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[Oct 18, 2015] What Prosperity Is, Where Growth Comes from, Why Markets Work

Notable quotes:
"... In 1959, noted American economist Moses Abramovitz cautioned that "we must be highly skeptical of the view that long-term changes in the rate of growth of welfare can be gauged even roughly from changes in the rate of growth of output." ..."
"... In 2009, a commission of leading economists convened by President Nicolas Sarkozy of France and chaired by Nobel laureate Joseph Stiglitz reported on the inadequacies of GDP. They noted well-known issues such as the fact that GDP does not capture changes in the quality of the products (think of mobile phones over the past 20 years) or the value of unpaid labor (caring for an elderly parent in the home). The commission also cited evidence that GDP growth does not always correlate with increases in measures of well-being such as health or self-reported happiness, and concluded that growing GDP can have deleterious effects on the environment. ..."
"... Our issue isn't with GDP per se. As the English say, "It does what it says on the tin"-it measures economic activity or output. Rather, our issue is with the nature of that activity itself. Our question is whether the activities of our economy that are counted in GDP are truly enhancing the prosperity of our society. ..."
"... Robert Shiller of Yale University, who ironically shared this year's Nobel with Fama, showed in the early 1980s that stock market prices did not always reflect fundamental value, and sometimes big gaps could open up between the two. ..."
"... And therein lies the difference between a poor society and a prosperous one. It isn't the amount of money that a society has in circulation, whether dollars, euros, beads, or wampum. Rather, it is the availability of the things that create well-being-like antibiotics, air conditioning, safe food, the ability to travel, and even frivolous things like video games. It is the availability of these "solutions" to human problems-things that make life better on a relative basis-that makes us prosperous. ..."
"... This is why prosperity in human societies can't be properly understood by just looking at monetary measures of income or wealth. Prosperity in a society is the accumulation of solutions to human problems. ..."
December 1, 2014 | Democracy Journal ( also reprinted in Evonomics )

The Price of Everything, the Value of Nothing

The most basic measure we have of economic growth is gross domestic product. GDP was developed from the work in the 1930s of the American economist Simon Kuznets and it became the standard way to measure economic output following the 1944 Bretton Woods conference. But from the beginning, Kuznets and other economists highlighted that GDP was not a measure of prosperity. In 1959, noted American economist Moses Abramovitz cautioned that "we must be highly skeptical of the view that long-term changes in the rate of growth of welfare can be gauged even roughly from changes in the rate of growth of output."

In 2009, a commission of leading economists convened by President Nicolas Sarkozy of France and chaired by Nobel laureate Joseph Stiglitz reported on the inadequacies of GDP. They noted well-known issues such as the fact that GDP does not capture changes in the quality of the products (think of mobile phones over the past 20 years) or the value of unpaid labor (caring for an elderly parent in the home). The commission also cited evidence that GDP growth does not always correlate with increases in measures of well-being such as health or self-reported happiness, and concluded that growing GDP can have deleterious effects on the environment. Some countries have experimented with other metrics to augment GDP, such as Bhutan's "gross national happiness index."

Our issue isn't with GDP per se. As the English say, "It does what it says on the tin"-it measures economic activity or output. Rather, our issue is with the nature of that activity itself. Our question is whether the activities of our economy that are counted in GDP are truly enhancing the prosperity of our society.

Since the field's beginnings, economists have been concerned with why one thing has more value than another, and what conditions lead to greater prosperity-or social welfare, as economists call it. Adam Smith's famous diamond-water paradox showed that quite often the market price of a thing does not always reflect intuitive notions of its intrinsic value-diamonds, with little intrinsic value, are typically far more expensive than water, which is essential for life. This is of course where markets come into play-in most places, water is more abundant than diamonds, and so the law of supply and demand determines that water is cheaper.

After lots of debate about the nature of economic value in the nineteenth and early twentieth centuries, economists considered the issue largely settled by the mid-twentieth century. The great French economist Gerard Debreu argued in his 1959 Theory of Value that if markets are competitive and people are rational and have good information, then markets will automatically sort everything out, ensuring that prices reflect supply and demand and allocate everything in such a way that everyone's welfare is maximized, and that no one can be made better off without making someone else worse off. In essence, the market price of something reflects a collective judgment of the value of that thing. The idea of intrinsic value was always problematic because it was inherently relative and hard to observe or measure. But market prices are cold hard facts. If market prices provide a collective societal judgment of value and allocate goods to their most efficient and welfare-maximizing uses, then we no longer have to worry about squishy ideas like intrinsic value; we just need to look at the price of something to know its value.

Debreu was apolitical about his theory-in fact, he saw it as an exercise in abstract mathematics and repeatedly warned about over-interpreting its applicability to real-world economies. However, his work, as well as related work in that era by figures such as Kenneth Arrow and Paul Samuelson, laid the foundations for economists such as Milton Friedman and Robert Lucas, who provided a devastating critique of Keynesianism in the 1960s and '70s, and recent Nobel laureate Eugene Fama, who pioneered the theory of efficient markets in finance in the 1970s and '80s. According to the neoclassical theory that emerged from this era, if markets are efficient and thus "welfare-maximizing," then it follows that we should minimize any distortions that move society away from this optimal state, whether it is companies engaging in monopolistic behavior, unions interfering with labor markets, or governments creating distortions through taxes and regulation.

These ideas became the intellectual touchstone of a resurgent conservative movement in the 1980s and led to a wave of financial market deregulation that continued through the 1990s up until the crash of 2008. Under this logic, if financial markets are the most competitive and efficient markets in the world, then they should be minimally regulated. And innovations like complex derivatives must be valuable, not just to the bankers earning big fees from creating them, but to those buying them and to society as a whole. Any interference will reduce the efficiency of the market and reduce the welfare of society. Likewise the enormous pay packets of the hedge-fund managers trading those derivatives must reflect the value they are adding to society - they are making the market more efficient. In efficient markets, if someone is willing to pay for something, it must be valuable. Price and value are effectively the same thing.

Even before the crash, some economists were beginning to question these ideas. Robert Shiller of Yale University, who ironically shared this year's Nobel with Fama, showed in the early 1980s that stock market prices did not always reflect fundamental value, and sometimes big gaps could open up between the two. Likewise, behavioral economists like Daniel Kahneman began showing that real people didn't behave in the hyper-rational way that Debreu's theory assumed. Other researchers in the 1980s and '90s, even Debreu's famous co-author Arrow, began to question the whole notion of the economy naturally moving to a resting point or "equilibrium" where everyone's welfare is optimized.

An emerging twenty-first century view of the economy is that it is a dynamic, constantly evolving, highly complex system-more like an ecosystem than a machine. In such a system, markets may be highly innovative and effective, but they can sometimes be far from efficient. And likewise, people may be clever, but they can sometimes be far from rational. So if markets are not always efficient and people are not always rational, then the twentieth century mantra that price equals value may not be right either. If this is the case, then what do terms like value, wealth, growth, and prosperity mean?

Prosperity Isn't Money, It's Solutions

In every society, some people are better off than others. Discerning the differences is simple. When someone has more money than most other people, we call him wealthy. But an important distinction must be drawn between this kind of relative wealth and the societal wealth that we term "prosperity." What it takes to make a society prosperous is far more complex than what it takes to make one individual better off than another.

Most of us intuitively believe that the more money people have in a society, the more prosperous that society must be. America's average household disposable income in 2010 was $38,001 versus $28,194 for Canada; therefore America is more prosperous than Canada.

But the idea that prosperity is simply "having money" can be easily disproved with a simple thought experiment. (This thought experiment and other elements of this section are adapted from Eric Beinhocker's The Origin of Wealth, Harvard Business School Press, 2006.) Imagine you had the $38,001 income of a typical American but lived in a village among the Yanomami people, an isolated hunter-gatherer tribe deep in the Brazilian rainforest. You'd easily be the richest Yanomamian (they don't use money but anthropologists estimate their standard of living at the equivalent of about $90 per year). But you'd still feel a lot poorer than the average American. Even after you'd fixed up your mud hut, bought the best clay pots in the village, and eaten the finest Yanomami cuisine, all of your riches still wouldn't get you antibiotics, air conditioning, or a comfy bed. And yet, even the poorest American typically has access to these crucial elements of well-being.

And therein lies the difference between a poor society and a prosperous one. It isn't the amount of money that a society has in circulation, whether dollars, euros, beads, or wampum. Rather, it is the availability of the things that create well-being-like antibiotics, air conditioning, safe food, the ability to travel, and even frivolous things like video games. It is the availability of these "solutions" to human problems-things that make life better on a relative basis-that makes us prosperous.

This is why prosperity in human societies can't be properly understood by just looking at monetary measures of income or wealth. Prosperity in a society is the accumulation of solutions to human problems.

These solutions run from the prosaic, like a crunchier potato chip, to the profound, like cures for deadly diseases. Ultimately, the measure of a society's wealth is the range of human problems that it has found a way to solve and how available it has made those solutions to its citizens. Every item in the huge retail stores that Americans shop in can be thought of as a solution to a different kind of problem-how to eat, clothe ourselves, make our homes more comfortable, get around, entertain ourselves, and so on. The more and better solutions available to us, the more prosperity we have.

The long arc of human progress can be thought of as an accumulation of such solutions, embodied in the products and services of the economy. The Yanomami economy, typical of our hunter-gatherer ancestors 15,000 years ago, has a variety of products and services measured in the hundreds or thousands at most. The variety of modern America's economy can be measured in the tens or even hundreds of billions. Measured in dollars, Americans are more than 500 times richer than the Yanomami. Measured in access to products and services that provide solutions to human problems, we are hundreds of millions of times more prosperous.

[Sep 05, 2015] Deflation and Money

"...Friedman and Schwartz were wrong about the cause and the cure of the Great Depression. Those who learned monetarism as the "new truth" are having a difficult time unlearning it. We need re-education courses for older economists and a new curriculum for younger ones."
"...I don't have the neo-classical faith in the "natural" healing powers of the economy as some people do. Seems more likely that the economy would settle in to a lower equilibrium given enough fiscal austerity."
"...But what if the FED is a rational captain of corporate capitalism. Better then the opportunistic demagogues in the congress. But still dedicated to wage stag "
"..."if wage increases for the business sector as a whole lag behind productivity increases deflation occurs"..."
Sep 05, 2015 | Economist's View
The summary "Deflation and money" by Hiroshi Yoshikawa, Hideaki Aoyama, Yoshi Fujiwara, and Hiroshi Iyetomiof says:
Deflation and money, Vox EU: Deflation is a threat to the macroeconomy. Japan had suffered from deflation for more than a decade, and now, Europe is facing it. To combat deflation under the zero interest bound, the Bank of Japan and the European Central Bank have resorted to quantitative easing, or increasing the money supply. This column explores its effectiveness, through the application of novel methods to distinguish signals from noises.

The conclusion:

...all in all, the results we obtained have confirmed that aggregate prices significantly change, either upward or downward, as the level of real output changes. The correlation between aggregate prices and money, on the other hand, is not significant. The major factors affecting aggregate prices other than the level of real economic activity are the exchange rate and the prices of raw materials represented by the price of oil. Japan suffered from deflation for more than a decade beginning at the end of the last century. More recently, Europe faces a threat of deflation. Our analysis suggests that it is difficult to combat deflation only by expanding the money supply

bakho said in reply to pgl...

Monetary policy weak is at the ZLB. Fiscal and regulatory can have much stronger effects and complete swamp monetary like a tidal wave to a ripple.
Exchange rates and other economic shocks have more effect than monetary policy at the ZLB.

Friedman and Schwartz were wrong about the cause and the cure of the Great Depression. Those who learned monetarism as the "new truth" are having a difficult time unlearning it. We need re-education courses for older economists and a new curriculum for younger ones.

bakho said in reply to pgl...

Efficiency standards backed by a carbon tax would be much more effective that a carbon tax alone.
Efficiency standards work for electric appliances and prevent a races to the bottom.

pgl said in reply to bakho...

True. It seems Carly and Jeb! do not want to regulate but rather to encourage innovation by giving subsidies to rich people. Not only is this Republican reverse Robin Hoodism on steroids - it will not has as much effect as a tax combined with regulations.

Simply put - conservatives should not be listened to as their agenda is not economic efficiency but rather making the Koch Brothers ever richer.

Peter K. said...

As a thought experiment I would wonder what bakho's re-education course would look like.

There is this paper, but could it be it says the same thing as those graphs which show the large increases in the monetary base would just sit there with at the Zero Lower Bound because of the liquidity trap?

The inflationistas were wrong that all of that monetary policy would cause runaway inflation.

But considering what needed to be done to move long-term interest rates, was it really large enough?

David Beckworth's blogpost in today's links suggests the Fed did what they wanted to do.

And maybe part of that was to offset the unprecedented fiscal austerity we say after Obama's stimulus ran out. (And that stimulus was pretty much canceled out by 50 little Hoovers.)

If monetary policy supposedly didn't move prices, I found it surprising that austerity didn't give us deflation as it did in Europe.

Maybe fiscal policy works better and more directly but if it is blocked or even reversed with austerity, monetary policy shouldn't be ruled because it is supposedly ineffective.

Maybe Friedman and Schwartz's maximalist claims aren't true, but that doesn't mean one should flip to the opposite extreme.

Bernanke says in a speech that Tobin suggested that the Fed could have mitigated the Great Depression by lowering long-term rates.

Peter K. said in reply to Peter K....

"What is the total number of months during the Ford, Carter, Reagan and Bush I administrations, plus the first term of Clinton, when the unemployment rate was lower than today?"

Peter K. said in reply to Peter K....

"The inflationistas were wrong that all of that monetary policy would cause runaway inflation."

When confronted they always say that once the economy normalized, all of those reserves will go rushing out into the economy causing inflation.

But the Fed says it will use Interest on Excess Reserves to manage that outflow.

Peter K. said in reply to Peter K....

"If monetary policy supposedly didn't move prices, I found it surprising that austerity didn't give us deflation as it did in Europe."

I don't have the neo-classical faith in the "natural" healing powers of the economy as some people do. Seems more likely that the economy would settle in to a lower equilibrium given enough fiscal austerity.

Paine said in reply to Peter K....

Very agreeably presented

But what if the FED is a rational captain of corporate capitalism. Better then the opportunistic demagogues in the congress. But still dedicated to wage stag

Egmont Kakarot-Handtke said...

Deflation? Uupps, price theory, too, is wrong
Comment on 'Deflation and Money'

The current economic situation is a clear refutation of both commonplace employment and quantity theory. The core of the unemployment/deflation problem is that the price mechanism does not work as standard economics claims.

The correct formula for the market clearing price in the simplified consumption good industry is given here

Roughly, the formula says that the consumer price index declines if (i) the average expenditure ratio falls, (ii) the wage rate falls, (iii) the productivity increases, and (iv) the employment in the investment good industry shrinks relative to the employment in the consumption goods industry. The formula follows from (2014, Sec. 5).

The more differentiated and therefore better testable formula is given here

The crucial message is that the wage rate is the numéraire of the price system. If at all, the quantity of money plays an indirect role via the expenditure ratio and the employment relation of the investment good and the consumption good industry.

The rule of thumb says: if wage increases for the business sector as a whole lag behind productivity increases deflation occurs (the rest of the formula kept constant).

For the rectification of the naive quantity theory see (2011) (I)/(II).

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2011). Reconstructing the Quantity Theory (I). SSRN Working Paper Series, 1895268: 1–28. URL
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL

Patrick said in reply to Egmont Kakarot-Handtke...

"if wage increases for the business sector as a whole lag behind productivity increases deflation occurs"

That certainly has the ring of truth to it.

The paradox of productivity?

Jason Smith said...

The relationship between money and prices is more complicated than a simple linear relationship can capture:

spencer said...

Despite deflation in Japan, over the last five years real per capita GDP growth has been greater than in the US.

Of course you have to be careful of these types of comparisons when the Japanese population is actually falling.

anne said in reply to spencer...

August 4, 2014

Real per capita Gross Domestic Product for United States and Japan, 2010-2014

(Indexed to 2010)

[ These last 5 years real per capita GDP has increased by 5.6% in the United States and 3.6% in Japan. ]

Peter K. said in reply to spencer...

Good point. This is why I am skeptical when I read people claim that Japan's extraordinary monetary policy has had no effect.

And even if Japan has done more than before courtesy of Abe and Yoda Kuroda, they also mitigate it with contractionary policy like by raising consumption taxes.

[May 08, 2015] Power The Essence of Corrupt Banking and Politics Is to Grow and Control the Debt

May 04, 2015 | Jesse's Café Américain

"Events have satisfied my mind, and I think the minds of the American people, that the mischiefs and dangers which flow from a national [central] bank far over-balance all its advantages. The bold effort the present bank has made to control the Government, the distresses it has wantonly produced, the violence of which it has been the occasion in one of our cities famed for its observance of law and order, are but premonitions of the fate which awaits the American people should they be deluded into a perpetuation of this institution or the establishment of another like it."

- Andrew Jackson, Sixth Annual Message, December 1, 1834

"Another cause of today's instability is that we now have a society in America, Europe and much of the world which is totally dominated by the two elements of sovereignty that are not included in the state structure: control of credit and banking, and the corporation.

These are free of political controls and social responsibility and have largely monopolized power in Western Civilization and in American society. They are ruthlessly going forward to eliminate land, labor, entrepreneurial-managerial skills, and everything else the economists once told us were the chief elements of production.

The only element of production they are concerned with is the one they can control: capital."

- Professor Carroll Quigley, Oscar Iden Lecture Series 3, 1976

Money is power. And those who control the money, if they have the will for it, can use it as a means to incredible power, to create debt, and to control it, thereby controlling the debtors, both as individuals, as communities, as regions, and whole nations.

This is the story of global trade deals, the Dollar, and the foul marriage between politics, money, and central banking. The more discretion and secrecy that is granted to those who create money and debt, the more vulnerable is the freedom of the people.

This is the story of Cyprus, of Greece, and of the Ukraine.

And there will be more.

This will to power is as old as Babylon, and as evil as hell.

"The powers of financial capitalism had another far-reaching aim, nothing less than to create a world system of financial control in private hands able to dominate the political system of each country and the economy of the world as a whole. This system was to be controlled in a feudalist fashion by the central banks of the world acting in concert, by secret agreements arrived at in frequent private meetings and conferences. The apex of the system was to be the Bank for International Settlements in Basle, Switzerland, a private bank owned and controlled by the world's central banks which were themselves private corporations.

Each central bank, in the hands of men like Montagu Norman of the Bank of England, Benjamin Strong of the New York Federal Reserve Bank, Charles Rist of the Bank of France, and Hjalmar Schacht of the Reichsbank, sought to dominate its government by its ability to control Treasury loans, to manipulate foreign exchanges, to influence the level of economic activity in the country, and to influence cooperative politicians by subsequent economic rewards in the business world."

Professor Carroll Quigley, Tragedy and Hope, 1966

"He promises you illumination, he offers you knowledge, science, philosophy, enlargement of mind. He scoffs at times gone by; he scoffs at every institution which reveres them.

He prompts you what to say, and then listens to you, and praises you, and encourages you. He bids you mount aloft. He shows you how to become as gods.

Then he laughs and jokes with you, and gets intimate with you; he takes your hand, and gets his fingers between yours, and grasps them, and then you are his."

John Henry Newman

Posted by Jesse at 8:03 PM

Category: audacious oligarchy, central banks, debt slavery, Federal Reserve, financial corruption, modern monetary theory, money corruption, political corruption

Mike Davis, Casino Capitalism, Obama, and Us

October 15, 2008 | Tomgram

Recently, while traveling in the West, I had lunch at a modest-sized casino set in a wild, barren-looking, craggy landscape. On the hills above it spun giant, ivory white, modernistic windmills, looking for all the world like Martian invaders from War of the Worlds. I hadn't been inside a casino since the 1970s -- my mistake -- and the experience was eye-poppingly wild. Venturing into its vast room of one-armed bandits and other games was like suddenly finding oneself inside a giant pinball machine for the digital age, everything gaudily lit, blinking, pinging, flashing, accompanied, of course, by a soundscape to match.

It was (as it was undoubtedly meant to be) strangely exhilarating, riveting, totally distracting, and a curious reminder right now of just how distracting "casino capitalism" -- as Mike Davis calls it in today's post -- really has been. For years, with all the economic bells and whistles, all the mansions and yachts, all those arcane derivatives, all the high-tech glamour and glory, with Americans pouring into the stock market (or at least their pension plans and mutual funds doing it for them), you could almost not notice the increasingly barren, rocky world outside the American casino. You could almost not notice the shrinking of real value, of actual productivity in this country. These last weeks, Americans -- those who weren't already outside, at least -- have been rudely shoved into the real world to assess what their value (personal, national, global) actually is.

The next president will look out over a new, far less dazzling, far more forbidding landscape. Mike Davis, author most recently of In Praise of Barbarians: Essays Against Empire, who is little short of a national treasure, offers his own incandescent view of the landscape, presidential, economic, and otherwise, from the ledge at the edge of the canyon. (While you're at it, check out a podcast of Davis discussing why the New Deal isn't relevant as a soluton today by clicking here.) Tom

Can Obama See the Grand Canyon?

On Presidential Blindness and Economic Catastrophe
By Mike Davis

Let me begin, very obliquely, with the Grand Canyon and the paradox of trying to see beyond cultural or historical precedent.

The first European to look into the depths of the great gorge was the conquistador Garcia Lopez de Cardenas in 1540. He was horrified by the sight and quickly retreated from the South Rim. More than three centuries passed before Lieutenant Joseph Christmas Ives of the U.S. Army Corps of Topographical Engineers led the second major expedition to the rim. Like Garcia Lopez, he recorded an "awe that was almost painful to behold." Ives's expedition included a well-known German artist, but his sketch of the Canyon was wildly distorted, almost hysterical.

Neither the conquistadors nor the Army engineers, in other words, could make sense of what they saw; they were simply overwhelmed by unexpected revelation. In a fundamental sense, they were blind because they lacked the concepts necessary to organize a coherent vision of an utterly new landscape.

Accurate portrayal of the Canyon only arrived a generation later when the Colorado River became the obsession of the one-armed Civil War hero John Wesley Powell and his celebrated teams of geologists and artists. They were like Victorian astronauts reconnoitering another planet. It took years of brilliant fieldwork to construct a conceptual framework for taking in the canyon. With "deep time" added as the critical dimension, it was finally possible for raw perception to be transformed into consistent vision.

The result of their work, The Tertiary History of the Grand Canyon District, published in 1882, is illustrated by masterpieces of draftsmanship that, as Powell's biographer Wallace Stegner once pointed out, "are more accurate than any photograph." That is because they reproduce details of stratigraphy usually obscured in camera images. When we visit one of the famous viewpoints today, most of us are oblivious to how profoundly our eyes have been trained by these iconic images or how much we have been influenced by the idea, popularized by Powell, of the Canyon as a museum of geological time.

But why am I talking about geology? Because, like the Grand Canyon's first explorers, we are looking into an unprecedented abyss of economic and social turmoil that confounds our previous perceptions of historical risk. Our vertigo is intensified by our ignorance of the depth of the crisis or any sense of how far we might ultimately fall.

Weimar Returns in Limbaughland

Let me confess that, as an aging socialist, I suddenly find myself like the Jehovah's Witness who opens his window to see the stars actually falling out of the sky. Although I've been studying Marxist crisis theory for decades, I never believed I'd actually live to see financial capitalism commit suicide. Or hear the International Monetary Fund warn of imminent "systemic meltdown."

Thus, my initial reaction to Wall Street's infamous 777.7 point plunge a few weeks ago was a very sixties retro elation. "Right on, Karl!" I shouted. "Eat your derivatives and die, Wall Street swine!" Like the Grand Canyon, the fall of the banks can be a terrifying but sublime spectacle.

But the real culprits, of course, are not being trundled off to the guillotine; they're gently floating to earth in golden parachutes. The rest of us may be trapped on the burning plane without a pilot, but the despicable Richard Fuld, who used Lehman Brothers to loot pension funds and retirement accounts, merely sulks on his yacht.

Out in the stucco deserts of Limbaughland, moreover, fear is already being distilled into a good ol' boy version of the "stab in the back" myth that rallied the ruined German petite bourgeoisie to the swastika. If you listen to the rage on commute AM, you'll know that 'socialism' has already taken a lien on America, Barack Hussein Obama is terrorism's Manchurian candidate, the collapse of Wall Street was caused by elderly black people with Fannie Mae loans, and ACORN in its voter registration drives has long been padding the voting rolls with illegal brown hordes.

In other times, Sarah Palin's imitation of Father Charles Coughlin -- the priest who preached an American Reich in the 1930s -- in drag might be hilarious camp, but with the American way of life in sudden freefall, the specter of star-spangled fascism doesn't seem quite so far-fetched. The Right may lose the election, but it already possesses a sinister, historically-proven blueprint for rapid recovery.

Progressives have no time to waste. In the face of a new depression that promises folks from Wasilla to Timbuktu an unknown world of pain, how do we reconstruct our understanding of the globalized economy? To what extent can we look to either Obama or any of the Democrats to help us analyze the crisis and then act effectively to resolve it?

Is Obama FDR?

If the Nashville "town hall" debate is any guide, we will soon have another blind president. Neither candidate had the guts or information to answer the simple questions posed by the anxious audience: What will happen to our jobs? How bad will it get? What urgent steps should be taken?

Instead, the candidates stuck like flypaper to their obsolete talking points. McCain's only surprise was yet another innovation in deceit: a mortgage relief plan that would reward banks and investors without necessarily saving homeowners.

Obama recited his four-point program, infinitely better in principle than his opponent's preferential option for the rich, but abstract and lacking in detail. It remains more a rhetorical promise than the blueprint for the actual machinery of reform. He made only passing reference to the next phase of the crisis: the slump of the real economy and likely mass unemployment on a scale not seen for 70 years.

With baffling courtesy to the Bush administration, he failed to highlight any of the other weak links in the economic system: the dangerous overhang of credit-default swap obligations left over from the fall of Lehman Brothers; the trillion-dollar black hole of consumer credit-card debt that may threaten the solvency of JPMorgan Chase and Bank of America; the implacable decline of General Motors and the American auto industry; the crumbling foundations of municipal and state finance; the massacre of tech equity and venture capital in Silicon Valley; and, most unexpectedly, sudden fissures in the financial solidity of even General Electric.

In addition, both Obama and his vice presidential partner Joe Biden, in their support for Secretary of the Treasury Paulson's plan, avoid any discussion of the inevitable result of cataclysmic restructuring and government bailouts: not "socialism," but ultra-capitalism -- one that is likely to concentrate control of credit in a few leviathan banks, controlled in large part by sovereign wealth funds but subsidized by generations of public debt and domestic austerity.

Never have so many ordinary Americans been nailed to a cross of gold (or derivatives), yet Obama is the most mild-mannered William Jennings Bryan imaginable. Unlike Sarah Palin who masticates the phrase "the working class" with defiant glee, he hews to a party line that acknowledges only the needs of an amorphous "middle class" living on a largely mythical "Main Street."

If we are especially concerned about the fate of the poor or unemployed, we are left to read between the lines, with no help from his talking points that espouse clean coal technology, nuclear power, and a bigger military, but elide the urgency of a renewed war on poverty as championed by John Edwards in his tragically self-destructed primary campaign. But perhaps inside the cautious candidate is a man whose humane passions transcend his own nearsighted centrist campaign. As a close friend, exasperated by my chronic pessimism, chided me the other day, "don't be so unfair. FDR didn't have a nuts and bolts program either in 1933. Nobody did."

What Franklin D. Roosevelt did possess in that year of breadlines and bank failures, according to my friend, was enormous empathy for the common people and a willingness to experiment with government intervention, even in the face of the monolithic hostility of the wealthy classes. In this view, Obama is's re-imagining of our 32nd president: calm, strong, deeply in touch with ordinary needs, and willing to accept the advice of the country's best and brightest.

