Archive for September, 2008

Right war, wrong battle

Wednesday, September 24th, 2008

The problem with the Bush/Paulson bailout plan is not—I repeat, NOT—the paychecks that financial corporation CEOs receive. Ezra Klein noted this yesterday as well. (With follow up today.) The NYT is now reporting that “Paulson Gives Way on CEO Pay.

Sure, it’d be frosting on the cake to have rescued corporations impose caps on their CEO’s salaries. But in the big picture? Big whoop.

  • It will not in any way affect whether tax payers are left holding the bag.
  • They will find a way around it and end up richer than you and me and everyone who reads put together. You know that, I know that, Congress knows that, Paulson knows that, so let’s not kid ourselves.
  • If this “concession” allows the current proposal to get through Congress, it will have been the greatest example of faux compromise in quite some time. It will have exchanged all hopes for responsible action with Jr. High level vengeance. We might get a little schadenfreude pleasure out of it, but it will be those Wall Street CEOs who get the last laugh, the kind of laugh that comes with seven or more zeros after it.

    Hrens: The First Death Rattle of Our Unsustainable Economy

    Wednesday, September 24th, 2008

    If the collapse of Wall Street these past few days has proven anything, it’s that our economic system is unsustainable—the philosophical underpinnings of capitalism (Never-ending growth! Infinite resources!) are a fairy tale. The free market model just doesn’t work.

    We hate to say we told you so.

    Rebekah and Stephen Hren, authors of The Carbon-Free Home: 36 Remodeling Projects to Help Kick the Fossil-Fuel Habit, have much more to say on the subject.

    Last week’s gyrations on Wall Street come as little surprise to most folks who have taken a critical eye towards our economic system. What you are seeing is the first death rattle of our truly unsustainable economy. We’ve been told for a long time that our way of life is unsustainable, which, we hate to point out, means that it cannot be sustained. To rephrase, it must end sometime! And that’s precisely what is happening.

    At the root of the financial debacle is the housing slump, which has a variety of causes. Primary among them is the fact that many lower and middle income folks are cash-strapped and can’t make their mortgage payments, especially as adjustable interest rates rise. Many of the homes sold to subprime lenders were new constructions built out in the boondocks, where the only available transportation is the automobile. As gas prices rose, these mortgage payments became that much more untenable. And gas prices rose because oil supplies have plateaued, having barely budged in the last four years. Even as supplies stagnated, demand in China, India, Russia, and Middle East has been growing at 5% to 10% a year, meaning less and less for us each year.

    Neoclassical economics, which is the philosophical underpinning of our financial system, did a decent job of describing what was going on in the world when access to supplies of raw materials were generally increasing. It is a philosophy of continual and never-ending growth. Unfortunately, when access to materials begins to become constrained, the multitude of inherent contradictions rises to the surface like the bloated carcass of a whale.

    A perusal of a few of the most obvious fallacies should prove enlightening.

    Just as we would look askance at a mother who believes her child will grow forever, or a gardener who believes their tomato plant will one day reach the heavens, the sanity of the economist who believes the economy can grow forever must be similarly suspect. Infinite growth is not possible in a finite world! Remember, it must end sometime!

    Likewise, the idea that neoclassical economics (also referred to as capitalism) is the most efficient economic system is complete and utter malarkey. What is efficient about everyone owning a car that they only use an hour or two a day? Or a lawnmower they use for thirty minutes once every two weeks? Or a tiller they might use once a year? Not only do these things have to be made from the finite materials of the earth, but people have to work in order to build them and afford them. From a resource use point of view, sharing is vastly more efficient than individual ownership.

    Capitalism is efficient at taking resources and converting these into a product, and then selling us this product whether we want it or not. What it does not take into consideration is that there might be any ill effect from the energy used, the waste created, the limits of raw materials, or whether the ownership of that product will in fact make us the slightest bit more content. Other than that, it’s perfect!

    Read the whole article here.

    Flipping the Script on Peak Oil

    Wednesday, September 24th, 2008

    The following has been excerpted and adapted for the web from The Transition Handbook: From oil dependency to local resilience by Rob Hopkins.

    When we look at the standard Hubbert curve, we see a mountain: a rise followed by a fall, an ascent followed by a descent. There is a sense that we have reached the peak and that now we have to grit our teeth for the long journey home, akin to an overexcited child at a birthday party being told it is time to go home. Perhaps the sense that we need to instill could come from turning this much-viewed graphic upside down. We might more usefully use the term ‘trough oil’.

