Ben Bernanke, Alan Greenspan, and the 8 Trillion dollar bubble...

With Fed Chairman Ben Bernanke up for confirmation of his new term, it bears remembering that - although he wasn't known by the public at the time - now-Chairman Bernanke was on both the Fed Board of Governors (under Greenspan) and the US Council of Economic Advisors. As Dean Baker points out (and has repeatedly mentioned in the past), Bernanke thus bears a substantial amount of responsibility for not reigning in the rampant financial and real estate speculation that led to this whole mess in the first place.

In the midst of all the political changes associated with the Obama era, it is important to remember that the current crisis has its roots as far back as Clinton's second term. In fact, if there is one thing I object to about the Obama administration, it is that the current economic policy team has been in the halls of power for well over a decade, and has presided over the persistent deregulation of financial markets worldwide. Bernanke, Summers, Geithner, and Greenspan were largely responsible for many of the causes of the current mess. I previously posted a discussion of the domestic causes of the crisis here.

For a refresher, they were:
(1) Interest rates, since 1980s stagflation, were kept perpetually below 6%, even in boom periods. These low rates helped feed the dot-com boom, speculation in Mexico and Asia (and Russia) in the mid-1990s, and the bubbles preceding the current crisis.
(2) Deregulation of financial markets under Clinton, approved of and argued for by both Larry Summers and Alan Greenspan (and implicitly by Ben Bernanke, given the Fed's position at the time). This is eerily reminiscent of the problems surrounding nearly every major financial crisis since 1990 - including the Savings and Loan Crisis, the Mexican peso crisis, and the Asian Financial crisis.
(3) The persistent maintenance of a strong dollar vis-a-vis, particularly, the Chinese renminbi. This led to a persistent current account deficit, and related capital account surplus, fueling the speculative bubbles. Again, as Dean Baker has pointed out, these imbalances are well within our control (though his proposed solution might be a bit extreme). Incidentally, this is also why the "China will dump US debt" scare is a sham.

The imbalances discussed above are readily recognized by any graduate student in economics or political economy - in fact, some of my undergraduates with minimal economics training have noticed them as well. It is utterly inexcusable that Bernanke, Summers, et al. failed to recognize their importance, and such ignorance can only be explained by either (a) greed or (b) ideological blindness in the face of clear evidence. In the first case, these individuals are corrupt; in the second, they are wholly incompetent.

It is time we said enough is enough.

BIS targets wrong people....

Apparently the BIS is worried about China's loosening of monetary policy potentially creating systemic risk.

That's all well and good, except for the fact that (a) the economy is still growing rapidly, (b) China's growth is fueled by exports, so an international investment glut is unlikely, to say the least, and most importantly (c) large lenders in China are maintaining Capital Adequacy ratios over 11 per cent.

When the banks collapsed in the Asian crisis of 1997-8, capital adequacy ratios were a mere 2-3%. In fact, standard provisioning under Basel II still runs in the 4% range. So, financial collapse, especially now that the major crisis has stabilized and international regulations are (hopefully) tightening, seems unlikely to say the least - especially in an economy where growth is NOT fueled by speculative bubbles. In short, China's looser monetary policy is far more constrained than the US and EUs policies, and backed by a much more solidly growing economy.

Dear BIS, please stop picking on the developing world, and start paying attention to the speculative financial markets fueling the current crisis - the ones in the US and EU!

Proposed Financial Transactions Tax is...

The single best idea for preventing another financial crisis and ensuring job growth in the middle class.

See the proposal here: http://www.defazio.house.gov/index.php?option=content&task=view&id=532

Justifications can be found here (the PDF file is especially useful; other links indicate broad-based support).

Geithner's plan to save the banks...

In order to help everyone cut through all the nonsense being spouted about financial bailouts and Geithner's plan, here's the basic concept of what the government is trying to do. I've tried to keep in as non-technical as possible, but there is some accounting lingo, because you can't get away from it in banking. I've also provided, below my quick op-ed, the link to the treasury documents and a thorough op-ed by Dean Baker of the Center for Economic and Policy Research. Baker is a lefty economist, similar to Stiglitz and Krugman, but this particular article provides very solid analysis of the pitfalls of Geithner's approach.