The Death of Keynesianism

But even if we concede to the Illinois senator a truly Rooseveltian or, even better, Lincolnian strength of character, this hopeful analogy is flawed in at least three principal ways:

First, we can't rely on the Great Depression as analog to the current crisis, nor upon the New Deal as the template for its solution. Certainly, there is a great deal of déjà vu in the frantic attempts to quiet panic and reassure the public that the worst has passed. Many of Paulson's statements, indeed, could have been directly plagiarized from Herbert Hoover's Secretary of the Treasury Andrew Mellon, and both presidential campaigns are frantically cribbing heroic rhetoric from the early New Deal. But just as the business press has been insisting for years, this is not the Old American Economy, but an entirely new-fangled contraption built from outsourced parts and supercharged by instantaneous world markets in everything from dollars and defaults to hog bellies and disaster futures.

We are seeing the consequences of a perverse restructuring that began with the presidency of Ronald Reagan and which has inverted the national income shares of manufacturing (21% in 1980; 12% in 2005) and those of financial services (15% in 1980; 21% in 2005). In 1930, the factories may have been shuttered but the machinery was still intact; it hadn't been auctioned off at five cents on the dollar to China.

On the other hand, we shouldn't disparage the miracles of contemporary market technology. Casino capitalism has proven its mettle by transmitting the deadly virus of Wall Street at unprecedented velocity to every financial center on the planet. What took three years at the beginning of the 1930s -- that is, the full globalization of the crisis -- has taken only three weeks this time around. God help us, if, as seems to be happening, unemployment tops the levees at anything like the same speed.

Second, Obama won't inherit Roosevelt's ultimate situational advantage -- having emergent tools of state intervention and demand management (later to be called "Keynesianism") empowered by an epochal uprising of industrial workers in the world's most productive factories.

If you've been watching the sad parade of economic gurus on McNeil-Lehrer, you know that the intellectual shelves in Washington are now almost bare. Neither major party retains more than a few enigmatic shards of policy traditions different from the neo-liberal consensus on trade and privatization. Indeed, posturing pseudo-populists aside, it is unclear whether anyone inside the Beltway, including Obama's economic advisors, can think clearly beyond the indoctrinated mindset of Goldman Sachs, the source of the two most prominent secretaries of the treasury over the last decade.

Keynes, now suddenly mourned, is actually quite dead. More importantly, the New Deal did not arise spontaneously from the goodwill or imagination of the White House. On the contrary, the social contract for the post-1935 Second New Deal was a complex, adaptive response to the greatest working-class movement in our history, in a period when powerful third parties still roamed the political landscape and Marxism exercised extraordinary influence on American intellectual life.

Even with the greatest optimism of the will, it is difficult to imagine the American labor movement recovering from defeat as dramatically as it did in 1934-1937. The decisive difference is structural rather than ideological. (Indeed, today's union movement is much more progressive than the decrepit, nativist American Federation of Labor in 1930.) The power of labor within a Walmart-ized service economy is simply more dispersed and difficult to mobilize than in the era of giant urban-industrial concentrations and ubiquitous factory neighborhoods.

Is War the Answer?

The third problem with the New Deal analogy is perhaps the most important. Military Keynesianism is no longer an available deus ex machina. Let me explain.

In 1933, when FDR was inaugurated, the United States was in full retreat from foreign entanglements, and there was little controversy about bringing a few hundred Marines home from the occupations of Haiti and Nicaragua. It took two years of world war, the defeat of France, and the near collapse of England to finally win a majority in Congress for rearmament, but when war production finally started up in late 1940 it became a huge engine for the reemployment of the American work force, the real cure for the depressed job markets of the 1930s. Subsequently, American world power and full employment would align in a way that won the loyalty of several generations of working-class voters.

Today, of course, the situation is radically different. A bigger Pentagon budget no longer creates hundreds of thousands of stable factory jobs, since significant parts of its weapons production is now actually outsourced, and the ideological link between high-wage employment and intervention -- good jobs and Old Glory on a foreign shore -- while hardly extinct is structurally weaker than at any time since the early 1940s. Even in the new military (largely a hereditary caste of poor whites, blacks, and Latinos) demoralization is reaching the stage of active discontent and opening up new spaces for alternative ideas.

Although both candidates have endorsed programs, including expansion of Army and Marine combat strength, missile defense (aka "Star Wars"), and an intensified war in Afghanistan, that will enlarge the military-industrial complex, none of this will replenish the supply of decent jobs nor prime a broken national pump. However, in the midst of a deep slump, what a huge military budget can do is obliterate the modest but essential reforms that make up Obama's plans for healthcare, alternative energy, and education.

In other words, Rooseveltian guns and butter have become a contradiction in terms, which means that the Obama campaign is engineering a catastrophic collision between its national security priorities and its domestic policy goals.

The Fate of Obama-ism

Why don't such smart people see the Grand Canyon?

Maybe they do, in which case deception is truly the mother's milk of American politics; or perhaps Obama has become the reluctant prisoner, intellectually as well as politically, of Clintonism: that is say, of a culturally permissive neo-liberalism whose New Deal rhetoric masks the policy spirit of Richard Nixon.

It's worth asking, for instance, what in the actual substance of his foreign policy agenda differentiates the Democratic candidate from the radioactive legacy of the Bush Doctrine? Yes, he would close Guantanamo, talk to the Iranians, and thrill hearts in Europe. He also promises to renew the Global War on Terror (in much the same way that Bush senior and Clinton sustained the core policies of Reaganism, albeit with a "more human face").

In case anyone has missed the debates, let me remind you that the Democratic candidate has chained himself, come hell or high water, to a global strategy in which "victory" in the Middle East (and Central Asia) remains the chief premise of foreign policy, with the Iraqi-style nation-building hubris of Dick Cheney and Paul Wolfowitz repackaged as a "realist" faith in global "stabilization."

True, the enormity of the economic crisis may compel President Obama to renege on some of candidate Obama's ringing promises to support an idiotic missile defense system or provocative NATO memberships for Georgia and Ukraine. Nonetheless, as he emphasizes in almost every speech and in each debate, defeating the Taliban and Al-Qaeda, together with a robust defense of Israel, constitute the keystone of his national security agenda.

Under huge pressure from Republicans and Blue Dog Democrats alike to cut the budget and reduce the exponential increase in the national debt, what choices would President Obama be forced to make early in his administration? More than likely comprehensive health-care will be whittled down to a barebones plan, "alternative energy" will simply mean the fraud of "clean coal," and anything that remains in the Treasury, after Wall Street's finished its looting spree, will buy bombs to pulverize more Pashtun villages, ensuring yet more generations of embittered mujahideen and jihadis.

Am I unduly cynical? Perhaps, but I lived through the Lyndon Johnson years and watched the War on Poverty, the last true New Deal program, destroyed to pay for slaughter in Vietnam.

It is bitterly ironic, but, I suppose, historically predictable that a presidential campaign millions of voters have supported for its promise to end the war in Iraq has now mortgaged itself to a "tougher than McCain" escalation of a hopeless conflict in Afghanistan and the Pakistani tribal frontier. In the best of outcomes, the Democrats will merely trade one brutal, losing war for another. In the worst case, their failed policies may set the stage for the return of Cheney and Rove, or their even more sinister avatars.

Mike Davis is the author of In Praise of Barbarians: Essays Against Empire (Haymarket Books, 2008) and Buda's Wagon: A Brief History of the Car Bomb (Verso, 2007). He is currently working on a book about cities, poverty, and global change. You can listen to a podcast of Davis discussing why the New Deal isn't relevant as a solution today by clicking here.

Noam Chomsky Obama's Emerging Policies

Press TV: Just finally Professor Chomsky, the US economy is dominating the news and the lives of all Americans and arguably the people around the world. [There's ] the $ 825 billion dollar package. How do you think the Obama people are going to handle this?

Chomsky: Nobody really knows. What is happening with the economy is not well understood. It is based on extremely opaque financial manipulations, which are quite hard to decode. I mean, the general process is understood, but whether the $800 billion, or probably larger government stimulus, will overcome this crisis, is not known. The first $350 billion have already been spent -- that is the so-called part bailout but that went into the pockets of banks. They were supposed to start lending freely, but they just decided not to do it. They would rather enrich themselves, restore their own capital, and take over other banks -- mergers and acquisition and so on. Whether the next stimulus will have an effect depends very much on how it is handled, whether it is monitored, so that it is used for constructive purposes. [It relies] also on factors that are just not known, like how deep this crisis is going to be.

It is a worldwide crisis and it is very serious. It is striking that the ways that Western countries are approaching the crisis [entirely contradict] the model that they enforce on the Third World when there is a crisis. So when Indonesia has a crisis, [or] Argentina and everyone else, they are supposed to raise interest rates very high and privatize the economy, and cut down on public spending, measures like that. In the West, it is the exact opposite: lower interest rates to zero, move towards nationalization if necessary, pour money into the economy, have huge debts. That is exactly the opposite of how the Third World is supposed to pay off its debts. That this seems to pass without comment is remarkable.

The Ugly Truth America's Economy is Not Coming Back By Dave Lindorff

President Barack Obama and his economic team are being careful to couch all their talk about economic stimulus programs and bank bailout programs in warnings that the economic downturn is serious and that it will take considerable time to bounce back.

I'm reminded of an experience I had with Chinese medicine when I was living in Shanghai back in 1992. I had come down with a nasty case of the flu while teaching journalism at Fudan University on a Fulbright Scholar program. <!--break>A Chinese colleague suggested I go to the university clinic. When I told him there wasn't much point since doctors couldn't do much for the flu besides recommend fluids and bed rest, he said, "That's Western doctors. You could go to the Chinese medicine doctors at the clinic. They can help you." I figured, what the hell, and we went. The doctor inquired into the lurid details of my illness-how my bowel movements looked, the color of the mucus in my nose, etc. He didn't really examine me physically. Then he prescribed an incredible number of pills and teas and sent me home with a huge bag of stuff, and instructions on the regimen for taking them through the course of each day. I followed the directions dutifully, and my colleague came by each day to check on my progress. By the fifth day, when I was still running a fever and feeling terrible, I told him I didn't think the Chinese medicine was working. He replied confidently, "Chinese medicine takes a long time to work."

I laughed at this. "Sure," I said. "But the flu only lasts a week or so, and now, when I get better, you'll say it was the Chinese medicine, right?"

He smiled and agreed. "Yes. You are right."

Obviously the Obama administration recognizes that it needs to keep the finger of blame for the current economic collapse squarely pointed at the Bush administration, which is certainly fair in large part (though the Clinton deregulation of the banking industry played a major part in the financial crisis and its enthusiastic promotion of globalization began the massive shift of jobs overseas that has left the nation's productive capacity hollowed out). But it also seems to recognize that it cannot tell the bitter truth, which is that our national economy will never "bounce back" to where it was in 2007.

America, and individual Americans, have been living profligately for years in an unreal economy, propped up by easy credit which inflated the value of real estate to incredible levels, and which led people to spend way beyond their means. Ordinary middle-class working people have been encouraged to buy obscenely oversized homes at 5% down, or even no down payment. They have been lured into buying cars the size of trucks, one for each driving-aged member of the family (in our town, so many high school kids drive to school that the school ran out of parking spaces and the yellow school buses, largely empty on their runs, are referred to by the students as the "shame train," an embarrassment to be seen riding). They've installed individual back-yard swimming pools, unwilling to share the water with their neighbors in community pools. Boring faux ethnic restaurant franchises of all kinds have befouled the landscape, filling up with families too stressed out to cook, and willing to endure over-salted, over-priced and tasteless cuisine and tacky plastic décor night after night.

Now this is all crashing down. Property values are in free-fall. Car sales have fallen off a cliff. Joblessness is soaring (At present, it's approaching an official rate of 8%, but if the methodology used in 1980, before the Reagan administration changed it to hide the depth of that era's deep recession, were applied, it would be 17% today, or one in seven workers).

Eventually, the economic slide will hit bottom and begin its slow climb back, as all recessions do, but there will be no return to the days of $500,000 McMansion developments, three-car garages and a new car every two or three years for both parents plus a car for each highschooler. Not only will banks no longer be able to offer such credit to clients. People, having been burned, will not be willing to borrow so much. Company health care benefits, pension programs or 401(k) matching programs that were slashed during this downturn will not be restored when the economy picks up again.

Over the last 20 years, America has degenerated into a nation of consumers, with 72 percent of Gross Domestic Product (sic) now being accounted for by consumer spending-most of it going for things that are produced overseas and shipped here.

That is not an economic model that is sustainable, and it is a model that has just suffered what is certainly a mortal blow.

What we are now seeing is the beginning of an inevitable downward adjustment in American living standards to conform with our actual place in the world. As a nation of consumers, and not producers, with little to offer to the rest of the world except raw materials, food crops, military hardware and bad films (none of which industries employ many people), we are headed to a recovery that will not feel like a recovery at all. Eventually, productive capacity will be restored, as lowered US wages make it again profitable for some things to be made here at home again, but like people in the 1930s looking back at the Roaring 20s of yore, we are going to look back at the last two decades as some kind of dream.

It would be better if the new administration would be honest about this, because with honesty, we could have a recovery program that would actually address the real critical issues facing the country-the decline of our educational system, the irrationality of official promotion of home ownership that has led to the proliferation not just of suburbs but of exurbs, the over-reliance on the automobile for transportation, the unprecedented waste of resources, the pillaging of the environment, not to mention the decimation of the retirement system and the creation of a vast medical-industrial complex that is sucking the life-blood out of families and businesses alike.

With honesty, we could also confront the other big obstacle to national recovery-the nation's obsession with militarism and foreign wars. The honest truth is that the US is technically bankrupt and in a state of chronic decline, and yet the nation persists in spending a trillion dollars a year on war and preparations for war, as though America were in mortal danger from foreign enemies.

The truth is that we are not threatened by Communism, by drug lords, or by Muslim Jihadists in any serious way. Rather, we have become our own worst enemy.

The administration could start by telling us all this straight up, but the problem is, most of us probably don't want to hear it, which explains why we're not hearing it. It also explains why we're about to blow another trillion or so dollars on propping up failing banks, funding pointless highway and bridge construction, and blowing up illiterate peasants in remote places like Afghanistan and Pakistan. _____________________

DAVE LINDORFF is a Philadelphia-based journalist. His latest book is "The Case for Impeachment" (St. Martin's Press, 2006 and now available in paperback edition). Lindorff spent five years reporting on China and Hong Kong for Business Week magazine. His current work is available at

[Dec 26, 2008] Disingenuous New York Times Story on Global Imbalances

naked capitalism
Since I am endeavoring to spend some time with my family, forgive me for dispatching this New York Times story, "Dollar Shift: Chinese Pockets Filled as Americans' Emptied."

The article buys, hook, line and sinker, then- Fed-governor Ben Bernanke's depiction of so-called global imbalances (the US borrowing from abroad to fund overconsumption; Japan, China, Taiwan, and the Gulf States running significant, persistent trade surpluses and oversaving). Bernanke chose to position the problem as a "savings glut" which had the convenient effect of placing responsibility for the problem overseas, particularly on the Chinese, who kept the renminbi cheap via a hard peg to the dollar. Key bits:

In March 2005, a low-key Princeton economist who had become a Federal Reserve governor coined a novel theory to explain the growing tendency of Americans to borrow from foreigners, particularly the Chinese, to finance their heavy spending.

The problem, he said, was not that Americans spend too much, but that foreigners save too much. The Chinese have piled up so much excess savings that they lend money to the United States at low rates, underwriting American consumption.

This colossal credit cycle could not last forever, he [Ben Bernanke] said. But in a global economy, the transfer of Chinese money to America was a market phenomenon that would take years, even a decade, to work itself out. For now, he said, "we probably have little choice except to be patient."....

Yves here. As far as I am concerned, this was rationalization of a clearly unstable and unsustainable pattern. But rather than try to find a way out, or at least keep it from becoming more pronounced, Bernanke recommended doing nothing. And it was NOT a market phenomenon, but the result (on the surface, at least) of China pegging the RMB at an artificially low level. Did we explore the possibility of WTO sanctions for the currency manipulation as an illegal trade subsidy? Apparently the US was acutely aware of this as a possibility, and took great care not to give private parties any grounds for using the RMB as the basis for a WTO action. This comes late in the article:
At the last minute [in 2006], however, Mr. Bernanke deleted a reference to the exchange rate being an "effective subsidy" for Chinese exports, out of fear that it could be used as a pretext for a trade lawsuit against China.
So we knew we had the nuclear option in our hands, and there was no will to use it. One has to wonder if there were any threats made in private. My gut says no, given the history here.

Back to the piece:

China, some economists say, lulled American consumers, and their leaders, into complacency about their spendthrift ways.
The problem with this characterization is it make the US a passive party and a victim in a paradigm that we embraced. And let us not forget it takes two to tango.

... ... ...

The article points out that we used cheap Chinese funding poorly:

But Americans did not use the lower-cost money afforded by Chinese investment to build a 21st-century equivalent of the railroads. Instead, the government engaged in a costly war in Iraq, and consumers used loose credit to buy sport utility vehicles and larger homes. Banks and investors, eagerly seeking higher interest rates in this easy-money environment, created risky new securities like collateralized debt obligations.
Let us turn to economist Thomas Palley for an alternative point of view as to where the problem originated, which in turn suggests other courses of action. Note that the material from Palley comes from 2007 and early in 2008, yet the Times gave no consideration to his or other dissenting-from-orthodox views.

Palley starts with the observation that our recent expansion was unbalanced. He sees the big problems as record trade deficits (the result of an overvalued dollar), and (related but somewhat separate) the erosion of manufacturing.

The emphasis on the role of manufacturing is interesting and credible. When you consider the lead times, inflexibility, and transportation costs of manufacturing in Asia (remember, even goods like furniture, which involve round-trip shipping, are often made in China) one has to wonder how we screwed up, particularly when I hear from clothing designers that the reject rate on Chinese garments is typically 50%.

... ... ...

A 2007 Wall Street Journal article, "Is Productivity Growth Back In Grips of Baumol's Disease?" supports Palley's hypothesis about the value of manufacturing:

In the 1960s, Mr. Baumol, now at New York University, and William G. Bowen, an economist who later became president of Princeton University, argued that because productivity growth in labor-intensive service industries lags behind that in manufacturing, productivity growth in service-oriented economies tends to sag.

Their famous example was a classical string quartet -- there are always four players in a quartet and it always takes about the same amount of time to perform a set piece of music. You can't get any more music out of the same number of musicians over that same period of time. Broadening that to other types of services, the implication is that rich countries such as the U.S. that tend to veer toward services would face higher prices as wages and costs rise....

Sectors where productivity is high and average labor cost low "are those things that can be automated and mass-produced," Mr. Baumol, now in his mid-80s and still teaching, said in an interview. "And things where labor-saving is below average are things that need personal care -- these are health care, education, police protection, live stage performance... and restaurants."


U.S. job growth has been concentrated in those latter sectors. More than half of the 1.6 million jobs added in the private sector in the past year have been in food services, health care and social services. Food services alone account for more than 20% of all new jobs this year, including government....

Population aging will shift more of the U.S. economy toward one-on-one services. The Labor Department estimates that between 2004 and 2014, seven of the 10 fastest-growing occupations will be in health care, and health-care employment will double the national average. Employment in leisure and hospitality will also outpace the average, though not by as much

Palley argues that the Fed, despite having given lip service to global imbalances, is in fact operating from and supporting a flawed paradigm.

From Palley:

The U.S. economy has been in expansion mode since November 2001. Though of reasonable duration, the expansion has been persistently fragile and unbalanced. That is now coming home to roost in the form of the sub-prime mortgage crisis and the bursting house price bubble.

As part of the fallout, the Federal Reserve is being criticized for keeping interest rates too low for too long, thereby promoting credit and housing market excess. However, the reality is low rates were needed to sustain the expansion. Instead, the root problem is a distorted expansion caused by record trade deficits and manufacturing's failure to fully participate in the expansion.

If the Fed deserves criticism it is for endorsing the policy paradigm that has made for this pattern. That paradigm rests on disregard of manufacturing and neglect of the adverse real consequences of trade deficits.

By almost every measure the current expansion has been fragile and shallow compared to previous business cycles. Beginning with an extended period of jobless recovery, private sector job growth has been below par through most of the expansion. Though the headline unemployment rate has fallen significantly, the percentage of the working age population that is employed remains far below its previous peak. Meanwhile, inflation-adjusted wages have barely changed despite rising productivity.

This gloomy picture justified the Fed keeping interest rates low. However, it begs the question of why the economic weakness despite historically low interest rates, massive tax cuts in 2001 and huge increases in military and security spending triggered by 9/11 and the Iraq war?

The answer is the over-valued dollar and the trade deficit, which more than doubled between 2001 and 2006 to $838 billion, equaling 6.5 percent of GDP. Increased imports have shifted spending away from domestic manufacturers, which explains manufacturing's weak participation in the expansion. Some firms have closed permanently, while others have grown less than they would have otherwise. Additionally, many have reduced investment owing to weak demand or have moved their investment to China and elsewhere. These effects have then multiplied through the economy, with lost manufacturing jobs and reduced investment causing lost incomes that have further weakened job creation.

The evidence is clear. Manufacturing has lost 1.8 million jobs during the expansion, which is unprecedented. Before 1980 manufacturing employment hit new peaks every expansion. Since 1980 it has trended down, but it at least recovered somewhat during expansions. This business cycle it has fallen during the expansion. The business investment numbers tell a similar dismal story, with spending being much weaker than in previous cycles.

These conditions compelled the Fed to keep interest rates low to maintain the expansion. That policy worked, but by stimulating loose credit and a house price bubble that triggered a construction boom. Thus, residential investment never fell during the recession and has been stronger than normal during the expansion. Construction, which accounted for 5 percent of total employment, has provided over twelve percent of job growth. Meanwhile, higher house prices have fuelled a borrowing boom that has enabled consumption spending to grow despite stagnant wages. This explains both increased imports and job growth in the service sector.

The overall picture is one of a distorted expansion in which manufacturing continued shriveling while imports and services expanded. This pattern was carried by an unsustainable house price bubble and rising consumer debt burdens, and that contradiction has surfaced with the implosion of the sub-prime mortgage market and deflation of the house price bubble.

The Fed is now trying to assuage markets to keep credit flowing, and it will likely soon lower interest rates. On one level that is the right response and it may even work again – though it does increasingly seem like sticking fingers in the dyke to prevent the flood. However, the deeper problem is the policy paradigm behind the distorted expansion, which is where the Fed is at fault and where it deserves criticism.

The ideological and partisan Alan Greenspan wholeheartedly endorsed corporate globalization and promoted the White House and Treasury's unbalanced expansion policies. The Fed's professional economics staff also seems to have dismissed domestic manufacturing's significance and endorsed corporate globalization in the name of free trade. Consequently, the Fed has tacitly supported the underlying policy paradigm that has given rise to America's distorted expansion. Despite talk about reducing global financial imbalances, the Bernanke Fed still seems locked in to this paradigm and that is where constructive criticism should now be directed.

And Palley gave a broader view of the fundamental problem in an early 2008 post:
The last twenty-five years have witnessed a boom in the reputation of central bankers. This boom is based on an account of recent economic history that reflects the views of the winners....

That said, there are other less celebratory accounts of the Great Moderation [the post 1980 smoothing of business cycles] that view it as a transitional phenomenon, and one that has also come at a high cost. One reason for the changed business cycle is retreat from policy commitment to full employment. The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages. That is what happened in the 1960s and 1970s. However, rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth.

Disinflation also lowered interest rates, particularly during downturns. This contributed to successive waves of mortgage refinancing and also reduced cash outflows on new mortgages. That improved household finances and supported consumer spending, thereby keeping recessions short and shallow.

With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending. Higher asset prices have provided collateral to borrow against, while financial innovation has increased the volume and ease of access to credit. Together, that created a dynamic in which rising asset prices have supported increased debt-financed spending, thereby making for longer expansions. This dynamic is exemplified by the housing bubble of the last eight years.

The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.

Given this, the Great Moderation could easily come to a grinding halt. Though high inflation is unlikely to return, recessions are likely to deepen and linger. If that happens the reputations of central bankers will sully, and the real foundation and hidden costs of the Great Moderation may surface. That could prompt a re-writing of history that restores demands for a return to true full employment with diminished income inequality. How we tell history really does matter.

Selected comments

john c. halasz:
Whereas I'm sympathetic to Richard Kline's POV and largely agree with it, I'd have a few nits to pick. For one, I don't think it's useful to readily fling around the term "fascist", since that strips the term of its historical/analytic specificity, and renders vague exactly what forms of authoritarian mobilization and domination might be actually operative. (The Christian right, for example, is best described as phalangist rather than fascist, whereas corporate domination might well be much more fluid as to which particular nodes of ideological coercion it attaches itself to). And appealing against "oligarchs" is a bit archaic and rhetorical overkill, when it's much more a matter of oligopolies operating in a supra-personal systemic dimension rather than of specific individual intentionalities. (Individuals or families are just as much operated on by, as operating on, aggregate system goals).

That said, I would add on that rent-capture is the dominant driving force of oligopolies, especially MNCs, (rather than static profit maximalization), and the high dollar policy amounts not just to a device to lower labor costs, ("the rate of exploitation", in an old jargon, though conventional market economics seems to possess no capacity to distinguish increases in the real distributable surplus product, leading to increased profits, from increases in the ratio of distribution of those surpluses to capital over labor), but to a means of seeking out and capturing rents from abroad, as well as domestically. (Smaller businesses operating in the shadow of the oligopolistic giants are then forced to follow similar cost-cutting strategies to at all survive). And needless to say, this rent-seeking largely operates through (over-)financialization of corporate operations, which draws rents off of the real productive economy, globally and domestically, and not just off the broad wage-class. Since the goal is the capture of rents, i.e., not just detaching them from underlying costs of production, but forestalling their further distribution, there results a decreasing appetite for renovating production through further real investment. (Why is there so little recognition that financial "asset inflation" amounts to a falling rate of profit through over-accumulation/under-investment of capital? The talk of a global savings glut is simply the obverse of an investment dearth). That both, globally and domestically, inequality/maldistribution of wealth and income has been on the rise amounts to an expression of successful rent-capture. Which results in further re-enforcement of the cycle of imbalances.

As for Bushevik fiscal policy, tax-cuts for the rich and spending to distribute further rents to the cronies, providing a source of funding to perpetuate the political machine, tax obligations were simply converted into government debt obligations to the wealthy, who then effectively sold them abroad to finance foreign equity investment and corporate FDI abroad, at higher rates of return. Remarkably little attention has been paid to the U.S. external debt, (except for the likes of Prof. Setser), and that is because the NIIP, the official measure of U.S. external debt, has been shrinking a bit, even as huge CA deficits have been rising, due to a boom in foreign equity markets, (which, ex Japan, far outstripped U.S. equity gains). Needless to say, though that generated an illusion of sustainability to the U.S. CA deficits, they solely benefited the wealthy investor class and the MNCs, since anyone else had little participation in those foreign markets, while facing wage stagnation and increasing indebtedness, amounting to a further mechanism for increased inequality. At last sighting, the NIIP stood at just south of $2.6 trillion, but if one adds up all the CA deficits since 1990, some $2.9 trillion is "missing" from the NIIP. Now that foreign equity markets have collapsed, the NIIP is about to balloon. It's only remarkable how little commentary has appeared on that specific issue.

What we're now facing is a twin global crisis of financial collapse due to excessive debt over-hang and emerging excess production capacity, since that capacity was built during the boom geared to excessive debt-financed consumption and continued to be built up based on illusory expectations and momentum from the boom. That leads to a somewhat paradoxical situation in which both excess debt and excess capacity need to be destroyed to re-balance the global economy. The political and economic means for accomplishing that outcome, especially in a coordinated and "orderly" way are by no means apparent. But it's not clear that policies that replace "good" public debt for bad private debt, and attempt fiscal stimulus, whether to boost consumption or investment demand, especially when the motives to do so are felt most by the fiscally and externally indebted countries, which have the least capacity to do so, exactly fit the bill. Rather, unlocking captured rents, through increased taxation on wealth, (more than income), increased regulation, partial nationalization, and increased publicly deliberated financing and planning of investment would likely figure in any functionally efficient approach toward rebalancing incomes and output in a sustainable way and restructuring industrial production, but ideological barriers render such options unlikely.