    Rather than a mountain, we could view the fossil fuel age as a fetid lagoon into which we have dived. We had been told that great fortunes lay buried at the bottom of the lagoon if only we were able to dive deeply enough to find them. As time has passed we have dived deeper and deeper, into thicker, blacker, stickier liquid, and now we find ourselves hitting against the bottom, pushing our endurance to the extreme, surrounded by revolting sticky tar sands – the scrapings of the fossil fuel barrel. We can just about see distant sunlight still glinting through the liquid above us, and our desperate urge to fill our lungs begins to propel us back upwards, striving for oxygen.

    Rather than being dragged every step of the way, we propel ourselves with focused urgency towards sunlight and fresh air. Viewed like this, the race for a decarbonised, fossil fuel-free world becomes an instinctive rush to mass self-preservation, a collective abandonment of a way of living that no longer makes us happy, driven by the urge to fill our lungs with something as yet not completely defined, yet which we instinctively know will make us happier than what we have now. Perhaps arriving in a powered- down world will have the same sense of nourishment and elation as finally breaking through the surface and filling our lungs with fresh morning air, marvelling once again at the beauty around us and the joy of being alive.

    Kuttner Guest-Blogs at

    Wednesday, September 24th, 2008

    Robert Kuttner is guest blogging at this week. In his post he presents an alternative to Secretary Treasury Henry Paulson’s $700,000,000,000 Wall Street bailout plan, which he calls, appropriately, “the Kuttner plan.” Paulson’s proposal would initiate a massive shift in the balance of government (favoring the Executive Branch, of course) and a complete lack of independent oversight; Kuttner’s plan calls for transparency and a reasonable amount of relief for the American taxpayer.

    Kuttner is the author of Obama’s Challenge: America’s Economic Crisis and the Power of a Transformative Presidency.

    Read Robert Kuttner’s blog on here.

    Photo courtesy of The Oregonian.

    Kunin: Sarah Palin’s Unnoticed Empowerment of Women

    Tuesday, September 23rd, 2008

    Gov. Sarah Palin appears disastrously unprepared for the Vice Presidency (let alone, shudder to think, the Presidency). And yet a distressing number of white women are flocking to the Palin and McCain McCain/Palin ticket. What’s up with that?

    Madeleine M. Kunin, author of Pearls, Politics, and Power: How Women Can Win and Lead examines this phenomenon through the lens of empowerment in her latest article on the Huffington Post.

    From the article:

    There is a group of women whose support for Palin does not have much to do with the issues or whether she is qualified to be President. Only 3 percent of likely women voters deemed her most qualified and prepared to be President.

    I hate to think that these women are supporting her just because she is a woman and “is like me.” But to some extent that is true. Almost all women have experienced–in a wide variety of ways–life-long forms of gender bias, both overt and subtle, in their families, at work, and in society. Most women have not had the opportunity to express their frustration or, their outrage. Turning the other cheek, remaining silent, denial, or smiling sweetly has been the most common rejoinders for many polite, conservative and liberal women.

    Now, with Sarah Palin, they have a chance to vent their frustrations in a positive way by cheering her, supporting a woman who is not “like them” in most ways, but is enough “like them” in some ways so they can see themselves in her, and share in her present triumph.

    Some of these same women cheered Senator Hillary Clinton–who is in most ways the exact opposite of Sarah Palin. She was prepared to be President, and she was vetted in a 16-month primary campaign. She spoke directly to women’s issues and was strongly pro-choice. But for some women these issues did not matter; they cheered her stamina, her grit, and her willingness to be in the political fight. In some odd, inexplicable way, Hillary made them feel stronger, more capable of standing tall at home and on the job. I got that message from a variety of women after I was first elected Governor in 1984. They felt proud to be women. They, to use a now well-worn phrase, felt empowered by my campaign, and my election.

    A similar phenomenon is happening with Sarah Palin. Just watching her stand and speak before a huge cheering crowd, giving “them” hell, is rejuvenating. It is as if we are hearing a long exhale from women who have had to suppress their true feelings about being put down all these years. It doesn’t make sense in terms of the issues; it is not logical. But it is a reality that whether she is prepared for the job or not, whether she is right on the issues or not, some women simply are enjoying the moment of seeing her there at John McCain’s side.

    Even I, a former Hillary supporter and now an enthusiastic Obama supporter, occasionally feel a little thrill when I watch her, even though I disagree with almost everything she says and would never vote for her.

    Read the whole article here.

    Video: Bernie’s Petition to Stop the Bailout

    Tuesday, September 23rd, 2008

    Senator Bernie Sanders (I-VT) just released this video urging us to sign his petition to stop the bailout of the Wall Street criminals and government cronies.

    I put it on YouTube for everyone to see. Watch Bernie, and then sign his petition at the link below.

    Sign the petition:

    A Fine Mess: Kuttner on Obama, McCain, and the Evolving Bailout Plan

    Tuesday, September 23rd, 2008

    The following article is by Robert Kuttner, author of Obama’s Challenge: America’s Economic Crisis and the Power of a Transformative Presidency.

