Glass-Steagall

Robert Rubin Is Still Wrong And Joseph Stiglitz Is Still Right

Zach Carter — Wed, 11 Aug 2010 11:46:45 -0400

Robert Rubin and Joseph Stiglitz are going public on jobs and the deficit, in what looks very much like a re-run of a major policy debate during the Clinton era. The dispute is simple—should the government focus on putting people back to work, or should it try to cut the deficit? Stiglitz wants to see more jobs, Rubin wants to shrink the deficit. Policymakers should listen to Stiglitz.

Rubin is the Democratic Party's Alan Greenspan. In the 1990s, he was heralded as a genius for making policy calls that ultimately wrecked the economy. Rubin pushed for deficit reduction instead of a jobs policy in the Clinton years, and was the driving force in the Clinton administration's devastating moves to deregulate Wall Street. For several years, Rubin's policies looked good. Despite the focus on the deficit instead of jobs, the Clinton years saw a huge boom in employment. Wall Street profits were through the roof, and the economy was roaring.

But at the end of Clinton's second term, it was clear that all of these good times had been fueled not by sound economic policy, but by a reckless and unsustainable Wall Street bubble. Banks were backing every dot-com business plan brought their way, and when everybody figured out that Pets.com was not going to be the next Home Depot, things fell apart. The economy slipped into a mild recession, which would have been devastating had policymakers not inflated a housing bubble to "rescue" the economy from the dot-com fallout.

Rubin was Clinton's Treasury Secretary, while Stiglitz served as Chair of Clinton's Council of Economic Advisors. Stiglitz fought all of Rubin's wrong-headed policies, but ultimately lost. Stiglitz was able to fend off some of the most outrageous financial deregulation, but when he left office, Rubin pounced and pushed through the repeal of Glass-Steagall, a Depression-era law that prevented banks from gambling in the capital markets casinos with taxpayer money. Facilitating that banking excess was a key cause of the 2008 financial collapse, and it was Robert Rubin's brainchild.

So why should anybody take Robert Rubin's advice on economic policy? On virtually every important decision during the Clinton years, Rubin got it wrong, and getting it wrong put the global economy on a path to destruction.

Well, here we go again, only this time, conditions are worse. Instead of unemployment hovering around 8 percent, it's near 10 percent, and nobody sees any sign of it abating significantly over the next year. Once again, instead of promoting a jobs agenda, Rubin wants to focus on the deficit. It's an instinct shared by most of Rubin's Wall Street colleagues (Rubin is a former co-Chairman of Goldman Sachs, and served on Citigroup's board in the years leading up to Citi's monstrous bailout). The same banker buddies who wrecked the economy and forced the government to spend trillions rescuing the banking sector.

By contrast, the deficit looks pretty good. Deficits are only an immediate problem when investors are worried about default or inflation, and demand a very high interest rate to compensate them for this risk. So if the deficit were a big deal right now, we'd see high interest rates on U.S. Treasury bonds. But we don't see that at all. Yesterday, the rate on the 10-year bond fell to 2.77 percent. During George H.W. Bush's presidency, the rate routinely eclipsed 9 percent.

But mainstream news anchors are giving Rubin a platform to spew Wall Street buzzwords in order to gin up support for a deficit reduction program. Fareed Zakaria interviewed Rubin on his CNN show this weekend, where Rubin had this to say:

I wouldn't do a major second stimulus because I think...we run a risk that it could be counterproductive in creating a lot of additional uncertainty and undermining confidence.

"Confidence" here means "investor confidence in the ability of the United States to pay off its debts." This is empty spin language. Investor confidence is measured by interest rates. Investors are currently signaling that they have more confidence in the United States' fiscal rectitude than they have had in decades. Borrowing money for new stimulus would not be punished by the market, and the cost of borrowing that money is at its lowest to the Treasury in decades.

If we don't spend money to create jobs, the private sector isn't going to be able to take care of it on its own. Businesses aren't hiring because there is no demand for their products. Put another way, since everybody is broke and out of a job, nobody can afford to buy things, which means businesses have no customers. Without any customers, businesses have no reason to hire people.