December 26, 2008 3:22 PM

Captured Congress, SEC and Financial Media Enabled Economic Meltdown INVESTIGATETHESEC.COM

Captured Congress, SEC and Financial Media Enabled Economic Meltdown

Captured Congress, SEC and Financial Media Enabled Economic Meltdown

I usually harken to George Friedman's latest Stratfor Geopolitical Intelligence report because the analysis is typically well thought out, clearly articulated and often insightful. But when he recently wrote: "Recessions occur when, as is inevitable, inefficiencies and irrationalities build up in the financial and economic system," he sounded like just another Wall Street apologist aping the mainstream financial media penchant for using weasel words like inefficiencies and irrationalities to characterize the deeds of wrongdoing that have finally brought the world's finances it its knees.

In eschewing its once noble calling to speak truth to power as the Fourth Estate, today's captured corporate media has become our 21st century fifth column, abusing the public trust from within by either failing to investigate and accurately report evidence of massive unlawful conduct, or on the rare occasions it does, by sugarcoating criminal deeds with words more aptly suited to boyish pranks– shenanigans, hijinx, mischief, monkeyshines and foolishess– rather than call a spade a spade and honestly label them the acts of consummate lying, cheating and stealing they are. Irrational exuberance and moral risk, indeed.

Friedman also doesn't seem to realize that the crisis now decapitating the world's economies didn't have to happen– would not in fact have happened if those charged with protecting the financial system and the investing public- namely Congress in general and the Securities and Exchange Commission in particular- had simply done their jobs, upheld their oaths, and seen to the enforcement of laws already on the books, instead of consistently looking the other way; or worse still, directly aiding their campaign contributors, benefactors, patrons, employers and future employers by contemptible acts of public disdain such as repealing Glass Steagel, allowing Reg Sho's grandfathering of billions in counterfeit shares, scuttling the systemic market protections provided by the uptick rule, and encouraging $62 Trillion in credit default swaps, insurance contracts in all but name, that would be void as against public policy for lack of "insurable interests" if called by their rightful name, as the courts should some day do.

While today's crisis had lots of chefs, the cake could never have been baked if certain of those in government had not unflinchingly aided the finance and banking industries in zero-sum gaming the system. Cloaked in the Gekkoesque doublespeak of deregulation, innovation, self governance and market efficiency, they fostered a free market system in which the only thing free about it was that insider participants (read banks, hedge funds, broker dealers and their minions) felt free to pillage and plunder at will; a system steeped in secrecy, cooked books, phony opinions, reckless ratings, ludicrous leverage, off balance sheet conduits, and zero accountability; a greedy, arrogant, amoral, some say sociopath culture of corruption, unfettered by the fear of ever being caught, having to admit wrongdoing, or suffer any meaningful punishment.

And why not, knowing their misdeeds would also be zealously overlooked or glossed over by a feckless financial media that dutifully ignored or proclaimed wrongs like naked shorting, stock counterfeiting, failure to deliver and options market maker fraud, mere mirages, while sucking up to billionaire short-seller hedge fund finaglers and ridiculing people like Overstock CEO Patrick Byrne, who valiantly tried to sound the warning.
This collective dereliction of duty (some might say treason, given the harm that has– and is yet to befall us) further emboldened the wheeler dealers in an already historically suspect system to make market manipulation and fraud not just the occasional aberration, but the very modus operandi and profit leitmotif. Of late, they've even gone so far as to naked short the gold and silver markets along with $2 trillion in US Treasuries!

Over the past ten years, increasing numbers of financial experts, economists, academics and market reform advocates like Byrne, Bob O'Brien, Dave Patch, Robert Shapiro and Susan Trimbath, along with tens of thousands of individual investors who've seen their retirement savings swiped in broad daylight, have repeatedly complained, cajoled and pleaded with Congress, the SEC and their industry owned and controlled accomplices at the ironically named Depository Trust Clearing Corporation to stop the carnage- but to no avail. (The DTCC's latest attack on investors which they call dematerialization, seeks to do away with all paper stock certificates, the only true evidence of share ownership, to be replaced by a "trust us" electronic record, known only to the DTCC).

While a rare few in Congress- notably Senators Grassley (IA), Specter (PA), and Sanders (VT)- seem to comprehend just how crooked, unfair and untrustworthy our markets and their regulators have become, one wonders how those who've charted the SEC's course over the past 8 years could have any doubts about it! As the agency explicitly created to first and foremost, uphold and protect the integrity of the markets and the best interests of the investing public, they have, with unceasing devotion, in the eyes of most informed observers, done the exact opposite– enabling wrongdoers to operate with almost total impunity. A bold faced license to steal.

As with the O.J. murder trial years back, there is a mountain of evidence of wrongdoing, but the jury in this case, Congress, the SEC, and the financial media have remained steadfastly deaf, dumb and blind to it.

The NY Times just reported that both the SEC and FBI seemed "taken by surprise" by former Nasdaq lead market maker and Chairman Bernard L. Madoff's alleged $50 billion fraud, while harmed investors are incredulous that the premier regulatory body and protector of the investing public could have missed such a towering Ponzi scheme. Authors of the NY Times "Your Money" column added their tin dime claiming "Thankfully, outright fraud is pretty rare," evidencing once again that at the paper of record, journalism itself is in a state of permanent recession.

[Dec 24, 2008] Have You Bought Into the Pay Double Standard?

Literature is rife with quotes and vignettes illustrating the gulf between the rich and everyone else. And those quips generally take class differences as a given.

Far more interesting and corrosive are the anecdotes that seek to get the public to accept status differences when the basis for them is shaky indeed.

One of my favorite examples comes in Animal Farm, when the original seventh commandment, "All animals are equal" becomes "All animals are equal, but some are more equal than others." Because hardly any of the animals (except the pigs, the leadership group) can read, most do not recognize that they have been had.

Consider the way in which views that are contrary to most wage earners' interests have been internalized (or at least are promulgated in the media). One meme I have noticed surfacing in the debate over the automaker bailout is that UAW employees are paid more than average workers.

Now in and of itself, that statement is meaningless. You need to have an idea of worker productivity to see whether that it out of whack (and for some odd reason, the bloated and highly paid management cohort almost never gets mentioned in these discussions, nor do the massive state level subsidies to the foreign transplants). Perhaps I missed it, but I do not recall seeing any longitudinal work on labor costs (that sort of analysis would help bring some badly needed facts to the table).

But why is framing the discussion around averages alone dangerous? Let's say we collectively want to bring car worker pay down to some sort of average. That has the effect of lowering the average. You will have groups that were formerly at the average that are now above it. And if you accept the implicit logic "above average pay is bad" (fill in the blank as to why), you have a race to the bottom due to pressure on the relatively better paid to take less which puts pressure on aggregate pay.

I imagine now that some of you are snorting that the automakers are an isolated example and I am generalizing beyond a single (albeit very large example). Well, this sort of logic is at work, with a vengeance, but in reverse among CEOs. And it certainly has proven remarkably effective.

While most commentators on CEO pay correctly focus on the role of options-based rewards in goosing pay from generous to stratospheric, the role of compensation consultants seldom gets the attention it merits.

One practice that I have seen get perilous little mention is where the pay targets are set. Based on their belief of what constitutes good modern practice (influenced in no small degree by the pay consultants) most boards set general target ranges for how they would like the CEO to be paid relative to peers. The comp consultant then helps define and survey the peer group's pay ranges, setting a benchmark for how the CEO in question is to be paid.

That all sounds fine, right? Well, except just as all the children at Lake Woebegone are above average, no board likes setting a target below peer group norms. I have heard of numerous examples of targets being set somewhere in the top half (66th percentile, top quarter, top 20%), hardly any at the mean, and none I know of below average (although GE's Jeff Immelt set his pay at a remarkably modest level, saying it was bad for morale and inappropriate for the CEO to be paid vastly more than other C-level executives). If readers know of any examples of companies (other than those with substantially owned by insiders) where the target for CEO pay is below the median of comparable companies, please let me know.

So with this mechanism in place, any CEO who has fallen below median pay who is targeted to be in a higher group will have his pay ratcheted up, independent of performance, merely to keep up with his peers, This increase raises the average and creates new laggards. The comp consultants have institutionalized a leapfrogging process that keeps them busy surveying competitor reward levels and keeps top-level pay rising relentlessly.

And there seems to be a creep in cultural values that accepts, nay endorses, the opposite process at work further down the food chain.


Very interesting.

On the one hand we have the race to the bottom at the lower end of the food chain, and on the other the race to the top at the top end of the food chain.

The mechanism for the race to the bottom being the demands of lowering the pay of above average wage earners in a land where everybody is below average and down with the Smiths, contrasted against a mechanism of levering an increase in pay at the top of the food chain to keep up with the Jones.

Carl Icahn, please visit his website on shareholder activism, as a checks and balance means to keep company management from straying egregiously as they are so wont to do. When we come out of the backside of this mess, shareholder activism that holds managements accountable is absolutely a path to follow or shall we say a means of redirecting management interests

Re UAW - isn't it that the workers at Toyota and the like earn less (for, I'd presume, about the same productivity, at least given results)?

In general, I consider average as the great means to mislead - median is much more meaningful for the comparison.

Of course, you're right on with the CEO compensation. There is a number of problems there:
- we gave the monkeys keys to the banana plantation and have no (easy) way of taking it back (I still believe that shareholders not being able to vote on the compensation is a reduction of their ownership rights).
- the pay is disproportional to any real positive impact most people could have.
- not the best, but often the best connected get the job. Moreover, even when we look at the best,we often see the luckiest instead, as the lucky ones taking pot shots end up in the last 1% tail of the distribution - not the best.
- at some point, the pay is reduced to just keeping the score, and becomes sort of arms-race (as you described).

Personally, I think the problem is more with the publicly owned companies than with private where the management is the owner. If you're the owner, it's up to you how much you scr*w your own company. In public one, you're scr*wing someone else.

The more I think about it, the more I'm starting to believe that publicly trading companies wasn't really that great an invention, due to the disconnect of ownership and management/responsibility.

December 24, 2008 3:07 AM
Richard Kline:
Just as a point of info, the 'Northern autoworker' vs. 'other [read Southern] autoworker' talking point, not to dignify it as an argument, is a total crock. Those non-Big Three plants built in the south were built there for a reason: prevailing _local_ wage rates were, then and now, historically lower than in areas where existing autoplants were built. Those areas also had much lower local benefit rates and expectations. Because those plants were explicitly non-union, and the UAW had no impact in organizing there, wages and benefits conformed to local rates rather than national rates. The appropriate comparison would be to compare northern autoworkers rates to prevailing local rates, and the same for the south---but not directly to each other. There are many, many other issues of this kind in comparing wages; these are not simple arguments.

What we get from those primarily Republican, Southern Congressfolk repeating hard right anti-union memes to an enabling media is simply, as it has been for two generations, a grab for job share, an attempt to syphon off a larger share of national production from existing plants by undercutting labor costs. Totally dishonest, but that should be obvious given the side of the aisle this is coming from.

And those pay consultants for the CEO class: when was the last time you heard them recommending a _decrease_ in wage levels for the sector and individuals they advise? The next time will be the first time. Sooooo, the game is rigged, in other words. The only variance in recommendations is between up and way up.

December 24, 2008 3:47 AM
All the apologists in the world cannot justify GM, Ford, and Chrysler paying so much more in labor, while taking so much longer, to produce cars that are less reliable and less attractive to consumers than those produced by the foreign automakers. You can blame management, and criticize their bloated pay packages. I'll agree with you. But you cannot excuse the UAW's constant reaching for more. The union, in cooperation with management, is responsible for Detroit's lack of competitiveness. There are no other actors that can be blamed.
December 24, 2008 4:32 AM
It is all well and nice to talk of pay. But the primary problem with both CEO's and UAW workers had very little to do with pay.
I vaguely remember reading that the UK had a period after WW2 into the fifties where executive compensation reached a level that was considered grotesque by the general population. the gov'ts response was to raise the top tax brackets with a rate of 85% for the uppermost bracket. That was England and that was then. This is the USA and now. Plumber Joe in Ohio comes to mind he would probably object to 85% on incomes over 10 million.
December 24, 2008 6:41 AM
What we have in the US is the seemingly unshakable belief that one's earnings represent fair compensation for one's contribution. It's the layman's equivalent of marginal productivity theory. Oddly enough, this belief cuts across the political spectrum. The fundamental error of this belief is exposed when we look at where each group on the political sprectrum sees the _exceptions_ to the rule. The left sees the "greedy CEOs and their _excessive_ pay" as the exception. The right sees the "greedy union workers and their _excessive_ pay" as the exception. The unbiased observer should quickly see what these two groups have in common - bargaining power. What needs to be discarded is the belief that market allocations of earning always represent fair estimations of contribution. They don't. They represent differences in bargaining power (and differences in available information, the institutional enforcement structure, etc.)
December 24, 2008 7:19 AM
Jim apparently has utterly missed the point of unions and their relationship to management. The purpose of a union is to attempt to push the envelope for workers. Jim is blaming the union for doing a good job. The role of management in this relationship is to push back. It's inane to expect the union to be equivalently incompetent in negotiations. If the company got a bad deal in negotiations, it's because management didn't do its job.

We don't have to go to Britain to find an example of tax rates that could help fix the broken executive pay system. In the US, as recently as the 70s, the top income tax bracket was 70%. I'd say we should put a 90% tax on total compensation greater than that of the US President, and 70% from there down to $200,000. Then make compensation greater than $200,000 ineligible for corporate tax deduction, and limit board compensation to the level of a US Senator. We could clear up this over compensation problem fairly quickly.


Well said.

I would only add that there also need to be inheritance taxes of 90% or more on inheritances in excess of $250,000, and capital gains need to be taxed at the same rate as salary and wages.

If it is not nipped in the bud soon, the rentier mentality will be the destruction of the nation.

[Dec 23, 2008] RIP Chicago School of Economics 1976-2008

December 23, 2008 | The Big Picture
I remember Mark Skousen once wrote a series of articles applauding the use of quantitative economics by some good, Austrian sympathetic economists, and he basically stated that the reason Chicago was so far ahead of the Austrians was because they positioned themselves on the inside (read: capitulated), and made the right players happy in Washington.

dead hobo:

Your passion for this topic is still viewing the world as more complicated than it really is. Your screeds yesterday about bad regulation were closer to the mark, although this one today has merit.

The heart of both arguments is this simple:

"Some people will steal anything they can, sometimes just to see the look on your face after they do it."

Regulation is both a preventative of this behavior and a most excellent tool of the predator. Economic theory can be twisted likewise. Predator would support free markets because they prompt efficiency and ultimate good .

A predator would also say more regulation is needed after making sure that the proposed regulations can be manipulated to allow him to legally pillage at will.

What is really needed are smarter people. However, since most people are both lazy and stupid, this will not happen soon. Rather, a new theory of something will emerge and captivate the world as the answer to everything. Predators, of course, will take over the new movement and lazy / stupid people will thank them for working so hard on their behalf.


"The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self-adjusting and the best role for government is to do nothing,"

"Instead, Galbraith, 56, says policy-makers are rediscovering the ideas of his father, Harvard professor John Kenneth Galbraith, and economist John Maynard Keynes of the University of Cambridge. Keynes, who died in 1946, argued that governments should spend to combat the unemployment that free markets tolerate."

I dont claim to really understand a lot of economics, but I still don't quite agree with all that has been written. Markets, I think are indeed self adjusting if you let them be. Just that there is a cost associated which not many are willing to pay. And maybe that cost would have been lower had the govt not tried to ward off the pain earlier for short term gain.

Yes, I dont trust the government too much. Their role should be minimal. Yes, there are instances where markets fail and regulation is required, but thats it.

Quite often you talk about repealing the Glass Steagall etc. Regulation does not mean only enacting a law, it is also govt in action when it repeals something. What were they thinking? What was the incentive? Lobbies, Self interest, Greed…

So when that was done, it was also something a result of government action only. When Fed does something stupid, it is again something that a State arm is doing. When the TARP comes out, it is again what the govt is doing. When a currency note is printed and dropped from the chopper, it is again an action by govt. Bailout after bailout, it is the govt action everywhere. Greed, corruption, bending of rules….

And you trust these guys to regulate well???
Just be careful what you wish for BR.

PJ : A B-School kiddie who executed trades one too many and wishes he hadn't.


Half of what you need to know to study economics is in today's NYTimes:

The title is "A Highly Evolved Propensity for Deceit." Lying, cheating, and stealing is a common feature of all more evolved animals. Humans are the best liers, cheaters, and thieves of the bunch. The Chicago School's theories make sense if cheating is rational, and being taken by a cheater is rational. Otherwise, and in fact, theories of rational actors don't work at the edges in human societies. As the liers and cheaters get more proficient, they expand the "edges" where they have control.

Just look at executive pay. Is it really market-based when CEOs stack their compensation committees with pawns and like-minded CEOs? Then the other CEOs can point to those with the best-stacked boards and highest compensation and claim they're being shorted. We end up with a class of people that have stolen their way to utterly irrational compensation. They can claim that they are just rational actors getting paid what the market will bear, but anyone with two functioning brain cells can see that they've rigged the game. That anyone would believe the nonsense is just proof that humans are also rigged to be rubes.


I don't know that the basic framework of the Chicago view is wrong. That is that one should be skeptical of propositions which rest on the assumption that people are not acting in their own best interest.

I think that in practice a subset took this too far to assume

1) People always act in their best interest. Unless you define best interest as the way people intend to act, this is simply not true. There is regret. There is even regret with full foreknowledge of the consquences.

Note that this implies that consumer utility DOES NOT equal happiness or satisfaction.

2) That market failure was negligible. That when people acted in their own best interest the market could generally be assumed to produce the socially optimal outcome. This is an empirical rather than theoretical question and truly powerful examples of market failure seem to be increasing in number.

However, the basic model of people as rational actors I think is sound. We just have to be sure not to confuse utility with happiness.


I am always amazed by those that adhere to strict idealogy. Be it religion, science, human behavior, whatever. It always assumes that whatever inputs I make the result will be predictable. One of the beauties of "real science" is that it is ever changing as new evidence comes forth. The future is unknowable.

These characters that create mathematical models with inputs of "human behavior" to predict what will happen in the markets are just as bad as idealogues. Reminds me of a long time ago when I was young in a faraway jungle. The generals told us what to expect because they studied this stuff at West Point. Unfortunately Charlie didn't read their books and thesis papers and mostly did the unexpected. We kept adapting on the run but the generals assured us that their plans would lead to ultimate victory.

They were all full of shit.


BR: Can't go all the way with you there. I don't think even Krugman would reject Friedmanism wholesale. In fact you personally are constantly railing against the Fed for running the printing presses which suggests you buy some of his monetarist theories or perhaps you'd forgotten that. Not all Keynes's theories are watertight although most are and indeed most governments of whatever political color really run their economies on his terms whatever conservatives may say. The same is true of Friedman although I'm not an expert by any means. The problem with Friedmanism as with any theory is when it becomes considered the ultimate doctrinal answer instead of part of puzzle. And that's what's tended to happen in this country over the last 25 years. The process has been assisted of course by a peculiar American adherence to certain myths about itself and society. Someone, I can't remember who, said economics is not a solution but an argument about a solution (or something similar). Friedman is like Keynes a part of the argument. A smaller part undoubtedly but a part nevertheless.


This from H.L. Mencken:

And here, more than anywhere else I know of or have heard of, the daily panorama of human existence, or private and communal folly–the unending procession of governmental extortions and chicaneries, of commercial brigandages and throat-slittings, of theological buffooneries, of aesthetic ribaldries, of legal swindles and harlotries, of miscellaneous rogueries, villainies, imbecilities, grotesqueries, and extravagances–is so inordinately gross and preposterous, so perfectly brought up to the highest conceivable amperage, so steadily enriched with an almost fabulous daring and originality, that only the man who was born with a petrified diaphragm can fail to laugh himself to sleep every night, and to awake every morning with all the eager, unflagging expectation of a Sunday-school superintendent touring the Paris peep-shows

He wrote that in 1922. The more things change the more they stay the same.

dead hobo:

A really good theory will also attract a servant class of ivory tower intellectuals who implicitly support the acts of predators, but confuse their theft and manipulations with efficient markets. They will provide this support as a matter of politics and purity of thought, without asking for profit. The predators view them as useful idiots and professional ball lickers.

For example, look at the WSJ editorial pages. Their heart is with free markets that are honestly run, warts and all. Their words tell a different story. Damn near every kook theory that claims to be a descendant of a free market is embraced and shouted out, much like a well dressed crazy person on a street corner would yell at invisible people. Some of the best theories that favor predators are "Supply Side Economics", "Trickle Down Economics", "The Laffer Curve" and a cornucopia of others. How can a predator not loves these people?

It's not that the support from intellectual ivory towers is lacking a conscience or part of a conspiracy. It's more like they don't have any common sense and confuse the leadership provided by predators as support for their crazy ideas.


I know it has been discussed many times that one of the reasons that pure deregulation always fails is because we as a society will not accept the natural consequences of that "orgy of greed." Then it turns into free markets for profit gains and socialized losses. I'm not so sure that deregulated markets would always fail if we collective chose to accept the natural losses. I can't help but think to the great depression and what an impression that left on so many people as changed their behavior (many were really good savers almost to excess) for decades. That was not a result of deregulated markets per se, but it does put forth an example of a condition we would have to accept if we want to accept deregulated markets. Like the stock market, you have to be willing to lose everything. No risk. No reward.

Dan Duncan:

Barry, by having not adhering to the Chicago School of thought, and posting the same on his blog is "doing a great service to our country and humanity"?

Serving all of humanity no less….

As an aside…if Barry, should somehow become delusional and turn all Fiedmanite on us, and post his thoughts about his conversion-would it too be a great service to humanity?

Do all opinions shared with yours' and expressed become a great service to humanity?

Forget the economic issues-that stuff is boring. What I'd like to know is:

Barry-what do you think-do you also feel as though you are perfoming a great service to humanity?

These blogs are fascinating….and funny, too!


BR: I don't have the slightest clue WTF you are talking about . . .


I got to this observation through biology. It was immediately clear that the efficient market hypothesis was just a dressed up economic version of "survival of the fittest."

It always struck me as tremendously stupid on its face, because every student who's gotten beyond bio 101 realizes that "fittest" isn't always "best."

Path dependency alone leads to a lot of insane workarounds in organisms and populations, workarounds that often fail and kill the organism. Not to mention, many natural systems are marked by shocking boom-and-bust cycles. And stable systems can become unstable very quickly if you introduce a new element. The useful insight isn't to say "we should welcome new species because the environment will self-adjust and rabbits will create a new stable equilibria for Australia," it's to look at a rabbit and say "whoa, there. This thing will f*** up everything. Rabbit stew in the customs impound lot tonight!"

Seriously, what kind of moron thinks "the market will self-adjust" is a brilliant insight? EVERYTHING self-adjusts. But that does not mean things will be GOOD. If we launched every nuke on the planet today, the environment would self-adjust and cockroaches would reign supreme. But we would all be dead. If we got rid of all organized government, we'd live in a gang state like Haiti. We'd self-adjust, but things would suck.

The point is to use insights about how the system operates free of constraint not to argue that no constraints are needed, but to figure out what constraints or other actions are needed to make it function better! It's to think about what we want out of this system (sensible investment in the real world) and to try and influence the market towards achieving the outcomes we desire in aggregate. To look for certain destructive patterns, and find mechanisms to counter those (sometimes it's just observation, sometimes it's allowing a counter-force that's developed to become stronger, sometimes it's forcing transparency, sometimes it's dragging off a guy in shackles).

But at base, it's the recognition that even robust systems are prone to massive collapse, and need management if you care to see them achieve a certain outcome. The goal is to see when a rabbit is headed for Australia (highly leveraged banks making crazy bets on CDOs?), and to stop it before it takes down everything. While, of course, allowing sheep and cows into Australia.

It's supposed to be hard, not magic.

[Dec 22, 2008] Blaming Bush for the Wrong Things By Barry Ritholtz

December 21, 2008 | NYT

The Sunday New York Times has a front page article more or less blaming Bush for the housing and credit crisis. Its part of their "The Reckoning" series, and it is in some ways, off base. The long article (written by 3 people) comes close to some real truths, but it veers off, focusing on some minor and irrelevant elements.

One side note: Critics of newspapers never seem to understand that headlines are not by the article's author(s), but by an editor. Hence, why the headline focus is sometimes misplaced or emphasizes the wrong issue.

This discussion is very nuanced, so if you get most of your news and information from talk radio or any of the Faux channels, well, you shouldn't bother reading any further. Pursuing this will only hurt make your brain hurt, or make you angry, or both.

Let's start out with a brief excerpt from Bailout Nation:

From Reagan to George W. Bush, each President of the past 25 years bears some responsibility for contributing to the belief that we can let markets govern themselves.

Of the four Presidents over that period of time, President George W. Bush is the one with the seemingly greatest culpability. Not just because this crisis happened on his watch - although that is reason enough to give him a fair share of responsibility. More significantly, the basis of his culpability is that he shared Greenspan's and Gramm's radical belief system - that markets could police themselves, and that all regulation was inherently bad. This philosophy colored all of the President's appointments to key supervisory positions, as well as his legislative agenda.

That philosophy, and the executive, administrative and legislative acts, including political appointments, is where we should focus our ire at the soon the be former-President Bush. The belief system that leads to the conclusion that really bad behavior in the corporate world needs no proscribing is where you should look to place blame.

That Bush had as a goal increased home ownership is, quite bluntly, irrelevant. It is a worthy goal, and certainly one that could be achieved without forcing the collapse of the financial system.

Indeed, as the chart at right shows (source: NYT), home ownership has increased every year since 1994. Funny, from that year and for each of the next 10 years, there was no collapse. You have to ask yourself why. No, the 1997 Tax Break, did not, as the NYT implied yesterday, Help Cause Housing Bubble. Home ownership was rising years before that went into effect.

What Bush did differently than prior Presidents was that he genuinely believed that regulations proscribing bad corporate behavior were unnecessary. It was that ruinous belief system, one he shared with other key players, that led to the crisis.

In fairness to Bush, many of the really bad policies that led to the boom and bust of Housing, and the collapse of credit, were in place before he was sworn into office. In particular, the repeal of Glass Steagall (Gramm-Biley-Leach Act), and the Commodities Future Modernization Act (CFMA), were both heavily lobbied for by the industry, sponsored by Phil Gramm, and passed by a Congress that didn't bother to read them. They were both signed into law by Bill Clinton. That set of legislation is where you begin to find answers to The Reckoning.


"Former Presidents Clinton, George H.W. Bush, and Reagan all have some responsibility, but far less. Bush Senior is probably the least culpable. Reagan did not reappoint Fed Chair Paul Volcker, and replaced him with Alan Greenspan. Regardless of other actions, this alone haunts his legacy, and gives the Gipper some degree of responsibility.

While some partisans have tried to paint the crisis a purely Republican debacle, history informs us otherwise. Yes, the GOP did control Congress from 1994 to 2006. However, President Clinton, a Democrat, bears a significant amount of responsibility too. He and his Treasury Secretaries, Robert Rubin and Lawrence Summers, each supported very limited regulation of free markets. Clinton, Rubin and Summers are one step behind W. in the hierarchy of proximate causes of the debacle." (Bailout Nation)

  1. larster Says:
    December 21st, 2008 at 10:13 am

    The Fannie/Freddie meme must be a staple of talk radio and Fox News, as every Repub that I know states it like the gospel truth. Everyone wants a simple explanation, which is why this propoganda works. Watch and see if they are successful in touting the Bush record of job growth. During the legacy tour Bush relentlessly touts his record of job growth, which you have consistently shown is simply not true.

  2. km4 Says:
    December 21st, 2008 at 10:23 am

    Bush has created a new hypertext linkage definition of kleptocracy* and massive US financial ponzi scheme to keep the bullshit US economy going where credit must flow like a raging river or America's house of cards goes bust trumps everything else.

    Mission accomplished and BOL to 98 or 99% of Americans for next ? years.

    *government by those who seek chiefly status and personal gain at the expense of the governed.

[Dec 22, 2008] What Does Regulation Regulate? By Barry Ritholtz

December 22nd | The Big Picture

Here's one of the simple truisms that gets lost in the political (i.e., bumper sticker) discussions.

Don't regulate the free markets! Don't interfere with innovation! Don't stifle incentives!

What bullshit.

