The American Interest
The Middle East & Beyond
Published on December 17, 2012
What’s Wrong and How to Fix It, Part 5: The Financial System

If we can get some kind of grip on the power of money in our electoral politics by going directly after television, then maybe we can proceed to assault the next great—indeed, probably the greatest—bastion of plutocratic corruption in the United States: our banking and financial elite.
Over the past four years I have come to understand a sobering fact: As important as banking and finance are as facets of our national life, and as elements in what has gone wrong in recent decades with it, only someone who has spent years in a day job inside these professions can really understand the debates now flying about around them. I am not one of these people, and I confess to amazement at how fickle I am at the mercy of those who have deep experience in these areas and issues.
For example, three years ago it seemed evident to me that we needed to resurrect some kind of separation between ordinary banking, investment banking and insurance. That separation was legislated into law after the Great Depression hit, and it is this separation that was abolished in 1999 with the disastrous Financial Services Modernization Act. That’s why the so-called Volcker Rule seemed to me to be an obviously wise idea. But then others who know finance well explained to me that if the rule, depending on how it was understood and implemented, ended up significantly shrinking the amount of liquidity in the system, it would probably do more harm than good. Both arguments make sense to me, but I don’t know enough about the subject to decide which is better.
It also seemed self-evident to me that there was something to the plaint that our banks had grown too large and two interconnected, so that we had a too-big-to-fail problem on our hands reminiscent in some ways of the key argument of the seminal election of 1912. I also credited the worry that after the shakeout our financial system was even more concentrated that before the meltdown. But then come to find out that bigness and interconnectedness really didn’t play much of a role in what happened in the autumn of 2008; it was just bad betting and over-reliance on new technological gimmicks no one really understood than mainly made the mess. So it has been plausibly argued by Steve Rattner, for example; but is it true?
True or not, Sandy Weill, creator of the mega-Citibank we know today, has urged a separation between ordinary and investment banking, and a Governor of the Federal Reserve system, Daniel Tarullo, called on October 16 for a cap on the size of banks, calculated as a percentage of GNP. His argument turned on concern that the market would get the idea that the government is guaranteeing these very large banks’ solvency, adding to their accident proneness regardless of the threat of contagion caused by interconnectedness. I think he’s right, but no sooner had Tartullo lunched that day when Barney Frank, of all people, came out against a cap, arguing that it would handicap American banks in international competition. Is his right? I don’t think so, but I don’t know.