Essentially, to fix the financial system, the government had three broad options:

(1) Sit back and do basically nothing, while encouraging the Fed to keep interests rates low. Allow "zombie" banks (those in the red) to borrow money from the Fed at 0 or 0.25%, invest that money in stable assets (e.g. 90-day treasury bonds) and use the spread on those bonds to gradually pay the losses on bad loans. This is the worst option for the economy, and similar to what Japan did in the 1990s. Under that approach, it could take a decade for the banks to recover, prologing the recession and keeping credit tight. People would still suffer, but they couldn't easily point a finger at the government, because they wouldn't have an obvious policy with big numbers to blame. Besides, the zombie banks are still being subsidized at the expense of those wanting to save in the economy (because of low interest rates), its just a blanket subsidy that those without economics/finance background won't notice.

(2) Temporarily nationalize the banks, inspect their books, and forcibly divest them of all the toxic assets. This approach would require the government to somehow value the assets - either by using the current market value (currently about 30 cents on the dollar), or some other method. Stiglitz, Baker, Krugman, and other left-of-center economists prefer this approach, and would like the valuation to be close to the reduced market price, to minimize the potential subsidies to the bank. Sweden used this approach in it's banking crisis, and had good success with it.
--- The upside: This approach also functions as a stress test, telling the government which banks are merely illiquid (don't have enough short-term cash to cover their debt) versus those that are insolvent (have more debt than assets, period). Given the government control of the banks, they could leave the illiquid ones alone, after removing the bad assets, but could use the nationalization to break up the insolvent banks - allowing the risky divisions (e.g. those focused on home lending) to go under, while keeping the profitable divisions as seperate companies. This also reduces the problem of banks that are "too big to fail." Also, if it turns out that the market is underpricing assets (possible, in the current panic), and the government pays less than they're worth, later on the road we make a profit (this has happened before, when the US bailed out Mexico in the mid-90s).
--- The downside: This arguably takes much more up-front government money, because they directly purchase the asset - which makes it a hard sell. Also, if the assets lose value, the government takes a loss (though this can happen under Geithner's plan, too). Lastly, the government might be under pressue from the bankers to overvalue the assets when they buy them - particularly because the public has no idea what they're worth.

(3) Some form of hybrid public-private approach, where the government entices private investors to purchase the bad assets, to remove them from the bank's balance sheets. Essentially, under Geithner's plan, the government creates a restricted market for these assets, by guarenteeing a loan to private investors. So, an investor will put 15% down, borrow the remaining 85% from the government at a low rate, and buy the asset. Also, the investor wouldn't have to pay back the government for the loan, if the asset went bad - so the only loss they would take is their initial investment of 15% of the asset price.
--- The upside: This approach takes less money down. Also, it harnesses the market to do the pricing for the government, requiring less staff time and (again, arguably) potential for screw-up by the government officials. It also (arguably) minimizes the potential losses on the part of the government, because they are simply providing a loan.
--- The downside: The biggest problem is that this "market" is distorted, because the government is subsidizing the purchase of the assets. Investors will be more willing to take risks, overpricing the assets of the banks, and leaving the government to pick up the tab. The higher price asset means that the government may end up spending as much or more money than it would in a simple nationalization plan. Also, the government is not as likely to make money on this plan, because they are loaning investors money at a low fixed rate, in order to buy mortgages that are likely to default. That low rate is likely much less than the potential value of the bad asset if it eventually pays off. After all, why take out a loan if you (the investor) won't profit on the deal? Lastly, the government doesn't have control over the individual banks, however temporarily, so we are likely to be left with the current "megabanks" who - in the event of another bubble - will put us through all of this again.

Hopefully that wasn't too confusing. In any case...

Here are the actual documents distributed by Treasury: http://financialstability.gov/

Here is an interesting op-ed analyzing the potential downfalls of this approach: http://www.guardian.co.uk/commentisfree/cifamerica/2009/mar/23/timothy-geithner-toxic-asset-plan

Two worries about Obama

Given the amount that we have heard about "change" coming to Washington in the Obama administration, let me mention that for all my support for some of the President-Elect's new policies (e.g. renewable energy, infrastructure spending, and health care), and guarded optimism about others (e.g. higher education finance reform), I still have worries about his willingness to tackle the biggest issues in national politics - the two "complexes" that constrain policy the most. They are (1) the "military-industrial complex" (term coined by President Eisenhower) and (2) the "Wall Street-Treasury complex" (term coined by centrist Columbia Economist Jagdish Bhagwati).

Military-Industrial Complex:

To really understand this issue, let me refer you to three sources. The first is a recent article in The Nation that is an excellent primer on the problem. This article identifies two central concerns and challenges related to our military spending.

The first is simple and straightforward: we should not be spending money on weapons systems adapted to an outmoded geopolitical situation - namely the Cold War. Big culprits include the F-22 Raptor, the Ballistic Missle Defense System, and arguably most of the US nuclear arsenal. An excellent line-by-line report identifying key programs to be targeted for reduction was done by Foreign Policy in Focus, and is entitled "A Unified Security Budget for the United States, FY2009."

