Thursday, September 18, 2008

How do we prevent this financial collapse from cascading into Great Depression II?

No one wants to reward bad behavior or should feel obligated to protect those who engage in risky behavior from the consequences. However, as this country’s financial institutions crumble the wealth of millions of Americans, who have acted quite responsibly, is evaporating in thin air.

There are multiple reasons for this disaster including the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act. (That's Gramm as in former Sen. Phil Gramm, a deregulation zealot and top economic adviser to John McCain.) But while there are various factors (or what Robert Kutner calls the seven deadly sins) resulting in the mess we are currently in it is, and has been, the zeal to deregulate our financial institutions and the greed of the deregulated that is undermining the American economy and public confidence in it. Action is required but substantive reform can only pull us out of this downward spiral if there is a philosophical turnaround in the minds of our elected leaders. We are seeing the results of those with faith in the “invisible hand” of markets. It’s time for adults to take over to deal with the real world as it is not as it should be based upon ideology.

Robert Kuttner has some suggestions on what should be done:

The current carnage on Wall Street, with dire spillover effects on Main Street, is the result of a failed ideology -- the idea that financial markets could regulate themselves. Serial deregulation fed on itself. Deliberate repeal of regulations became entangled with failure to carry out laws still on the books. Corruption mingled with simple incompetence. And though the ideology was largely Republican, it was abetted by Wall Street Democrats.

Why regulate? As we have seen ever since the sub-prime market blew up in the summer of 2007, government cannot stand by when a financial crash threatens to turn into a general depression -- even a government like the Bush administration that fervently believes in free markets. But if government must act to contain wider damage when large banks fail, then it is obliged to act to prevent damage from occurring in the first place. Otherwise, the result is what economists term "moral hazard"-- an invitation to take excessive risks.

Government, under Franklin Roosevelt, got serious about regulating financial markets after the first cycle of financial bubble and economic ruin in the 1920s. Then, as now, the abuses were complex in their detail but very simple in their essence. They included the sale of complex securities packaged in deceptive and misleading ways; far too much borrowing to finance speculative investments; and gross conflicts of interest on the part of insiders who stood to profit from flim-flams. When the speculative bubble burst in 1929, sellers overwhelmed buyers, many investors were wiped out, and the system of credit contracted, choking the rest of the economy.

In the 1930s, the Roosevelt administration acted to prevent a repetition of the ruinous 1920s. Commercial banks were separated from investment banks, so that bankers could not prosper by underwriting bogus securities and foisting them on retail customers. Leverage was limited in order to rein in speculation with borrowed money. Investment banks, stock exchanges, and companies that publicly traded stocks were required to disclose more information to investors. Pyramid schemes and conflicts of interest were limited. The system worked very nicely until the 1970s -- when financial innovators devised end-runs around the regulated system, and regulators stopped keeping up with them.


… no matter how much taxpayer money the Federal Reserve and the Treasury keep pumping in, they can't turn dross back into gold. The next administration and the Congress need to return the financial economy to its historic task of supplying capital to the real economy -- of connecting investors to entrepreneurs -- and shut down the purely casino aspects of the system that have only enriched middlemen and passed along huge risks to everyone else.

Reform One: If it Quacks Like a Bank, Regulate it Like a Bank. Barack Obama said it well in his historic speech on the financial emergency last March 27 in New York. "We need to regulate financial institutions for what they do, not what they are." Increasingly, different kinds of financial firms do the same kinds of things, and they are all capable of infusing toxic products into the nation's financial bloodstream. That's why Treasury Secretary Hank Paulson has had to extend the government's financial safety net to all kinds of large financial firms like A.I.G. that have no technical right to the aid and no regulation to keep them from taking outlandish risks. Going forward, all financial firms that buy and sell products in money markets need the same regulation and examination. That will be the essence of the 2009 version of the Glass-Steagall Act.

Reform Two: Limit Leverage. At the very heart of the financial meltdown was extreme speculation with esoteric financial securities, using astronomical rates of leverage. Commercial banks are limited to something like 10 to one, or less, depending on their conditions. These leverage limits need to be extended to all financial players, as part of the same 2009 banking reform.

Reform Three: Police Conflicts of Interest. The conflicts of interest at the core of bond-raising agencies are only one of the conflicts that have been permitted to pervade financial markets. Bond-rating agencies should probably become public institutions. Other conflicts of interest should be made explicitly illegal. Yes, financial markets keep "innovating." But some innovations are good, and some are abusive subterfuges. And if regulators who actually believe in regulation are empowered to examine all financial institutions, they can issue cease-and-desist orders when they encounter dangerous conflicts.

We're talking about a Roosevelt-scale counterrevolution here. But nothing less will prevent the financial collapse from cascading into Great Depression II. And the public should never again forget that this needless collapse was brought to us by free-market extremists.

You can read his entire article here which include his “seven deadly sins” or causes of the current mess. I recommend it.

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