Kuttner on the Meltdown
posted by Frank Pasquale
What’s the bottom line from today’s crisis? A lot of people once written off as Cassandras are looking quite prophetic. And the stock of laissez-faire Pollyannas is dropping faster than the Dow.
Robert Kuttner was one of the first public intellectuals to systematically indict the failures of our financial system. He has just posted a brilliant article on The American Prospect explaining “Seven Deadly Sins of Deregulation — and Three Necessary Reforms.” Here’s some basic historical context from his piece:
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.
This process accelerated over the past 15 years or so, as people like Frank Partnoy and Timothy Canova have noted. Enormous campaign contributions from the financial services industry helped assure regulatory lethargy. And now we face an epochal change in our financial landscape:
The world of banking was divided for decades largely into two kinds of businesses. Commercial banks took deposits and made loans, making a decent return under the burden of heavy regulations designed to protect depositors [emphasis added]. Securities firms took no deposits and were lightly regulated, which let them take big risks and rake in big profits – and occasional losses. More recently, some of the biggest institutions, such as Citigroup and UBS AG, combined both businesses.
Now, as many securities firms are falling following ‘financial wizardry’, the balance of power is shifting. ‘There is a recognition that when the dust settles. . . the construct of the industry will be different,’ [one expert said].
The fact that pejorative characterizations like “burden[some]” and “heavy” are used to describe the very framework that saved the commercial banks from the fate of the securities firms shows just how far from reality much contemporary discourse on finance has become. It’s almost like saying “laboring under the heavy burden of vaccination, he avoided typhoid fever.” I’ve come to expect bias from Murdoch’s WSJ, but this is a bit rich.
Ezra Klein suggests one indisputably necessary step to implement in the wake of this disaster:
I’d start with an immediate push to equalize the tax treatment of incomes derived from private investment. It’s an odd quirk of the tax system that simply treating income as income will be judged a punishment, but so be it. These guys have lost any public sympathy they ever had and sacrificed their ability to claim that they’re taking advantage of lenient tax treatment to create value for the rest of us. Close the loophole.
Or, as Peter Wilby puts it:
Many of the super-rich specialise in shifting money around, allegedly so it can be used most productively. This . . . may be described as a service: wealth management for the world. Now the credit crunch has revealed that financiers, to put it mildly, did a less than brilliant job and that large sums ended up in their own pockets. Indeed, the high earnings in the finance industry came mostly from the speculative activity that got us into the present mess. One must wonder how long the world will continue paying for this kind of service.
Here is Kuttner’s bottom line on what to do about the crisis. Combine it with Shiller’s program, and I think we may begin mapping a way out of this nadir.
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.
It’s interesting to compare this to pages 396-402 of Partnoy’s Infectious Greed….and to the worries expressed in John Brenner’s The Boom and the Bubble. Both these books were written years before the current crisis.
UPDATE: Here’s useful perspective from the increasingly indispensable Thomas Friedman:
We are at the end of an era — the end of ‘leave it to the markets’ and of the great cop-out that less government is always better government,” argues David Rothkopf, a former Commerce Department official in the Clinton administration and author of a book about the world’s financial leaders who brought about this crisis: “Superclass: The Global Power Elite and the World They Are Making.”. . .
In sum, government’s job is to police that fine line between the necessary risk-taking that drives an innovation economy and crazy gambling with other people’s savings in ways that threaten us all. We need to make sure that what happens in Vegas stays in Vegas — and doesn’t come to Main Street. We need to get back to investing in our future and not just betting on it.
September 17, 2008 at 8:14 pm
Posted in: Administrative Law, Securities
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Responses (2)
Jack S. - September 18, 2008 at 2:59 am
Perhaps the reform should be rephrased not as “more government” but as “less complicated, but more effective government”.
I’m not expert on banking and finance regulation, but from my experience with FCC and telco regulation, we’d probably be better off by throwing the whole lot out and starting over from scratch. I find that the argument of “it’s too complicated to change it” has most of it’s basis in that the system is so broken that it can’t be fixed by grafting on new regulations.
Bill - September 18, 2008 at 12:14 pm
So this is an indictment of laissez-faire capitalism? Sounds more like an indictment of “crony capitalism” where regulations have become ad hoc based on your ability to buy a piece of centralized power.
The fact of the matter is that the market process is working because failure is part of that process. This failure process is extremely painful now because of the magnitude of the recent bubble. And until someone takes a serious look at monetary policy and the role of the Fed, we will not solve this problem.
Sounds noble, but how are you going to determine which investments are the correct ones?
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