The second issue is more fundamental and concerns the position of the US in the world. We have, since WWII, become accustomed to using our military to project influence into the world. Part, though not all, of this is related to energy politics (one of the many reasons for renewable energy). Overall, we have over 700 bases and outposts stationed in foreign countries. Perhaps the most comprehensive coverage of this issue has been done by esteemed political scientist Chalmers Johnson, emeritus at UC San Diego. For a list of some of his fairly regular op-eds, see this page at AlterNet. More importantly, see the trilogy he wrote on US intelligence, military, and the potential decline of the American Republic - including parallels to Rome and Britain. The books can be found on Amazon, and are titled: Blowback, The Sorrows of Empire, and Nemesis.

As the article in The Nation mentions, Obama has signaled that he wants a shift out of Iraq and into Afghanistan, but he hasn't signaled that he is willing to take on the Pentagon's ever increasing budget requests or its unwillingness to phase out old programs - to say nothing of whether we should take a fundamental look at where we have bases and why. I voted for Obama because I think he understands that we're looking at a multipolar world. Unfortunately, I don't have any indication that he's willing to take on the established old guard at the Pentagon. Toning down our militarism is the central component to finding a new place in the world. We need to remove our "big brother" and "world policeman" mentality and return to a simple concern with our own national security. Besides, the only thing that will force more military responsibility on other countries is if we don't have the resources to do it all for them.

The Wall Street-Treasury Complex:

My problem here is much simpler - Obama's economic team is populated by old-guard economists, many of whom contributed to the rise of the "Washington Consensus" and the deregulation of financial markets that got us into this mess. When your house falls down, do you hire the same contractor who built it in the first place? I take a little hope that the Treasury Secretary is Tim Geithner, and having a respected hand there is important, but I would be much happier if the economic policy posts weren't completely filled with Robert Rubin's protégés. Rather than complaining about it too much myself, let me suggest two good sources. The first is this article from the NYTimes, and the second is this op-ed by Dean Baker at CEPR.

In short, it remains to be seen if change is really coming to Washington. Old habits die hard, and people are often loathe to unlearn ideas they formed over decades-long careers. Who will Obama listen to, and how will he synthesize their opinions? Is there enough diversity to ensure a proper balance? All of his advisors are bright, well-educated, and experienced - but it remains to be seen if they are stuck in their ways.

Shadow Summit details

If anyone is looking for more specifics on what events are being held when and where at the Shadow Summit - here is a link: http://globaljusticeaction.wordpress.com/

Shadow Summit to G20 this weekend!

November 14-16 2008
Forum will be held November 15th at Luther Place, 1226 Vermont Ave NW
People's Summit Against the G20

While George W. Bush hosts a meeting to promote flawed top-down ideology, IPS and friends invite you to a summit for "the rest of us."

We know the global financial crisis cannot be fixed by those who created it. Join us this weekend for the People's Summit to demand new ideas, people over profit, and democratic control over resources.Nine events are planned for the summit this weekend. For the full schedule of events, please visit Global Justice Action. The weekend's activities will culminate in a People's Forum on Saturday, November 15 and will include:

* An introduction to the financial crisis and its foundation in global capitalism
* Breakout groups, with experts, to further explore energy, the housing crisis, and other factors that contributed to the financial crisis
* A fishbowl discussion on alternatives to capitalism, exploring local, national and global models
* A movement discussion and networking opportunities

The closing panel on international perspectives will feature:

* Martin Khor, Director of the Third World Network, and board member of the International Forum on Globalization
* Njoki Njehu, long-time Director of the Fifty Years is Enough Network
* Lidy Nacpil, Filipina activist and long-time leader of Jubilee South
* Moderator: John Cavanagh, Director, Institute for Policy Studies

Read the Global Call to learn more about the People's Forum and add your voice to those calling for a new, democratized economic system.

Sponsors: Bank Information Center, Casa de Maryland, Global Justice Action, International Forum on Globalization, Institute for Policy Studies, Jobs with Justice, Students for a Democratic Society, US Action, and the Washington Peace Center

Financial Crisis: Revisited

Hey folks, since I finally finished my series on the financial crisis, and since we now have a new administration - I thought I would re-post the links.

Financial Crisis Part I: The Antebellum - details the fairly immediate domestic historical causes of deregulation and the housing bubble. There is more that could be said here about the impact of international globalization, portfolio account liberalization, parallels with the East Asian crisis of 1997, and if the IMF has a role - but for now I'll leave those issues alone.