So in the near-term, jobs and deficit reduction are in direct conflict. If you go after the deficit, you are going to hammer the unemployment rate. What's more, recent efforts by countries to cut their deficits by reducing spending have actually been counterproductive. Ireland slashed social programs, only to see its deficit increase, because the spending cuts hurt economic growth so much that the government's tax revenues declined dramatically.

Rubin wants to implement a deficit reduction plan now that would take effect in two years. Long-term deficit reduction isn't a terrible idea, economically. The biggest threat to U.S. fiscal stability over the next several decades is the increasing cost of health care, which drives up Medicare expenses. While it's not an immediate necessity, a program designed to bring down the cost of health care over the next couple of decades would in fact be a good idea (Contrary to Republican attacks, President Barack Obama's health care bill actually does cut health care costs and will reduce the deficit over the long-term. Nevertheless, more could be done.).

The trouble is, there is very little evidence right now that the economy is going to be okay in two years, and Medicare isn't going to bankrupt the government in two years. Cutting spending while the economy is still weak means hurting jobs and slowing growth. Even the Federal Reserve is clearly worried about the prospect of a double-dip recession, which is why it embarked on a new program yesterday to lower interest rates further in order to make borrowing money cheaper for American citizens and businesses.

Stiglitz sees things differently. If we want a healthy economy, we have to have financially healthy households. That means getting people back to work, and it means spending serious money to create those jobs. He was right in the 1990s. He's right today.

Wall Street Reform: Five Key Fights After The Bill Is Signed

Zach Carter — Wed, 21 Jul 2010 10:05:46 -0400

Today, President Barack Obama will sign into law the first serious effort to regulate Wall Street in decades. The bill has much to be said for it, but the unfortunate truth is that it ducks several of the most critical reforms needed to protect our economy from banker abuse. As regulators work to implement the legislation, reformers must turn up the heat on Congress to adopt further reforms, and recognize political opportunities to further economic progress.

Five policy fights stand out as particularly pressing. Many of these policies can be implemented this year, while others will probably have to wait until the next Congress. All of them are critical to ensuring that our financial sector works to support a healthy economy, instead of a reckless bonus machine.

1. Break Up The Banks

Not long ago, breaking up the banks was viewed as an impossible pipe dream, but when the Senate finally weighed in on the matter in May, a surprisingly high number of Senators supported it, with even a handful of Republicans voting to bust 'em up (five other Republicans abstained, afraid of voter backlash from a vote for Wall Street excess). The plan ultimately failed, of course, so what has changed since May? Fannie Mae and Freddie Mac.

Congress will have to decide the fate of the two mortgage giants sometime in the relatively near future. There are plenty of problems with Fannie and Freddie, but the overriding disaster was caused by the firms' quest for private profits with an implicit government guarantee. For years, investors allowed Fannie and Freddie executives to make reckless bets, expecting that taxpayers would pick up the tab if the firms got into trouble. That situation meant huge profits for Fannie and Freddie until the companies totally blew up, at which point taxpayers did indeed eat the losses (this had nothing to do with affordable housing efforts—Fannie and Freddie were mimicking their Wall Street competitors by purchasing loads of lousy mortgage-backed securities issued by Wall Street banks). That's the exact problem posed by megabanks Goldman Sachs, Citigroup, Morgan Stanley, Bank of America, J.P. Morgan Chase and Wells Fargo. When Congress begins debating the future of Fannie and Freddie, no solution will be complete without dealing with the same too-big-to-fail problem posed by the megabanks.

2. Tax Wall Street Gambling

The financial crash of 2008 was a direct result of wild and unrestrained speculation on Wall Street—raw gambling that creates big risks while doing nothing to boost the broader economy. There's no law of economics that says this kind of activity needs to take place, and taxpayers can make serious money by reining it in. In London, financiers are subject to a tiny tax on their securities and derivatives trades. The tax is small enough that it doesn't discourage serious long-term investment in productive businesses, but significant enough to make traders think twice about buying huge volumes of securities only to dump them a few minutes or hours later.