    Support for the Paulson plan continued to unravel late Monday and Tuesday morning, as the Treasury Secretary prepared to face two days of scorching hearings on Capitol Hill. In many ways Paulson is the worst possible ambassador for a plan that would give him carte blanche to bail out Wall Street, as a senior representative of the very Wall Street club that created the mess.Until now, Paulson has faced fairly tame questions from talk show hosts. Today and tomorrow, he will face populist outrage from senators and representatives; and many Republicans will be as indignant as Democrats. The political far-right, over the past 48 hours, has united against the plan. Some on the right, such as those at Cato and Heritage, oppose the idea as principled libertarians who think government should keep hands off the economy, come what may. Others, like Newt Gingrich, have never cared much for Wall Street. More moderate Republicans have also lashed out at Paulson, reflecting the anger of their own constituents, in hopes of saving their own skins. Washington today is filled with born-again regulators.

    Senators will point out that Paulson has even positioned some of his Wall Street cronies to profit both from advising the Treasury and from getting a piece of the action; and that Paulson’s original plan included nothing for Main Street. His testimony will be self-annihilating, and will only intensify the popular backlash.

    Financial experts have increasingly expressed skepticism about the technical aspects of the plan. For the scheme to work, the Treasury would have to pay prices for dubious assets well above their current market prices. This could create windfalls for the very people who brought us this mess, but not necessarily restore the system to health. Many argue that stabilizing the mortgage sector by helping homeowners directly would do more to redeem the value of mortgage-backed securities than having the government buy otherwise worthless securities backed by mortgages homeowners can’t afford.

    All of this has weakened Paulson’s hand, and given Democrats a lot more leverage to add provisions that insert more of the public interest into the deal. These will prove very hard for Paulson and Republicans to oppose. The Senate Democratic Caucus is scheduled to meet this morning, and Senators with whom I spoke late Monday were in a tough mood.

    It now appears that Democrats, at minimum, will get:

    • A second stimulus package as companion legislation.
    • Substantial mortgage relief for homeowners, not just bankers.
    • Some kind of independent supervisory board to which Paulson must report.
    • Some equity position for the government, in exchange for all this cash
    • Some limits on executive windfalls for participating companies.

    The bill could well depend on a majority of Democrats supporting it, with a majority of Republicans voting against it—either because they reject the entire idea of a bailout, or because they don’t like the Democratic add-ons, or because they need populist cover with their constituents, or because they expect the plan to fail and don’t want the blame.

    The effect on the two presidential campaigns is likewise intriguing and paradoxical. For the first time in the history of the Republic, both presidential candidates are sitting senators, and both will cast votes on the plan.

    At Obama headquarters, my sources say there is an internal debate about what it would take for Obama to vote for the bill. If the bill is significantly toughened, the odds are that he will support it. The vote will enable him to assume one of his favorites stances—the progressive who bridges differences. He can claim that by hanging tough, the Democrats dramatically improved a badly flawed and self-interested Republican bill. This will display Democratic unity and concern for a broad public interest, nicely contrasting with Republican opportunism and disarray.

    John McCain, meanwhile, has spent the past two days trying to reposition himself to Obama’s left, expressing outrage at Wall Street’s “greed,” attacking the Paulson plan as too friendly to Wall Street, and even proposing a $400,000 compensation cap on executives whose firms benefit from the plan. But commentators and the Obama campaign have had a field day pointing out McCain’s serial reversals on these issues.

    At this writing, McCain seems more likely to cast a vote against the plan than Obama. If McCain does vote against the plan, and it is not sufficient to stabilize financial markets, he can say, “I told you so” and cast himself as the agent of real change and Obama as the establishment man. McCain’s campaign is sinking so fast that he has little to lose by throwing this Hail-Mary pass—except for reinforcing the sense of Republican opportunism and disunity. But if the government spends $700 billion and financial markets keep tumbling, McCain could look like a seer.

    On Wall Street itself, financial markets that had rallied last week in hopes of a quick rescue, braced themselves for another day of losses. Even if enacted, the plan could contain amendments that would cut into profits. And if the rescue did successfully stem the carnage in the banking sector, that in turn might bring down more hedge funds that have prospered by betting against bank stocks and mortgage securities. So Congress will be debating the plan against a background of escalating damage in money markets—which briefly stabilized last week only on the promise of a nearly instant $700 billion bailout.

    Last night, I found myself on CNN’s Lou Dobbs’ show, with David Cay Johnston of the New York Times and Bill Gross of Pimco, the rare senior Wall Street critic of the financial razzle-dazzle and a man I have long admired. But last evening, Gross took a shameful dive, lavishing praise on Paulson and defending the plan. This puzzled both Dobbs and me—until I read an item in this morning’s New York Times including Gross among those whose firm hopes to get some business managing assets for the Treasury. Et tu, Bill?