Financial Crisis Part II: The Conflagration - details the majority of the major banking collapses (I wrote this before Washington Mutual collapsed and merged with JP Morgan Chase). It also gives a sketch of the bailout and impact on national debt, trying to keep things in perspective. I think, in retrospect, that my critique was a bit conservative in this section, and the move towards actual equity shares in the banks is a good one, because it confers additional and more sustained oversight. One thing to keep in mind: the social role of the financial sector is not to make profits, it is to provide stability, transparency, and liquidity to producers and consumers alike - so that the economy continues to function. It needs to do this efficiently, but we need to remember that financial profits do not generally reflect actual productivity increases or the health of the real economy. In fact, when fueled by speculative investment, they typically prop up bubbles like the one we just saw. If there is any segment of the economy that should be stringently regulated, even to the point of quasi-nationalization, it is the banking sector (I do make this point in part III).

Financial Crisis Part III: A New Regulatory Framework - details my take, based partly on analysis from Dean Baker at CEPR (who, incidentally, is one of the few economists who has legitimately predicted all of this for years), on how we can input smart and targeted regulation to prevent the excesses of speculative activity, provide public oversight, and root the calculus of financial companies in long-term sustainable profits - rather than short-term bubble-burst activity.

So - for those who missed it the first time, or who are new readers, or only read part of it - there is my take on what we should do (roughly).

To come later - I will probably try and provide a framework for the Obama administration - how we should be focusing on changing or restructuring our society to be more dynamic, sustainable, and capable of providing legitimately equal opportunity for all.

Financial Crisis: Part III – A New Regulatory Framework

One thing that is clear, following the debates last night, is that the candidates are a little sketchy on the precise reforms that are necessary to prevent another crisis. In Part II of this series, I cataloged the damages of the past few months, and proceeded to explain that we need to accept the reality that a large bailout, like it or not, is necessary for our country’s renewed financial health. The candidates, fortunately, seem to accept this reality. However, they seem unsure on exactly what we should do in terms of long-term reform. In this post, the third and hopefully final post on what I think needs to be done to resolve the crisis; I provide a set of suggestions on how we can reform our governance of financial markets to prevent a recurrence of the current situation. As I mentioned in the last post, some of my suggestions take a cue from Dean Baker at CEPR, though I do differ from him in a few areas.

Before I move into the diagnosis, however, here is a brief comment on my take on the candidates’ economic philosophies. From what I heard last night, I think that Senator Obama’s general philosophy coincides with my impression of specific measures that need to be taken, while Senator McCain seems to still oppose additional regulation in favor of finding bureaucrats to use as scapegoats for a crisis that they could not fully prevent. As I explained in Part I of this series, the Republican Congress of 1999 removed key regulations and handicapped regulators in dealing with this crisis. Blaming regulators for not having the tools at their disposals is nothing if not counterproductive. We need to fix the problems, not look for yet another person who we can blame.

Building with Bricks, Instead of Straw

So, exactly what should we do to prevent another catastrophe? Here are five potential reforms that could have a great deal of impact in reducing volatility and the bubble-bust cycle.

First, all forms of traded assets need to be traded on public exchanges regulated by either the Securities Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC). Believe it or not, not all of the instruments that are traded happen on these exchanges. Debt swaps, which are a major part of this situation (mortgage packages are debt securities, after all), are traded off of the exchanges. This makes it very difficult for regulators to access reliable information on the volume and volatility of trading.

Second, Fannie Mae and Freddie Mac need to be subject to more stringent oversight, and perhaps should remain renationalized. Their job, after all, is to repackage mortgages to maintain market solvency. They are a market facilitator, not a profit-focused institution, and a focus on short-term profits is a good part of what got us into this mess. At minimum, there should be two conditions: (1) Fannie and Freddie should be limited in size (in terms of the percentage of the mortgage market they are backing), and (2) Restrictions placed on the riskiness of mortgages that are backed by the institutions. Limiting their size ensures they don’t become overburdened and carried along with asset waves, and limiting the riskiness of their investments ensures they remain solvent and prevents Wall Street from gambling with taxpayer money.