One of the best ways to win a debate is to control the language used. This was one of the elements George Orwell was discussing in 1984, and why the language in the novel was degraded to phrases like "double plus good." All nuance was dismissed. He who controls the language controls the political economy is what Orwell was saying. In modern times, its done not with boot-jacks and guns, but with catchphrases and clever marketing. Its not as heavy handed, its just more insidious.

When we discuss "Regulations," we are talking about regulating human behavior. And that behavior can range from following misplaced incentives to falsifying accounting data to overtly legal but destructive actions - like putting people into loans they knew (or reasonably should have known) were likely to default.

What a terrible sham the no "regulation cry" has been. It is really a vote for no rules against illegal and/or criminal behavior . . .

  1. Scott F Says:
    December 22nd, 2008 at 6:59 am

    Nineteen Eighty-Four's title, its terms, its language (Newspeak), and its author's surname are bywords for personal privacy lost to national state security.

    "Orwellian" denotes many things. It can refer to totalitarian action or organization, as well as governmental attempts to control or misuse information for the purposes of controlling, pacifying or even subjugating the population.

    "Orwellian" can also refer generally to twisted language which says the opposite of what it truly means, or specifically governmental propagandizing by the misnaming of things; hence the "Ministry of Peace" in the novel actually deals with war and the "Ministry of Love" actually tortures people. Since the novel's publication "Orwellian" has in fact become somewhat of a catch-all for any kind of governmental overreach or dishonesty and therefore has multiple meanings and applications.

    Deregulation = Free markets = Economic Collapse

  2. Marcus Aurelius Says:
    December 22nd, 2008 at 7:03 am

    Regulations are laws, and laws, regulations. A society without laws? Yes, let's try that.


  3. Mark E Hoffer Says:
    December 22nd, 2008 at 7:07 am

    "He who controls the language controls the political economy is what Orwell was saying."

    and, we need its Twin:

    "He/That which controls the Currency controls the Financial Economy"

    in order to decrypt our present circumstances..

  4. VoiceFromTheWilderness Says:
    December 22nd, 2008 at 8:23 am

    Absolutely, couldn't have said it better. The breakdown in honesty, and clarity of thinking that accompanies the succesful introduction of lies into public discourse is a hallmark of this age. The plethora of people walking around chanting slogans from 'economic-religions' without having the slightest bit of personal insight into the validity or lack thereof of these slogans is staggering. The fact that most think they are saying something that is 'there own idea' and not something that has been planted in their heads for the purposes, and benefit, of others is equally staggering.

    The imputed glory of 'the market' would be hilarious if it wasn't such a nasty con. I site again the case of Leo Farnsworth - the inventor of television who died penniless (and dreaming of fusion power as a comeback) - his hardwork, and personal vision of the birth of a great and wise age of learning and knowledge brought on by television stolen from him (after he made it work) by David Sarnoff at CBS. 'The Market' is full of pickpockets, con artists, and overpowering force used in pursuit of personal profit, left to itself it will rapidly (astonishingly rapidly) collapse into free for all with a very few emerging victorious, ready for the battle the next day.

    Too bad in their desperate need for more they destroyed the most well balanced economy in the world, and the most open society in the world.

    Think Hank Paulson can order us up a new golden age? Think he's even trying?

  5. dead hobo Says:
    December 22nd, 2008 at 8:37 am

    Are you asking about regulation that is protectionism or about regulation that prevents people from doing bad things to you. [BR: this has nothing to do with protectionism -- it is about deregulating the banking and financial markets]

    Most people don't like protectionist regulation, unless they are the ones receiving income as a result of the protectionism. Government imposed monopolies are pretty good for business if you are in the protected class. They suck royally if you are paying higher prices because competition isn't allowed.

    Predators will always be among us and poorly written regulations regulation prevent them from doing what makes them feel best. Slick con artists will find lazy and ignorant politicians who promote 'freedom from excessive government' as a mantra and the predators will support their efforts to make the world safe for said predators.

    People are basically stupid. One way to convince an angry mob that predators need protection is make an outrageous claim and say 'you're next if they get us'. For example, 'pulling a gun from a cold dead hand' can be equated to the need for free markets to allow 30 or 40 to 1 leverage with OPM and high management fees.

    In fact, the current SEC can be used as the poster child for the concept of Lazy Stupidity and Empty Suit Management. GWB is the new high water mark for that concept and will be tough to beat … unfortunately somebody will eventually. The current Republican Party has been and will continue to be the party of the predator and continue to celebrate institutional laziness, only it will be done with eloquence and wedge issues. The media will act impartial and embrace institutional stupidity because some advertisers support wedge issues and all day news cycles require a lot of hot air to fill up. Also, people like to be told how to feel, not encouraged to think.

    Predators and institutional laziness will always be here. You are naive and dreaming if you think real changes are coming. TARP trickle down economics is another government grant to exploit. Anecdotal stories abound about the lack of credit keeping the economy down, yet several oceans of money intended to free up credit have only created a minimum state of liquidity. Executives are protecting themselves. Uncle Stupid is failing to put the cash where it needs to actually be. The lower price of gas and other second level effects of lowered commodity prices are having a greater effect, I would argue.

    Regulation is really a tool for the creative and ambitious predator.

  6. debreuil Says:
    December 22nd, 2008 at 8:50 am

    I totally agree, no regulation is essentially saying 'no laws in the bank robbery industry' - pthat would cause at least a lot of labor unrest, more likely a bidding war for talent. This time though, the gains were given to people, but in the form of debt. This resulted in people not complaining (they ended up having a boat and a second car anyway), and yet not actually sharing in the gains in productivity. I don't know if this was planned or not (I doubt it), but by this logic, a lot of that debt that the average person is carrying should really have been gains in wages. So instead of a gain, it is like a double loss (you pay the loan plus the interest, which gets killer as you close in on default - plus the stress of ruin!).

    For the record I'm not in debt, so this isn't some way for me to try and get a free lunch : ). I was one of the stupid people who saved and went without things I couldn't afford. Now that I'm faced with helping pay for it all (along with everyone else here), I'm just wondering who's getting all the loot. Any time there are huge gains in productivity that translates into money for someone - that is what money represents at the end of the day after all.

    I'd like to blame the person with the mortgage they can't afford, but something just doesn't smell right about that. I know a lot of people in that situation, and they generally work hard and don't seem to have a lot more that they 'deserve' given what they do. I think the natural workings of the 'wages market' has really been corrupted by easy credit, which is a fancy way of stealing from people.


  7. dead hobo Says:
    December 22nd, 2008 at 9:12 am

    debreuil Said:
    December 22nd, 2008 at 8:50 am

    One thing that has certainly happened is that while productivity has been increasing fairly rapidly, wages have been stagnating or worse. Normally that would cause at least a lot of labor unrest, more likely a bidding war for talent. This time though, the gains were given to people, but in the form of debt.

    Excessive credit is a root cause of inflation, as in too much money chasing too few goods. The printing press is not the only form of monetary creation. Low credit standards are a symptom of excessive credit. Excessive credit creates rising prices for things that people can borrow money to get. It caused high real estate prices, high commodity prices, high demand for big ticked appliances, and more. Excessive and inflationary credit has no relationship to wages, unless you are a commission salesman and you are profiting from inflated asset prices.

    Nobody forced anyone to borrow to excess. Nobody can cry 'It's Not My Fault'. I took advantage of low credit and refinanced THE OUTSTANDING BALANCE ONLY on terms that just keep getting better and better (see previous posts for details). I didn't go out and buy tons of crapola that still needs to be paid for and may not even exist any longer. As I said above, people are stupid. They believed that they were getting something for nothing.

    Rising productivity in a labor market that has high employment means employers have at least one bright spot to look at. High unemployment and fear for one's job tends to calm a lot of labor unrest. Also, the idea that hard work improves one's chances of not losing the current job motivates higher productivity for a while.

  8. Barry Ritholtz Says:
    December 22nd, 2008 at 10:10 am

    I am referring to "radical deregulation" - allowing the players in the markets to operate without oversight, supervision, or reasonable constraints on leverage.

    I am not discussing ordinary regulations …

[Dec 22, 2008] Has Beggar Thy Neighbor Started

naked capitalism
In a very good Financial Times piece, Wolfgang Munchau in passing mentions "unsynchronised monetary policies" and suggests that the Fed's aggressive move to quantitative easing (oh, we don't dare call it that, the Fed insists its flavor is different) will force the ECB to follow suit to a fair degree. Munchau does not consider this to be a plus:
I am sceptical about the benefits of the Fed's new policy of quantitative easing. We do not have a liquidity crisis, but a solvency crisis, which expresses itself in large spreads and dysfunctional money markets. I cannot see how adding more and more liquidity to the system solves this problem.

Instead of propping up each bank, and swamping the market with cash, we need to restructure and shrink the banking system, as a first step to a sustainable solution to this crisis. Quantitative easing without deep structural financial reform could cause lot of trouble in the long run.

I think, however, there is a case for temporary interest rate cuts in Europe, but only on condition that this policy would be forcefully reversed once credit markets start to recover, and once the economy emerges from the slump.

But we should not delude ourselves into thinking that monetary policy can save the world. It can play a useful role, especially since we do not have the stomach for an optimal fiscal policy response. But it will not prevent the worst slump of our generation.

Selected comments
Brenda Rosser:
Yves Smith said: "How smart is it to advocate open trade when some countries stack the deck by having artificially cheap currencies? That is tantamount to an export subsidy, but we haven't done much except jawbone China very late in the game..."

And vice-versa, of course. The US government has pursued an artificial 'strong dollar' policy for a long time and this has served American global corporations extremely well. Including those operating in China and exporting to the US.

"Half of the world's 500 billionaires and a third of the 27 million millionaires call the USA their home. Five of the top ten banks are US, six of the top ten pharmaceutical/biotech companies, four of the top ten telecommunications companies, seven of the top information technology companies, four of the top gas and oil companies, nine out of the top ten software companies, four of the top ten insurance companies and nine of the top ten general retail companies. The concentration of economic power is even more evident if we look at the top ten companies in the world: 90 percent are US owned; of the top 25, 72 percent are US owned; and of the top 50, 70 percent are US owned. Within the inner circle of the biggest companies, the US has an overwhelming presence and dominance. Africa and Latin America are absent from the list. And the so-called Asian Tigers have three companies among the top 500, less than 1 percent. World markets are divided up among the 238 leading US and 153 European companies and banks. 80% of the leading oil and gas companies are US and EU owned. These sales earn high profits and are used to payoff or buy up allies and the armed forces in strategic regions. The US spends more than $400 billion on defense - about half the world total.."

Facts on the US Economic Empire
by etra Jaimers. Eat the State. Volume 7, #3 October 9, 2002

naked capitalism There is no playbook

Well, what we all suspected has now been made official. From the New York Times:
Mr. Paulson and other senior advisers to Mr. Bush say the administration has responded well to the turmoil, demonstrating flexibility under difficult circumstances. "There is not any playbook," Mr. Paulson said.

Why am I not surprised to see that what ought to be viewed as a failing is instead spun as a virtue?

I have mixed feelings about the article in which this juicy quote appears, "White House Philosophy Stoked Mortgage Bonfire." While it does chronicle some of the ways that the Bush "ownership society" vision, which included raising the level of homeownership, it makes the Administration sound like a bunch of hapless innocents, who had good goals but failed to see that the implementation of their objectives left a great deal to be desired

But in private moments, aides say, the president is looking inward. During a recent ride aboard Marine One, the presidential helicopter, Mr. Bush sounded a reflective note.

"We absolutely wanted to increase homeownership," Tony Fratto, his deputy press secretary, recalled him saying. "But we never wanted lenders to make bad decisions."

That is more than a bit of revisionist history. If you don't believe in oversight, pray tell how are you going to assess the quality of decisions being made? The view, until so many investments came a cropper, was that any agreement freely entered into by two parties was OK (well, as long as it doesn't involve illegal substances or copyright theft).

And the article never questions the thesis that homeownership is a good thing, merely that the envelope should not have been stretched to make it happen. We've questioned that view, and Felix Salmon has found some useful data (his latest is that "Homeownership Makes You Fat and Unhappy").

But the article nevertheless has some quotes near and dear to our heart, such as:

"This administration made decisions that allowed the free market to operate as a barroom brawl instead of a prize fight," said L. William Seidman, who advised Republican presidents and led the savings and loan bailout in the 1990s. "To make the market work well, you have to have a lot of rules."

Seidman unwittingly exposes the fundamental contraction at the root of the "free market" construct" for markets to work well enough for parties to deal with each other on a transactional basis (ie, no or limited pre-existing relationship), there HAS to be some level of regulation. And Madoff illustrates that dealing with a supposedly known party with long-established relationships isn't safe).

And in an amusing bit of synchronicity, another New York Times story, a comment by Alan Blinder, takes on Paulson's sorry record of TARP course-changes. While most of the arguments are familiar, Blinder dispatches them convincingly and colorfully. For instance:

So here we are, looking at an all-too-familiar story. The administration that brought you the Iraq war and the Katrina response is locking in another disaster before it leaves town. What to do?
You can read the piece here.
Yves Smith:

I wrote this for another purpose, but I think it will serve here:

Since the 1980s, Americans increasingly subscribe to notion that so-called free markets are superior to government intervention. This false dichotomy has led to sloppy thinking and bad policy.

"Free markets" is a fantasy every bit as removed from planet Earth as the 65 lemmas "everyone uses and knows everyone uses Taylor- Nash bargaining" construct discussed earlier.

It's impossible to have private ownership of any kind without protection of property rights; that alone presupposes a government. Indeed, development economists have found the lack of clearly defined, enforceable ownership, particularly of land, is a serious impediment to progress. Moreover, negotiating is not cost-free; one of the reasons organizations exist is to lower contracting expenses.

Free market proponents have called for a wide-scale dismantling of regulation, asserting that private mechanisms are always better than public. Stripped to its core, the argument boils down to efficiency, that less intervention yields more profit.

But the exhortations went further than that. Milton Friedman repeatedly evoked the idea of "free people, free markets,' conflating libertarian thinking with the struggle for independence and the Wild West.

But the Wild West was, well, wild and often ungoverned. As another bit of American iconography reminds us, black hats t roam freely until grizzled John-Wayne-type lawmen intercede.

A market without rules looks a lot like a brawl. Power prevails. Consider: the stock market never would have come back in a meaningful fashion after the 1929 crash in the absence of sweeping federal regulation in 1933 and 1934. Investors realized only too late that the speculative bubble resulted from not just enthusiasm for new technology but also rampant market manipulation and false reporting. The new rules helped entice investors back by assuring timely and complete disclosure and barring trading practices that could operate to the public's detriment.

Moreover, this ideology has failed to deliver the goods....not only does the free market faith suffer from internal contradictions, but more important, the times it was put into practice, such as Chile, advocates claimed success when the experiments were a dismal failure. In fact, in Chile's case, the economy got back on track only when Keynesian reforms (aka government spending, anathema to libertarians) were implemented.

Now I have a simple thought experiment: how do you buy a computer in your "free markets" world? You do not have any of the present consumer protections. How can you verify that it is a good computer? You need to hire someone to test that it really functions as advertised, or be competent to run such tests yourself. What happens if the computer craps out in four weeks? Friedman posited that courts would be the method of enforcing property rights. You'd have to go to court every time something did not work as advertised. I can tell you from personal experience that litigation is time consuming and emotionally draining.

Regulation facilitates commerce. It reduces the amount of negotiation, due diligence, and the cost of enforcement.

Greenspan and Democracy

December 18, 2008 | Robert Reich's Blog

Alan Greenspan, writing in the current issue of the Economist, argues that in the future banks will need more of a capital cushion than they needed before the crisis because holders of bank liabilities will require them to hold more capital. "Today, fearful investors clearly require a far larger capital cushion to lend" to financial intermediaries. In other words, there's no need for additional regulations requiring banks to have more capital. The financial market will take care of itself. Greenspan has learned nothing at all.

In 2004 and 2005, when many economists warned that a speculative bubble in home prices and home construction posed a risk to the financial system, Greenspan brushed aside such worries, saying housing prices never declined. Before that he had resisted calls for tighter regulation of subprime mortgages and other instruments which allowed people to borrow far more than they could afford. He had also opposed tougher regulation of derivatives. Almost a decade earlier, Greenspan had urged Congress to knock down the regulatory walls that separated investment and commercial banks, thereby inviting investment banks to place huge bets with other peoples' money.

Barely two months ago, when Greenspan appeared before Congress to explain what had happened to the economy, Representative Henry Waxman asked him pointedly: "Were you wrong?"

"Partially," Greenspan responded. "This crisis has turned out to be much broader than anything I could have imagined."

It might be argued that Alan Greenspan's failure of imagination was not just about the scale of the crisis. More basically, his ideology had made it difficult for him to imagine what could happen when financial markets are left to themselves. He had supposed that the interplay of millions of self-seeking individuals would make government regulation unnecessary – except to prevent outright fraud or theft. To Greenspan and others like him, the global financial market represented the almost perfect form of the free market, because buyers and sellers were could gather almost unlimited information about one another, at almost instantaneous speed, at very low cost. Not only would the financial market be self-correcting, but it would automatically give us everything we might reasonably wish from it.

Greenspan's real failure of imagination was his inability to believe there are useful market rules beyond those that protect private property and prevent outright fraud. This, presumably, was why he kept insisting for so long that government be held at bay.

But now the United States has chosen to deal with the financial crisis by buying up a significant fraction of the shares of the nation's major banks and its largest insurance company, underwriting the loans of a large portion of the nation's home-lending industry, and is on the verge of underwriting the nation's largest automobile makers. Yet little if any of this largesse has found its way to the broader public – to homeowners in danger of defaulting on their mortgages and losing their homes, small businesses close to insolvency, state and local governments cutting public services because of budget shortfalls, families unable to afford health insurance, or young people unable to obtain loans to finance university tuition.

The ideology of a perfectly self-correctly free market has given way to what might be described as a raid by America's biggest banks and corporations on the public purse, supposedly justified by benefits to the broader public which seem never to materialize. What happened to the ideology? On closer inspection, it turned out to be something of a cover all along.

During the same years Greenspan called for deregulation of financial markets, Wall Street was accelerating its bankrolling of the U.S. Congress. Securities and investment firms contributed larger and larger amounts of money – not just to conservative Republicans who might expect such support but also to Democrats who had never been so graced before. According to Center for Responsive Politics, Wall Street firms dramatically increased their contributions to both parties during these years. Their share of total donations to the Democratic Senatorial Campaign Committee, for example, rose continuously, from 5 percent during the 1999-2000 election cycle to 15 percent by the 2007-2008 cycle.

The money was accompanied, and often raised, by Wall Street lobbyists who pushed Congress in the same direction Greenspan urged – blocking regulation of derivatives, weakening oversight of subprime mortgage lending, and preventing the Securities and Exchange Commission from doing its job.

To take but one example, the collapses of Enron, WorldCom, and several other giant corporations in 2002 revealed a troubling pattern of credit-rating agencies repeatedly assuring investors that such companies were good investments until just before they went under. When the Securities and Exchange Commission asked Congress for additional authority to oversee the credit-rating agencies, Wall Street and its lobbyists blocked the measure. With hindsight, it's clear why. Wall Street investment banks were paying the agencies to rate various mortgage backed securities after first advising the firms that issued them – and collecting fees – on how to package them to get high ratings. Years later many of these same securities, based on risky loans, would prove to be worthless, threatening financial institutions worldwide.

Apparently Greenspan hasn't learned anything from all this, but the rest of us have no excuse. The real choice ahead is between democratic capitalism and authoritarian capitalism. China is perfecting the latter. But unless we are careful we – the citizens of democratic capitalist nations – will discover that our form of capitalism has become more authoritarian than democratic. The current economic crisis surely poses a test for capitalism. But it is also a test of democracy.

Selected Comments

Here's the real tip of the iceberg that should have let financial managers, government regulators and pundits know something was terribly wrong.

In 2007, the top annual income of a hedge fund manager was 33-year-old John Arnold, whose earnings that YEAR was $1.5-$2 billion. That's with a "B". The tweak in the tax code taxed his income at 15% (as if it were a capital gain) rather than 35%, the top of the individual tax rate. This "quirk" in the code saved Arnold over $300 million in his 2007 income taxes. Poor #10 on the list! David Shaw "only" earned pocket change of $600-$700 million for the year and only saved $120-$140 million in taxes. Does it make sense that hedge fund managers should be taxed at a lower rate than their maids and chauffeurs?

Can anyone rationalize why anything any 33-year-old in the world could do to warrant earning $2 billion for the year? Wouldn't you think this would make someone scratch his/her head and say "Whassup with that?" And he gets taxed at a lower rate than me?
RS Love:
Great minds think alike... Stiglitz on Capitalist Fools says the same things...

Democracy (if that's what you call our "professional" form of government) has been defeated from within. Wall Street lobbyists, captains of industry, wealthy families and individuals have long ruled this country with their money. $$$ Even Warren Buffett knows this and enjoys the privileges that come with controlling vast amounts of capital.

Imagine if the super banks had been allowed to fail... the carnage would have at least been democratic in the sense that anyone with a bank account would have been impacted as would have the shareholders...

Without a revolution, years from now, we'll be back to the same old ways and the same billion dollar bonuses for answering phone calls on Wall Street.

Free market, unregulated capitalism will never go away. We'll just call it something else.
Rob Morrison:
"The real choice ahead is between democratic capitalism and authoritarian capitalism". Why be so polite? Let us call authoritarian capitalism by its original name: fascism. The real choice is between government "of the people, by the people and for the people" (democracy) and government by an authoritarian oligarchy (fascism). Back during the first gilded age Rutherford B Hayes said "free government cannot long endure where people cannot secure a home, an education or support in old age". Is anyone paying attention?
Rob Morrison said:

The real choice is between government "of the people, by the people and for the people" (democracy) and government by an authoritarian oligarchy (fascism).

Bingo! ......and most of the people I talk with are brainwashed into believing Democracy is Socialism......So rather than support Democracy, they are running like lemmings into Fascism.
Greenspan is too old to remember anything about past lessons. I thought we put him out to pasture.
Free Markets are not Fair Markets.

The Free Market had too many issues such as conflicts of interest, lack of transparency, excessive leverage, and no real oversight.

Gathering assets from ordinary citizens without exposing the real risk should be a crime.
How many investors knew about the 30 times multiples of leverage in the investment banking and insurance systems...NOBODY.

A Free Market must disclose risk to risk takers. That didn't happen. That is the root problem. Because… if risk was known… then these firms would have never had the opportunity to gather such vast amounts of wealth and expose our national economy to this devastation of wealth.

Greenspan should be in jail for his stupidity, if nothing else.

Anonymous DWP

Thursday, 18 December, 2008

Larry Summers says something silly Robert Waldmann


According to Ezra Klein (who is very gentle in his criticisms) Summers wrote the following

As for [Milton] Friedman -- I'm not so sure he looks bad. What is most screwed up today? GSEs, Citibank, regional banks. What is most regulated? Same list. What is least screwed up? Hedge funds and the like. What is least regulated?
Summers didn't mention investment banks or non bank mortgage companies. Many of Them are not currently "screwed up" mainly because they no longer exist.

I mean he just overlooked the little problems at Lehman Brothers and Countrywide.

The argument about hedge funds is totally invalid. Look, I'm not regulated at all and I'm not bankrupt. Most individuals are in less financial distress than say citibank. The reason isn't that individuals are not subject to regulation -- it is that banks often have enough sense not to loan too much to individuals (notice I am just talking relative -- most people aren't in bankruptcy court and no individual has been bailed out yet).

The government doesn't have to regulate us, because relatively few potential creditors trust us.

long rant after the jump

update: On non bank mortgage companies look at the mortgage lender implodometer

I stress I am criticizing 2 sentences. I trust Klein to not deliberately distort meanings by removing context, but I don't know the context.

This goes for individuals who want to play the market. Our counterparties demand that we put up the money first and keep an account with them with a positive value. That goes for me you and hedge funds. They interact with the rest of the world in two ways

1) they have investors who invest at least $100 million each and who can't stage a run as they can withdraw only on scheduled occasions

2) they have repo accounts at investment banks. Accounts, sortof like you and me. The investment banks make sure that the hedge fund never ever owes the bank money.

You can't go bankrupt if no one will lend to you because no one trusts you.

However, we need some financial institutions that we trust (lets call them banks). If you want trust you need regulation.

Larry Summers is very smart. I found him to be a really excellent PhD supervisor who made outstanding constructive criticisms (and getting a dissertation out of me was not easy as it required extreme diplomacy, patience and kindness). Still the quoted passage is nonsense.

Posted by Robert at 4:00 AM

Comments (20)

Anna Lee

Thursday, December 11, 2008

It is just that most "ordinary people" can't do as much damage. I seem to recall a teenager years ago that ran a scam of issuing rumors to run up penny stock and, when the stock rose, took profit off the top. I think there have been several cases similar to this. The cases are vigorously prosecuted and people have been heavily fined and sent to jail. So a penny stock bubble, driven willfully up for profit is different. What is the difference, I ask. Is it that it is easier to prove intent? Is it that the "greed" is traceable to an unlicensed player or someone not considered an "expert"? Perhaps we should have waited until these small time criminals started losing money and infused them with more to do with as they please without paying back those that they scammed or preventing them from manipulating the market again. One of these people in CA was fined heavily and, a few years later, arrested for trying to defraud a bank.

When a fly-by-night financial adviser gets a license and invests clients assets to maximize his profit at the expense of soundly investing the clients money, no one sees this as fraud if there is a paper trail saying that that client received a disclaimer, based on market risk. But this is really expert advice risk. The same goes for annuities sold to old people by experts from insurance companies.

The "experts" selling bad investments should know their products better than anyone else. But we say "buyer beware" as though even a blue collar worker should know more than the expert he hires. If the scam emails had been ended with a disclaimer mentioning risk, would the teenager be arrested? I don't know but I tend to think so.

So Robert, I think the issue is much more complex than either you or your major professor are acknowledging. When does the financial professional go from professional to greedy?

With the housing bubble, even the non-professional could see that the house prices were unaffordable if rates went up. Professionals couldn't? I don't buy it. We didn't know about no-doc, no-down, liar, etc. loans but, if we had, many of us would have doubted those sales. Are we to believe that professionals that knew didn't see it? I think they saw it and bought into a ridiculous idea - it wouldn't ever end because of equally as funny loan packages. That's incompetence and greed if you ask me, but, as opposed to penny stock scams, perfectly legal.


Anna Lee

Thursday, December 11, 2008

So criminals at the low end have the law against them to deter their behavior but professionals can just offload their criminal conduct onto the unwary client because no regulation is there or the regulations aren't enforced to make their conduct illegal.

How does anyone even know if some hedge funds manipulate markets? Some hedge funds have lost gobs of money on the funny loan packages. Should they have know what they were buying? Did they have no reason to question the rating agencies? Did they lead many people into commodity speculation in an attempt to buffer their loses? I'm not saying they did - these are just Internet gossip - but the point is that unregulated means "don't know". Because of their exclusive clients one believes hedge funds to be trying to do the best for clients, but there may be a few out there, like the few individual penny stock scammers, trying to manipulate the markets. Maybe not.

I agree as a whole with what you say about money up-front but might I make one point of how banks have trusted individuals and given them credit to play the market? The bank gives people credit lines on credit cards. Over time these have not had clear links to assets. Then they created 0% for a year come-on credit card offers. People have been known to tap that credit line, invest it in the market, return it to the bank before the end of the offer and keep the earnings. People who don't simply use interest bearing accounts but invest in stock could lose a lot of money. The bank trusted them to invest the money smartly. But the laws have been written to make the person accountable even through a bankruptcy. So law changes the trust a bank gives the customer. When risk was shifted away from the bank, the bank became eager to give out "loans" to individuals without regard to their ability to pay it back. The bankruptcy law, a regulation-like mechanism, was wanted by the banks. They wanted regulation on anyone other than themselves. They wanted no accountability on their business processes to allow wild-west lending to maximize their profits. Well... Crash!

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Thursday, December 11, 2008

May I op-ed this piece Anna Lee?


Anna Lee

Thursday, December 11, 2008

Yes, if you promise to clean it up. I didn't really proof it as I was in a hurry to get to the JSKit discussion.