Similarly, I was initially attracted to criticisms of Fannie Mae and Freddie Mac, specifically that they used their protected status as a government-created and sponsored enterprise to muscle in on the private mortgage market, thus egging on the private sector to take on more risky methods of operation to maintain profitability. I was also frustrated by the resistance of Freddie and Fannie to Obama Administration efforts to facilitate the refinancing of underwater mortgages at more affordable rates. It seemed to me that if Freddie and Fannie were established in the first place to help middle-class and lower middle-class Americans to achieve and maintain homeownership, then paying so much attention to the balance sheet of their shareholders constituted a betrayal of their own mandate. But it then came to my attention that if Freddie and Fannie were to help underwater homeowners who were in arrears on their payments, that would incentivize those making payments to stop doing so. If that happened, the dynamics of moral hazard might result in worse outcomes for everyone.
I’m not alone. Lots of other people who are expert in some professional domain or another probably find themselves feeling like dopey little kids when they try to understand banking and finance. So I lack detailed programmatic proposals on this subject; it would be presumptuous of me to put any forth. But I do have some questions and some instincts that help me tell fish from fowl, and also fair from foul in this era of plutocracy through which we are suffering.
My main question concerns, once again, governmental design issues. Most advanced democracies have centralized government oversight of banking and insurance; the United States does not. Not only do we have a divide between Federal and state regulation of banks, but even on the Federal level we divide oversight and regulation between commodities, securities, banking, insurance and credit unions. Why do we do this, allowing many large financial corporations to arbitrage the regulatory environment looking for the least constraining regime? What are the consequences of these divisions? We virtually never discuss such questions. We need to.
Similarly, most other capitalist democracies have a central or a national bank; the United States, despite every effort Alexander Hamilton exerted, really does not. (This is a long and fascinating history.) Instead, we have peculiar system in which money gets into circulation by the government essentially giving money to federally chartered banks in return for bank assets of sometimes very dubious value. This, too, has a history—after World War II there was a pressing need for housing construction and mortgage support for young soldiers returning home, but not enough capital to support the need. So the government used the banking system to liquefy the economy and get its pulse up. Along with the GI Bill, this method helped create the suburban middle class of the postwar era. But we still do this, now essentially giving or loaning federally chartered banks basically free money (the interbank loan rate is zero), with which they often turn around and buy Treasury notes at 3 percent interest. This is like the banks charging rent to the government for the right to use its own money.
If that were all they did with the Fed’s money, things would not be so bad. But that isn’t all they do. When the banks then act as agents of investment (which they have been able to do again with alacrity since 1999), they are able to use this virtually free or borrowed-at-zero-interest money to bid up the price of assets—housing, for example, or technology stocks before that, or higher education both before and since—creating bubbles and distorting markets far and wide. With the enormous sums of Fed bailout money in 2008 and 2009, the same people who brought us the housing bubble and the student loan bubble, both abetted by Federal government tax policies, began to invest big time in gold, energy and commodities. Gold aside (that’s merely causing the despoliation of the Peruvian Amazon), the result is that we now have, very predictably, significantly higher oil and food prices worldwide.1 As always, the poorest people the world over are suffering most from this casino-like contraption we call a banking system. Why do we allow such shenanigans? Take a sideways plutocratic guess.
So, as to my intuitions, when I learned that hordes of overpaid Wall Street lobbyists were intent upon killing the Volcker Rule, that told me that, whatever its downsides, it was and remains basically a good idea. When I found out that the main sponsors of the Dodd-Frank legislation both benefited luxuriously from campaign donations provided by Freddie and Fannie, I understood why that legislation did not even mention these key sources of our financial meltdown. When I discovered how much Timothy Geithner knew about Wall Street stratagems, like systematically falsifying interest rates, when he was head of the New York Federal Reserve Bank, I prepared to dismiss anything he says about the subject as biased in favor of the parasitic financial “industry” from which he comes and to which he doubtlessly will want to return.2 I am not saying that a Wall Street insider should by definition never be Secretary of the Treasury. Franklin Delano Roosevelt made Joseph Kennedy the first head of the Securities and Exchange Commission because he reasoned that it took a crook to catch a crook. It is hard to argue with that as a general principle. But I am saying that this is probably not the time for such a Secretary of the Treasury.
A lot of people exclusively blame the high rollers on Wall Street for gaming the system in the interests of greed. I don’t doubt that many of them have done exactly that, and that their political protectors have let them do it within the law—even rigging the IRS code to reward short-term “flip-it” speculation as opposed to long-term wealth creation. The code wildly advantages wealth over income, which, I cannot stress too much, are not the same things.