    The only constructive thing about this fine mess is that it will very likely sweep out the party of the casino economy. Rebuilding an economy in which Wall Street once again serves Main Street will take a while longer.

    Vermont’s Bernie Sanders and His Argument Against the Bailout

    Tuesday, September 23rd, 2008

    Senator Bernie Sanders (I-VT) is a national treasure. He never fails to speak his mind with passion and clarity. Too often he is dismissed as the kookie-haired Senator from the bluest state in the nation. (And Proud of It!) But Bernie is a man of the people. And in these times when it is difficult to see where Washington stops and Corporate America begins, public servants like Sanders are rare and valuable.

    Case in point. Bush, McCain, and fellow cronies are in the process of socializing Wall Street as a means of avoiding a the total collapse of our economy that their unregulated “trickle-down-economics” has been flirting with for the better part of the last few years. At its core this simply means that American taxpayers are bailing out the companies that are foreclosing on our homes, calling in our loans, and canceling our lines of credit. The upper-class economy has been booming at the expense of the middle-class economy and suddenly the American economy is in trouble. And we’re supposed to reward the greedy and corrupt by buying their companies.

    Bernie Sanders has something to say about that. If you have time, this argument against the bailout as proposed is worth watching.

    Kuttner: Calling Paulson’s Bluff

    Monday, September 22nd, 2008

    The following article was contributed to by Robert Kuttner, author of Obama’s Challenge: America’s Economic Crisis and the Power of a Transformative Presidency.

    Treasury Secretary Hank Paulson spent the past two weeks playing a game of chicken with firms like Lehman Brothers and A.I.G. Now he is playing even higher-stakes chicken with Congress and the economy.

    Paulson’s storyline is that the credit markets are frozen, and unless Congress passes a “clean bill”–his way–disaster lies ahead. He spent a busy Sunday morning on the talk shows ducking questions on what would happen if Congress didn’t act—and what might still happen if it did.

    One senior Congressional Democrat told me, “They have a gun to our heads.” Paulson behaved as if he held all the cards, but in fact the Democrats have a lot of cards, too. The question is whether they have the nerve to challenge major flaws in Paulson’s plan as a condition of enacting it.

    Paulson also faces serious defections in Republican ranks, with several key senators and congressmen resisting a bailout of this scale. Sen. Richard Shelby, the ranking Republican on the Senate Banking Committee, speaking on CBS’s “Face the Nation,” flatly blamed the crisis on greed and deregulation, and questioned the terms of Paulson’s plan.

    Paulson’s bill would give him carte blanche to spend up to $700 billion over the next 24 months to buy toxic securities from financial firms. This presumably would “unclog” capital markets, the financial economy would begin functioning normally again, and then the government would recoup what it could.

    The plan is outrageous on several levels. It demands nothing from these firms in return. It holds the Treasury Secretary accountable to no one. And it extends the most generous terms to Wall Street while offering nothing to Main Street.

    House Financial Services Chairman Barney Frank, speaking Sunday morning on “Face the Nation,” gave the flavor of what Democrats will demand, if they hang tough: An economic stimulus to go with the Wall Street bailout; more refinancing help for borrowers; and some limits on windfall gains to corporate executives. These provisions would improve the bill, and Democrats would win either way: if they were included, more help would be on the way to working families. If they lost, and the bill passed without these provisions, it would make crystal clear the difference between the parties.

    Ideally, the Democrats should go even further.

    • The bailout bill should be explicitly tied to a commitment to re-regulate all types of financial institutions. The bill’s authority should expire after six months, so that when the next Congress re-authorizes any bailout authority it would be combined with tough comprehensive regulation.
    • Any private company that sells assets to the Treasury should be subjected to stringent limits on executive windfalls.
    • The government should get an equity position in the firms it helps, proportional to the help that it gives.
    • Treasury should be authorized and directed to take controlling interest in some firms, and take over their management, if course that provides the greatest potential savings to taxpayers. For example, when an FDIC-insured bank goes broke, the FDIC either merges it into a healthy bank, or takes it over and runs it for a time while it pays off depositors, to make sure that it is run properly. It does not just bail out the incumbent management that created, and profited from, the mess
    • There should be a recapture provision, so that if firms end up profiting from this bailout, the government gets its money back.
    • Part of the $700 billion should be for mortgage refinancings, and authority for cities and towns to acquire foreclosed properties and put buyers and renters back in them.
    • The package should include at least $200 billion of new economic stimulus, in the form of aid to states, cities, and towns, for infrastructure rebuilding, more generous unemployment and retraining benefits, and green investment.