Third, we should establish a public administrative body to assess the riskiness of investments, much as Moody’s and Standard and Poor do now. One of the chief problems leading up to the crisis was the incestuous and corrupt nature of the rating organizations. In essence, they were “in cahoots” with the investment bankers. This public organization should work in tandem with the Federal Reserve. In fact, one key measure that could be put in place to add some teeth to the body would be to place a risk premium on the interest rates charged by the Fed, if a bank allows its balance sheet to sour. A declining credit rating could also automatically trigger negotiations and intervention by the Fed. This could operate in much the same way as debt covenants between private corporations and banks do today. A side benefit of this system is that it forces banks to lend more conservatively, which could stem the trend of Americans piling up their debt until they can barely make minimum payments. It could help reinvigorate a culture of saving now and spending later, rather than the opposite trend that has appeared in today’s consumer culture. High domestic savings rates are almost universally accepted as signs of a healthy and sustainable economy.

Fourth, we need to find a way to break into what has been dubbed the “Wall Street-Treasury Complex” by Columbia economist Jagdish Bhagwati. Hank Paulson, for example, was CEO of Goldman Sachs from 1999-2006 – presiding over the height of the bubble – before becoming Secretary of the Treasury. Preventing this is even more important with respect to the Federal Reserve. Federal Reserve members should go through a full appointment process, requiring the “advice and consent of the Senate” (see Article II, Section 2, paragraph 2 of the US Constitution), as is the case for most other federal officials (e.g. Supreme Court Justices). This could be a requirement of a full senate vote (the standard procedure). Another approach that might make sense is the approval of both the Senate Banking and House Financial Services committees (current Chairs: Chris Dodd and Barney Frank), since many congressmen may not understand the “ins and outs” of finance. In either case, there needs to be an approval process by which the duly elected representatives of the American people have a voice.

Fifth, we should implement two targeted and small tax policies that can minimize speculation and volatility, while at the same time taxing those responsible for this mess in the first place – making them pay for most of it, and not the average taxpayer. The first tax would be a tax on financial transactions, valued at less than 1%. This tax has negligible impact on those investors who are buying and holding for a longer time period, but has a significant impact on the profit margins of speculative day-traders. One estimate suggests this tax could bring in $100 billion in extra revenue. The second tax is a parallel measure attached to currency trading (another 1% or lower tax), known as a “Tobin tax” for the economist who came up with the idea. It has the same impact, removing the profit incentive on speculative currency trading and forcing people to buy and hold for longer periods. This helps to prevent the flight of portfolio capital and precipitous currency devaluation. The proceeds of this tax could be diverted to the foreign exchange reserves, allowing for the US to manage our currency more effectively and combat Chinese currency undervaluation. This will be particularly useful as our economic clout diminishes relative to rapidly developing economies (e.g. China, India, Brazil, Russia), and the dollar ceases to be the “standard” currency of international trade.

The list I have outlined above is in no way meant to be exhaustive. I do think that the above measures could have a beneficial impact, stabilizing the global economy and focusing our energies on productive economic activities, rather than speculative finance. As usual, I welcome any comments you all may have.

Financial Meltdown: Part II - Bailing Out the Banks

As I write, Congress and the President are wrangling over what to include in a massive bailout package, intended to save Wall Street from itself. In Part I of this series, I provided what a friend termed the "antebellum" to this lovely financial conflagration. I'm going to assume you've all read that post, so you might want to read it before tackling this one. Part I details the domestic economic and regulatory causes of the current crisis, and can be found here. The current post is divided into two parts: an overview of the current situation and an assessment of what is needed to bail out the system. There is going to be a third part, discussing what to do to prevent a recurrence.

Overview: They Huffed, and Puffed, and Blew the House Down

Over the past few months, and especially in recent weeks, the entire operations of Wall Street have been turned upside down. Earlier this year, there were five major stand-alone investment firms on Wall Street. Earlier this month, the four largest still remained. Now there are none. Both major publicly guaranteed housing firms had to be nationalized by the government. Even normal mortgage institutions, protected by regulations governing loan-loss provisions, have required substantial assistance. The federal funds rate, in a time of upward pressure on inflation due to commodity prices, remains at a mere 2%. Given the speed of things, let's take stock of the principal damages. Here is a list of those companies requiring significant government intervention thus far.

Investment Banks: Smallest to Largest
Bear Stearns: Government brokered a buyout by JP Morgan Chase, valued at $10 per share. The government issued a $30 billion to JP Morgan Chase to support its purchase.
Lehman Brothers: Bankrupt, government unwilling to save, currently being scavanged by Barclay's PLC.
Merrill Lynch: Purchased by Bank of America to avoid insolvency.
Morgan Stanley: Announced it would become a "bank holding" company (like Citigroup), subject to stricter regulation.
Goldman Sachs: The giant investment firm, long the envy of Wall Street, also announced it would become a bank holding company, subject to stricter regulations. Warren Buffet has announced he will but $5 billion in preferred stock, and the company will issue another $5 billion in common stock to raise capital.

