expect to be bailed out – after all bank ‘A’ is simply too big to fail.

So moral hazard has the perverse effect of turning the yahoo, French cuff crowd on Wall Street, that epicenter of capitalist cheerleading, into a bunch of socialists.

They loot the banks for private gain and then leave the corpse for us to revive. More to the point: they have the gall to expect to be allowed to do this. They get all hissy when someone points out their utter incompetence and they counter by claiming we don’t understand banking – filled as it is with jargon and abstract modeling nowadays.

My position is that any industry that loses as much as banking did, and destroys as much wealth along with it, and then requires life support from the public, has little room for hubris.

Bankers are the ones, based upon their demonstrated performance, who don’t understand banking. Unless, that is, your definition of banking is a scheme to bilk the public of a fortune before retiring to the Hamptons/Connecticut/Park Avenue.

These people are the world’s richest socialists. Even the hey day of the Politburo failed to match this crowd for the looting and personal aggrandizement rife on Wall Street.

So, as we turn our attention to bank reform we need to engineer a way to remove these guys from our payroll. They cost too much. Next time they gamble it has to be with their own money. And if they need our cash for help some of them have to go bankrupt before we pay up.

Eliminating moral hazard is easier said than done however. Banks are central to the economy. That’s why they get away with the games they do.

So to attack them we need to target carefully. We may not be able to eliminate moral hazard but we can make it really painful for these dangerous people to rob us again.

We can make them put up more capital. Perhaps a part of the capital base has to be contributed by the trader/managers of the bank. Perhaps the top paid folks only get capital shares and not cash. Irredeemable shares for some period – say ten years. Force them to have skin in the game sufficient to make them think twice about risk. We need to send Goldman Sachs back to the days of real partnership, not this faux, quasi socialist, partnership that they revel in today. Partners should lose every cent – yes even the Hamptons cottage – they own before the taxpayer puts up a dime.

Then we can also penalize banks that get too big: force them to double the capital set aside for all assets over a certain size. Heck triple it. Do something to stop these behemoths swamping us.

Next: they should write ‘living wills’. One of the big problems today is the web of hiding places that banks syphon off their money into so they can avoid taxes. Their corporate structures are impenetrable. This was one of the main reasons no one wanted AIG to go belly up: no one had a clue where all the money was and what the consequences would be. A corporate living will would remedy this: it is a blueprint for bankruptcy. Once in place living wills vastly reduce the risks of a bank failure. As such they reduce the ability of a bank to force us to pay for its folly.

I would go further and break up the big banks, but that isn’t too popular. No one nowadays has the fortitude of Teddy Roosevelt we are all too beholden to corporate America. Oh well.

Lastly: the banks who get embroiled in the Byzantine labyrinths of derivative trades, cross-trades, swaps, swaps of swap, trades of cross swapped trades and so on, all of which has now been shown to add to rather than subtract from risk, should be penalized via extra capital requirements. make them pay for playing these games. The entire derivatives market needs a good dose of reality: hedging makes a ton of sense for a mid-west farmer trying to organize his/her cash flow. But the rest of the entire market is useless: it merely is a way to generate fees for lawyers, bankers, and accountants, none of whom, apparently, have a clue about the consequences of their actions.

Need I remind you of my bete noir: credit default swaps on US bonds? The insanity inherent in that transaction beggars belief.

So make them pay.

They should put up extra capital against derivatives. And the traders should have their pay linked directly to the successful unwinding of the deals. If the deal goes bad, the trader goes bankrupt. Simple. Clean. Effective.

The best way to contain the evils of moral hazard is to make it personal.

And until we drain the banking system of moral hazard we can be assured we are headed back into another bubble and thence into another recession.

That’s why bank reform is important.

/ / , , /

Lame (Really Lame) Reform Part 2

It doesn’t improve overnight. Having vented my frustration at the extraordinarily limp regulatory response to the financial crisis yesterday I thought I would take a deep breath and come back today refreshed. My hope was that I would discover something I overlooked before which would then redeem the proposal.

No such luck.

“So the solution to bad risk management is to be wrong more quickly?”

A second reading merely confirmed my opinion: this proposal, which will most likely get watered down in Congress is lame stuff. I am not alone: the folks at The Baseline Scenario agree, as does Joe Nocera in today’s New York Times.

I won’t repeat my rant from yesterday, but I will provide you with more color.

Even the tone of the preamble is dull. It is almost entirely couched in a bureaucratically passive voice. No blame is apportioned. No fingers are pointed. There is no ire. This is despite the devastation that the failure of the financial system wrought. Instead what we get is a dry, detached, and deliberately evasive intonement of the things that need to be corrected. Some of the things that is. The big stuff? Not so much.

Nobody did anything wrong apparently. These were all jolly good chaps who just happened to be in the middle of a storm – that they had nothing to do with. What rotten luck!

Oh my.

Where, oh where, is the spine?

Some parts even read like a banker wrote them. The banks that are ‘to-big-to-fail’ mustn’t be ‘over regulated’ just in case that stifles our economic growth … or their profits? So instead of making sure that they can’t ruin our economy again, we will try to nudge them towards better behavior. After all we mustn’t hurt their feelings must we?

At another point we are told that banks should do their risk analysis more speedily. As if getting those models of theirs to run more quickly would help. How about getting the models right? We are going to rely on the old, and quite obviously wrong, models. So the solution to bad risk management is to be wrong more quickly?

Ugh.

I suppose I have to give up. Clearly there is no real intent on fixing the system. There are pages and pages of detailed proposals: exactly what you’d expect from a major bureaucratic effort. Lots of it seems very sensible. But none of it attacks with gusto the essential point: as long as there are banks big enough to ruin our economy we cannot run an effective economic policy. They will always have the potential to destroy our wealth. So what are we going to do with them?

Paul Volcker tells us that if they are too big to fail they should be severely limited in what they do. For instance they should be banned from trading derivatives on their own account. That eliminates the gambling part of banking and turns them into utilities churning out gobs of credit card, auto, and business loans. That sounds sensible. It won’t stop the from losing money in a future recession, but it would probably stop them from causing it. You know: like they caused this one with their gambling. I realize that such severe limits on activity takes all the fun out of banking and may even drive all that ‘top talent’ out. But after this crisis I have a yen for making sure the big banks are emasculated. Neutered. Like my big old cat: they can lumber around dull and staid and not do any harm. Heck they even become lovable.

Overall the entire proposals document oozes with smooth bureaucratic pablum. It seems designed not to upset the sensibilities of the bankers who caused our crisis and whose recklessness has cost millions of people their livelihoods. On the contrary, while banker lobbyists will not doubt claim that the proposals stifle the industry and cramp its innovative abilities, I see nothing in it that will stop a repeat asset bubble inflation and therefore economic crash: the document bends over backwards to avoid recrimination.

It’s as if we taxpayers simply love forking over cash to banks so that they can continue gambling and profiteering safe in the knowledge we will clean up after them.

We do don’t we?