    The Democratic leadership should force Republicans to take votes on provisions like these. The early signs were that they would be pushing hard for a two or three.

    Yesterday, a key lobbyist for the financial services roundtable, Scott Talbott, warned,

    “We’re opposed to adding provisions that will affect [or] undermine the deal substantively,” The Roundtable’s members are banks, securities firms and insurance companies, the prime beneficiaries of Paulson’s proposed bailout. He warned that any effort to attach other provisions would be a deal breaker.

    But excuse me, it is the financial industry that is coming hat-in-hand to the government, not vice versa. The industry has no leverage here, except to the extent that Congress lets itself be intimidated. Paulson is insisting on a “clean” bill, but as Barney Frank put it, helping Main Street as well as Wall street does not dirty the bill.

    The two precedents for large scale bailouts, Franklin Roosevelt’s Reconstruction Finance Corporation, and the Resolution Trust Corporation of the 1980s, gave government much more authority over the firms that it bailed out.

    Paulson is playing this more as the investment banker that he used to be, than as a steward of the public interest. This is a dubious deal, with all the gain going to Wall Street and all the risk going to taxpayers. Congress should not be intimated by his threats to hold his breath and turn blue of he doesn’t get his way.

    The Solution: Rebuilding Secure Financial Markets

    Monday, September 22nd, 2008

    Economist and author Robert Kuttner saw the writing on the wall long before many in Washington were even aware of the looming economic collapse. He was so incensed by the lack of foresight by our nation’s leading financial giants that he wrote Obama’s Challenge: America’s Economic Crisis and the Power of a Transformative Presidency. The book is nothing short of prescient.

    Here’s an excerpt:

    In the current financial collapse, all of the complex, separate abuses that caused the current crisis really boiled down to three: too much speculation with borrowed money; too little transparency and disclosure; and too many insider conflicts of interest. These abuses, in turn, were the bitter fruit of deregulation. The parallels to similar abuses of the 1920s are exact.

    All of these abuses will need to be remedied. We did precisely that as part of the New Deal. But beginning in the 1970s, much of the New Deal system of financial regulation was repealed in the name of more modern and innovative markets that supposedly did not need government. By 2000, a clean, transparent financial system that had made American capital markets the envy of the world was destroyed. The business geniuses who brought America this wisdom are now humbled by events. Their allies and enablers among financial economists based convoluted theories on the general premise that financial markets were entirely self-correcting. These economists are roughly in the position of pre-Copernican astronomers who hung elaborate models on the premise that the sun revolved around the earth. They should seek honest employment.

    Former Federal Reserve chairman Paul Volcker, in a high-profile address to the Economic Club of New York last April, put it well:

    We have moved from a commercial bank centered, highly regulated financial system, to an enormously more complicated and highly engineered system. Today, much of the financial intermediation takes place in markets beyond effective official oversight and supervision, all enveloped in unknown trillions of derivative instruments. It has been a highly profitable business, with finance accounting recently for 35 to 40 percent of all corporate profits.

    It is hard to argue that the new system has brought exceptional benefits to the economy generally. Economic growth and productivity in the last 25 years has been comparable to that of the 1950′s and 60′s, but in the earlier years the prosperity was more widely shared.

    In the last months of the lame-duck Bush administration, however, something very odd happened. As the situation became more dire, with threats to the largest banks and to mortgage giants Fannie Mae and Freddie Mac, as well as the looming risk of a general financial collapse, Treasury Secretary Henry Paulson became a reluctant paladin of big government. Paulson had assumed office in June 2006 with an agenda of further financial deregulation. In the months after he joined the cabinet, there was a well-coordinated flurry of activity with reports by conservative task forces all pointing to the evils of financial regulation, including a Committee on Capital Markets Regulation chaired by Paulson himself. That body’s report, released in November 2006, recommended several steps toward regulatory weakening in the name of greater competitiveness.

    However, by the time Paulson issued a follow-up report in March 2008 on behalf of a resurrected President’s Working Group on Financial Markets, reality had overtaken his design. In mid-2007, credit markets had suddenly frozen because of fallout from the subprime collapse. The Federal Reserve had to advance hundreds of billions of dollars to banks to keep credit flowing. So Paulson’s 2008 report was a thoroughly contradictory overlay of two documents— one expressing his earlier dogma praising the genius of unregulated markets, the other promoting government rescue and promising stricter supervision of large banks that posed systemic risks.

    Thus did the champion of deregulation become the leader of a squad tasked with cleaning up the mess deregulation had made. Paulson, improvising as he went along, offered a deus ex machina as his counterweight to further deregulation. He proposed to give the Federal Reserve yet-to-be-defined blanket authority to monitor the largest commercial and investment banks, to make sure that none were posing excessive risks to the system. The trouble with this approach is that by the time a large institution shows signs of distress, it is far too late.