Anna Lee

Thursday, December 11, 2008

{This comment was originally directed to a banned commenter. That comment was deleted by a moderator. BW}
None of your explanations of my motivations or thoughts as I wrote the post are correct. I guess you just start with an assumption that a person is stupid and put in stupid stuff they didn't say to prove it.


Bruce Webb

Thursday, December 11, 2008

Anna Lee as mentioned at the JS-Kit discussion you don't need to reply to HWMNBN.

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Anna Lee

Thursday, December 11, 2008

Bruce, I saw that. Sorry that I am feeling a bit frisky today. Cats happen.

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Thursday, December 11, 2008

Larry Summers talking nonsense? Hardly. "Nonsense" refers to whimsical or frivolous commentary without meaning. Summers is defending his record and charting a course of action. Since he has the President's ear on economic policy, the appropriate description is "unrepentant and disturbing."

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Thursday, December 11, 2008

Rdan, Please delete the post with all the formatting. That was unintentional on my part.

{Are you fricking kidding? Banned is banned. And you expect the guy that banned you to clean up your screwed up HTML? BW}

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Thursday, December 11, 2008

Larry Summers is a shill for the deregulation nitwits. He does not, did not, and will not deserve his position.

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Don Lowell

Thursday, December 11, 2008

We need Summer's and Rubin the hell out of the loop.


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Thursday, December 11, 2008

Robert, "I'm not regulated at all and I'm not bankrupt."

Just to take this a little further, your unregulated financial/economic situation may not be perfect, but if I was to impose regulations on your financial/economic activity in order to benefit me do you think your financial/economic circumstance would be improved? And if not, would further regulations improve your circumstances?

The above argument is merely a thought exercise to bring the macro level of government regulating business for the benefit of others down to the micro level for easier understanding.


Bruce Webb

Thursday, December 11, 2008

FA. A bunch of extraneous HTML crept into your post and so I cleaned it up. BW


Bruce Webb

Thursday, December 11, 2008

Hmm. It came back. A little mystery for RDan to unravel.



Thursday, December 11, 2008

A lot of very smart people seem to think highly of Summers. Still, though, I can't get past this feeling that we are putting one of the arsonists in charge of coordinating the firefighting.



Thursday, December 11, 2008

Bruce, thanks for the effort.

The HTML may show up on this post also.


Robert Waldmann

Thursday, December 11, 2008

Dear FA

I don't think that everything should be regulated. I never said that I did. You seem to assume that either one must advocate reguilating everything or advocate regulating nothing.

Loose banking regulation didn't work the last time it was tried (trial period ended in the 30s). There is very strong evidence that deposit insurance and lenders of last resort improve economic performance. If there are such programs, then regulation is needed to prevent banks from paying heads I win tails the FDIC loses.

We have recently seen (again) that investment banks and non bank mortgage lenders who aren't covered by deposit insurance and don't normally have a right to borrow from the FED have gotten themselves into trouble. Right now, almost everyone agrees that public intervention is needed. That is by not regulating we have, in effect, allowed agenst to play heads I win tails the treasury looses -- and it has cost us a lot of money.

Oh and what about money market funds. Sort of like bank accounts but not FDIC insured, not regulated as much and no premium payments to the FDIC. However when the money market fund run came, they turned out to have FDIC insurance without paying for it, because the alternative was allowing the relatively lightly regulated medium between firms and investors collapse and have a worse recession or depression than we are having.

Look FA, Alan Greenspan an old much celebrated Randian fanatic has admitted that his view has been proven false. Are you more stubborn that Greenspan or further right wing ?



Thursday, December 11, 2008

My email to one Wall Street reporter who wrote about Summers and Geithner:


Your point on Summers not having so much of the blame for the failure of the Derivatives Market would probably come across better if Summers had not actively campaigned against any regulation in testimony to Congress in 1998/99 with regard to Brooksley Born's attempts to regulate it. His role may be minor in relation to Greenspan's more vocal oppostion to regulation; but, he did adovcate the same in support of Greenspan. Geithner was in the thick of it with Summers. So we have two holdovers who played a minor and contributing roles in today's crisis. I, for one, am not so self assured they will not do the same.

That Rubin would mention that Summers needs to be put in his place or sat upon is credible as his mouth appears to get the better of him in other arenas such as his tenure at Harvard. Intellect does not presume common sense and sensitivity. While Summers may have superior intellect, he has demonstrated a lack of common sense and sensitivity towards issues and others. And does Rubin still work for Sandy Weill? One has to wonder where we would be if Glass-Steagall had not been repealed and Section 20 of it interpretted differently by Greenspan. We still have the Commodity Futures Moderization Act to contend with also. How will Congress, CFTC, and the SEC get around it in order to regulate a market that still is reminescent of the Wall Street Wild West?

I did enjoy your article "Summers, Geithner Have Baggage, Not Fatal Flaws;" I just do not necessarily agree with all of it. Thank you for writing it as few have addressed the issues you confronted in it.


His response (a nice and civilized one):

"Thanks very much for commenting on my column. The world looks very different than it did when Summers was arguing against regulation of derivatives. I'm sure he and Geithner will be pushing for major changes in regulation. What's going to be really interesting is whether the financial services industry, which has been very effective in warding off tighter oversight and increased capital requirements will still be effective after all the carnage."

Robert, it appears that we can not teach an opinionated dog new tricks. Given his past as being the "water boy" for Greenspin in 1998 onward, his comments have substaniated my suspicions about his ilk. Geither is his protege of sorts. Now I am worried.


[Dec 14, 2008] Larry Summers says something silly

And this is not the first time. "If it walks like a duck and quacks like a duck, it must be a duck."
Angry Bear

Robert Waldmann

According to Ezra Klein (who is very gentle in his criticisms) Summers wrote the following

As for [Milton] Friedman -- I'm not so sure he looks bad. What is most screwed up today? GSEs, Citibank, regional banks. What is most regulated? Same list. What is least screwed up? Hedge funds and the like. What is least regulated?
Summers didn't mention investment banks or non bank mortgage companies. Many of Them are not currently "screwed up" mainly because they no longer exist.

I mean he just overlooked the little problems at Lehman Brothers and Countrywide.

The argument about hedge funds is totally invalid. Look, I'm not regulated at all and I'm not bankrupt. Most individuals are in less financial distress than say citibank. The reason isn't that individuals are not subject to regulation -- it is that banks often have enough sense not to loan too much to individuals (notice I am just talking relative -- most people aren't in bankruptcy court and no individual has been bailed out yet).

The government doesn't have to regulate us, because relatively few potential creditors trust us.

long rant after the jump

update: On non bank mortgage companies look at the mortgage lender implodometer

[Dec 14, 2008] Broken Government Our Broken Government

The 2008 presidential race produced its share of philosophical and political disputes, but one broad area of agreement underlined the campaigns of both nominees: The federal government is not functioning as it should. A McCain ad began, "Washington's broken. John McCain knows it," while one of Barack Obama's spots warned, "The truth is that while you've been living up to your responsibilities, Washington has not."

In fact, the executive branch is proving unable to meet many of its most basic obligations to the American public. And the public appears to be increasingly uneasy. National polls show that less than 30 percent of Americans approve of President George W. Bush's job performance, among the worst numbers since pollsters began tracking presidential approval in the 1940s. A mid-November Gallup Poll showed that 87 percent of respondents were dissatisfied with the way things are going in America today.

Just how bad is this government dysfunction? In an effort to answer that question, the Center for Public Integrity embarked on an examination of the worst system security, the military and veterans affairs, health care, transportation, financial management, consumer and worker safety, and more - failures which adversely affected ordinary people and made the nation a less open or less secure place to live. While some are, by now, depressingly familiar, many are less well-known but equally distressing. And though the list is diverse, it also reflects some recurring - and troubling - themes.

Some of these problems were in place well before George W. Bush's inauguration, but were exacerbated by his policies or worsened by his administration's actions (or inactions). Many of the failings are tied to Bush appointees who appear to have been selected primarily on the basis of ideology and loyalty, rather than competence. Every administration has its share of political cronies, of course, but the examples of the past eight years seem especially stark:

The administration has also displayed what's at best a lukewarm interest in independent oversight, often siding with business over consumers and special interests over the public. The results have had dramatic consequences in a variety of sectors. Among the examples:

Much of the function of the federal government shifted from public employees to private contractors, as federal spending on contractors nearly doubled from FY 2001 to FY 2006, jumping from $234.8 billion to $415 billion. These contracts often lacked competitive bidding processes and effective oversight and suffered from cost overruns and poor execution.

Finally, the White House and its political appointees have frequently inserted themselves into matters of science, overruling experts and suppressing reports that did not coincide with the administration's philosophy. The nonpartisan Union of Concerned Scientists warned that "political interference in federal government science is weakening our nation's ability to respond to the complex challenges we face."

"I think we'll look back on this period as one of the most destructive periods in American public life . . . both in terms of policy and process," Thomas E. Mann, senior fellow at the nonpartisan Brookings Institution, told the Center. "The broken government is not limited to one end of Pennsylvania Avenue; it involves the executive and legislative branches, which both contributed to embracing policies and actions that have come back to haunt us."

How did we get here? The answers go back decades. Since the Ronald Reagan years substantial portions of the Republican Party have believed that the federal government operates inefficiently, and is more often part of the problem than part of the solution. That philosophy has underscored a continuing quest to dismantle pieces of the federal government and to regulate as little as possible. Reagan famously joked that "the nine most terrifying words in the English language are: 'I'm from the government and I'm here to help.'"

That thinking was adopted by some Democrats as well. Bill Clinton and Al Gore were elected in 1992 promising to "reinvent government," eliminate excessive regulation, and cut the size of government. Clinton's "Putting People First" plan called for a 25 percent reduction in the White House staff and elimination of 100,000 jobs in the bureaucracy, and the 42nd president largely delivered. Amid outsourcing, government shrinkage, and deregulation, Clinton declared, "The era of big government is over."

George W. Bush enthusiastically picked up the anti-government, anti-regulation mantle. In his first address to Congress in 2001, Bush declared: "Government has a role and an important role. Yet too much government crowds out initiative and hard work, private charity, and the private economy. Our new governing vision says government should be active, but limited; engaged, but not overbearing."

Behind the limited government mantra was the gnawing perception - pushed hard by Vice President Dick Cheney - that the reforms of the post-Watergate era had dangerously weakened the presidency. Cheney and others in the administration thus began advocating a more "unitary executive" - a vision of the president as a singularly powerful chief executive. Over time, Bush enthusiastically bought in. The concept of the "unitary executive" only further empowered Bush and his allies as they plowed forward with their vision of spending cuts, deregulation, and concentration of power within the confines of White House.

"In my judgment, there's a clear connection between the Bush administration's governing philosophy and the abuse of power we have seen in the last eight years," presidential historian Robert Dallek told the Center. "The Bush-Cheney assumption has been that the post-Watergate reforms weakened the presidency and a president's ability to deal with foreign dangers. Much of what they have done has been an attempt to right this so-called imbalance. The result has been a resurgence of the imperial presidency."

"We saw genuine distortion in the constitutional system, an exaggerated sense of presidential power and prerogative and acquiescence by a Republican Congress in the face of the first unified Republican government since Dwight Eisenhower," Mann added. "That led to abuses. Certainly, it led to bad policies, because Congress wasn't challenging the executive along the way and overseeing it. And I think it encouraged a diminution in the capacity of government to deal with important problems."

But a series of cataclysmic events has started to change the nation's view of what the government's role should be - and has necessarily altered some of the administration's approach to governing. Those events have also put new strains on federal operations and have brought the consequences of federal failure into sharper relief.

First came the tragedies of September 11, 2001. The Bush administration determined that in order to keep the nation safe from further acts of terrorism, a major expansion of law enforcement, intelligence, and military operations was required. While no major terrorist acts have occurred on American soil since, the dramatic growth of the nation's security apparatus has been a messy, expensive process involving missteps, bureaucratic turf battles, and the creation of the Department of Homeland Security - the largest government reorganization since 1947.

Then came Hurricane Katrina in 2005, which killed a reported 1,698 people - and in the process laid bare a response that was chaotic at best, dysfunctional at worst. The breakdown in emergency response at all levels of government also demonstrated that some catastrophes and crises are so large that they truly require federal government organization and management.

Most recently, the financial meltdown and the administration's attempts to bail out the financial services sector have caused many to conclude that deference to the "trust us" mantra of Wall Street and unquestioned faith in the free market's ability to self-regulate required re-thinking.

All the while, globalization's myriad impacts continue to be felt at home. Increased trade with other countries has resulted in a flood of new imports that must be monitored for both safety and homeland security. A host of scares involving dangerous food, drug, and toy imports have made clear the need for more oversight of products manufactured overseas. Meanwhile, cargo holds carrying potentially dangerous weapons require port security officials to screen more freight than ever before.

As a result, today - in the midst of a historic transfer of power - the pendulum appears to be swinging the other way in regard to regulation and the role of government, among Republicans as well as Democrats. It is thus an opportune moment to provide an inventory of just what's broken - and perhaps a bit of a blueprint for just what needs fixing.

Causes Free Market Ideology

The Baseline Scenario
Joseph Stiglitz, the 2001 Nobel Prize winner and the most cited economist in the world (according to Wikipedia) has an article aggressively titled "Capitalist Fools" in Vanity Fair that purports to identify five key decisions that produced the current economic crisis, but really lays out one more or less unified argument for what went wrong: free market ideology or, in his words, "a belief that markets are self-adjusting and that the role of government should be minimal."

The five "decisions," with Stiglitz's commentary, are:

  1. Replacing Paul Volcker with Alan Greenspan, a free-market devotee of Ayn Rand, as Fed Chairman. (Incidentally, when I was in high school, I won $5,000 from an organization of Ayn Rand followers by writing an essay on The Fountainhead for a contest.) Stiglitz criticizes Greenspan for not using his powers to pop the high-tech and housing bubbles of the last ten years, and for helping to block regulation of new financial products.
  2. Deregulation, including the repeal of Glass-Steagall, the increase in leverage allowed to investment banks, and the failure to regulate derivatives (which Stiglitz accurately ascribes not only to Greenspan, but to Rubin and Summers as well).
  3. The Bush tax cuts. Stiglitz argues that the tax cuts, combined with the cost of the Iraq War and the increased cost of oil, forced the Fed to flood the market with cheap money in order to keep the economy growing.
  4. "Faking the numbers." Here Stiglitz throws together the growth in the use of stock options - and the failure of regulators to do anything about it - and the distorted incentives of bond rating agencies - and the failure of regulators to do anything about it.
  5. The bailout itself. Stiglitz criticizes the government for a haphazard response to the crisis, a failure to stop the bleeding in the housing market, and failing to address "the underlying problems-the flawed incentive structures and the inadequate regulatory system." (There's regulation again.)

I have a lot of sympathy for the argument that deregulation was a significant cause of the crisis. Calling it "deregulation" is not entirely accurate, because there are not that many major regulations you can point to that were actually repealed. Glass-Steagall is one, but I'm not sure that was centrally important. Even if commercial banks and investment banks had not been allowed to combine, I still think commercial banks would have made foolish loans, and investment banks would have still bought them to package them into securities. Actually, a lot of the subprime lending was done by specialized mortgage lenders - not by the hybrid institutions created by Glass-Steagall - until they got bought up at the peak of the boom.

In addition to traditional deregulation, I think there was a failure to enforce existing regulations, and a failure to create new regulations to keep pace with innovation in the financial sector. On paper, federal bank regulators have a great deal of power already. For example, the Office of the Comptroller of the Currency, which regulates national banks, has the following powers (from their website):

The FDIC similarly has the power to examine banks, assessing issues such as capital adequacy, asset quality, and liquidity (those three concepts should be familiar to anyone following the crisis over the last three months). Now, it is true that most people failed to see the huge insolvency risks in the banking sector before they became frighteningly visible this fall. But most people aren't bank regulators, either.

Perhaps more importantly, there was a failure to keep regulation up to date with changes in the financial sector. The event that has gotten the most attention is the passage of the Commodity Futures Modernization Act in December 2000, which, among other things, preempted any regulation of credit default swaps. Another example is the hands-off attitude that was taken toward hedge funds, even as they became a larger and larger part of the financial system, and even after the crisis caused by the near-collapse of Long-Term Capital Management in 1998. Another is the failure of regulators to adapt to the proliferation of new types of subprime lending, recounted in the New York Times article with the great title, "Fed Shrugged as Subprime Crisis Spread."

What could better regulation have accomplished? It could have reduced the growth of exploding subprime loans that borrowers had no chance of paying off. It could forced credit default swaps onto exchanges. It could have required greater disclosure by financial institutions of off-balance sheet positions. It could have brought more of the "shadow banking system" into the light. It could have forced banks to increase their capital. It could have prevented AIG from taking huge unbalanced credit default swap positions. In summary, it could have slowed the growth of the bubble and made the systemic risk in the financial sector more visible.

Well, maybe. I don't want to convey the impression that it's possible to have a perfect level of regulation, and there certainly is such a thing as too much regulation. And any administration that tried to regulate the financial sector more closely would have faced bitter, vicious, well-financed opposition from the industry itself. The truth is we don't know what the consequences of different regulations would have been. Also, even with better regulation, there still would have been trillions of dollars sloshing around, and lots of greedy people trying to divert it their way, and lots of bubble-prone investors. But in general I think Stiglitz is right that we have definitely erred on the side of too little regulation for quite a while now.

Stiglitz also raises the issue of incentive structures, which I think is a special case of the issue of regulation. One of the cardinal principles of undergraduate economics is that firms are rational profit-maximizing actors. This is widely understood to mean that firms act in the best interests of the shareholders who own them. However, in the real world, firms are controlled by their senior executives, who are loosely controlled by the board of directors, who are partially controlled by the CEO and very tenuously controlled by large institutional investors. During bailout season, we've all heard the phrase "capitalizing the upside and socializing the downside" or something to that effect - shareholders get the profits and taxpayers get the losses. But there's another version of this that applies even without a taxpayer bailout.

Stiglitz is right that stock option-based compensation provides disproportionate rewards to executives (relative to shareholders) when stock prices rise and underproportionate risks to executives when stock prices fall. Even though, in general, it's better for everyone for the stock price to go up and worse for everyone for it to go down, the benefits (as a function of stock price) differ for the two groups. This induces executives to take excessive risks and to take steps to boost short-term profits at the risk of long-term losses. But I don't think the solution is government regulation to ban certain forms of compensation, because I just think it won't work; boards of directors can be very creative about finding ways to pay CEOs obscene amounts of money. This is basically a corporate governance problem, and the solution is some form of increased disclosure by companies and increased shareholder rights, so shareholders can more easily replace directors who are complicit in paying CEOs obscene amounts. Both of these things (disclosure and shareholder rights) probably require new regulations or legislation.

It's also important to remember that the U.S. was not the only country that had a housing bubble, and there was plenty of other bubble-like activity around the world, such as huge amounts of lending by Western and Central European banks into Eastern Europe and Latin America. Right now those banks are being burned as much by their emerging market investments as they are by their purchases of U.S. mortgage-backed securities. So when we talk about regulation, we have to remember that we live in a global financial system, and even if there were a virtuous country out there - call it Perfectistan - it would still be hurting today as a result of the downturn of the global economy. But the U.S. is still at the center of it all, for better or for worse.

Mirabile Dictu! Rubin Takedown by the Wall Street Journal! by Yves Smith
November 28, 2008 | naked capitalism
This ought to be a celebratory event, the scrutiny of a powerful player in the financial system who heretofore seemed immune to criticism. And what is interesting about the spotlight on Citigroup consigliere and board member Robert Rubin is that, unlike Greenspan, the reassessment is starting while he would still appear to have his hands on the reins of power. After all, he is still on Citi's board; his protege Timothy Geithner is slotted to become Treasury Secretary, his buddy Larry Summer is head-of-the-National-Economic-Council-in-waiting.

Yet if the reaction in New York is any indication, the outrage about the speed and size of the second Citigroup rescue is considerable, and a recent Wall Street Journal piece fingered Rubin as a moving force behind Citi's disastrous strategy to take on more risk in debt markets in pursuit of profit and better competitive rankings. And the only consequences to Rubin will be (hopefully) lasting damage to his reputation. But he gets to keep his cash and prizes.

Rubin refuses to take an iota of responsibility for the bank's tsuris (and that also comes from the Goldman playbook. The firm always circles the wagons and admits nothing). Get a load of this:

Robert Rubin said its problems were due to the buckling financial system, not its own mistakes, and that his role was peripheral to the bank's main operations even though he was one of its highest-paid officials.

"Nobody was prepared for this," Mr. Rubin said in an interview. He cited former Federal Reserve Chairman Alan Greenspan as another example of someone whose reputation has been unfairly damaged by the crisis.

Yves here. Unfairly damaged? Is this what leadership amount to in America? You have the power, you get the perks, but you only take credit for the good stuff?

A very simple psychological construct places people on a spectrum of internalizing versus externalizing (boldface ours):

When something goes wrong, we look for answers as to why-what caused this? How we deal with setbacks has enormous implications for how we feel about ourselves during these difficult times. Some people take the responsibility onto themselves-"it must have been because of something I did or didn't do." We can call these people internalizers because they internalize the responsibility. This can lead to feelings of depression if one's self-esteem takes too much of a beating. However, sometimes there is also the promise of a brighter future-"maybe I can do this differently next time so it turns out better." Other people are more likely to place the controlling factor outside of themselves-"it must have been someone else." We can call these people externalizers. In some cases, they will act out in anger over a bad situation. Externalizing frees them of any feelings of self-criticism or guilt, but it also leaves them powerless over the situation unless circumstances change. So, the price they pay is that they don't learn anything new.
Salesmen are typically externalizers.

Note the uncanny parallel in word choice with Rubin in this tidbit:

The self-talk of the Externalizer is all about the defectiveness of others and the "unfairness of it all."
Back to the Journal:
Its [Citi's] troubles have put the former Treasury secretary in the awkward position of having to justify $115 million in pay since 1999...
Yves again. Please, his pay should have been questioned long before now. He did not have his name on any deals, and he claims not to have gotten his hands dirty. Indeed, he contends the problem was not the strategy, but the execution, and by implication he had nothing to do with that.

Are we expected to buy that? Did any firm that went out on the risk curve do well? The only reason Goldman was less damaged for a while was that two traders told the management committee that they thought subprime was way overvalued and the firm put on shorts that exceeded its long position. That was serendipity (combined with some intellectual flexibility in the top ranks).

Back to the Journal:

Mr. Rubin said his pay was justified and that there were higher-paying opportunities available to him. "I bet there's not a single year where I couldn't have gone somewhere else and made more," he:..

Yves again. Yes, and I could make a lot more money dealing drugs, or better yet, providing financing to terrorists (one of my buddies says they make an absolute fortune). The issue is did you deliver value to Citi that bore any relationship to what you were paid? What you could have made elsewhere doing something different is a distraction from the question at hand.

To Rubin again:

Mr. Rubin said it is a company's risk-management executives who are responsible for avoiding problems like the ones Citigroup faces. "The board can't run the risk book of a company," he said. "The board as a whole is not going to have a granular knowledge" of operations.....
They do at Sandater, in fact, they consider that to be the board's most important responsibility. They meet twice weekly. Investment banks, when they were private, had management committees that similarly watched risks like a hawk. So "can't" is counterfactual. "Generally don't" is more accurate. The wipeout in the banking industry strongly suggests that this deliberate inattention to one of the most important determinants of profits and long-term survival was a fatally flawed policy.

Back to the Journal:

The decision has been blamed in part for Citigroup's problems, including the growth of its CDO holdings amid signs the mortgage market was unraveling. Mr. Rubin doubts that's true. "It was not an inflection point," he said, but "I just don't know what would have happened" if the decision had been different.

At the time, Mr. Rubin was saying in speeches that most assets were overvalued. He would quote a noted investor he knew as saying that "the only undervalued asset class in the world is risk."

Yves again. So he denies that the CDOs or the assumption of more risk had anything to do with Citi's near death experience, despite the evidence in the form of huge writewdown on recent positions. And at the same time he was supporting Citi's bigger bets, he was saying externally, in public, that assets were overpriced and investors were not getting paid enough for risk assumption? It will never happen, but I would love to see a great litigator like David Boies have a go at Rubin under oath.

There is much more in this article, but it illustrates a pathology operative in our society. Why have we gravitated to leaders and advisors who built Potemkin villages and tell us that is progress, and then deny that they have any responsibility? This pattern has become widespread in Teflon CEOs and public officials. And the converse delivers better results. Jim Collins, in his book Good to Great, found that the CEOs of the very best performing companies were modest, shared credit for what went right and took blame for failures, the opposite of the Rubin/prevailing US pattern. And they also paid themselves modestly by modern standards. More on this topic (What's this?)

Citi's leverage: 280! (Leverage by the Numbers, Part 2) (Option ARMageddon, 11/24/08)

You Should Listen to Jim Rogers (World Beta - Engineering Targete..., 11/19/08)

Citi's Leverage (Option ARMageddon, 11/17/08)

Read more on Citigroup at Wikinvest


Being a fairly partisan Democrat, Rubin had me snowed right up to the triggering events of August 2007. It's really quite remarkable how quickly the veils have fallen. I now think of him as one of the very best proof points for Christopher Hitchens' long ago remark (before he lost his mind) that the biggest myth of American politics is that there are two parties.
November 28, 2008 11:05 PM
Edward Harrison:
Rubin's denial here highlights the fact that Obama has a coterie of laissez-faire free market types running his economic team. The question is: what takeaways will these advisors make given the present crisis?

The analogue to Rubin's comments would be to assume that the execution of laissez-faire, free market economics was poor rather than looking "internally" for factors that are endogenous to a deregulated, market-driven approach.

The anti-regulation model is flawed in that it assumes one can set the strategic course and let the market proceed without significant oversight. This is market fundamentalism and it is a strategic flaw both at Citigroup and system-wide.

November 28, 2008 11:28 PM
He's another one of the jerks who blames everything on the number crunchers on low salary in the Risk Management department. It would be good to see some risk land right on him.

This country is really screwed up. We should wipe out the financial system, filled as it is with leeches like Rubin, and start over. Zero out the value of their holdings, then invite them to Congressional hearings and consider criminal prosecutions.

We need to see some punishment, heavy hurtful punishment that these guys cannot escape despite all their maneuvers. We need to take it out of their hides. Otherwise the little people in this country will see no justice at all.

November 28, 2008 11:36 PM
The little people?
November 28, 2008 11:48 PM

It is so bad at Citi that the Audit Committee (made up of board members and a few lack luster "auditors") lack any background in either risk or financial services. It is chaired by the former head of the NSA. Now he knows a lot about puzzles and things blowing up - but CDO's? Additionally the Citi Auditors are so completely focused on auditing to process and guidelines that they never took into account real risk the firm was exposed to.

When your "last line of defense" (aka Audit) is totally clueless then you have massive problems. The whole board should be sacked and the members of the Audit Committee should be charged with criminal negligence. What a disgusting joke the whole thing is.

WE WANT BLOOD! Offering up Rubin will not be enough. Let's frog walk the yes men through the whole organization and send a message to these corporate vampires that their days are numbered.

November 29, 2008 12:06 AM
They are going to try to follow the same policies that worked well in the 1990's after the savings and loan debacle, that resulted in massive growth and eventually a budget surplus. Their will be a decidedly different result this time around...
November 29, 2008 12:14 AM
"Rubin's denial here highlights the fact that Obama has a coterie of laissez-faire free market types running his economic team.ket types. Granted, they're not calling for the worker's of the world to unite, control the means of production, etc., but they are tinkerers of the first order.

Mercantilists, like Hamilton, not capitalists like Jefferson. Favoring one sector or another, one business or another, manipulating the money supply, etc., with the imprimatur of government; that's not capitalism, that's mercantilism - a bridge to eurosocialism.

November 29, 2008 12:51 AM
Rubin and guys like him masquerade under labels such as free trade and open markets.

They are your typical variety crook. It just so happens that all these crooks run many of our major corporations and own all of the political elite as well as the DC conventional wisdom.