This tax—known as a financial transactions tax or a tax on Wall Street gambling—is a double-win for economic stability. It limits destructive speculation, while raising revenue for the government. How much? According to the Center for Economic Policy and Research, a tax on trading would reap somewhere between $177 billion and $354 billion a year. If right-wingers want to make a fuss about the budget deficit this year, make them put their money where their mouth is and adopt a financial transactions tax.

A transactions tax is also one of the most effective ways to rein in outrageous Wall Street bonuses. If banks can't score huge profits from gambling, they can't pay out bonuses based on those profits.

3. End The Foreclosure Nightmare

The foreclosure crisis has been deepening unabated since 2006. That is a public policy obscenity: politicians rushed to rescue bankers who pushed predatory garbage loans on the public, while leaving troubled homeowners to fend for themselves.

Foreclosures are being fueled by gimmick accounting schemes that are artificially boosting bank profits—and bonuses. Home prices are down dramatically from their bubble-peak levels, and they aren't coming back—it was a bubble, after all. That means that millions of borrowers owe more on their mortgages than their homes are worth. When they have trouble making payments, they can't sell their house and find a more affordable place—foreclosure is the only option.

But borrowers are only up against the wall because banks are refusing to reduce their debt burdens to reasonable levels. If banks cut the amount that borrowers owed on their mortgages to whatever the house is actually worth, then borrowers could afford to keep their homes, and bank accounting would reflect their actual financial condition. Instead, banks are refusing to negotiate with borrowers and booking bogus accounting profits on loans that are never going to be repaid.

There are several ways to make banks play fair. Right now mortgages cannot be renegotiated in bankruptcy—unlike every other kind of consumer debt. Congress could change that. Lawmakers could also adopt a right-to-rent policy, requiring banks to let foreclosed borrowers rent their homes for several years at a fair market rate. Since banks don't want to be landlords, this policy would give borrowers some negotiating leverage. Other options don't require Congressional action at all—the administration could simply urge bank regulators to exercise more vigilant oversight of mortgage accounting practices. The government could also exercise its powers of imminent domain to buy up mortgages at a discount, requiring banks to take losses, and then cut borrowers a break.

4. Prosecute Fraud

The Big Crash of 2008 was fueled by absolutely staggering levels of fraud at multiple levels of the financial system. The FBI warned of an "epidemic" in mortgage fraud starting in 2004, and bankers ran wild with these disastrous loans in every way they could think of. They invented new devices to hide debt from investors, mislead their investors on exposure to toxic mortgages, and concocted abusive derivatives to screw over their own clients. According to the United Nations, banks went so far as to help launder hundreds of billions of dollars in drug money in order to get their hands on quick cash when markets froze up.

More than 1,100 bankers went to jail in the aftermath of the savings and loan crisis, but we've seen almost no serious action this cycle to ensure that financial fraud does not go unpunished. We need strong action against both individuals who commit fraud and the companies that tolerate it. Without prosecutions and indictments, the outrageous behavior of the past decade will be repeated, and soon.

5. Stop Subsidizing Risky Business

The bill Obama signs today includes two critical measures to rein in big banks—an end to taxpayer subsidies for derivatives dealing, and a ban on risky proprietary trading. The trouble is, both measures were punched through with tremendous loopholes at the last minute, rendering them extremely weak.

Commercial banks perform some of the most critical functions in the economy, accepting consumer deposits and extending loans that keep society moving. Banks receive key taxpayer perks designed to ensure that those activities are safe and productive: cheap loans from the Federal Reserve and deposit insurance from the FDIC. But after Congress ripped away the Glass-Steagall Act in 1999, banks started engaging in all kinds of other businesses that weren't essential to the core financial functions of accepting deposits and making loans. Since these banks still had access to taxpayer perks, citizens were actively subsidizing these riskier businesses. When Congress deregulated the derivatives market in 2000, things got even worse. Five big banks now hold over $300 trillion in derivatives—trillion with a 't'—just waiting for an AIG-style blow-up. When big banks succumb to those risks, those essential loan-and-deposit activities break down, and the result is an economic disaster.