The greed question, insofar as it is in play as a causal factor, bears incidentally on the philosophy of regulation. If our business elites are essentially honest people who understand the difference between getting rich and creating wealth, then we don’t need very rigorous regulatory systems to protect ourselves from their avarice. We would do much better with greater transparency and less detailed regulation anyway. At the same time, if our business elites are essentially selfish and dishonest short-term manipulators in the business of selling debt rather than financing the production of value, then no system of regulation, no matter how tightly drawn, will do us that much good. It is as the motto of my alma mater has it: “Leges sine moribus vanae.”As matters stand now, I have a low opinion of this elite. I have that opinion because I know people who were part of it, but left in disgust when the ideal of serving clients turned into a racket to exploit them instead—and none of the leaders at the top firms did anything about it.
But even a distorted tax code and a rash of personality defects don’t entirely explain what happened in the autumn of 2008. Rather, there is a relevant history here that does help to explain it. In a nutshell, the advent of digital technology made the professions of stockbroker and bond dealer obsolete. Those professions were based ultimately on proprietary access to certain kinds of information, and the internet destroyed that protected access. So bankers and related professionals sought other ways to make money, and technology helped them do that, too: It made possible the aggregation, blending and marketing of risk in ways that had heretofore been impossible. This process began to run at warp speed, far outdistancing any attempt to understand or regulate it—indeed, the financial plutocracy, in part by placing its own folk in positions of key influence, made sure that government could not understand and regulate what was going on.
The plutocrats outside and in the government were sure that this supercharged, high-speed model of finance capitalism they had created was safe as well as lucrative. It wasn’t safe, but when it crashed in 2007–08 the plutocrats within made sure that taxpayers shelled out, indirectly at least, to clean up the wreckage.3 They also made sure that, after the crisis had abated, no real changes to the system would be made. So for some at least, the whole deal remains extremely lucrative. So yes, what the large banks have done has not been pretty, and some of it has been quite sordid; but it’s government policy, bought or rented as it may be, that enabled and in many ways encouraged the banks to act as they did.
In light of this, it seems to me that the least we can do, and probably the most we can get away with these days, is to finally empanel a commission of genuinely disinterested wise men to take a cold, hard look at the system we now have. They need to look at the whole system with the aim of identifying misalignment of interests between bankers and the common weal, at perverse incentives within the tax code and at rating agencies, and at government regulatory bodies and how they are connected, or more likely not connected, as the case may be. This commission should be authorized to propose an integrated repair for what they find needs fixing. It should also be set up like the BRAC: Congress can vote thumbs up or thumbs down on the package proposed as a whole, but it cannot amend it to death by a thousand plutocratic cuts.
It still amazes me that after what happened in the autumn of 2008 (and since) no such commission was impaneled, leading us to conjure up all sorts of fixes to a problem we made so little effort to understand in the first place. My guess is that the reason no such commission was impaneled was that financial plutocracy that rents the Congress did not want it to be impaneled. Of course there were plenty of forensic analyses of the meltdown outside of the U.S. government, but they had no influence over the government.
It also amazes me, therefore, that anyone could think that Dodd-Frank actually changes anything significant. Capital requirements are somewhat higher, and that’s good (but not good enough). But it is still okay for well-heeled financial services businesses to bet against their own clients with their own money, and risk that of others at no real cost to themselves. Trillions of dollars worth of derivatives are still unreported and unregulated. High-speed trading, which now accounts for about 65 percent of all stock trades in the United States, is the new source for a range of insider abuses that are clearly wrong but not yet illegal; other countries have created limits, but the financial plutocracy has so far prevented legislative or regulatory action in the United States. Outrageous salaries for finance gurus have not diminished one iota, nor has their overweening sense of entitlement. No institutional checks against structural uncertainty have been put in place. Dodd-Frank never really challenged Wall Street business as usual in the first place, and to the extent it did at all, Wall Street lobbyists make sure those little slip-ups went nowhere. That is why when President Obama claimed in his most recent State of the Union address that his Administration had acted to prevent a repeat of the financial meltdown, an obvious reference to Dodd-Frank, it constituted one of the biggest whoppers ever told from that podium.
Not that I ever put much faith in a prospective Romney Administration to do any better. Governor Romney may not himself be a member of the parasitic financial plutocracy, but he sleeps with it in the person of Goldman Sachs. I don’t know what it will take to reform this sector, except another, even worse collapse and the subsequent summoning of enough political backbone to finally do something about it. That would be painful, but it’s probably the only way.
Past Entries:
Part 1: Introduction, and Globalization/Automation
Part 2: Political/Institutional
Part 3: Corruption/Plutocracy
Part 4: Television and Politics
Notes:
1When I say predictable, I mean it specifically. See, first, Peter Hartcher’s “The Amazing Bubble Man”, which was published in 2005, and then Hartcher’s “The Death of Money.”
2A similar view from an Obama Administration insider is Sheila Bair, Bull By the Horns (Free Press, 2012). Bair was FDIC chair during the early years of the Administration.
3It is not technically correct to say that taxpayers directly paid for the bailout, since the vast majority of that money—$8.5 to $14 trillion, depending on how you count—was newly created by the Fed and not scooped out of existing Treasury resources. But taxpayers have paid and will pay in the future indirectly in several ways, so the common parlance is not entirely wrong.

