Attack the Disease, Not the Symptoms
Wednesday, 01/13/2010 - 10:00 am by Marshall Auerback | 8 Comments
Obama still doesn’t get it on how to rein in Wall Street.
Conceptual confusion remains at the heart of President Obama’s economic policy. The latest example of this is the decision to try recoup for taxpayers as much as $120 billion of the money spent to bail out the financial system, most likely through a tax on large banks, according to the NY Times.
For once, the American Bankers Association has a point when it argues that imposing yet another fee on the industry would obviously decrease its ability to lend. The new fees will effectively function as a tax, raising the banks’ cost of capital, which invariably will mean a demand for a correspondingly higher return on capital from the borrower to facilitate a loan.
It may well be just to have a punitive “polluter pays” principle, but that’s not the rationale provided by the Obama Administration, which seems determined to do everything possible to avoid offending the banks. Rather, the new levy appears to be aimed at addressing rising anger over bonuses.
Yet again, then, we are addressing symptoms, not underlying causes. The American public justifiably finds the bankers’ bonuses to be offensive. But the real problem is the overall structure of banking itself, and it is this which needs to be fixed. However pleasing the political optics, new bank levies won’t achieve the goal of eliminating systemically dangerous banking practices and could well make things worse for borrowers.
For the most part, the proposed new fees proposed by Obama’s economic team work at cross purposes with overall policy. All they do is raise the common cost of funds for banks, which effectively is passed on to the consumer, whilst current Federal Reserve policy has been to lower rates.
Higher borrowing costs are not exactly what the American economy needs right now, particularly in light of the most recent unemployment data from December, which points renewed deterioration in the job market (there were 661,000 people who gave up looking for work; add them back in, and mark them as unemployed, and the unemployment rate goes up to 10.4%).
Additionally, there is more misconceived deficit terrorism. The fees are supposed to help “finance” the budget deficit, but the new levies on the banks do not “fund” anything, Collecting taxes or fees in no way increases the government’s ‘hoard of funds’ available for spending. By the same token, when the Federal Government spends, the funds spent don’t ‘come from’ anywhere, any more than the points on a scoreboard ‘come from’ somewhere at the football stadium or the bowling alley.
And Obama’s policy is reactive: it comes in response to banking activities which have gone horribly wrong (and the concomitant populist anger that the subsequent bailout packages have engendered), rather than addressing the fundamental reason for the bailouts - namely, the reckless actions of the bankers themselves - activities which will not be banned under the newly proposed financial reform packages being legislated by the House and the Senate.
As we’ve said before, banks are public/private partnerships. In reality the only useful thing a bank should do is to facilitate a payments system and provide loans to credit-worthy customers. In the words of “Winterspeak”:
For banking to do the job it is meant to do (i.e. make loans that will be paid back), a bank should be required to keep all loans it makes on its books until maturity. It should be forbidden to participate in any secondary markets, in any way. It should not run a prop trading desk. It should not sell insurance. It should not have a fee-for-service business. It should simply conduct its own credit analysis, make loans, and service them. And in return for providing this public purpose, a bank shall have a reserve account at the Fed.
A simplistic restoration of Glass-Steagall (whereby investment and commercial banking activities are completely separated) neither eliminates the problem of Wall Street firms that are “too big to fail”, nor does it address the underlying practices which created systemic risk in the first place, largely because securitization has blurred the distinction between commercial and investment banking. The demise of Bear Stearns and Lehman Brothers shows that unsustainable bank-funded asset price booms can and do occur even among smaller banks, or even non-bank financial entities such as GMAC.
“Too big to fail” is a nice slogan. However, the proper way to legislate real financial reform is to establish markets that are liquid and deep. This means relying on a large number of smaller institutions carrying on traditional banking activities, rather than having these activities concentrated in the hands of limited number of highly capitalized global institutions. The former creates vibrant competition and a more stable banking system with less systemic risk, whilst the latter is anti-competitive and even more prone to systemic risk, given the large concentration of deposits in the hands of a minimal number of banks today, along with their insistence to perpetuate highly destabilizing activities contrary to public purpose.
“Too much concentration of function to fail” is more of a mouthful, but it gets to the nub of the problem. Far better to prevent the activity which has necessitated the bailouts, instead of conjuring up more faux populist measures which do nothing but attack the symptoms of the problem. Though U.S. authorities often like to pretend that their hands are tied by other regulators, in fact the U.S. holds a trump card in this situation: It can ban the banks of any country that does not seriously regulate its banks along the lines proposed above from doing business here.
Unfortunately, these distinctions are clearly lost on the Obama Administration, whose main concern these days is to placate the angry peasants, rather than curb Wall Street’s anti-social and highly destructive behavior. If adopted, the latest measures will achieve nothing. Perhaps the FCIC hearings will not only serve to educate the public of what went wrong, but also guide the President’s economic team toward a more sustainable banking model. But don’t hold your breath waiting for it.
Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.
Another change I’d like to see is the re-privatization of the investment banking function. When investment banks were partnerships the partners’ own wealth was at risk. As public firms executives have transferred this risk onto others making themselves immune from the downside but big winners on the upside.