November 29, 2008 1:06 AM
I have known Rubin for over a year now. You can never get a straight answer out of him. I think the best descriptions of read of him are "forked-tongue", reptilian. The guy does not have an honest bone in his freakin' body.
November 29, 2008 1:08 AM
OK, why can't I get the movie "Weekend at Burnie's" out of my head?


November 29, 2008 1:18 AM
Dear God,

Please make sure Volker and Obama read Nakedcalitalism twice a day, including all the comments, and thus please allow them to not be hoodwinked by a bunch of political banker assholes that will go on destroying America. While your at it, can you make sure that people like Rubin are exposed on a regular basis for the scumbags they are and then help shame them to a point, where they beg for mercy!

November 29, 2008 1:20 AM
i agree that the top guys should be hurt, really hurt. busted up and left to bleed on wall street if not have their heads placed on pikes.
and the underlings should be in stocks up and down the street to also show what happens if you pull this shit again. then returned to prison at night, for a number of years, perhaps ten to fifteen.
the money is good, but don't mess up.
November 29, 2008 2:27 AM
When Citi was (very hastily) bailed out, Treasury and the Fed basically said: "No change in management, it could be too disruptive."

Wonder how much say Rubin had in this incredibly stupid and arrogant decision.

November 29, 2008 2:53 AM
"He cited former Federal Reserve Chairman Alan Greenspan as another example of someone whose reputation has been unfairly damaged by the crisis."

Well...Rubin was right this time. It was very unfair to the truth to have Greenspan's reputation take a hit so light that it amount to a slap on the wrist.

The guy should've been declared fuckhead of the century.

November 29, 2008 2:57 AM
Right now I think most of here assume that nothing with happen to these monkeys, other than a little negative publicity in the press. But what if the crisis deepens, and the economy collapses in a significant way? The masses could get quite angry.

It's too bad people like Rubin aren't Japanese and honorable. I'd personally buy him a knife.

November 29, 2008 3:36 AM

The answer to your question "The issue is did you deliver value to Citi that bore any relationship to what you were paid?" is simply yes, he did.

Rubin was Citigroup's biggest supporter in the Clinton administration, was heavily involved in lobbying for passage of the Gramm-Leach-Bliley Act that made permanent the Citi/Travelers merger, and resigned as Treasury Secretary to join (only a few weeks later) Citigroup's board.

Considering the money Citigroup has earned over that time span, I think Rubin earned his pay and then some.

November 29, 2008 3:53 AM
Woah, so is Rubin saying that citigroup paid him to do nothing? If he wasn't involved in any of the risktaking projects that initially produced profits, then he did "bothing"? And he was paid over 100 million for doing nothing?

which is worse; taking responsibility for the failure of judgement or admitting you were the financial institutions' ken doll?

November 29, 2008 5:59 AM
It was pretty clear to me that Rubin took the job at Citigroup with the idea of not having any responsibility except providing connections with the powers-that-be. He'd get a big office and a big desk and a big nameplate and a big check, but only have to make a few telephone calls every once in a while. And sure, any number of institutions who have paid more to have the same connections.

Rubin probably felt justified in accepting the huge money because he had been in government for eight years, being reasonably selfless, while his brethen were pulling in the big bucks (and the bucks kept getting bigger) out in the private sector. So it was his due - his payback.

So sure Rubin is a jerk - I personally deplore the most his role in fostering the stock and Nasdaq bubble, but I think there is strong competition with his role in the Asian crisis. His idea that one cannot have too much confidence in the future is the classic spiel of the snakeoil salesman; in fact, too much confidence is just as much a problem for an economy as too little.

But Rubin's not the only one. The larger problem is American culture - which since Reagan has been driven mad.

November 29, 2008 6:27 AM
patrick neid:
Rubin is just the first name on a long list of Dem operatives like their Repub counterparts that seamlessly move from politics to business and back again each time making millions more.

Look at Rahm Emanuel, leaves DC becomes a investment banker and 2 1/2 years later pockets 16 million. Retires! Even had time to sit on the Fannie board leaving as the scandal started to run for Congress in 2001.

Jamie Gorelick with no finance background becomes Vice Chairman of Fannie Mae, makes her millions and leaves after a scandal. And who can forget Terry McAuliffe who makes a $100,000 investment in an unknown company in 1997 after working for the Clinton/Gore 1996 campaign and two years later sells it for 20 million. The company, the infamous Global Crossing.

What do they all have in common? They use the same excuses as Rubin and furthermore they get away with it. The Enron people went to jail for cooking the books. The Fannie Mae folks cooked the books contributing ten's of millions of dollars to their bank accounts while walking free leaving us with the trillion dollar bill. For entertainment some of them now advise Obama.

I could waste all day on the list.

November 29, 2008 6:50 AM
it's a classical case of lack of accountability which will call into question the kind of envisaged change. At least Greenspan said "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms." Does Mr. Rubin know how many layoffs there are now at Citi and how many hare being caused by his/its model of banking?

Summary of unconvenient truths of this crisis

November 29, 2008 8:15 AM
Despite Rubin's championing of Graham Leach Bliley, that legislation was good and reflected reality that was continually being litigated. De-regulation is not the culprit, in fact, B of A couldn't have done the deal with Merrill (assuming it goes through) Morgan Stanley and Goldman couldn't have changed their charters to bank holding companies in order to attract new capital under the byzantine provisions of Glass Steagall.

Where Rubin failed Citi was relying on the okey doke of the "moral obligation," pressured investment grade rating, credit default swap labyrinth. He knew better or should have. Because he failed Citi, of course, he put us all on the hook.

The bloom should come off the rose of his and any Clinton administration official's stewardship of the economy and how effective they were. It is as persistent as that of FDR's acumen in guiding America through the GD. Rubin's failure is Summer's and since Geithner has been his understudy...

November 29, 2008 8:25 AM
That's a great setup Rubin had at Citigroup.

Earn all of the money, have no "knowledge of operations", and none of the responsibility. Must be a great job to have.

He is at the very heart of the corruption which drove Wall Street to destroy our financial system and our economy.

And yet he is the same person that Obama is using as his closest advisor to select his top finance people in the next Presidency. Rubin tells Obama to pick his closest cronies (Geithner and Summers) to be his top financial guys. This same Obama which was supposed to be all about "CHANGE".

Since Obama has been elected as President, he has proven himself to be a total out-and-out fraud. He has appointed a whole coterie of well connected Washington insiders to staff his Administration. This "CHANGE" was a real bill of goods that he sold the American people. Not that I believed it to begin with, but I am terribly disgusted watching this whole spectacle.

And yet from all indications, since he's been elected, the media is still having one big honeymoon with this guy (Camelot II). He's Kennedy, he's FDR, he's Lincoln....blah, blah, blah.

The media should be systematically taking Obama and Rubin apart with no mercy. This media only cares to sell a story and entertain. The lack of critical analysis is most appalling (especially when this entire system is on the brink of total destruction).

Rome burns, and yet people still watch the circuses.

November 29, 2008 8:40 AM

Have been reading this excellent blog a few weeks now, but am surprised that I have seen no mention or reference to N.N. Taleb and his book The Black Swan.

This Citi/Rubin story is exactly one of the things he is talking about. Even if Citi had stacked the Audit committee with the most expert risk managers they still would have had a problem (most likely anyway).

The fault is at a deeper level. The whole knowledge base of Economics (risk mgmt, VAR, Black-Scholes etc.) is suspect. Just look at how many other institutions that are having serious problems. Did they all make the same mistake as Citi and not have enough risk people?

There is now a different lay of the land. The whole business of evaluating risk has to be looked at from a completely new and much more conservative perspective (conservative with a small c, I don't think this is a partisan problem).

And not only that, this cycle of everyone being the expert after every bubble/crisis and explaining exactly what went wrong and how to fix it next time has to end. Be humble people! We just have to accept that the financial ecosystem is far more complex than what we can understand and control.

I haven't seen any writing in that vein. What all this implies to me is careful (less?) regulation with much, much more conservative economic actors.

November 29, 2008 8:47 AM
Steve J.:
And the only consequences to Rubin will be (hopefully) lasting damage to his reputation. But he gets to keep his cash and prizes.

Thus, we practically guarantee another financial fiasco. We need a radical change in the culture on Wall Street.

November 29, 2008 9:15 AM
K T Cat:
Last night I got bored and switched on the tube. On Turner Classic Movies, the Gary Cooper flick, Seargent York was just winding up. At the end, after having won the Medal of Honor and being feted in NY as a huge hero, York returns to his native Tennessee and the girl he loves, thinking he is penniless. He asks her if she will wait for him for a few years while he works to save the money to buy a farm where they both can live.

(Note to Brad Pitt and George Clooney: he did not suggest that she put on 4" heels while he robbed a casino.)

Decades after that film was made and a few more after it could ever be made again, we have Rubin slithering away from Citigroup, Obama and McCain promising us dollars dropped from helicopters, GM and the UAW begging for alms, and all manner of depravity on TV. Then we act surprised at each new event where someone flees the responsibilty for their actions.

Culture trumps all.

November 29, 2008 9:31 AM
The looting of America took place on GW Bushs' watch. Whatever you want to say about rubin or any of the dems, the dems had no influence over the rebubblican super majority, none.

The current mess is basically the same game the rebubblicans ran to create the S&L crisis. Is rubin's self-serving behaviour deplorable ? Yes. Should he have taken on Sandi Weil and Chuck Prince ? Yes.

Greenspan's book names the day that he and rubin began lobbying the world's central banks to create the liquidity tsunami that led to this worldwide mess. "It became apparrent that the US could not continue as an island of prosperity in an ocean of poverty".

At the end of Clinton's tenure, the budget was in pseudo balance. What has come after was the rebubblicans. Let's not forget that.

November 29, 2008 10:11 AM
Gentlemutt: Sometimes it takes awhile for the Time magazine curse --- in this case extremely well-deserved and long overdue --- to become evident:,16641,19990215,00.html

Feb 15, 1999 issue, google 'time magazine covers' if need be.

With any luck these three clowns will be so brokedown in another year that they will be autographing reprints to raise cigarette money for their new husbands in jail...

Brooksley Born for Treasury Secy!

November 29, 2008 10:35 AM
I've noticed a change in the portrait of Rubin in the ongoing series of stories featuring him.

Last week, he was portrayed as having understood clearly that these new financial innovations were based on increased leverage and risk. In fact, he said that is how investors make more money. Which is true, but doesn't justify these particular products. However, in admitting that, say, CDOs are meant to push the envelope of risk for more profits, he did manage to clearly state a fact that many people are trying to deny in justifying their investments. Many people are trying to claim that they saw these investments as less risky. So, I found Rubin's admission very valuable.

Now, he seems to be focusing less on the risk of the products than on the financial crisis we are in, and saying that no one could have predicted the crisis we're in. However, even if that's true, it doesn't deny the fact that Citi's investments are part of the root cause of the current crisis, which are poor loans and over-leveraged investments. In other words, as he said earlier, pushing the envelope on risk.

I don't see it working, precisely because of the Citi bailout. From my perspective, he was clearly a believer in the view that if there was a financial crisis, the government and Fed had implicitly and explicitly agreed to intervene in a financial crisis, and save the major financial institutions. It is this belief in a guarantor which helped the big guys to laugh in the face of ultimate moral hazard. So, he's correct. He never predicted this. He never predicted this reaction by citizens to this bailout. After all, it was part of our system, and what we have now is just the guarantors of the system, taxpayers, paying the bill. How can he be blamed for clearly seeing how the system works, while the rest of us do not?

Don the libertarian Democrat

November 29, 2008 11:07 AM
Yes Yves, you hit on the fundamental problem of contemporary American society, power is not accountable, we no longer have self-government.

It was obvious to all who were paying attention what the Clinton/Rubin lot were doing, but gas was a dollar a gallon and the Nasdaq was 5000.

Now the piper's being paid, but those who had the best seats at the party, get to ditch the tab, and many still hold power.

Broken banks put state back in the driving seat by Philip Stephens

We are watching a bonfire of the old orthodoxies as well as of the vanities. This week Barack Obama promised to spend hundreds of billions of taxpayers' dollars to prop up the sinking US economy. Gordon Brown's British government announced it would soak the rich to pay for an economic rescue package.

In between times, the Bush administration all but nationalised Citigroup, the world's largest bank. For good measure it threw another, yes another, $800bn into the effort to thaw US credit markets. Everywhere you look, Keynes's demand management is replacing Adam Smith's invisible hand; printing money, a mortal sin under the fracturing Washington consensus, is the new prudence.

Something big is happening. What started out as a series of pragmatic ad hoc responses by governments and central banks is moving the boundary between state and market. Politicians are now overlaying expediency with ideology. Government is no longer a term of abuse.

Things could move still faster in the months ahead. With their myriad rescue schemes and loan guarantees, the US and British governments have nationalised their respective banking systems in all but name. The banks pretend they are still answerable to their shareholders, but it is a charade. They survive only with the explicit financial guarantee of the state.

Still, the markets remain frozen, starving business of the oxygen of credit. Unless things change soon, the politicians will have little choice but to take direct control, and quite possibly, ownership, of the banks. Nationalisation could be the first act of an Obama presidency. That at least would put some substance into all those loose analogies with FDR.

Either way, the simple fact that public ownership is viewed as a serious option – and Mervyn King, the governor of the Bank of England, said as much this week – tells you how far we have travelled from the liberal orthodoxies of recent decades. What was hailed as the new financial capitalism is making way for old-fashioned state direction. The politicians, meanwhile, are reclaiming some of the language of that earlier age. Higher taxes on the wealthy are no longer taboo; regulation has been rehabilitated; markets can fail.

It seems only yesterday that the onward march of the Anglo-American model of liberal capitalism – small government, fiscal prudence, deregulation, flexible and open markets – set the shape and tempo of the global economy. Some European governments fought a long rearguard action against what one of my French friends calls the hyper-capitalism of the "Anglo-Saxons". But to a greater or lesser degree all made their accommodations.

In the US and Britain, the centre-left learned it could win elections only by accepting the Reagan-Thatcher settlement. Bill Clinton, a Democrat, wrote the requiem for big government.

In Britain, Tony Blair, aided and abetted by Mr Brown, built New Labour's electoral success on the promise that it was as much a friend of individual aspiration as of social justice. As proof, it promised never to raise the top rate of income tax from the 40 per cent set by the Thatcher government in the 1980s. As for markets, there was no one more scornful than Mr Brown of the continental European model of a more regulated social market capitalism.

That was then. This week Mr Brown said he intended to raise the top tax rate to 45 per cent. This would be the new dividing line with David Cameron's opposition Conservatives. The measure will raise only a fraction of the revenues needed to staunch the haemorrhaging of the nation's public finances. What matters is the political symbolism: for Mr Brown, fairness now trumps aspiration.

Until quite recently, it was possible to say that rescuing the financial system was calculated to save rather than sink liberal capitalism. As after past recessions, the system would survive the shock more or less intact.

To a degree the assumption still holds true. I have yet to see a politician climbing on to a soapbox to proclaim the ideological case for nationalising the banks. Mr Obama has promised a Rooseveltian strategy to rebuild America's infrastructure, but he is careful to talk about active as opposed to big government.

The leading members of Mr Obama's economic team were among the most enthusiastic apostles of liberal markets during the Clinton presidency. Main street America did not vote to throw out the capitalist baby with the bankers' bathwater.

Even as he tosses overboard the emblems of New Labour, Mr Brown, too, is wary of suggesting that government should take more control over the lives of ordinary voters. After a spate of bad headlines, Downing Street now insists that higher taxes for the wealthy are an "extraordinary measure for extraordinary times".

The caution is understandable. Voters want security against wild-west capitalism. They do not want to be smothered by the state.

For all that, the boundaries have moved. Busts always provoke a backlash. More often than not, all is forgotten in the subsequent upswing. But this time it is more than a bad hangover. The consequences of the crash of 2008 will be felt well beyond the eventual recovery.

For one thing, the banks are going to be under state administration, if not ownership, for a very long time. The old capitalism (and by that I mean the variety that until this year we called the "new" capitalism) was predicated on a financial system that created an endless supply of cheap credit. It will take more than a cyclical upturn before politicians again allow banks to manufacture money on such an epic scale.

That will demand deep structural adjustments in economies kept afloat on the sea of credit. The US, Britain and the other boom-to-bust economies will find the world no longer willing to finance their domestic housing and borrowing booms. Voters, meanwhile, will absorb the message that it is no longer a self-evident truth that ever more liberal markets deliver painless prosperity.

The risk is that the recalibration will go too far: that innovators and entrepreneurs will be put in the stocks with investment bankers; and that fettered markers at home will be accompanied by protectionism abroad. Lest we forget, for all its manifest flaws, a liberal trading system has delivered hundreds of millions of people from abject poverty.

The market has lost its magic, but we do not know whether Mr Obama can properly rehabilitate government. So the shape of a new settlement is far from clear. What is certain is that things cannot be as they were.

Was the Great Depression a monetary phenomenon - Paul Krugman Blog

A central theme of Keynes's General Theory was the impotence of monetary policy in depression-type conditions. But Milton Friedman and Anna Schwartz, in their magisterial monetary history of the United States, claimed that the Fed could have prevented the Great Depression - a claim that in later, popular writings, including those of Friedman himself, was transmuted into the claim that the Fed caused the Depression.

Now, what the Fed really controlled was the monetary base - currency plus bank reserves. As the figure shows, the base actually rose during the great slump, which is why it's hard to make the case that the Fed caused the Depression. But arguably the Depression could have been prevented if the Fed had done more - if it had expanded the monetary base faster and done more to rescue banks in trouble.

So here we are, facing a new crisis reminiscent of the 1930s. And this time the Fed has been spectacularly aggressive about expanding the monetary base:

Ben goes for broke

And guess what - it doesn't seem to be workiing.

I think the thesis of the Monetary History has just taken a hit.Comments

  1. Dear Paul

    I think that what is proving to the current crisis is that the theories of Milton Friedman were completely wrong. The ideas of market fundamentalism of Friedman, implemented over the past 30 years, we are on the brink of this precipice at which the economy (and many economists) are to blame for their lack of vision to the history and the reality of world trade.
    Jean Baptiste Say, the economist who summarizes the thinking of classical economics (1804), said that "the products are exchanged for goods." So does the market. And if they are roles, roles that should be reflected reality. Friedman developed the theories of the "animal spirits" who invented false papers and without value.
    Lots of economic theory is collapsing in the same manner as the twin towers: one floor on the other creating a large cloud of dust. It's de meltdown of the economic fundamentalism.

    - Marco Antonio Moreno
  2. First of all, it's way too soon to say that the Federal Reserve's actions are not working.

    Second, it's not the same situation as the great depression, the US was not the economic leader of the world in 1930. Furthermore, the world had just seen a war that wiped out up to 1/3 of the working population in some countries.

    Third, the fault still may lie in the fed and the money system. The fed has only tried one real monetary policy, expand or contract the money supply with higher or lower interest rates. Well, until they started buying assetts to keep them artificially high.

    What about money theory like Silvio Gessell's or any of the lesser known economists which advocate a large departure from the traditional interest/infaltion theories?

    It's a good idea to increase liquidity, but unless it increases the 90% of the populations (the little guys) ability to do business, purchase and generate wealth it doesn't matter what the fed does. We'll still be headed for a recession/depression/chaos.

    - Theodore V.
  3. 7. November 28, 2008 2:52 pm Link

    Isn't it a reasonable argument that monetary tightening triggered the twin processes of deleveraging of debt and deflating bloated asset market prices in both the cases? But now like a nuclear chain reaction, it is hard to control it's rate.

    - Evan

  4. 8. November 28, 2008 2:53 pm Link

    I too have heard that the Federal Reserve was responsible for the Great Depression, but it has nothing to do with anything said by monetarist Milton Friedman.

    Are you familiar with the book "Economics and the Public Welfare: A financial and Economic History of the United States, 1914-1946″? It is by Benjamin M. Anderson, and was originally published in 1949. His history matches up fairly well with the theories of Ludwig von Mises, a teacher to both Frederick A. Hayek and Alan Greenspan.

    According to Anderson's history, there had been a large expansion in the Federal Reserve System during World War I, and with increased size came increased expense. Banks purchased government securities in order to keep up total earning assets. This would have been about 1920-3, if I remember correctly. However, this increased reserve balances of member banks which they used in the process of paying off their debt to the Federal Reserve banks. As such there the credit supply rose and interest rates fell - simply as an unintended byproduct at the time.

    However, inflating either the money or credit supply necessarily affects the economy unevenly. There is the point of entry, where the money actually enters the economy and products are bought with it - leading to increased, artificial demand for those products which has not been paid for by increased production, but which competes which demand that is paid for by existing production - leading to a distortion in the price system.

    In the case of inflating the credit supply, the distortion in the price system consists first and foremost of artificially lowered interest rates - which make long-term investments appear less expensive relative to short-term investments. Malinvestment ensues - which will be uncovered as malinvestment once interest rates rise back to their natural level - as determined by supply and demand.


    Benjamin Anderson notes that, "A Chase Economic Bulletin of March 27, 1923, protested against the artificially generated expansion of bank credit as masking the underlying shortage of real capital which four years of war and four more years of disorganization after the war had brought about, and urged that higher interest rates be called for, both to increase the volume of savings and to make sure that the capital that was created would be used for the most important purposes. The tendency to substitute bank credit for real capital was looked upon as a very ominous tendency." Nevertheless, the Federal Reserve System expanded the credit supply again in 1924, and then to an even greater degree in 1927, ending in 1928. (See Chapter 11: The Money Market, 1920-23– Renewed Bank Expansion.)

    It appears that the Great Depression of 1929 was to some extent anticipated as a likely result of the continued policy of artificially expanding the credit supply. However, those warnings were unheaded, and the result is now history.

    - Timothy Chase
  5. 9. November 28, 2008 3:09 pm Link

    Krugman: It hasn't discredited Friedman entirely. Maybe the situation would be much worse if the Fed weren't expanding the monetary base. After all, we've had some very negligible quarterly GDP growth the first two quarters, and the annual growth for the third quarter was -0.5%. Employment is pretty bad, but in terms of GDP we're kind of holding together… at least for now.

    Granted, I personally don't think monetary policy can't do much as of now, and I think the idea that the Fed could have prevented the Great Depression is an exaggeration… but this hasn't delivered the final blow to monetarism when you consider the question, "why aren't things much worse?" And, you see, one possible answer may be monetarism.

    - Daniel R
  6. 10. November 28, 2008 3:16 pm Link

    Yupp. Keynes was right after all.

    Sure looks like we're in a massive liquidity trap at the moment. But Bermanke is being very creative at the moment to loosen things up.

    But we need a big does of classic fiscal stimulus.

    - Jay Yamada
  7. 11. November 28, 2008 3:18 pm Link

    There was no financial derivatives market in the 1920s -1930s so its hard to see how a direct comparison can be made between then and now.

    Today, there is an unregulated international market in financial derivatives with our biggest lending institutions placing huge bets that exceed the GNP of the entire planet.

    This unregulated financial derivatives market needs to be closed, the folks who lied to investors about their true financial condition need to be placed behind bars, and the incestuous boards of directors need to be completely purged.

    Then there needs to be new regulations established to absolutley ensure that this type of amoral and unethical business behavior never happens again.

    Tthats my longshot for the day. See you at Aqueduct…

    - Dave P.

[Nov 28, 2008] Financial Hurricane Batters World Capitalism

Many progressive commentators have put the blame for this crisis on fraud and greed, or on lax regulation. All of which are certainly in play. But these explanations do not get to the essence of what is happening, to the cause of the problem. This crisis is the outcome of the fundamental workings of the capitalist system.

The analysis that follows is framed by these core points:

  1. There is an essential relationship between the vast enlargement of the financial sector in the U.S., and the general phenomenon of financialization, and the deepening globalization of capitalist production of the last 15 years. And central to this dynamic has been the relationship between U.S. imperialism and China.
  2. Through the course of this growth and expansion, severe imbalances have built up between the financial system-and its expectation of future profits-and the accumulation of capital, that is, the structures and actual production and reinvestment of profit based on the exploitation of wage-labor.
  3. A "dirty little secret" of this crisis is the enormous weight of militarization of the U.S. economy.

[Nov 28, 2008] Calculated Risk Hoocoodanode


Earlier today, I saw Greg "Bush economist" Mankiw was a little touchy about a Krugman blog comment. My reaction was that Mankiw has some explaining to do. A key embarrassment for the economics profession in general, and Bush economists Greg Mankiw and Eddie Lazear in particular, is how they missed the biggest economic story of our times.

Sure, quite a few people got it right. But those that saw it coming were frequently marginalized. This was a typical response from the right (this is from a post by Professor Arnold Kling) in August 2006:

Apparently, the echo chamber of left-wing macro pundits has pronounced a recession to be imminent. For example, Nouriel Roubini writes,
Given the recent flow of dismal economic indicators, I now believe that the odds of a U.S. recession by year end have increased from 50% to 70%.
For these pundits, the most dismal indicator is that we have a Republican Administration. They have been gloomy for six years now.
Sure Roubini was early (I thought so at the time), but show me someone who has been more right!

And this brings me to Krugman's column: Lest We Forget

... Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories?

Why did so many people insist that our financial system was "resilient," as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world?

Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

One answer to these questions is that nobody likes a party pooper. ...

There's also another reason the economic policy establishment failed to see the current crisis coming. The crises of the 1990s and the early years of this decade should have been seen as dire omens, as intimations of still worse troubles to come. But everyone was too busy celebrating our success in getting through those crises to notice.

Krugman goes on to argue that the Obama Administration should not put off financial reform; "The time to start preventing the next crisis is now."

I agree.

But in addition to looking forward, I think certain economists need to do some serious soul searching. Instead of leaving it to us to guess why their analysis was so flawed, I believe the time has come for Mankiw, Kling and many other economists to write a post titled "Why I was wrong".

The Reckoning - Citigroup Saw No Red Flags Even as It Made Bolder Bets

"Our job is to set a tone at the top to incent people to do the right thing and to set up safety nets to catch people who make mistakes or do the wrong thing and correct those as quickly as possible. And it is working. It is working."

Charles O. Prince III, Citigroup's chief executive, in 2006

In September 2007, with Wall Street confronting a crisis caused by too many souring mortgages, Citigroup executives gathered in a wood-paneled library to assess their own well-being.

There, Citigroup's chief executive, Charles O. Prince III, learned for the first time that the bank owned about $43 billion in mortgage-related assets. He asked Thomas G. Maheras, who oversaw trading at the bank, whether everything was O.K.

Mr. Maheras told his boss that no big losses were looming, according to people briefed on the meeting who would speak only on the condition that they not be named.

For months, Mr. Maheras's reassurances to others at Citigroup had quieted internal concerns about the bank's vulnerabilities. But this time, a risk-management team was dispatched to more rigorously examine Citigroup's huge mortgage-related holdings. They were too late, however: within several weeks, Citigroup would announce billions of dollars in losses.

Normally, a big bank would never allow the word of just one executive to carry so much weight. Instead, it would have its risk managers aggressively look over any shoulder and guard against trading or lending excesses.

But many Citigroup insiders say the bank's risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers eager to increase short-term earnings - and executives' multimillion-dollar bonuses - failed to rein them in, these insiders say.

Today, Citigroup, once the nation's largest and mightiest financial institution, has been brought to its knees by more than $65 billion in losses, write-downs for troubled assets and charges to account for future losses. More than half of that amount stems from mortgage-related securities created by Mr. Maheras's team - the same products Mr. Prince was briefed on during that 2007 meeting.

Citigroup's stock has plummeted to its lowest price in more than a decade, closing Friday at $3.77. At that price the company is worth just $20.5 billion, down from $244 billion two years ago. Waves of layoffs have accompanied that slide, with about 75,000 jobs already gone or set to disappear from a work force that numbered about 375,000 a year ago.

Burdened by the losses and a crisis of confidence, Citigroup's future is so uncertain that regulators in New York and Washington held a series of emergency meetings late last week to discuss ways to help the bank right itself.

And as the credit crisis appears to be entering another treacherous phase despite a $700 billion federal bailout, Citigroup's woes are emblematic of the haphazard management and rush to riches that enveloped all of Wall Street. All across the banking business, easy profits and a booming housing market led many prominent financiers to overlook the dangers they courted.