    As the crisis deepened, Paulson at the Treasury and Ben Bernanke at the Federal Reserve lurched from ad hoc bailout to ad hoc bailout, with no coherent regulatory theory or policy either to prevent unacceptably risky behavior before the fact, or to determine when to bail out an institution after it got into trouble. A bank deemed “too big to fail” because of the risk of spillover dangers was like Justice Potter Stewart’s famous definition of pornography: You just knew it when you saw it. Indy Mac, a medium-size regional bank, was allowed to fail. But Bear Stearns, Fannie Mae, and Freddie Mac got taxpayer bailouts. In the shotgun acquisition by Citi, Bear’s shareholders lost almost everything. Fannie’s were partly protected. So it goes.

    By August 2008, the government had brokered an emergency takeover of Bear Stearns by JPMorgan Chase at fire-sale prices, putting $29 billion of taxpayer money at risk; offered a general line of credit to large investment banks that previously enjoyed no special government guarantee or supervision; put government capital at the disposal of Fannie Mae and Freddie Mac; and invited banks and investment companies to exchange dubious paper for Treasury bills, in order to recapitalize banks and move markets in risky securities that nobody else wanted to buy. The Fed, which has about a trillion dollars at its disposal, tied up something like 40 percent of its own capital in these serial rescues.

    All of this was done under the Federal Reserve’s emergency authority enacted during the Roosevelt administration. With the exception of the Fannie Mae/Freddie Mac bailout, none of it had congressional authorization, nor did the Bush administration announce an explicit reversal of the general policy of financial deregulation. All the moves had the same panicky, ad hoc character.

    Now, it is a very good thing that Paulson put aside his ideological blinders and worked with Ben Bernanke and Tim Geithner at the Federal Reserve to prevent the credit freeze from becoming a complete economic collapse. But people like Paulson, former head of Goldman Sachs, want the emergency rescues without the prudential regulation. The next administration will need to combine the two strategies, as Roosevelt’s did.

    In the summer of 2008, a new and alarming element deepened the crisis: runs on banks, but with two twists. Deposits were insured by the Federal Deposit Insurance Corporation—a core part of the New Deal that had not been repealed during the orgy of deregulation. So there was no reason for depositors to trigger runs on banks, the traditional worry prior to creation of the FDIC. But these new runs were shareholder runs. As details of the crisis unfolded, it became ever clearer to investors that bank balance sheets were seriously weakened in two distinct respects.

    First, these balance sheets were full of dubious securities that suddenly nobody wanted to buy. These included not just securities based on subprime loans but also other exotic forms of securitized credit backed by everything from car loans to credit cards, and even more abstruse securities that insured other securities against default. If banks followed normal accounting practices and “marked to market” securities that had no buyers and technically had a value of zero, the banks would be declared insolvent. In a credit crunch, it was this fear that caused the Fed to pump so much emergency liquidity (money) into the banking system. In fact, the agency that governs financial accounting standards moved, under pressure from the SEC and the Treasury, to scrap a rule that required banks to mark down the valuation of their assets to their current trading value (in many cases zero)—lest all the large banks be judged insolvent. Second, much of the banks’ fee and interest income had been based on underwriting or trading these very same securities, or making other highly leveraged and highly risky deals. If this lucrative line of business was suddenly no longer available, banks not only had trouble on their balance sheets in the reduced value of their assets—they also had serious problems with their earnings.

    As these twin vulnerabilities became apparent and bank losses mounted, shareholders began fleeing banks. No bank was big enough to be safe. During the first seven months of 2007, when the broad stock market lost about 20 percent, the index of bank stocks went down almost by half. Some large regional banks did far worse. Cleveland-based National City Bank’s stock was down 90 percent. Washington Mutual fell 76 percent. The stock of the Swiss-based global giant UBS lost 70 percent. Shares in the flagship brokerage firm Merrill Lynch lost more than half.

    In the case of a commercial bank, the value of a bank’s shares is a major portion of the equity against which it can lend. The other major component of bank equity is its capital reserves. As losses mounted in 2008, both forms of capital footings took a huge hit, worsening the general credit contraction.

    One other factor deepened the crisis—the abuse and proliferation of “short selling.” This twist also has instructive ideological implications. In selling a stock short, an investor who thinks a stock price is headed downward borrows the shares from a broker, delivers them to a purchaser, buys back the identical number of shares on the open market after the price has fallen, and then pockets the difference. This is how some investors make money in a falling market. The practice of short selling doesn’t do much damage in a normal market, but organized on a large scale it can turn a bear market into a crash.