I don’t know exactly how we can return to this model. Certainly we can’t do it by legislative fiat. However, maybe there is some way we could structure the tax system so that it would be in the interest of these executives to be some sort of private partnership rather than a public company. Perhaps not taxing partnership earnings that are re-invested in the firm? I don’t know but I’d certainly like to see some discussion on this among the commentators/observers that I read on the internet and see/hear on tv/radio. So far I haven’t heard anyone address this.
Posted by Victoria Posner | January 13th, 2010 at 10:16 am
“The demise of Bear Stearns… shows that unsustainable bank-funded asset price booms can and do occur even among smaller banks… ‘Too big to fail’ is a nice slogan. However, the proper way to legislate real financial reform is to establish markets that are liquid and deep. This means relying on a large number of smaller institutions carrying on traditional banking activities, rather than having these activities concentrated in the hands of limited number of highly capitalized global institutions.”
I don’t think I understand. If small banks can contribute to the price booms in question, why do we can to ‘rely on a large number smaller institutions’? Shouldn’t we -both- do some trustbusting and curtailing of dangerous financial activity?
Posted by James Call | January 13th, 2010 at 10:30 am
Aaargh, typos… in the above I meant, “why do want,” not “why do we can”.
Posted by James Call | January 13th, 2010 at 10:30 am
First, contrary to the author, the industry already has the ability to lend. It just isn’t either because it has better opportunities to invest its hords of accumulated funds and/or because the government has fostered too much ambiguity in future banking regulation. Do the banking reform already and let the banks play within those rules.
Second, a couple questions:
–Why can’t we reinstitute investment banking by legislative fiat?
–Why can’t we reinstitute a form of Glass-Steagall again?
–Why should a bank’s ‘facilitator’ banking operations be able to be milked by its ‘casino’ operations?
–Why does corporate governance work so badly as to allow senior executives’ compensation to pillage a company and its shareholders?
Posted by ric wolf | January 13th, 2010 at 10:42 am
I think that a return to Glass-Steagall will ultimately be the only thing that can be done. Also a regulator that actually acts like a regulator. The Fed failed egregiously in regulating the banks. Though I think that the requirement that the Fed also try and stabilise the economy does not help. Germany had a very successful central bank because its sole target was inflation. When it tried to keep the economy buoyed after the dot.com bubble collapse it lowered interest rates too much. Fearing a collapse in the real economy. If they had kept rates higher property prices would not have had a boost from so much cheap money.
The biggest factor of all is that all over the world governments have caved into hedge funds and lowered capital gains taxes. So much so that most people made more from asset bubbles than they did working. Raising capital gains taxes would eliminate the needs to raise other taxes and also reduce the returns from such speculation in future. The bonus is that it would help plug the gaps in many governments books.
Tinkering with leverage rules and breaking up universal banks will complete obliterate the need for a levy on banks which will inevitably be passed on to customers. If the banks are smaller it will be much harder to pay billion dollar bonuses.
Posted by David Lazarus | January 13th, 2010 at 11:52 am
Nic
The industry always has the ability to end, but chooses not to if they can’t find creditworthy borrowers. This goes back to a point I made earlier which is that the focus should be on enhancing aggregate demand and incomes, which in turn facilitates a borrower’s ability to service his/her debts. The imposition of a new fee ultimately increases the cost of capital, which creates a higher threshold for the borrower. It’s not productive policy.
You could reintroduce Glass-Steagall, but as I said, it doesn’t solve the problem, given the blurring of investment banking and commercial banking activities.
James, my point is that you’ve had almost 150 smaller banks fail, get taken over by the FDIC, expunged of bad assets, and new management installed. Has the world collapsed when the FDIC undertook these “Friday Night Specials”? No, because they were small enough that a bankruptcy of one small institution was not going to create a huge systemic risk. If you have lots of smaller banks performing similar roles, not only do you have more competition, but if one falls by the wayside, then it is not as disruptive. By contrast, what do you think happens to the global economy if a JP Morgan or Citi were to fail? JP Morgan virtually monopolises the credit default swap market, and you want to minimise that concentration of function (actually, you want to abolish it, but that’s a separate issue).
Victoria, I like your idea.
I also think there is a compelling need to take the profit out of going broke if institutions are going to be rescued. That is, one might decide to rescue banks for the sake of protecting national income, but no bankers should ever be rescued. This is a key point that many apologists for banks like to confuse. In the New Deal, Jesse Jones, Chair of the Reconstruction Finance Corporation, required letters of resignation from the top three bankers of any institution receiving aid. These were not always accepted, but their mere existence was a potent deterrent to repeat behavior. A contemporary regime along these lines would reach considerably further down into the financial institution’s hierarchy, modify contracts so that even promised bonuses could not be paid, and make heavy use of clawbacks. A vital aspect of all such regimes has to be legislation that makes it impossible to pay off credit default swaps merely because the government assumed control of a firm, which should not be read as an endorsement of credit default swaps, an abomination, if ever there was one.