While much of the damage inflicted on Citigroup and the broader economy was caused by errant, high-octane trading and lax oversight, critics say, blame also reaches into the highest levels at the bank. Earlier this year, the Federal Reserve took the bank to task for poor oversight and risk controls in a report it sent to Citigroup.

The bank's downfall was years in the making and involved many in its hierarchy, particularly Mr. Prince and Robert E. Rubin, an influential director and senior adviser.

Citigroup insiders and analysts say that Mr. Prince and Mr. Rubin played pivotal roles in the bank's current woes, by drafting and blessing a strategy that involved taking greater trading risks to expand its business and reap higher profits. Mr. Prince and Mr. Rubin both declined to comment for this article.

When he was Treasury secretary during the Clinton administration, Mr. Rubin helped loosen Depression-era banking regulations that made the creation of Citigroup possible by allowing banks to expand far beyond their traditional role as lenders and permitting them to profit from a variety of financial activities. During the same period he helped beat back tighter oversight of exotic financial products, a development he had previously said he was helpless to prevent.

And since joining Citigroup in 1999 as a trusted adviser to the bank's senior executives, Mr. Rubin, who is an economic adviser on the transition team of President-elect Barack Obama, has sat atop a bank that has been roiled by one financial miscue after another.

Citigroup was ensnared in murky financial dealings with the defunct energy company Enron, which drew the attention of federal investigators; it was criticized by law enforcement officials for the role one of its prominent research analysts played during the telecom bubble several years ago; and it found itself in the middle of regulatory violations in Britain and Japan.

For a time, Citigroup's megabank model paid off handsomely, as it rang up billions in earnings each quarter from credit cards, mortgages, merger advice and trading.

But when Citigroup's trading machine began churning out billions of dollars in mortgage-related securities, it courted disaster. As it built up that business, it used accounting maneuvers to move billions of dollars of the troubled assets off its books, freeing capital so the bank could grow even larger. Because of pending accounting changes, Citigroup and other banks have been bringing those assets back in-house, raising concerns about a new round of potential losses.

To some, the misery at Citigroup is no surprise. Lynn Turner, a former chief accountant with the Securities and Exchange Commission, said the bank's balkanized culture and pell-mell management made problems inevitable.

"If you're an entity of this size," he said, "if you don't have controls, if you don't have the right culture and you don't have people accountable for the risks that they are taking, you're Citigroup."

Questions on Oversight

Though they carry less prestige and are paid less than Wall Street traders and bankers, risk managers can wield significant clout. Their job is to monitor trading floors and inquire about how a bank's money is being invested, so they can head off potential problems before blow-ups occur. Though risk managers and traders work side by side, they can have an uncomfortable coexistence because the monitors can put a brake on trading.

That is the way it works in theory. But at Citigroup, many say, it was a bit different.

David C. Bushnell was the senior risk officer who, with help from his staff, was supposed to keep an eye on the bank's bond trading business and its multibillion-dollar portfolio of mortgage-backed securities. Those activities were part of what the bank called its fixed-income business, which Mr. Maheras supervised.

One of Mr. Maheras's trusted deputies, Randolph H. Barker, helped oversee the huge build-up in mortgage-related securities at Citigroup. But Mr. Bushnell, Mr. Maheras and Mr. Barker were all old friends, having climbed the bank's corporate ladder together.

It was common in the bank to see Mr. Bushnell waiting patiently - sometimes as long as 45 minutes - outside Mr. Barker's office so he could drive him home to Short Hills, N.J., where both of their families lived. The two men took occasional fly-fishing trips together; one expedition left them stuck on a lake after their boat ran out of gas.

Because Mr. Bushnell had to monitor traders working for Mr. Barker's bond desk, their friendship raised eyebrows inside the company among those concerned about its controls.

After all, traders' livelihoods depended on finding new ways to make money, sometimes using methods that might not be in the bank's long-term interests. But insufficient boundaries were established in the bank's fixed-income unit to limit potential conflicts of interest involving Mr. Bushnell and Mr. Barker, people inside the bank say.

Indeed, some at Citigroup say that if traders or bankers wanted to complete a potentially profitable deal, they could sometimes rely on Mr. Barker to convince Mr. Bushnell that it was a risk worth taking.

Risk management "has to be independent, and it wasn't independent at Citigroup, at least when it came to fixed income," said one former executive in Mr. Barker's group who, like many other people interviewed for this article, insisted on anonymity because of pending litigation against the bank or to retain close ties to their colleagues. "We used to say that if we wanted to get a deal done, we needed to convince Randy first because he could get it through."

Others say that Mr. Bushnell's friendship with Mr. Maheras may have presented a similar blind spot.

"Because he has such trust and faith in these guys he has worked with for years, he didn't ask the right questions," a former senior Citigroup executive said, referring to Mr. Bushnell.

Mr. Bushnell and Mr. Barker did not return repeated phone calls seeking comment. Mr. Maheras declined to comment.

For some time after Sanford I. Weill, an architect of the merger that created Citigroup a decade ago, took control of Citigroup, he toned down the bank's bond trading. But in late 2002, Mr. Prince, who had been Mr. Weill's longtime legal counsel, was put in charge of Citigroup's corporate and investment bank.

According to a former Citigroup executive, Mr. Prince started putting pressure on Mr. Maheras and others to increase earnings in the bank's trading operations, particularly in the creation of collateralized debt obligations, or C.D.O.'s - securities that packaged mortgages and other forms of debt into bundles for resale to investors.

Because C.D.O.'s included so many forms of bundled debt, gauging their risk was particularly tricky; some parts of the bundle could be sound, while others were vulnerable to default.

"Chuck Prince going down to the corporate investment bank in late 2002 was the start of that process," a former Citigroup executive said of the bank's big C.D.O. push. "Chuck was totally new to the job. He didn't know a C.D.O. from a grocery list, so he looked for someone for advice and support. That person was Rubin. And Rubin had always been an advocate of being more aggressive in the capital markets arena. He would say, 'You have to take more risk if you want to earn more.' "

It appeared to be a good time for building up Citigroup's C.D.O. business. As the housing market around the country took flight, the C.D.O. market also grew apace as more and more mortgages were pooled together into newfangled securities.

From 2003 to 2005, Citigroup more than tripled its issuing of C.D.O.'s, to more than $20 billion from $6.28 billion, and Mr. Maheras, Mr. Barker and others on the C.D.O. team helped transform Citigroup into one of the industry's biggest players. Firms issuing the C.D.O.'s generated fees of 0.4 percent to 2.5 percent of the amount sold - meaning Citigroup made up to $500 million in fees from the business in 2005 alone.

Even as Citigroup's C.D.O. stake was expanding, its top executives wanted more profits from that business. Yet they were not running a bank that was up to all the challenges it faced, including properly overseeing billions of dollars' worth of exotic products, according to Citigroup insiders and regulators who later criticized the bank.

When Mr. Prince was put in charge in 2003, he presided over a mess of warring business units and operational holes, particularly in critical areas like risk-management and controls.

"He inherited a gobbledygook of companies that were never integrated, and it was never a priority of the company to invest," said Meredith A. Whitney, a banking analyst who was one of the company's early critics. "The businesses didn't communicate with each other. There were dozens of technology systems and dozens of financial ledgers."

Problems with trading and banking oversight at Citigroup became so dire that the Federal Reserve took the unusual step of telling the bank it could make no more acquisitions until it put its house in order.

In 2005, stung by regulatory rebukes and unable to follow Mr. Weill's penchant for expanding Citigroup's holdings through rapid-fire takeovers, Mr. Prince and his board of directors decided to push even more aggressively into trading and other business that would allow Citigroup to continue expanding the bank internally.

One person who helped push Citigroup along this new path was Mr. Rubin.

Pushing Growth

Robert Rubin has moved seamlessly between Wall Street and Washington. After making his millions as a trader and an executive at Goldman Sachs, he joined the Clinton administration.

Mr. Weill, as Citigroup's chief, wooed Mr. Rubin to join the bank after Mr. Rubin left Washington. Mr. Weill had been involved in the financial services industry's lobbying to persuade Washington to loosen its regulatory hold on Wall Street.

As chairman of Citigroup's executive committee, Mr. Rubin was the bank's resident sage, advising top executives and serving on the board while, he insisted repeatedly, steering clear of daily management issues.

"By the time I finished at Treasury, I decided I never wanted operating responsibility again," he said in an interview in April. Asked then whether he had made any mistakes during his tenure at Citigroup, he offered a tentative response.

"I've thought a lot about that," he said. "I honestly don't know. In hindsight, there are a lot of things we'd do differently. But in the context of the facts as I knew them and my role, I'm inclined to think probably not."

Besides, he said, it was impossible to get a complete handle on Citigroup's vulnerabilities unless you dealt with the trades daily.

"There is no way you would know what was going on with a risk book unless you're directly involved with the trading arena," he said. "We had highly experienced, highly qualified people running the operation."

But while Mr. Rubin certainly did not have direct responsibility for a Citigroup unit, he was an architect of the bank's strategy.

In 2005, as Citigroup began its effort to expand from within, Mr. Rubin peppered his colleagues with questions as they formulated the plan. According to current and former colleagues, he believed that Citigroup was falling behind rivals like Morgan Stanley and Goldman, and he pushed to bulk up the bank's high-growth fixed-income trading, including the C.D.O. business.

Former colleagues said Mr. Rubin also encouraged Mr. Prince to broaden the bank's appetite for risk, provided that it also upgraded oversight - though the Federal Reserve later would conclude that the bank's oversight remained inadequate.

Once the strategy was outlined, Mr. Rubin helped Mr. Prince gain the board's confidence that it would work.

After that, the bank moved even more aggressively into C.D.O.'s. It added to its trading operations and snagged crucial people from competitors. Bonuses doubled and tripled for C.D.O. traders. Mr. Barker drew pay totaling $15 million to $20 million a year, according to former colleagues, and Mr. Maheras became one of Citigroup's most highly compensated employees, earning as much as $30 million at the peak - far more than top executives like Mr. Bushnell in the risk-management department.

In December 2005, with Citigroup diving into the C.D.O. business, Mr. Prince assured analysts that all was well at his bank.

"Anything based on human endeavor and certainly any business that involves risk-taking, you're going to have problems from time to time," he said. "We will run our business in a way where our credibility and our reputation as an institution with the public and with our regulators will be an asset of the company and not a liability."

Yet as the bank's C.D.O. machine accelerated, its risk controls fell further behind, according to former Citigroup traders, and risk managers lacked clear lines of reporting. At one point, for instance, risk managers in the fixed-income division reported to both Mr. Maheras and Mr. Bushnell - setting up a potential conflict because that gave Mr. Maheras influence over employees who were supposed to keep an eye on his traders.

C.D.O.'s were complex, and even experienced managers like Mr. Maheras and Mr. Barker underestimated the risks they posed, according to people with direct knowledge of Citigroup's business. Because of that, they put blind faith in the passing grades that major credit-rating agencies bestowed on the debt.

While the sheer size of Citigroup's C.D.O. position caused concern among some around the trading desk, most say they kept their concerns to themselves.

"I just think senior managers got addicted to the revenues and arrogant about the risks they were running," said one person who worked in the C.D.O. group. "As long as you could grow revenues, you could keep your bonus growing."

To make matters worse, Citigroup's risk models never accounted for the possibility of a national housing downturn, this person said, and the prospect that millions of homeowners could default on their mortgages. Such a downturn did come, of course, with disastrous consequences for Citigroup and its rivals on Wall Street.

[Nov 19, 2008] No change, no hope Obama's Transition Economic Advisory Board by Willem Buiter's

"It's actually a good thing that the group has a dearth of economists.Apologies to your profession, but they gave us some very stupid ideas over the past few decades. Remember the Laffer Curve? How about Efficient Market Hypothesis? That was a poor excuse for truth, eh?" Actually there have been several economists predicting the housing crush since 2004-5 (e.g. Shiller, Roubini, Krugman)

November 10, 2008 |

I'm afraid this post is going to be rather boring (the comment "What's new?" is taken as made). I intend to take you on a trip through Barack Obama's Transition Economic Advisory Board.

It members are:

  1. DAVID E. BONIOR, a former Democratic Congressman from Michigan and John Edwards's campaign manager. Has been active in union advocacy. He is now a professor of labour studies at Wayne State University. He opposes NAFTA and abortion. He has a BA and MA, but I cannot find out in what subject(s). He is 63 years old.
  2. WARREN E. BUFFETT, the billionaire investor and chairman of Berkshire Hathaway; he has a BS and MS in Economics. He is 78 years old.
  3. ROEL C. CAMPOS, a lawyer and former member of the Securities and Exchange Commission under appointed by Bush Jr. He is 58 or 59 years old.
  4. William H. Daley, a senior executive at JP Morgan Chase, former Commerce Secretary under Clinton and chairman of Al Gore's presidential campaign. He is a lawyer. He is 60 years old.
  5. WILLIAM H. DONALDSON, a former Chairman of the S.E.C. As Chairman, Mr. Donaldson presided over the meeting at the SEC on April 28, 2004, held at the request of the major Wall Street investment banks. These requested that the SEC release them from the so-called "net capital rule" - the requirement that they hold capital reserves in their brokerage units. The request was granted, and leverage in the investment banks exploded. He is a CFA. He is 77 years old.
  6. ROGER W. FERGUSON Jr., Chief Executive of TIAA-CREF, former vice chairman of the Federal Reserve, with special responsibility for regulatory issues. He is an economist. He is 57 years old.
  7. JENNIFER M. GRANHOLM, Governor of Michigan. She is a protectionist ('Fair Trade' fan) and a lawyer. She is 49 years old.
  8. ANNE M. MULCAHY, Chairwoman and Chief Executive of Xerox. She has a degree in English and journalism. She is 56 years old.
  9. RICHARD D. PARSONS, Chairman of Time Warner; he is a former banker and a lawyer. He is 60 years old.
  10. PENNY S. PRITZKER, Senior executive, Hyatt; she was national finance chairwoman for the Obama campaign. She has a BA in Economics and a JD/MBA. She is 59 years old.
  11. ROBERT B. REICH, Author, academic and former Labor Secretary under Clinton. He is a lawyer. He is 62 years old.
  12. ROBERT E. RUBIN, Chairman of Citigroup and former Treasury Secretary under Clinton. He is a lawyer. He is 70 years old.
  13. ERIC E. SCHMIDT, Chairman and chief executive, Google. He has a degree in Electrical Engineering and Computer Sciences. He is 53 years old.
  14. LAWRENCE H. SUMMERS, Academic and former Treasury Secretary under Clinton. He is an economist. He is 53 years old.
  15. LAURA D'ANDREA TYSON, Academic and former chairwoman of the President's Council of Economic Advisors and of the National Economic Council under Clinton. She is an economist. She is 61 years old.
  16. ANTONIO R. VILLARAIGOSA, Mayor of Los Angeles and former union organiser. He failed the California Bar exam four times. He is 55 years old.
  17. PAUL A. VOLCKER, former chairman of the Federal Reserve under Carter and Reagan. He is an economist. He is 81 years old.

A few features of this list jump out at the reader:

They're old! The mean age is 61.9 years and the median is 60. Old age is good. I plan to enjoy it extensively and expect to be listened to respectfully by young whippersnappers. But even so… The youngest member is 49 years old. Were there no persons in their early 40s, their 30s or their late 20s who could brighten up this sexagenarian coterie?

Too few serious economists! There are far too few members with an serious background in economics, capable of grasping the complexities of the financial crisis, budgetary policy, monetary policy, international trade and global financial issues, tax reform, prioritising infrastructure spending, the economics of education, health insurance, health care, education and the environment. Experience running a business is of no help when it comes to preparing for and planning broad structural economic reforms. Most of this Transition Economic Advisory Board appears completely out of its depth - dead wood at best - a ball and chain at worst. I count only four of the 17 members as card-carrying, qualified economists – Roger Ferguson, Larry Summers, Laura Tyson and Paul Volcker. Where are Austan Goolsbee, Jason Furman and Peter Orszag? Where are Jo Stiglitz and Paul Krugman? If they are otherwise engaged, there are dozens of intelligent, wise and politically savvy younger economists who could play a useful role in the presidential transition process.

Far too many lawyers! I count eight of them. America is held back and at times almost suffocated by an overgrown legal infrastructure and an overweening legal profession, much in the same way that the UK was held back and almost suffocated by organised labour during the last years before Margaret Thatcher came to power.

Lest I be the target of a class action suit by the US legal profession, let me state here that (a) some of my best friends are (or were) lawyers and that (b) a limited quantum of lawyers is necessary to support the essential infrastructure of the rule of law. Unfortunately, in the US, the legal profession has grown to an astonishing size and has become a veritable succubus preying on the body politic and on the economic resource base of the country - the ultimate rent-seeking, wealth destroying profession. According to Legal Reform Now! there are 1,143,358 lawyers in the US, one for every 200 adults. The main problem is not that there are over a million socially unproductive lawyers in the US. The problem is that these lawyers are an essential component of a dysfunctional legal framework that has created the most litigious society in the world. The damage this dysfunctional legal framework causes must be measured not primarily by the direct cost of litigation, astounding though it is, but through the actions not undertaken and the creative and productive deeds not done because of fear of litigation. The first thing we do…

Except for a depressingly small minority among them, lawyers know nothing. They are incapable of logic. They don't know the difference between necessary and sufficient conditions or between type I and type II errors. Indeed, any concept of probability is alien to them. They don't understand the concepts of opportunity cost and trade off. They cannot distinguish between normative and positive statements. They are so focused on winning an argument through technicalities, that they no longer would recognise the truth if it bit them in the butt. If you are very lucky, a lawyer will give you nothing but the truth. You will never get the truth, let alone the whole truth. Things have degenerated to the point that lawyers and the legal profession not only routinely undermine justice, but even the law.

But the American political system is completely dominated by this largely socially unproductive and parasitic profession. Consider the membership of the House and the Senate (according to the Congressional Research Service 170 members of the House (out of 435) and 60 Senators (out of 100) are lawyers). Consider the professional training and background of past and future presidents (including Obama, 26 out of 44 presidents were lawyers) - and weep.

They are protectionist! David Bonior, Jennifer M. Granholm (both Michigan politicians), Antonio Villaraigosa and Robert Reich are all 'fair traders', that is, rabid protectionists. Laura Tyson has long been a crypto-protectionist and Larry Summers has stepped repeatedly over the boundary between legitimate critiques of certain extravagant claims concerning the joys of globalisation and simple trade protectionism.

They are the unalluring faces of past failures! Roel Campos and William Donaldson served on the SEC when this organisation aided and abetted the excesses of the investment banks that contributed so much to the financial and economic crisis now facing us. Robert Rubin has been a life-long leading light in the banking system that has just imploded and is dragging the real economy with it. William Daley is Robert Rubin lite. Both Rubin and Summers were deeply involved in the Clinton era bail-outs in emerging markets. Both exhibited the characteristic myopia and inability to make credible commitments that turned many of these bail-outs into moral hazard incubators. Larry Summers in particular has never seen a bail-out he did not like and never one so large that he did not want to boost its size further. He will have a field day in the current crisis.

The one beacon of hope in this fog of mediocrity is Paul Volcker, a truly great man with more character, intelligence and vision than the rest of the Board put together. But can he, on his own, salvage this wreck in the making? I hope so, but I doubt it.

To summarize: the members of Obama's Transition Economic Advisory Board are too old, too uninspiring and too much part of the problem to deliver the change America needs and to keep alive the hope that Obama may have inspired through his election. A wasted opportunity.


  1. "Obama is a lawyer himself isn't he?"

    According to the media he was a "brilliant legal scholar" at Harvard - the only problem is nobody seems to have anything that proves that. He didn't submit anything to legal journals or the college papers - nothing. We're not allowed to see his transcripts either. He has never represented any clients in court where we could see the records to see how he talked - we have nothing.

  2. "Both exhibited the characteristic myopia and inability to make credible commitments that turned many of these bail-outs into moral hazard incubators. Larry Summers in particular has never seen a bail-out he did not like and never one so large that he did not want to boost its size further. He will have a field day in the current crisis."

    Too good! The post is brilliant, even though I like Robert Reich. Can I print the comments about lawyers as a broadside?

  3. It's actually a good thing that the group has a dearth of economists. Apologies to your profession, but they gave us some very stupid ideas over the past few decades. Remember the Laffer Curve? How about Efficient Market Theorm? That was a poor excuse for truth, eh? I suggest that anyone who has not read and understood The Black Swan be excluded from consideration as a serious thinker about the potential for future events. Given the way they talk about the future and the present, that seems to exclude most economists.

    As for the over-representation of lawyers, well, you had some very poor lawyers in the Bush administration. It's about time we fixed that.

    The only point on which we agree is that the age of those listed is a bit much. Age 15 is about the peak of intellectual flexibility in the human mind. Nevertheless, I don't want a group of 15 year olds deciding the fate of the world.

    Thanks for your attention.

    Posted by: Michael Atlass | November 11th, 2008 at 10:11 pm | Report this comment
  4. A question for Professor Buiter.

    During my life I have encountered three main objections to free trade, namely:

    1. That free trade between two economies when one is stronger than the other it is only good in the short run because in the long run it ends up by robbing the weaker one of the possibility of creating or developing its own industrial base. Case in point, the colonial trade practices.

    2. That the benefits from free trade tend to be distributed in conformity with the 20/80 rule creating or reinforcing dualism within the same economic space or creating unacceptable distortions in income distribution a fact that cannot be corrected due to the lack of political will. Case in point, the neocolonial practices.

    3. That the benefits from free trade tend to be highly asymmetric when the other party has an 'unfair' advantage. And as to what may constitute unfair advantage it can be anything ranging from factor price differentials to lack of access to distribution networks. Case in point, the present 'Fair Trade' cries.

    The first two objections are history now but the third one it is not.

    We all know since the time of David Ricardo that countries with a comparative advantage should trade as from that it will result a more efficient allocation of resources.

    We also know from Pareto that an allocation of resources for a set of countries that can make at least one country better off without making any other worse off is an improvement.

    But we also know that the current global imbalances are unsustainable.

    Question. How can we deal with the current trade imbalances without destroying free trade? What mechanism can be created to take the global trade system back to the point of equilibrium. Is it too late for that?

    Posted by: Peter Carvapai | November 12th, 2008 at 12:56 am | Report this
  5. No surprise, the Democratic Party like the Republican Party stands for status quo-not change.
    If the American people wanted change they would have elected a 3rd party president along with a new Congress. Political advertising uses the world change like Exxon does clean energy.
    Enjoyed your post.

    Posted by: ron caldwell | November 12th, 2008 at 4:12 pm | Report this comment

  6. Being an economist is a weakness here. The neoclassical synthesis does not understand how financial markets interact with the real economy. A few applied economists-finance guys do understand, but they are usually not in academia, much less politics, which do not tolerate novel views well.

    I could assemble a team of economists-finance guys (male and female) that get it, but they would get little respect from the economics/political establishment.

    They would advise that there is not much to do except take the pain from the debt bubble that is deflating, or go the Japan route and string it out, which is what the politicians seem to favor, though they won't admit it.

    Posted by: David Merkel, | November 12th, 2008 at 7:37 pm | Report this comment
  7. This reads like the WSJ comments section.

    Folks, we've had decades of beggar-the-American-worker economic policies. This list is indeed a step in another direction. Get used to it. When the 'free market' folks were in charge, they turned the American economy into a casino which was rigged to reward the rich. Your day is done. As our economy continues to crater, your day will be history. Go whimpering into your chilly financial caves.

    The fact is the USA suffers from a dearth of real investment and a surfeit of speculation. That's your responsibility. Face it: your theories failed the test of reality.

    Step aside.

    Posted by: lark | November 12th, 2008 at 8:06 pm | Report this comment

Mirabile Dictu! Congress is Mad at Paulson for Lying!

...Paulson is insisting that Congress release the remaining $350 billion of the now-misnamed Troubled Assets Repurchase Program so he can hand out more cash to his industry buddies. Congress will be damned if it gives Treasury any more money, given that the funds have so clearly been dispensed with no controls to favored parties. But since they don't dare say the taxpayer has been ripped off (that would call their judgment into question for acquiescing to the hastily drafted and aggressively sold TARP), they will pound on Treasury as many ways as they can.


Yves Smith:
Anon of 2:27 PM,

The problem is that Paulson bullied (and I do mean bullied) Congress into passing this bill. He took the leadership and told them if the bill wasn't passed, there would be financial armageddon, which he apparently described in some detail. That was part of the reason for the revolt by the rank and file. They weren't included in the scare mongering lecture.

Now remember, the bill was considerably renegotiated. There was the 3 page original Treasury version, a version from Congress (not Frank, Dodd?) a 110 page version after that, and the final porky 400+ page monstrosity which substantively wasn't hugely different from the original once you took out the pork.

The reason I have trouble defending Paulson is that while the bill was being negotiated, I am told by people with direct knowledge of the proceedings that some of the key Congressional negotiators raised several times the issue of capital injections into banks. I am also told that Paulson did indeed have his change of heart before the bill was finalized.

If true, then why couldn't he have allowed language to be included that made that option more explicit and if he needed to save face, say something like, "Look, that isn't what we are contemplating, but other experts are saying we should look at that too. We'll put some non-binding language in and take it under advisement." Then he could come back and say. "You guys were right, this is a good idea."

This at best is childish and immature. The only reason I can think of for not allowing language to be put in that reflected his changed intent was that some constraints might be put around it, constraints that would help the taxpayer and keep this from being a handout to his buddies. There is no defensible reason for him not to have allowed a few phrases to broaden the possible uses to be slipped in WHILE the bill was being negotiated, particularly it was responsive to issues Congressmen were raising!

Does it make any difference what CONgress says? congress is in the hands of big business and big corporations. They're not looking out for the little guy, their actions show that. There was huge public opposition to the bail out package. All this market intervention has done little to prevent the crisis from unfolding and has saddles more debt on the people.

Let the bad debt be liquidated, damn the banks. We'll get back. The world has to choose, 2 years of sharp pain and swift recovery or 10 years or more of stagnation and deflation ala japan, just worse as it will be global. DOW 4000 here we come.

November 15, 2008 1:47 AM

What about all of the asset management contracts that were being fought over a few weeks ago? Are they still being paid for a job that no longer exists?

Kashkari was hired on for a job that he just testified does not exist. Why is he there? Talk about offering someone up. No one saw that coming.

Wasn't there some fighting over disclosure of the term of these 'asset management' contracts?

November 15, 2008 2:17 AM

Congress has proven over the last 8 years that it is irrelevant. They neither listen to the people, or understand the deeper ramifications of their actions. The real levers of power rest with whomever resides in the White House. This does not bode well for our democracy.

November 15, 2008 2:22 AM

Yves, I have a question on your viewpoint. I do agree wholeheartedly with your disgust at the TARP and Paulson's approach to his job. The only point I'm not persuaded on is that, even given the stupidity of Paulson's intitial buy-up-the-assets plan, is this: isn't it possible even for a fool or knave to realize, sincerely, that he was wrong? I differ with you in that I don't find it implausible that while the TARP was being passed, and toward the end of the period of debate on it, which lasted around two weeks or so as I recall, it finally dawned on Paulson that the buy-the-assets approach was wrong, but that he felt nevertheless that the best thing to do at that point was to go ahead and let the bill pass, and then do what he could from there to change things via interpretation, or just get another bill passed. He does not have the option, in his role, of giving the Congress or the nation a stream-of-consciousness account of his thinking. Had he said, oops, sorry, the consequences might have been pitchforks in the street within a week (remember, the money markets were shutting down while this was all going on). Again, I really do not at all like how he has handled the crisis; his instinct seems to be to deal with the "optics" of things, and keep the monkey show going, rather than to really fix the problems with our brave new over-leveraged, over-derivativized financial system. But I do wonder if you are not going just one step beyond fair in not allowing that even a guy who is really wrong-headed can honestly change his mind, yet be hamstrung in his ability to say so as you or I might by the, oh, momentum or tragic logic of emergency legislation being passed with all of the world's business and political press watching him. Would it really have worked for Paulson to change his mind publicly at the last minute? I would be interested in seeing you further explain your, to me, overly dire interpretation of this narrow question (and again, outside of this, I think you are dead right about the TARP and Paulson).