Other Institutions:
American International Group (AIG): Massive insurance company with over $1 trillion in assets. Government bailout of $85 billion for a 79.9% equity share in the company and ability to suspend dividends to common and preferred stock.
Fannie Mae/Freddie Mac: Federal takeover (79.9% equity) and bailout valued at $200 billion. Combined, the two institutions hold debt and mortgage-backed securities valued at around $5 trillion. The current agreement requires that "each GSE’s retained mortgage and mortgage backed securities portfolio shall not exceed $850 billion as of December 31, 2009, and shall decline by 10% per year until it reaches $250 billion."
IndyMac: Seventh-largest mortgage originator in the US, largest bank in Los Angeles area, with assets of around $32 billion (deposits valued at $19 billion). Taken over by FDIC, which guarentees deposits up to $100,000 (and 50% thereafter).
Washington Mutual: Largest Savings and Loan institution in the US, assets valued at over $300 billion. Worries persist about its financial health.

As far as I know, that covers all of the major problems in the past few months. Although, at the rate things are going, I might have missed one. In general, it might be an exaggeration to say that the financial sector is reverting to a pre-1929 conditions, but not by that much. The economy, despite media hyperbole, is not going to crash to Great Depression levels. The country should remain fairly well protected from that level of crash. Social security, Medicare, Medicaid, unemployment insurance, and the FDIC did not exist until the New Deal. Accounting standards and financial regulation through the SEC are also significantly stronger than before the Depression. Each of these measures affords some containment and security, a buffer against hard times.

However, if you will recall my previous post, one of the crucial post-1929 pieces of financial legislation was Glass-Steagall, which separated investment banks from mortgage banks. The repeal of that particular provision of Glass-Steagall in 1999 was a monumental mistake and opened the economy to systemic financial risk. The collapse, acquisition, or change of the investment banks into bank holding companies serves to exacerbate this problem, by and large. The increased concentration of capital into mega-banks concentrates management, distorts market incentives, and removes a layer of insulation from the financial markets. It connects personal deposits even more directly to risky investments taken on by the investment bankers. It also concentrates wealth in the hands of fewer institutions, meaning if one institution collapses, it in itself creates systemic risk. Imagine is Citigroup, with assets of over $2 trillion, were to go bankrupt! Perhaps the only ray of sunlight is that the bank holding companies are all subject to tighter regulation than normal investment banks, and access to deposits and the required loan-loss provisions can make the collapse of an institution more difficult.

Suffice it to say that the contagion has spread throughout the system, and no one has gone untouched. What is needed is a constructive solution with significant long-term components, based in an understanding of where the economy stands. What this means is that any bailout program needs to address long-term regulations as urgently as it needs to ensure short-term financial solvency. This trend could be disastrous if it continues.

I recently posted a link to an in-depth analysis by CEPR. What follows is my take on how we should modify financial governance in the wake of the current crisis. My take on long-term regulation is somewhat similar to Dean Baker at CEPR, but I do disagree with him on how to handle the current bailout. Also, his article is a bit technical and geared towards those with a significant background in economics and finance; I will try to make mine more accessible.

Bailing Out the Banks, but Not the Bankers

Given the sheer magnitude of the current situation, the primary focus of a bailout should be on efficiently flushing the toxic assets from the financial system. It is tempting to quail at the size of the Bush Administration’s proposal, but a full-fledged purge is exactly what the current situation requires. Japan in the 1990s attempted a succession of small stimulus plans and rescue packages, yet the economy remained in the doldrums for a decade, and the banks have only recently become profitable again. On the other hand, following the advice of the IMF, South Korea allowed the banking sector to collapse following the burst of the East Asian real estate bubble in 1997-8, and the economy underwent a severe contraction. In fact, the one country that survived the crisis with the least pain was Malaysia, which made sudden and decisive use of capital controls to prevent the flight of foreign portfolio investment (currently a problem for the US, as well).

In practice, this means that we need to put concerns about the national debt on hold until the financial system recovers. It is tempting to assume that debt, as debt, is a bad thing for the economy. However, government debt is not the same thing as your personal credit card debt. What matters is the cost of meeting debt-service obligations, and whether the debt-creating expenditures create more growth than debt-service. In the case of rescuing the US financial system, it is almost certainly money well spent. Additionally, talk of US debt problems are somewhat overblown. Government debt, by itself, has virtually zero correlation with the health of the economy. Consider that Japan has the 2^nd-highest debt-to-GDP ratio and remains at the center of innovation. A number of countries that have low debt-to-GDP ratios remain underdeveloped (see the CIA World Factbook). Keeping this in mind, a $700 billion bailout is only 5% of the USA’s $14 trillion GDP. Even if all that money is not repaid, this takes out debt-to-GDP ratio from 61% to 66% - hardly a dire increase. The United States is not likely to run out of creditors, as we are the main anchor of the global financial system, and 5% of GDP is certainly a reasonable price tag for the targeted removal of toxic assets from the financial system.