Posted by Marshall Auerback | January 13th, 2010 at 12:00 pm
That’s what I thought; thanks for the clarification.
Posted by James Call | January 13th, 2010 at 2:15 pm
I have heard that the difinition of insanity is to repeat doing something after the same negative results are obtained. It seems like this has continued to ocurr in our economy in the last 75 years.
I have been sending the enclosed article to many people and have been receiving favorable feed back from them. I would like to receive as much feed back as I can from you.
Solving The Unemployment and Foreclosure Crisis
The US economy has a major unemployment and foreclosure crisis. Millions of people are in the process of losing their homes or are going to be losing a home in the future.
The foreclosure prevention programs the government has created are very expensive and have failed miserable. With 75 billion dollars allotted only 26 thousand homes mortgages have been permanently modified. Unemployment is at 10% and may be rising. Something different must be tried. What the government is doing is not working!
I want to discuss with you, a different approach to economic recovery. Normal capital markets cannot solve this economic crisis because collateral values have decreased so much and so many homes have underwater mortgages. It cannot be provided by the capitalist entity because it is still healing and will experience a relapse if interest rates continue to rise.
To solve the unemployment and foreclosure crisis and stabilize mortgage interest rates, we must start by doing two things.
First, we need to create a mortgage with terms that fit the current economic conditions; It must reduce foreclosures and improve employment by increasing total economic demand in the economy.
The new mortgage I am proposing would improve the economy and the financial condition of Fannie Mae, Freddie Mac and the banks. I call it the 30 yr. 2010 STABILITY MORTGAGE. It would have a starting interest rate of 3% and increase 1/4% a year. (3% is currently more than 300% above the inflation/deflation rate. Mortgage rates have been historically 100% above the inflation rate. The current mortgage interest rate is over 500% above the inflation rate). The interest rate would cap out at 5%. The borrower would have to qualify at the 5% interest rate. Mortgages that are underwater would have their unpaid balance reduced by an amount equal to 20 to 30% of their monthly payment amount each month for 10yrs or until the mortgage equals the current possible sale price of the home. (Reducing the mortgage monthly by a small amount would be less of a loss than by reducing the mortgage by foreclosure or a short sale. It would also be better for the banks, investors and the homeowner.) If FNM, FRE and the Fed said they would buy a mortgage with a 3% starting rate, the banks would offer it to the public. Temporarily, if necessary the US Treasury would buy the GSEs bonds. (Treasury would receive the money back when the Fed bought the MBSs from the GSEs) The banks would earn the fees for arranging and servicing the home mortgage. FNM&FRE would have less loses from foreclosures. They would be collecting interest on a larger mortgage than if they foreclosed or short sold the home. The securities the Fed currently holds would go up in value and should be sold to investors to reduce the Fed’s balance sheet. The Fed would buy the new mortgage backed securities and sell them to investors, after home prices stabilized and the mortgage interest rate, on the new mortgage, had risen above the 10yr T-Bill rate.
The new Mortgage would stabilize home prices and eliminate the foreclosure inventory. After the foreclosure inventory is eliminated homes should appreciate slowly when the Zero Inflation Taxation Policy in enacted.
Enacting the ZERO INFLATION TAXATION POLICY is the second thing we should do. This policy will help prevent another economic crisis similar to the one that we are currently experiencing.
In the last decade we have had the dot com bubble. The real estate bubble, the commodities bubble (corn and oil) and almost the leveraged buy out bubble. The Fed was not able to do anything about these bubbles with the tools they have, without disrupting the US and world economies, as they did in the early 1980s by raising interest rates to 17%.
The excessive use of credit in business, investment and consumption got us into this economic crisis. Our income tax system encourages credit use and investing with credit. This is fine as long as the economy needs more credit use but when the economy is showing signs of excessive credit use, such as economic bubbles and inflation, credit encouragement should be curtailed and money investments (savings and bond investments) should be encouraged to maintain balance in our economy.
If we first use the income tax to guide investors and consumers before the Fed raises interest rates this will maintain the lowest possible interest rates and maintain the value of existing bonds and securities. Enact the Zero Inflation Taxation Policy
Conclusion: Foreclosures should decrease if the mortgage reduction plan is put into effect and the mortgage starting interest rate is reduced to 3%. The homeowner purchasing power will increase by 50% of their monthly interest payment if their current mortgage interest rate is 6% or more the first year and then slowly decrease the following seven years. With increased consumer purchasing power, total demand would increase, there by employment would increase. The banks would become stronger because their customers would become financially stronger and the collateral for small business loans would be stabilized. For more information go to: http://www.economysflaw.wordpress.com/
Sincerely
Leonard C. Tekaat
economysflaw@yahoo.com
http://www.economysflaw.wordpress.com/ Read Alternative Economic Stimulus Plan and other economic papers.
Jan 8, 2010
Leonard C. Tekaat is a retired economic analyst, economic scholar, businessman, financier, investor, author and former candidate for California Congress. I have over forty years in the financial world.
Posted by Leonard C. Tekaat | January 13th, 2010 at 2:20 pm