    In the summer of 2008, short sellers (many of them hedge funds) smelled blood in the financial waters. They savagely bid down the price of bank stocks. Human nature being what it is, many short sellers invented or passed along rumors that exaggerated the weak condition of several large banks. Executives of Bear Stearns blamed their demise on rumormongers and short sellers. The venerable firm of Lehman Brothers seemed headed for insolvency, pulled down by short sellers’ rumors that turned out to be untrue. The same psychology threatened Fannie Mae.

    The legal status of such rumor mongering is ambiguous. Short selling is permissible, but deliberately manipulating markets is a felony. Deciding when passing along a juicy rumor becomes deliberate market manipulation is a Jesuitical endeavor at best. But in July 2008, one of the most ideologically conservative Securities and Exchange Commissions since the institution was created during the New Deal did something startling. Faced with organized short-selling raids that were depressing the stocks of major financial institutions and threatening their very solvency, the SEC rushed out an emergency thirty-day order warning that it would be on the lookout for short-selling abuses against the shares of nineteen flagship financial firms, and would vigorously go after violators. The order prohibited new short sales of shares in such wounded giants as Lehman Brothers, Merrill Lynch, Citigroup, Fannie Mae, and Bank of America unless the seller had already borrowed the stock. Christopher Cox, one of the most anti-regulation ideologues ever to chair the SEC, boasted, “There have long been clear rules in place that prohibit market manipulation. But for the entirety of its 74-year history until 2008, the Commission has never brought an enforcement action of this kind.”

    Behind this surprising turnabout hangs a tale. Reformers have actually been trying to ban short selling since the late 1920s. For generations, however, conventional financial economists have defended short selling as helping to lubricate the efficient functioning of markets. Anyone who argued that short selling was needless mischief that did nothing for the real economy was ridiculed as a hopeless radical.

    In fact, the original design of Franklin Roosevelt’s 1934 securities legislation recognized the hazards of short selling and sought to ban it outright. One of the many abuses of the 1920s had been market manipulation via short selling, known as bear raids. Even before Roosevelt took office, liberal members of Congress had introduced legislation to either discourage short selling by collecting windfall taxes on the proceeds, or simply prohibit it.

    The Securities Exchange Act of 1934, policing the conduct of stock exchanges and creating the Securities and Exchange Commission, was the object of fierce battles between progressives and conservatives in the Congress and the country. The draft bill included a flat ban on short selling as well as other abuses that came back to haunt financial markets in the past two decades—excessive leverage, conflicts of interest, and favored treatment of insiders. But by the time the Wall Street lobbies got finished with the bill—enlisting small-town bankers and national networks of retail stockbrokers as their allies—all these teeth had been removed.

    For eight decades, short selling has been part of the financial landscape. It is a mark of just how dire are current conditions that in 2008 a panicky and conservative SEC that doesn’t much believe in regulation embraced an ad hoc remedy that had eluded even Roosevelt. The fact that Wall Street, at the nadir of its disgrace in 1933, still had the clout to block these reforms suggests something of the residual power that the Obama administration will be up against.

    The men and women currently in charge of the executive branch, deep believers in laissez-faire, have no coherent theory of financial regulation, so their separate emergency measures lack policy coherence. In their hearts, they oppose what they are being compelled to do in a crisis. And so we still have a system that privatizes speculative gain and socializes the risks. Obama, unlike Bush, will have an entirely different cast of cabinet and regulatory officials as well as technical experts, all of whom presumably believe in the enterprise of regulation.

    Criteria for prudent regulation need to rebuilt from the ground up. The core principle is that any financial institution that creates credit (and thereby creates risks that could undermine the system) needs to be subjected to the same kind of regulatory criteria—whether that institution calls itself a bank, a mortgage company, an investment bank, a hedge fund, or a private equity firm. Indeed, if Congress were to extend requirements on capital adequacy, leverage, and greater transparency from commercial banks to investment banks, Goldman Sachs (a very lightly regulated investment bank) would turn itself into a hedge fund. And if Congress extended prudential requirements to hedge funds, Goldman would become a private equity company.

    The point is that these financial firms increasingly all do the same kinds of things. And they buy and sell products with one another, many of them poorly understood, highly speculative, and sometimes toxic; it all goes into the same financial bloodstream. Last year, about 60 percent of the credit created in the United States was created by lightly regulated firms other than depository institutions. As Barack Obama grasped so well in his Cooper Union speech, which I quoted in chapter 1, “We need to regulate institutions for what they do, not what they are.”

    As he declared in that speech last March, when many Democrats were still rather timid about confronting the ideology of deregulation head-on,

    There needs to be general reform of the requirements to which all regulated financial institutions are subjected. Capital requirements should be strengthened, particularly for complex financial instruments like some of the mortgage securities that led to our current crisis. We must develop and rigorously manage liquidity risk. We must investigate rating agencies and potential conflicts of interest with the people they are rating. And transparency requirements must demand full disclosure by financial institutions to shareholders and counterparties.