If hedge funds want to speculate, fine (though they should be subjected to a financial transactions tax), but economically essential banks shouldn't be subsidized for injecting enormous risks into the economy. If banks want to hedge risks with derivatives, that's fine too, but they shouldn't be getting subsidies for dealing derivatives to other firms and amplifying speculative activity in the financial system.

Scaling Back Our Bloated Financial Sector

Zach Carter — Wed, 26 May 2010 16:38:31 -0400

It's been apparent for several weeks that the Wall Street reform bill will not cut down the largest U.S. banking behemoths to a safe and manageable size. But individual oversized banks are not the only problem Big Finance poses to the economy—the overall sector is much too large, and if we do not shrink it, we'll be dealing with difficult economic conditions for years to come.

Right before the banking system crashed, the financial sector accounted for an astonishing 40 percent of corporate profits. That share of the economy plunged as banks sought their bailouts, but by the end of 2009, finance was back, again accounting for almost 36 percent of corporate profits.

When the financial industry takes up that much of the economy, it becomes a big problem for two reasons. First, instead of serving as a catalyst for broader economic growth, finance is simply devouring other sectors of the economy. Like money, finance is not a goal in and of itself—it's just a way to support goods and services that make life better. At 40 percent of profits, finance is not supporting that activity, it's destroying it.

Second, for finance to take up 35 to 40 percent of the total profit pie, it has to be engaging in a lot of raw speculative gambling, rather than economically productive lending. That creates a tower of speculation that can easily topple with a single event—and the resulting mess can be very hard to clean up. As Nomi Prins has detailed, between 2002 and 2008, only about $1.4 trillion in subprime mortgages were issued, while about $14 trillion in securitized bets were derived from these mortgages. When the subprime market cratered, all that speculation made a big problem much bigger.

So in addition to cutting the biggest banks down to size, we also need to scale back the entire financial sector. There are a handful of provisions in Wall Street reform packages approved by the House and Senate that would help accomplish that goal. Unfortunately, the bank lobby, and in some cases, the Obama administration itself, is fighting those provisions. Here they are:

1. Capital and Leverage

Banks amplify their bets in the capital markets by using leverage—borrowing a lot of money. If you buy $10 million worth of stock, and it goes up 10 percent, you make a ten percent return-- $1 million. But if you borrow $490 million, put up $10 million of your own money, and put all of it into the same stock, a 10% gain in the stock price scores you $50 million—a 500% return (it would actually be a little less, as you'd have to pay interest on that $490 million loan, but you get the idea). But if the stock drops just 2 percent, you lose all of your own money, and find yourself $490 million in debt. You are ruined.

Rep. Jackie Speier, D-Calif., managed to squeeze an amendment capping bank leverage at 15-to-1 into the House reform bill, meaning that banks could not borrow more than $15 for ever $1 they put up. That's good-- less leverage means less overall financial activity. Sen. Susan Collins, R-Maine, managed to get a weaker, but related provision into the Senate bill, which would force megabanks to reduce their leverage.

Unfortunately, the Treasury Department and the Federal Reserve are fighting both amendments. Even worse, as Mike Konczal notes, the Treasury is also fighting hard against international agreements to limit bank leverage.

2. Derivatives spin-offs

Five big banks control over 96% of the derivatives market, which totals literally hundreds of trillions of dollars. One of the reasons this market is so big is that banks fund these operations with deposits. Since the government guarantees bank deposits against losses, this funding is cheaper than anything else the bank can get outside of the Federal Reserve, which also lends to all five of those banks. Sen. Blanche Lincoln, D-Ark., pushed a provision through the Senate which would bar any commercial bank that deals derivatives from receiving Fed loans. In practice, this would force the banks to move their derivatives dealing operations into a separately capitalized subsidiary.

The banks, Treasury and the Fed are all fighting this provision tooth-and-nail because it would significantly alter the way the derivatives business is funded. Instead of being able to rely on cheap government money, banks would have to finance their derivatives operations in the more expensive capital markets. When something gets more expensive, people do it less, so the Lincoln plan (authored by Sen. Maria Cantwell, D-Wash.) would trim back the derivatives casino.