If we look around, we can also see a lot of recrimination and blame. This is tempting, but somewhat counterproductive. Certainly, we need to strictly limit “golden parachute” payoffs to the executives that ran their companies into the ground. Just as certainly, these limits will likely not be as strict as the CEOs deserve (if you make a company bankrupt, I don’t personally think you deserve anything). However, we should not attempt to blame the shareholders and wait until companies absolutely need rescuing to do anything. Dean Baker suggested that shareholders need to be punished – but most shareholders are not board members, most are people who invested their retirement savings in a 401(k) mutual fund that then invested in these companies. Even if they did invest on their own, given the faulty risk ratings on many of these assets, and a lack of insider info, they could not be expected to know that profits would not continue – particularly since this bubble has been 5-10 years in the making, and most financial analysis only goes back to ten year averages (at most). Perhaps board members deserve to take a loss, but we should not punish innocent investors for making a decision based on the information that was available to them before the bubble burst.

It might be thought that I’m coddling Wall Street, despite my claims that executive compensation needs to be limited. What I have in mind is a two-step process; the limitations on Wall Street come in the form of regulations intended to prevent a recurrence of this disaster.

There are two things that need to be addressed in making this bailout effective and efficient, without unduly burdening the government or rewarding institutions and executives who ran themselves into the ground. Here I take two cues from Dean Baker. First, given the corruption and incestuous nature of the private risk appraisal industry, preventing gaming of the proposed auction process is a real problem. One way to avoid this is to make executives personally liable for the misreporting of auctioned assets - allowing them to be sued for assets that underperform (e.g. default more often than) their risk rating (outside a statistical margin of error, say +/- 5%). Faced with potential lawsuits, executives would think twice about misrepresenting risk to the US Treasury. Second, the government should not be responsible for repaying loans to companies that it bails out, if those loans were made within the financial quarter preceding the bailout. The creditors who made those loans, for instance to Bear Stearns or Lehman Brothers, had access to their books and knew their financial situation when they agreed to make the loans – they should be forced to suffer the consequences. This should prevent creditors from making last-minute high-return loans risk-free in expectation of government bailouts should default occur.

Sorry for the length – it’s been a complicated couple of months on Wall Street. Part III of this series will address long-term regulations to prevent a reoccurrence of this mess.

Bailout Terms?

Well, I haven't had time to do my own diagnosis of the current situation, to make long-term suggestions. In the meantime, here is an excellent and detailed piece by Dean Baker at CEPR on what the terms of the bailout should be. His take leans a little further towards heavy regulation then I would, but many of his suggestions have a great deal of merit.

Financial Meltdown: Part I

Well, I think it’s about time I weighed in on the current financial crisis. Sorry this took me so long, but I needed time to do some real research to sort through all the opinions. What follows is an analysis of the root causes and history behind this crisis, as well as who to blame (because blaming people is so much fun!). This is part I of II, because the next post will assess the government’s response and what should be done.

First off, let’s get one thing clear. This is not the fault of the Bush Administration. Frankly, the only real things the Bush Administration did to contribute were (a) allow deregulation to stay around and (b) spend too much money on ill-founded wars. Their fault lies in overextending the government’s resources so they don’t have the resources to properly handle what they’ve been given. This crisis has been building since before Bush was elected.

If we can’t blame “everyone’s favorite target,” then who can we blame? No one person is 100% responsible, but a significant portion of the blame is shared by Alan Greenspan and the Republican Congress of 1999-2000. Each of these entities shares some responsibility the twin causes of the current crisis: the housing bubble and deregulation.

