[I]f it quacks like a bank it has to be regulated like a bank…. [F]inancial institutions should be regulated for what they do, not for what they are…. So whether you call yourself a commercial bank or an investment bank or a private equity company or Charlie Brown, if you’re giving credit, you are creating risks for the system and you need to be kept honest.
Terrance Heath of Campaign for America’s Future talks to author, economist, and co-founder of The American Prospect Robert Kuttner about the Stock Market Crash of 1929, the Meltdown of 2008, and four steps to avoid the Depression of 2009.
Terrance Heath: In his column about the 79th anniversary of the 1929 Wall Street Crash, Professor Maury Klein asked, “Is it 1929 all over again?” Is it?
Robert Kuttner: Yes, this is 1929 all over again. For the same reasons. The crash of 1929 was caused by too much speculation, with too much borrowed money, with too many conflicts of interest and too little transparency. And in the 1930’s the New Deal mostly repaired that by much tighter regulation of banks, much stricter supervision of conflict of interest, much greater controls on leverage and much grater disclosure for investors.
But it fixed the problem for the known universe of financial institutions, and after the ’70s all kinds of new exotic financial instruments were invented. And because deregulation came back into fashion, and the right wing really took over the conversation as well as government regulators did not keep up with the new instruments that Wall Street invented. And so all the same kinds of abuses crept back in, and it took about 20 years until the house of cards was so high and so rickety that you then had the same kind of crash.
TH: When did the rolling back of those New Deal measures start?
RK: Well, it’s interesting; it happened in fits and starts. Some of it was deliberate and some of it was simply people taking advantage of other things that had happened. For instance, in the period between 1971 and 1973 the Nixon administration dismantled one of the main pillars of Bretton Woods from 1944, which had created a regime of fixed exchange rates and along the way prevented a great deal of international speculation in currencies
So, after the 1970s little by little you had a whole category of speculation that had been prohibited by the ground rules obtained in the ’50s and ’60s, namely a lot of currency speculation. You had the so-called eurodollar market of dollars that existed in Europe that are not really regulated by anybody.
Then in the ’70s also you had Wall Street taking something that had been the monopoly of Fannie Mae back when Fannie Mae was a public institution and part of the government, namely the securitization of mortgage, and privatizing it, and having lower standards than Fannie Mae did.
Again this was OK from the first decade or so but then when securitized mortgages rendezvoused with subprime and subprime rendezvoused with contracts written against the risk of bonds going bad, the whole house of cards just goes higher and higher and because in the ’80s and the ’90s Democrats fingerprints were on this, too. Regulators were not really interested in keeping up with these new risk products that Wall Street invented.
So, then in 1999, the capstone of this is the repeal of the Glass-Steagall Act. One other aspect of this was Greenspan’s failure to enforce the Home Ownership Equity Protection Act of 1994, which, had Greenspan enforced it, subprime never would have happened, because that legislation required anybody who made mortgage loans to use sound underwriting standards. And you had Democrats and Republicans preventing the Commodity Futures Trading Commission from regulating many categories of derivatives.
So it was in the air, the idea that whatever Wall Street invents is by definition efficient, by definition virtuous, by definition self-regulating, and little by little a whole parallel banking system gets created that is beyond the scope of what the regulators can monitor.
TH: Beyond enforcing what’s already in place, what needs to be done — and can be done — to put the brakes on this crisis?
RK: Let me reduce it to basic principles, and Barack Obama gave a wonderful speech to this effect on March 28th at Cooper Union in New York, where he basically said if it quacks like a bank it has to be regulated like a bank. He basically said financial institutions should be regulated for what they do, not for what they are.
And that’s the point. So whether you call yourself a commercial bank or an investment bank or a private equity company or Charlie Brown, if you’re giving credit, you are creating risks for the system and you need to be kept honest. So the problem is that in recent years something like 60 percent of the created was created institutions that are not part of banking system, institutions like subprime mortgage institutions and people creating credit swaps and all sorts of exotic derivatives that are not even understood by the people that create them, let alone by the people who buy them or by the regulators.
So you need to eliminate what some people call the shadow banking system, institutions that are not banks but that do what banks to, and every kind of institution needs to have capital requirements, needs to have limitations on leverage, it needs to have limitation of conflicts of interest. And there are some specific abuses, like the abuses on the part of the bond rating agencies that were walking conflicts of interest. And the fact the that derivatives are traded outside of stock exchanges or commodity future exchanges, so that nobody knows what they’re worth until there’s a crisis and and they turn out to be worth nothing.
TH: One thing Maury Klein pointed out was that the Great Crash and the Great Depression were separate events, the Depression taking more than a year after the crash to make its grip on the economy felt. Have we dodged a depression yet? Can we still?
RK: We’re still in danger of one and whether we have one or not depends entirely on what the next administration does. A depression is preventable and I think there are four things that the next administration has to do. This administration has done one of them rather badly, and it hasn’t done the other three at all.
The first thing it has to do is recapitalize the financial system. And Paulson has gone about that in a very clumsy way.
If the government and the taxpayers are going to put money into banks, they need much greater supervision of banks, not just the banks that get the money but the banking system in general. So the second thing we need to do is re-regulate it to that you don’t invite more speculation, more bubbles and more crashes and more bailouts.
The third thing we need to do is put a floor under housing prices. The way Paulson has gone about this, you rescue the banks, you rescue the bondholders, and if the mortgage holder gets any relief, it’s incidental or accidental. We need direct federal refinancing of mortgages, so that this downward spiral of housing prices ceases.
And then most importantly we need massive public spending to compensate for the huge hit that demand is taking. Some of that can be deficit-financed in the short run. Some of it can be financed by raising taxes on very wealthy people, and winding down the war.
And if the next president does all those things, we’ll have a recession but we won’t have a depression. If the president lets this thing get out of control and plays catch-up we could well have a depression.
What’s interesting is that if you look at how long it took after October 24th for the air to come out of the economy, and those were the years when Hoover dithered and didn’t do enough to prevent a crash from turning in to a depression, and that’s why it’s so important that the next president get out ahead of this.