3. Consumer Financial Protection Agency

One way banks eat up the broader economy is by simply stealing from consumers. Just about everyone has had a bad experience with a credit card, mortgage or overdraft rip-off. These are, first and foremost, bad for our pocketbooks. But what is bad for our pocketbooks is bad for other businesses—it means we have less to spend on goods and services. So by screwing consumers, banks are really sticking it to the broader economy.

The existing bank regulators at the Federal Reserve and the Office of the Comptroller of the Currency simply have not enforced consumer protection rules over the past decade. Their primary goal is ensuring bank profitability, so if banks profit from consumer abuses, they don't really care. We can end this system of abuse by establishing a strong, independent Consumer Financial Protection Agency (CFPA) tasked only with looking out for consumers. The House language on the CFPA gives the agency more independence and broader authority to both write and enforce regulations than the Senate version, but it also exempts abusive auto dealers from the agency's jurisdiction, which the Senate version does not do.

So what else in the bill will cut back on our oversized finance system? Not much. There is a very weak version of the Volcker Rule, which bans banks from gambling with taxpayer money, but it will take years to implement and can easily be gutted by regulators. That leaves a handful of key provisions that should be focus of the reform fight next year:

1. A financial transactions tax.

Many of our current economic woes are tied to excess speculation in finance. By imposing a tiny tax on trades of stocks, bonds and derivatives, the government can discourage rank speculation while bringing in a lot of revenue for the federal coffers. A tax of just a few tenths of one percent will not seriously effect long-term investors. But for speculators who place big bets on the movement of stocks over the course of an hour, or for flash traders who buy and sell millions of shares in less than a second, this kind of tax actually would matter. Based on trading volumes from 1997, which are vastly lower than today's trading volumes, economist Dean Baker estimates that this tax could bring in $100 million a year in tax revenues, even if the overall trading volume fell by 25 percent.

2. Glass-Steagall

Banks don't just use taxpayer-guaranteed deposits to back their derivatives bets, they also fund all kinds of risky securities businesses with deposits. In the 1930s, Congress passed the Glass-Steagall Act, which barred banks that accept deposits and make loans from operating in the securities markets. By separating taxpayer guarantees from risky activity, the move made that risky activity less profitable, and by extension, less profuse.

3. Regulate Hedge Funds and Private Equity

The current bill doesn't really do anything to rein in these shadowy entities. They'll now have to register with the SEC . . . just like Bernie Madoff.

In Defense Of The Volcker Rule

Zach Carter — Tue, 18 May 2010 09:39:07 -0400

Some version of Wall Street reform is going to pass the Senate this week. The question now is how strong that reform will be. There are still three crucial battles to be waged, all of which would significantly change the way Wall Street does business. We will not fix Wall Street with this round of legislation, but we can reduce taxpayer exposure to bailouts and rein in consumer banking abuses. I'll address the Volcker Rule in this post, and tackle consumer protection and derivatives issues later this week.

One of the most important battles in the next few days will be over the Merkley-Levin amendment, which would require regulators to implement some version of the Volcker Rule. The Volcker Rule would ban economically essential commercial banks from engaging in reckless proprietary trading. "Prop trading," as it is known on Wall Street, allows banks to gamble with taxpayer funds by making speculative trades in the securities markets with taxpayer-guaranteed deposits. It's economically inefficient, it establishes grotesque conflicts of interest between bankers and their clients, and creates big bailout bills when the bets backfire. We want commercial banks to be doing important economic work like making loans. We do not want them to be taking on totally unnecessary risks in the pursuit of short-term profit, and prompting epic bailouts when that risk backfires.

The existing Senate language crafted by Sen. Chris Dodd, D-Conn., is not strong enough to end the excesses inherent in prop trading. Dodd would require regulators to conduct a study of whether prop trading by commercial banks endangers the economy, and then allow—but not require—them to write regulations to fix any problems.

Merkley-Levin, by contrast, would force regulators to ban prop trading by commercial banks, and establish a set of criteria that future regulators could not legally evade. While regulators would have some leeway in defining key aspects of the rule, they would have much less authority to impose weak rules than they have under Dodd's language. Merkley-Levin is a significant step in the direction of economic progress, but it has sparked some recent debate in the financial blogosphere, earning the ire of the Economics of Contempt (EoC) blog, which in turn has lead economist and blogger Mark Thoma to question the ultimate usefulness of the amendment.