    It logically follows that some entire categories of financial transactions and instruments need to be banned as adding more risks than benefits. We should revisit the old arguments about short selling. There is a strong case that the abuses outweigh any benefits. We should reconsider the original draft of Roosevelt’s securities legislation, which proposed to make it illegal for members of stock exchanges to trade for their own accounts as an inherent conflict of interest with their arm’s-length service to their customers. We need to investigate the inherent conflict of interest in the stock exchanges’ specialist system, in which traders can also profit by trading ahead of their customers.

    Bond rating agencies, as presently constructed, display multiple conflicts of interest. They are paid by originators of securities for consulting work to enable those securities to earn a triple-A rating—bestowed by the same bond rating agencies. Had these agencies operated at arm’s length, bonds based on subprime mortgage loans would have fetched few buyers. The bond rating companies, which do business with firms that insure securities against default, systematically punish municipal bonds with lower ratings than comparable private-sector bonds to help the insurance firms capture fees. The whole system would be more efficient and transparent if bond rating were vested in a public or nonprofit institution, whose costs could be covered by a very small fee on all financial transactions.

    We need to recall and reclaim the fundamental purpose of credit and capital markets—channeling funds from investors to entrepreneurs. The whole business has become riddled with middlemen who invent complex products that add little to the efficiency of credit markets, magnify systemic risks, and mainly serve to line their own pockets and corrupt their confederates.

    Supervision needs to be tightened across the board, and not just of the largest institutions, based on explicit criteria of safety and prudence. This approach could not be ventured by the Bush administration, both because the clock ran out and because it was considered an ideological abomination. Reconstructing principles of financial regulation will fall to Obama.

    In making the case for a reversal of ideology and practice, Obama needs to help the public grasp the astonishing double standard in current policy. Trillions of dollars of help are going to bail out the nation’s wealthiest speculators and the financial institutions that they put at risk of collapse. The usual rules are waived for these emergency bailouts, while tens of millions of ordinary Americans suffering from these abuses get little or nothing. As John Bogle, founder of Vanguard Group of mutual funds and the rare Wall Street statesman, aptly put it, “The banks are too big to fail and the man in the street is too small to bail.”

    There is also an international dimension to restoration of effective financial regulation. Many hedge funds and private equity firms are registered offshore in regulatory havens that provide even less regulation than the feeble scrutiny such firms get in the United States. If we are going to apply Obama’s principle that we must “regulate institutions for what they do, not what they are,” then there can’t be an all-purpose loophole for those domiciled offshore. This is not as difficult as it sounds. All it would take is a rule that any financial firm that does business with a bank operating in the United States must be subjected to a level of scrutiny equal to that of domestic firms. Many of our trading partners, nations whose economies are suffering grave harm because of a financial crisis created in the United States, would welcome this regulatory toughening.

    Obama needs to define the moment. And he needs to begin anew. Presumably, he will assemble the best minds—a set of advisers who have an entirely different conception of the necessary role of financial regulation—and reclaim a theory of market failure based on the potent evidence of recent events. Here, too, Obama will have to fight an undertow, for much of the deregulation that spawned the current financial disaster dates to the Clinton administration. The Clinton Treasury Department was headed by Robert Rubin, a fervent believer in deregulation, who provides Obama with occasional advice and who is cited as a wise counsel in The Audacity of Hope. Even Rubin, however, is singing something of a different tune after the credit collapse.

    Obama’s administration will need to sort which practices must be prohibited outright as inherently prone to abuse, and which should be subject to exactly what sort of tighter regulation, and by which new or old government agencies. Only then can he send Congress legislation to implement policy. And along the way, he needs to rely on his gift as a teacher—as Roosevelt did in the banking crisis of 1933, and Obama himself did so brilliantly in his Cooper Union address.

    However, turning around public and congressional opinion on the subject of financial regulation will be no mean feat. Wall Street welcomes the bailouts; it still resists the regulation. A massive job of public education will be required. Before this financial crisis ends, the government may well end up recapitalizing America’s banks. One could fairly say that the process has already begun, piecemeal, based on the ad hoc bailouts orchestrated by Secretary Paulson and the Federal Reserve. We have been here before, but with a difference. In the 1930s, Roosevelt’s Reconstruction Finance Corporation recapitalized many banks and corporations. But the difference was this: On a parallel track, the New Deal was also building a modern system of financial regulation to spare future generations the pattern of speculation, crash, and bailout. This is now the historic task of the Obama administration. It should not have been necessary a second time.

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