Let’s start with the easy case, and the immediate cause of this crisis: the housing bubble. The fault for the housing bubble lies squarely on the shoulders of the Federal Reserve. That means Alan Greenspan. Housing prices have declined 20% since this crisis began, but that’s only half of the 70% increase in real terms they saw from 1973-2007 (170%*-20% = -34%). In comparison, housing prices remained steady in real terms from 1948-1973 (source: CEPR). This has a direct correlation with average fixed-rate mortgage rates and the federal funds rate over that period. Mortgage rates peaked in 1981 at around 16-18%, and have steadily declined since. It’s understandable that Paul Voelcker would want to begin lowering these rates; the initial spike was a monetary policy move to stem the inflation of the late 1970s, and rates needed to come back down eventually. However, Greenspan continued the trend through 1992, with the federal funds rate bottoming at 3%. Since 1992, the funds rate has not peaked above 6.5%, and has remained below 6% for the majority of that time. In essence, Greenspan allowed the economy to overheat, precipitating the tech bubble burst, and now the housing bubble, by keeping the cost of credit at artificially low rates, allowing companies and homeowners to live beyond their means for an extended period of time. Eventually, that time runs out.

The second case, deregulation, is a little more complicated. However, if we want to play the blame game, the majority of the blame falls on three Republican Congressmen: Representatives James Leach (R-IA) and Tom Biley (R-VA) and Senator Phil Gramm (R-TX). These three gentlemen were behind one monumentally foolish piece of regulation: the “Gramm-Leach-Biley Financial Services Modernization Act of 1999” (official Senate site). Gramm-Leach-Biley repealed part of the “Glass-Steagall Act of 1933.” To begin with, let me provide a little history.

The Glass-Steagall Act was an extremely important piece of New Deal legislation intended to combat the collapse of the financial sector that precipitated the Great Depression. It had two crucial provisions: (1) establishing the Federal Deposit Insurance Corporation (FDIC), which insures bank deposits up to a value of $100,000, and (2) prohibiting bank holding companies from owning investment banks, insurance corporations, securities firms, hedge funds, etc. The first key provision, the FDIC, is still in place. But Gramm-Leach-Biley repealed the second key provision, allowing the merger of mortgage banks with insurance, investment, and commercial banking services. For example, shortly after Gramm-Leach-Biley was passed, Citibank became Citigroup following its acquisition of Travelers Group (an insurance company). It is worth noting that Gramm-Leach-Biley was passed with well over a 2/3 majority and was veto-proof.

Now, why is all of this so bad? Doesn’t this simply make the financial sector more dynamic and flexible? Shouldn’t that be a good thing? Well, another word for “dynamic and flexible” is “volatile”.

Sometimes, a piece of legislation is put in for a legitimate reason. The reason for the Glass-Steagall provisions was to prevent another run on the banks, like the one that happened in 1929-1930. The FDIC ensures that people get their money, even if a bank collapses, and the separation of savings banks from commercial and investment banks prevented banks from taking huge losses on speculative investments and using people’s savings to back them up. Gramm-Leach-Biley changed all that, allowing the merger of the different classes of institutions. (Sidenote: European and Japanese systems allow the merged types too, but have a significant government dialogue and oversight over the types of investments made, which helps to minimize volatility and ensure longer-term investment goals.)

So what happened in the crisis? In order to raise capital, the savings/mortgage bank subsidiaries of financial corporations (e.g. the Citibank portion of Citigroup) issue mortgages. The investment portions of different corporations (e.g. Bear Stearns, Lehman Brothers) then packaged a number of mortgages into securities – including blending subprime and prime mortgages together under one risk rating – and purchased portions of those securities to provide extra operating capital to the banks, allowing the mortgage banks to make more loans (including mortgages). After all, the excess money had to go somewhere! The insurance portions of the new conglomerates (e.g. AIG, Travelers Group) then insure the risk of taking on these new mortgage-backed securities in case of default. The conglomerates are then faced with risk from the same mortgages in three different sections of their books. Originally, this was hailed as “risk-diversifying,” and in cases of normal operation, it might be – after all, in a period of stable housing, it provides a measure of security as mortgages are felt to be safe. Unfortunately, it happened during a housing bubble, and further exacerbated the number of mortgages being offered. Eventually, you run out of reliable clients. Some people don’t own houses because their credit isn’t good enough and they don’t have the income (I should know, I’m a graduate student!)

So, the subprime housing bubble bursts. Now, rather than losses being confined to one sector, they are magnified throughout the entire financial system. Bear Stearns was the first to fall, then Lehman Brothers, then AIG, and Merrill Lynch. Only two of the original five investment firms have escaped relatively unscathed – the largest two, Morgan Stanley and Goldman Sachs. Even the quasi-public mortgage backers – Fannie Mae and Freddie Mac – have needed a bailout. Quite simply, deregulation was a mistake, premised on a foolish assumption that growth can happen indefinitely. Well, it can’t. The market needs to undergo periodic corrections, and regulation exists to make sure that those corrections don’t cause the whole system to collapse. More on this and the government response in the next post.