EoC is wrong. Merkley-Levin is a very significant piece of legislation, which is why the GOP is threatening to filibuster it. EoC alleges that there are three fatal loopholes to Merkley-Levin. To my mind, none of them are important, and one is just flat wrong. I'll address them in order of simplicity.

First, EoC claims that Merkley-Levin would allow banks to simply move all of their prop trading offshore, citing legislative language that would permit:

(G) Proprietary trading conducted by a company pursuant to paragraph (9) or (13) of section 4(c), provided that the trading occurs solely outside of the United States and that the company is not directly or indirectly controlled by a United States person.

EoC has misread the provision. The second half of this sentence explicitly prohibits banks from moving their prop trading offshore. The key language is "not directly or indirectly controlled" by a U.S. bank. If Citigroup opens a London subsidiary to do its prop trading, that will be illegal, because Citigroup, a U.S. company, controls the subsidiary.

On to the next alleged loophole. EoC claims:

Merkley-Levin actually weakens the Volcker Rule by creating a whole bunch of new categories of exceptions to the prop trading ban . . . (1) trades 'in connection with underwriting'; (2) market-making trades; and (3) trades 'in facilitation of customer relationships.' Regulators still have to use the rulemaking process to define 'market-making,' which will no doubt encompass any trade which can be justified as a hedge against any risk the bank faces in its trading book.

First, it is simply not the case that this language actively weakens the Volcker Rule. While some key definitions are left for regulators to work out on their own, this is still better than the existing Dodd approach, which amounts to: "Please regulators, conduct a study." Dodd opposed the Volcker Rule from the get-go, and that's why his language is exceptionally weak. EoC's alternative to the Merkley-Levin language simply doesn't make sense—he says regulators—the people he doesn't trust to flesh out Merkley-Levin—should have broad leeway to write their own rules:

People often ask why I say that complicated financial regulations can't be written at the statutory level. The reason, sorry to say — which Merkley-Levin demonstrates quite well — is that Congress sucks at writing complicated financial regulations.

Here's the problem: If regulators are hellbent on interpreting Merkley-Levin in a way that would gut the substance of the reform, then they certainly aren't going to get tough on prop trading with the much broader Dodd language, which just lets regulators do whatever they want.

On to the third alleged loophole. The legislation allows for, "Risk-mitigating hedging activities designed to reduce risks to the banking entity or nonbank financial company." EoC says this gives banks broad leeway to claim that proprietary trades are really legitimate hedges against risks in other aspects of the bank's business—even when that business is in another subsidiary of the bank.

This is much ado about nothing. If regulators really want to say that a prop trade is a useful hedge, this so-called loophole won't make it any easier to stop them than the Dodd language would. In other words, if regulators do not want to enforce the law, no legislative language is going to stop them (see Alan Greenspan, mortgage fraud).

The closest we can come to protecting the financial system against bad regulators is to follow the advice of Nouriel Roubini and others, who argue that Congress should ban economically essential commercial banks from engaging in any securities underwriting, market-making or derivatives dealing activities whatsoever. Commercial banks were barred from these businesses when the Glass-Steagall Act was in effect from the 1930s into the 1990s, and throughout that era, banking was a perfectly profitable and competitive business that did not require massive and costly bailouts.

Ultimately, we should reinstate Glass-Steagall. But that doesn't mean that Merkley-Levin should be rejected. At this point, it is clear that Glass-Steagall is not going to be seriously considered during this legislative cycle, and the Volcker Rule would still empower good regulators to go after one of the most dangerous forms of financial recklessness. If Congress approves Merkley-Levin, the Volcker Rule would immediately become law. Without the amendment, we'll have to wait for a study, and wait for the heads of various regulatory agencies to agree on whether proprietary trading is even dangerous, a process that has been designed to prevent the Volcker Rule from ever being finalized. Nothing can completely immunize the financial system against bad regulators. But Merkley-Levin does about the best job possible to make the Volcker Rule a regulatory reality.

Next up: Blanche Lincoln's derivatives bill.