  • Tom

    You mentioned empaneling a group of genuinely disinterested wise men to look over the finincial system.

    Where are you going to find these unicorns?

    • Adam Garfinkle

      They aren’t unicorns, Tom. I’d start with George Shultz, add Paul Volcker, Simon Johnson, Robert Shiller, Sheila Bair, Jessica Einhorn, Fred Bergsten, Brooksley Born, John Taylor, John Snow perhaps, and a few others. I’d also add a small committee of international advisers, one each I can think of from Britain, Australia, Canada, Israel and Japan (and maybe SIngapore) What all these folks have in common is experience and a track record of being basically right, combined with a profound lack of interest in future government service. Some are Democrats and some are Republicans, and some are independents. If you don’t recognize most of these names, you have some remedial research to do on this subject. Unicorns, indeed…..

  • Anthony

    New challenges recommend something more than a “general theory” and, in addition to wise men, recommend perhaps engaged citizens. So, Part 5: The Financial System implies that we risk severe societal damage by allowing our financial establishment to degenerate into a field of careerists seeking success and affluence; the present American position. As Jeffrey Sachs writes, “our world is not amenable to mechanistic rules.”

  • dan berg

    I would add Gary Gorton and recommend any of his papers or recent e book.

  • Matthew Brotchie

    Adam,
    I want to thank you for these series of posts. I have learned so much from these, now the dysfunction and corruption of our government is less abstract and more tangible. This is the best college course I never had. I would suggest that you, Walter Russell Mead, and Francis Fukuyama do an informal round table podcast on this dysfunction so we can hear were you disagree and agree on he nature of our plutocracy, the cultural shifts Charles Murray wrote about this year, and how dire the consequences might be for our country. I would gladly buy it if you put it up for sale. You might be surprised to how powerful a medium podcasts have become. Thank you again and happy holidays.

  • Elf

    I’m glad you acknowledge the pervasive corruption, however you should consider that these people have thought of that and aren’t likely to empower some panel of old wise men to dismantle their Empire. They’ve also thought of what to do when the music stops. They have the best chairs. You don’t need a panel of old men for..anything. You need a body of honest young men, this panel would be along the lines of the Committee for Public Safety. Please note I am a free market Libertarian. Normally the correct object of public policy is to mediate evil not eradicate it. Normally. In this case nothing less will do.

  • Jim.

    Chris Taylor did a workmanlike job, recently, of saying what went wrong with the Options side of our financial system.

    The problem is, I haven’t yet seen a critique of the Black-Scholes formula that notes that it has a Great Big Gaping Hole in it, which anyone who’s worked in stochastic modeling should be able to spot immediately…

    … it never takes into account that prices are affected by underlying reality: it only measures the “noise” of those measurements.

    According to everything I’ve read about it, it looks like Black-Scholes breaks if a price actually moves in anything other than a random (Gaussian) manner. If there’s a real downward or upward trend, or if there’s an underlying risk trend that historical data doesn’t adequately cover, B-S isn’t going to save your bacon.

    In fact, by giving investors confidence where it’s not warranted, it amplifies the effects of crises when they happen.

    Picture someone who’s invested in Buggy Whip futures, at the beginning of this century. Black-Scholes would tell them they’re adequately hedged against a collapse if they simply look at where prices are versus past volatility.

    Or, to bring things up to the more recent day, run Black-Scholes (or similar model) against a market that with very low-frequency fluctuations, like California real estate. Would Black-Scholes have allowed anyone to adequately hedge against the early 90′s crash? How about the late 00′s crash?

    Would Black-Scholes have saved any oil purchasers hit by the ’73 embargo? How about someone trying to protect themselves against the steady rise in the price of steel and copper during the 00′s Chinese building boom? Nope, not at all.

    Ignoring these realities does not provide any kind of beneficial, providential “Hiding hand”. It’s reckless, willful ignorance, plain and simple.

  • Yisroel Markov

    “It still amazes me that after what happened in the autumn of 2008 (and since) no such commission was impaneled…”

    So what about the Angelides Commission:
    http://en.wikipedia.org/wiki/Financial_Crisis_Inquiry_Commission