November 15, 2008 2:27 AM

Yves Smith:
Anon of 2:27 PM,

The problem is that Paulson bullied (and I do mean bullied) Congress into passing this bill. He took the leadership and told them if the bill wasn't passed, there would be financial armageddon, which he apparently described in some detail. That was part of the reason for the revolt by the rank and file. They weren't included in the scare mongering lecture.

Now remember, the bill was considerably renegotiated. There was the 3 page original Treasury version, a version from Congress (not Frank, Dodd?) a 110 page version after that, and the final porky 400+ page monstrosity which substantively wasn't hugely different from the original once you took out the pork.

The reason I have trouble defending Paulson is that while the bill was being negotiated, I am told by people with direct knowledge of the proceedings that some of the key Congressional negotiators raised several times the issue of capital injections into banks. I am also told that Paulson did indeed have his change of heart before the bill was finalized.

If true, then why couldn't he have allowed language to be included that made that option more explicit and if he needed to save face, say something like, "Look, that isn't what we are contemplating, but other experts are saying we should look at that too. We'll put some non-binding language in and take it under advisement." Then he could come back and say. "You guys were right, this is a good idea."

This at best is childish and immature. The only reason I can think of for not allowing language to be put in that reflected his changed intent was that some constraints might be put around it, constraints that would help the taxpayer and keep this from being a handout to his buddies. There is no defensible reason for him not to have allowed a few phrases to broaden the possible uses to be slipped in WHILE the bill was being negotiated, particularly it was responsive to issues Congressmen were raising!

November 15, 2008 2:43 AM

Yves, thanks for fleshing out your view, in response to my earlier 2:27 a.m. comment. I get where you are coming from now.

November 15, 2008 3:07 AM

This exemplifies the culpability of the past administration. People drawing the inference to the Romanization of America by the the currant US policy makers is resolute. I no further care about the market but, wish to make sure the present bandits don't get away with their loot.

As and old American flag once proclaimed "Don't tread on us"

Neocons out Americanize or Patriot that position.


November 15, 2008 4:38 AM

doc holiday:
Re: release the remaining $350 billion of the now-misnamed Troubled Assets Repurchase Program

It is time to re-name this pig, like maybe Fraudulent Asset Re-Packaging Service (FARPS)

November 15, 2008 4:41 AM

I like Taxpayers Underwriting Risky Debt (TURD)

November 15, 2008 7:26 AM

It appears to me that Paulson realized that his initial idea (to buy up banks' bad debt) wasn't going to work, so he decided to try something else. Now, when did he come to this realization? Did he decide this before the bill was passed, or afterwards?

IIRC economists from everywhere were saying buying bad bank debt wasn't going to work, that it would be hard to find the correct value, and could make things worse if done improperly. But, Paulson's later ideas have barely gotten off the ground before they got shot down too (renegotiating bad mortgages, buying CC debt, etc).

So now he's just going to shovel money at the banks (isn't that what buying non-representative shares of stock is, basically?) in the hopes that they'll act responsibly with it and start lending again. Is Paulson naive or is he betting that Congress and the citizenry are idiots?

November 15, 2008 9:22 AM

Matt Dubuque:
The American press was COMPLETELY silent on how asinine it was to pick a 35-year old baby (Kashkari) to head up TARP.

NO PERSON 35 years old has the life experience to manage 750 billion dollars.

Period. Case closed.

NO PERSON 35 years old has the life experience to manage 750 billion dollars.

Much less someone who is only "above average" and whose biggest qualification, if you read through the lines of what Paulson said at the time, seemed to be that he sleeps just 4 hours a night.

And again, the American press, dumbed down to the extreme, didn't know what a stupid appointment Kashkari was.

Matt Dubuque

November 15, 2008 9:24 AM

Congress isn't mad enough. they will do nothing. hearings are just a song and dance show for the tv audience. there will be no consequences.

November 15, 2008 10:23 AM

The American Experiment in Liberty and Democracy is over
and we have already reverted back to the much more normal style of governance the human condition have put upon themselves over the millennia – a tyranny of the State.

"Supreme Court Justice Louis Brandeis warned, "The greatest dangers to liberty lurk in the insidious encroachment by men of zeal, well meaning but without understanding." The freedom of individuals from compulsion or coercion never was, and is not now, the normal state of human affairs. The normal state for the ordinary person is tyranny, arbitrary control and abuse mainly by their own government. While imperfect in its execution, the founders of our nation sought to make an exception to this ugly part of mankind's history. Unfortunately, at the urging of the American people, we are unwittingly in the process of returning to mankind's normal state of affairs." Destroying Liberty - A MINORITY VIEW, WALTER E. WILLIAMS

November 15, 2008 11:18 AM

Hank Paulson's Mom:
"and the final porky 400+ page monstrosity which substantively wasn't hugely different from the original once you took out the pork."

Yves, just to be sure we have the record straight on the TARP timeline, I believe that the "pork" wasn't added to the TARP bill, but that TARP was grafted onto an existing House bill for procedural reasons. In other words, the extra pages were not a way to sneak pork into the bill; they were an original House bill that the Senate used (by grafting TARP onto) in order to bypass a procedural problem with the Senate originating spending bills (and pass TARP quicker).

- Hank Paulson's Mom

November 15, 2008 11:20 AM

They're beating up on Kashkari because that's what a MiniMe is for: You beat up on the MiniMe when you don't have the nerve or the brawn to go beat up on the REAL Dr. Evil.

November 15, 2008 11:27 AM

what g. said.

November 15, 2008 11:56 AM

They will hand over the next $350m with little resistance. This is all a charade. Since Congress (nor the White House) really doesn't understand the economy they have no choice but to trust the Treasury.

November 15, 2008 12:05 PM

It is remarkable (and admittedly late, but late is better than never) that Congress is developing a spine and pushing back at Hank Paulson's unprecedented land grab. Even better they got mad at something that made your humble blogger nuts. Trust me, I am highly confident that no Congressional aide picked up on the issue via this blog, but you did have to be paying attention to catch Paulson's dishonesty, and to their credit, they took notice.

Of course, this is all part of a larger Kabuki drama. Paulson is insisting that Congress release the remaining $350 billion of the now-misnamed Troubled Assets Repurchase Program so he can hand out more cash to his industry buddies. Congress will be damned if it gives Treasury any more money, given that the funds have so clearly been dispensed with no controls to favored parties. But since they don't dare say the taxpayer has been ripped off (that would call their judgment into question for acquiescing to the hastily drafted and aggressively sold TARP), they will pound on Treasury as many ways as they can.

But this is a central issue. Paulson was brazen enough to say that he had misrepresented his intentions while the bill was still being renegotiated. From our earlier post, "Paulson Now Admits Mendacity." And that means Congress can say they were sold a bill of goods:
From the text of Paulson's remarks today (boldface ours):
During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets-our initial focus-would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks.
Either way you cut this, it's a lie. Either Paulson let his intentions be misrepresented via his silence, or he is now falsely claiming to have changed direction earlier than he did. Nouriel Roubini has claimed that Treasury was resisting the idea of of inserting language that would allow for capital injections into banks but that some members of Congress thought it was necessary, and put statements into the Congressional record via floor debates to allow for that interpretation. Roubini further contends that Paulson changed his mind only as a result of the adverse market reaction after the bill was signed.

But if Roubini is wrong and Paulson's statement is accurate, it is still completely in keeping with the conduct of an Administration that told the public that there were weapons of mass destruction in Iraq. The bill was drafted to be extraordinarily vague and sweeping, and yet did not clearly give Paulson the authority he now says he realized back then that he needed while it was still being renegotiated.
Now to the fulminating from the legislature, via the Financial Times:
A senior US Treasury official came under attack on Friday as critics of the $700bn bail-out from the left and the right questioned whether the Bush administration had deceived members of Congress over how the funds would be used.

Congressional leaders, including Chuck Schumer, a Democratic senator, and Spencer Bachus, a Republican congressman, applauded a Treasury move this week to scrap plans to purchase troubled securities in favour of direct capital injections into financial institutions.

But at a hearing on Friday, Dennis Kucinich, a liberal Democrat, and Darrell Issa, a conservative Republican, lashed out at Neel Kashkari, the Treasury official in charge of the bail-out, for ignoring "congressional intent".

The criticism pointed to deeper unease about the Treasury's handling of the rescue among rank-and-file legislators, which could make it more difficult for the administration to secure approval from Congress for the final $350bn of funds that it is expected to seek.

"I want to know whether Congress was lied to or whether there was a team all along that had an alternate idea of how the money was spent," Mr Issa said, before demanding to know the "time and date" Hank Paulson, Treasury secretary, had decided to abandon his initial plan.

Mr Kashkari said the legislation authorising the $700bn bail-out had been designed to give the Treasury broad flexibility to adapt its strategies. At the same time, he said, as the bail-out was being negotiated in Congress, "credit markets were deteriorating much more quickly than we had expected".

He also defended the Treasury against claims that it was not doing enough to immediately help homeowners at risk of foreclosure, arguing that "every American" would benefit from stability in the financial system....

Some lawmakers have expressed concern that, because Treasury will not be buying mortgage securities as planned, it will have less power to modify home loans on a large scale.
I welcome reader comment, but I assume the reason for beating up on Kashkari was 1) he was testifying and 2) it may have been hoped that someone not well seasoned in the art of speaking before Congress would be more likely to slip and make an embarrassing admission. But Goldman employees are well practiced in the art of minimal disclosure.

posted by Yves Smith at 1:30 AM on Nov 15, 2008

[Nov 13, 2008] A Credit Crisis or a Collapsing Ponzi Scheme By PAM MARTENS

November 13, 2008 "Counterpunch"

Purge your mind for a moment about everything you've heard and read in the last decade about investing on Wall Street and think about the following business model:

You take your hard earned retirement savings to a Wall Street firm and they tell you that as long as you "stay invested for the long haul" you can expect double digit annual returns. You never really know what your money is invested in because it's pooled with other investors and comes with incomprehensible but legal looking prospectuses. The heads of these Wall Street firms have been taking massive payouts for themselves, ranging from $160 million to $1 billion per CEO over a number of years. As long as new money keeps flooding in from newfangled accounts called 401(k)s, Roth IRAs, 529 plans for education savings, and hedge funds (each carrying ever greater restrictions for withdrawing your money and ever greater opacity) everything appears fine on the surface. And then, suddenly, you learn that many of these Wall Street firms don't have any assets that anybody wants to buy. Because these firms are both managing your money as well as having their own shares constitute a large percentage of your pooled investments, your funds begin to plummet as confidence drains from the scheme.

Now consider how Wikipedia describes a Ponzi scheme:

"A Ponzi scheme is a fraudulent investment operation that involves promising or paying abnormally high returns ('profits') to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. It is named after Charles Ponzi...One reason that the scheme initially works so well is that early investors – those who actually got paid the large returns – quite commonly reinvest (keep) their money in the scheme (it does, after all, pay out much better than any alternative investment). Thus those running the scheme do not actually have to pay out very much (net) – they simply have to send statements to investors that show how much the investors have earned by keeping the money in what looks like a great place to get a high return. They also try to minimize withdrawals by offering new plans to investors, often where money is frozen for a longer period of time...The catch is that at some point one of three things will happen:

(1) the promoters will vanish, taking all the investment money (less payouts) with them;

(2) the scheme will collapse of its own weight, as investment slows and the promoters start having problems paying out the promised returns (and when they start having problems, the word spreads and more people start asking for their money, similar to a bank run);

(3) the scheme is exposed, because when legal authorities begin examining accounting records of the so-called enterprise they find that many of the 'assets' that should exist do not."

Looking at outcomes 1, 2, and 3 above, here's where we are today. The promoters have clearly not vanished as in outcome 1. In fact, they are behaving as if they know they have nothing to fear. As over $2 trillion of taxpayer money is rapidly infused through Federal Reserve loans and over $125 Billion in U.S. Treasury equity purchases to keep these firms from collapsing, the promoters are standing at the elbow of the President-Elect in press conferences (Citigroup promoter, Robert Rubin); they are served up as business gurus on the business channel CNBC (former AIG CEO and promoter, Maurice "Hank" Greenberg); they are put in charge of nationalized zombie firms like Fannie Mae (Herbert Allison, former President of Merrill Lynch); they are paying $26 million and $42 million, respectively, for new digs at 15 Central Park West in Manhattan, where their chauffeurs have their own waiting room (Lloyd Blankfein, CEO of Goldman Sachs; Sanford "Sandy" Weill, former CEO of Citigroup, who put his penthouse in the name of his wife's trust, perhaps smelling a few pesky questions ahead over the $1 billion he sucked out of Citigroup before the Fed had to implant a feeding tube).

We are definitely seeing all the signs of outcome 2: the scheme is collapsing under its own weight; there are panic runs around the globe wherever Wall Street has left its footprint.

But outcome 3 is the most fascinating area of departure from the classic Ponzi scheme. Legal authorities have, indeed, examined the books of these firms, except for one area we'll discuss later. They found worthless assets along with debts hidden off the balance sheet instead of real depositor funds. Instead of arresting the perpetrators and shutting down the schemes, Federal authorities have developed their own new schemes and pumped over $2 trillion of taxpayer money into propping up the firms while leaving the schemers in place. Equally astonishing, Congress has not held any meaningful investigations. This has left many Wall Street veterans wondering if the problem isn't that the firms are "too big to fail" but rather "too Ponzi-like to prosecute." Imagine the worldwide reaction to learning that all the claptrap coming from U.S. think-tanks and ivy-league academics over the last decade about efficient market theory and deregulation and trickle down was merely a ruse for a Ponzi scheme now being propped up by a U.S. Treasury Department bailout and loans from our central bank, the Federal Reserve.

Fortunately for American taxpayers, Bloomberg News has some inquiring minds, even if our Congress and prosecutors don't. On May 20, 2008, Bloomberg News reporter, Mark Pittman, filed a Freedom of Information Act request (FOIA) with the Federal Reserve asking for detailed information relevant to whom the central bank was giving these massive loans and precisely what securities these firms were posting as collateral. Bloomberg also wanted details on "contracts with outside entities that show the employees or entities being used to price the Relevant Securities and to conduct the process of lending." Heretofore, our opaque central bank had been mum on all points.

By law, the Federal Reserve had until June 18, 2008 to answer the FOIA request. Here's what happened instead, according to the Bloomberg lawsuit: On June 19, 2008, the Fed invoked its right to extend the response time to July 3, 2008. On July 8, 2008, the Fed called Bloomberg News to say it was processing the request. The Fed rang up Bloomberg again on August 15, 2008, wherein Alison Thro, Senior Counsel and another employee, Pam Wilson, informed the business wire service that their request was going to be denied by the end of September 2008. No further response of any kind was received, including the denial. On November 7, 2008, Bloomberg News slapped a federal lawsuit on the Board of Governors of the Federal Reserve, asserting the following:

"The government documents that Bloomberg seeks are central to understanding and assessing the government's response to the most cataclysmic financial crisis in America since the Great Depression. The effect of that crisis on the American public has been and will continue to be devastating. Hundreds of corporations are announcing layoffs in response to the crisis, and the economy was the top issue for many Americans in the recent elections. In response to the crisis, the Fed has vastly expanded its lending programs to private financial institutions. To obtain access to this public money and to safeguard the taxpayers' interests, borrowers are required to post collateral. Despite the manifest public interest in such matters, however, none of the programs themselves make reference to any public disclosure of the posted collateral or of the Fed's methods in valuing it. Thus, while the taxpayers are the ultimate counterparty for the collateral, they have not been given any information regarding the kind of collateral received, how it was valued, or by whom."

As evidence that Bloomberg News is not engaging in hyperbole when it uses the word "cataclysmic" in a Federal court filing, consider the following price movements of some of these giant financial institutions. (All current prices are intraday on November 12, 2008):

American International Group (AIG): Currently $2.16; in May 2007, $72.00

Bear Stearns: Absorbed into JPMorganChase to avoid bankruptcy filing; share price in April 2007, $159

Fannie Mae: Currently 65 cents; in June 2007 $69.00

Freddie Mac: Currently 79 cents; in May 2007 $67.00

Lehman Brothers: Currently 6 cents; in February 2007, $85.00

What all of the companies in this article have in common is that they were writing secret contracts called Credit Default Swaps (CDS) on each other and/or between each other. These are not the credit default swaps recently disclosed by the Depository Trust and Clearing Corporation (DTCC). These are the contracts that still live in darkness and are at the root of why the Wall Street banks won't lend to each other and why their share prices are melting faster than a snow cone in July.

A Credit Default Swap can be used by a bank to hedge against default on loans it has made by buying a type of insurance from another party. The buyer pays a premium upfront and annually and the seller pays the face amount of the insurance in the event of default. In the last few years, however, the contracts have been increasingly used to speculate on defaults when the buyer of the CDS has no exposure to the firm or underlying debt instruments. The CDS contracts outstanding now total somewhere between $34 Trillion and $54 Trillion, depending on whose data you want to use, and it remains an unregulated market of darkness. It is also quite likely that none of the firms that agreed to pay the hundreds of billions in insurance, such as AIG, have the money to do so. It is also quite likely that were these hedges shown to be uncollectible hedges, massive amounts of new capital would be needed by the big Wall Street firms and some would be deemed insolvent.

Until Congress holds serious investigations and hearings, the U.S. taxpayer may be funding little more than Ponzi schemes while companies that provide real products and services, legitimate jobs and contributions to the economy are left to fail.

Pam Martens worked on Wall Street for 21 years; she has no security position, long or short, in any company mentioned in this article. She writes on public interest issues from New Hampshire. She can be reached at [email protected]

Comments (5)

[Nov 13, 2008] The High Priests of the Bubble Economy

Dean Baker goes full bore after two deserving targets, Bob Rubin and Larry Summers, at TPM Cafe. Key excerpts:

Along with former Federal Reserve Board chairman Alan Greenspan, Rubin and Summers compose the high priesthood of the bubble economy. Their policy of one-sided financial deregulation is responsible for the current economic catastrophe.

It is important to separate Clinton-era mythology from the real economic record. In the mythology, Clinton's decision to raise taxes and cut spending led to an investment boom. This boom led to a surge in productivity growth. Soaring productivity growth led to the low unemployment of the late 1990s and wage gains for workers at all points along the wage distribution.

At the end of the administration, there was a huge surplus, and we set target dates for paying off the national debt. The moral of the myth is that all good things came from deficit reduction.

The reality was quite different. There was nothing resembling an investment boom until the dot-com bubble at the end of the decade funnelled vast sums of capital into crazy internet schemes. There was a surge in productivity growth beginning in 1995, but this preceded any substantial upturn in investment. Clinton had the good fortune to be sitting in the White House at the point where the economy finally enjoyed the long-predicted dividend from the information technology revolution.

Rather than investment driving growth during the Clinton boom, the main source of demand growth was consumption...

The other key part of the story is the high dollar policy initiated by Rubin when he took over as Treasury secretary...

A lowered dollar value will reduce the trade deficit, by making US exports cheaper to foreigners and imports more expensive for people living in the US. The falling dollar and lower trade deficit is supposed to be one of the main dividends of deficit reduction. In fact, the lower dollar and lower trade deficit were often touted by economists as the primary benefit of deficit reduction until they decided to change their story to fit the Clinton mythology.

The high dollar of the late 1990s reversed this logic. The dollar was pushed upward by a combination of Treasury cheerleading, worldwide financial instability beginning with the East Asian financial crisis and the irrational exuberance propelling the stock bubble, which also infected foreign investors.

In the short-run, the over-valued dollar led to cheap imports and lower inflation. It incidentally all also led to the loss of millions of manufacturing jobs, putting downward pressure on the wages of non-college educated workers.

Like the stock bubble, the high dollar is also unsustainable as a long-run policy. It led to a large and growing trade deficit. This deficit eventually forced a decline in the value of the dollar, although the process has been temporarily reversed by the current financial crisis.

Rather than handing George Bush a booming economy, Clinton handed over an economy that was propelled by an unsustainable stock bubble and distorted by a hugely over-valued dollar...

While the Bush administration must take responsibility for the current crisis (they have been in power the last eight years), the stage was set during the Clinton years. The Clinton team set the economy on the path of one-sided financial deregulation and bubble driven growth that brought us where we are today. (The deregulation was one-sided, because they did not take away the "too big to fail" security blanket of the Wall Street big boys.)

For this reason, it was very discouraging to see top Clinton administration officials standing centre stage at Obama's meeting on the economy. This is not change, and certainly not policies that we can believe in.

[Nov 13, 2008] Tim Duy's Fed Watch

11/12/2008 | Calculated Risk
Professor Duy writes a regular column at Economist's View called Fed Watch - it is definitely worth reading (as is Economist's View).

From Fed Watch: Misguided Policies

From the wires:
Such comments always leave me with a sick feeling in my stomach – if policymakers are waiting for the housing market to rebound, they had better be prepared for a long wait. ... I think the biggest potential for policy error lies in maintaining the delusion that preventing housing, and by extension, consumer spending, from adjusting is central to fixing the nation's economy. Policy would be best focused on supporting the inevitable transition away from debt-supported consumer dependent growth dynamic.

Housing prices are falling because fundamentally the price of housing became unaffordable.
emphasis added

Dr. Duy offers some suggestions for policy makers:
Policymakers need to come clean with the American public: Future patterns of growth will simply be less dependent on consumer spending. We are entering a period of structural adjustment, and it will be painful. We spent decades pretending that the relentless focus on producing nontradable goods and relying on a ballooning current account deficit to hide our lack of productive capacity was an appropriate policy approach. But ultimately, those policies have failed us, with stagnant income growth for median income families and the deepest recession since the 1980's (or even worse).

This admission, however, in no way, shape, or form means policy options are limited. The admission simply defines your policy. In the short term, policy can cushion the transition by expanding the social safety net. In the medium term, if consumption is falling, and private investment is unable to compensate, then the federal authority should fill the gap. There is no shortage of sectors of the economy that offer opportunities for investment. In so many ways, we are running on the fumes of the infrastructure investment made by the last generation. Roads, bridges, channels, etc. – you name it, there is an opportunity. Or human capital, via education?... Reasonable policymakers free from ideological constraints can develop a host of potential projects without relying on bridges to nowhere.

Investment in infrastructure makes sense, especially since construction (and construction employment) is one of the hardest hit sectors of the economy. And with the commercial real estate slump picking up steam (and more construction job losses to come), what better area to invest than in the infrastructure of the U.S.A.?

[Nov 12, 2008] Paulson Now Admits Mendacity

took up the theme, admittedly with less choler:
There does indeed seem to have been a visible change in Treasury policy since the election. Until that point, it cared a little about optics. Now, it's giving monster bailouts to the likes of AIG and American Express; it's dragging its feet on homeowner relief; and in general Hank Paulson's Wall Street buddies seem to be getting much better access than anybody in Detroit. And no one's even trying very hard to defend these actions in public: they know they'll be out of a job in January anyway, so they're just doing what they want to do and what they feel is right, without caring much whether anybody else agrees with them
Ed Harrison provided an alert on another bit of Treasury dishonesty, although the admission was coded, so you'd have to be paying attention to catch it. From the text of Paulson's remarks today (boldface ours):
During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets-our initial focus-would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks.
Either way you cut this, it's a lie. Either Paulson let his intentions be misrepresented via his silence, or he is now falsely claiming to have changed direction earlier than he did. Nouriel Roubini has claimed that Treasury was resisting the idea of of inserting language that would allow for capital injections into banks but that some members of Congress thought it was necessary, and put statements into the Congressional record via floor debates to allow for that interpretation. Roubini further contends that Paulson changed his mind only as a result of the adverse market reaction after the bill was signed.

But if Roubini is wrong and Paulson's statement is accurate, it is still completely in keeping with the conduct of an Administration that told the public that there were weapons of mass destruction in Iraq. The bill was drafted to be extraordinarily vague and sweeping, and yet did not clearly give Paulson the authority he now says he realized back then that he needed while it was still being renegotiated.

As I said in a post titled, "Paulson's Cosmetic, Cynical Financial Regulation 'Reform'":

Why is it that the media feels compelled to take pronouncements from government officials more or less at face value? By now, they ought to know that if someone from the Bush Administration is moving his lips, odds are it's a lie.

Nothing has changed, neither the dishonest of the Bush crowd nor the reluctance of the media to call them on it.
Selected Comments
Cut the guy some slack, he is working overtime, and on sundays. I do feel sorry for him, considering the fact that he does _not have to_ do anything, legally that is.

And comparing the essentially powerless against whats' coming Paulson with the bloody neocon junta, that could do literally _what they wanted_ at the height of their misrule of deception, is too far, Yves. Not even the same sport.

November 12, 2008 6:40 PM

Assuming what he said was true and he's not an idiot, if you want to get totally down the rabbit hole on this ....

Assume what we wanted to do all along was give money to the banks, no strings. Perhaps the best way to do it is to first suggest overpaying for assets and then get "pressured" into giving money to banks instead. Either way he wins. If they go with (A), shovel in the money that way. If they go with (B), shovel in the money that way. If he had gone with direct capital injections to start and he got pushbank (and he was guaranteed to get pushback of some kind), he would have had no plan B. And the plan A before the plan A was to ask for total unfettered authority with the original 3 page request.

So, the direct injections with no strings would have seemed like a ridiculous giveaway if he started with that position, so he started with something even more ridiculous (overpaying for assets) which was still ridiculous, so he started with something even MORE ridiculous like a blank check. Eventually, capital injections seemed like bowing to public pressure and the no strings part was a "reasonable compromise".

Perhaps that's giving them too much credit.

ECB goes nuclear as EU leaders plan to 'civilise' capitalism

The monetary blitz was welcomed in Brussels, where EU leaders were meeting yet again, just days after agreeing to the most comprehensive bank bail-out in history. "We are not at the end of the crisis, we are still living in dangerous times," said Jean-Claude Juncker, Luxembourg premier and Eurogroup chair.

He issued a stark reminder that life is going be very different for the banking elite as governments move to restore the lost discipline of the Bretton Woods financial order and attempt to "civilise" capitalism, the code word for clamping down on the City – dubbed "the Casino" in Europe.

"Let everyone remember after this crisis, who solved it. Politicians did, not bankers," he said. Mr Juncker added that this episode would have a profound effect on the euro debate in Britain.

"The British prime minister had to beg to be let into the room. I'm sure that when the storm is over, the British will think about whether they shouldn't become an equal in all decision-making bodies."

German Finance Minister Peer Steinbrück echoed the warning. "When a fire's burning in the global financial markets, it has to be put out, even if it's a case of arson. But then the arsonists have to be held responsible, and spreading flames must be outlawed.''

In a key change, the ECB is providing unlimited liquidity for longer-term loans to force down the market rates used to price mortgages in the Eurozone. The aim is to help banks pass along last week's half-point cut in interest rates before the region's economy starts to seize up altogether.

The standard for collateral has been slashed from A- to the once unthinkable level of BBB-, allowing distressed banks to offload securities that cannot be sold on the open market. It greatly widens the range of instruments and – crucially – lets banks use their dollar assets for the first time.

The radical shift in policy suggests that the ECB is now deeply alarmed by the crunch facing European banks as a violent unwinding of debt leverage across the world forces them to repay huge sums in dollars.

Goldman Sachs estimates that non-US banks have liabilities of $12 trillion (£6.8 trillion) on dollar balance sheets. The European, British, and Swiss banks make up the lion's share, and they have used leverage far more aggressively than US banks. Analysts say the European banks will need to raise $400bn in fresh capital – no easy feat at a time when burned investors are keeping their distance.

[Oct 24, 2008 ] Fair Game - They're Shocked, Shocked, About the Mess - By GRETCHEN MORGENSON

Published: October 24, 2008

It started acting up on Wednesday, spinning wildly as executives from the nation's leading credit-rating agencies testified before Congress about their nonroles in the credit crisis. Leaders from Moody's, Standard & Poor's and Fitch all said that their firms' inability to see problems in toxic mortgages was an honest mistake. The woefully inaccurate ratings that have cost investors billions were not, mind you, a result of issuers paying ratings agencies handsomely for their rosy opinions.

Still, there were those pesky e-mail messages cited by the House Committee on Oversight and Government Reform that showed two analysts at S.& P. speaking frankly about a deal they were being asked to examine.

"Btw - that deal is ridiculous," one wrote. "We should not be rating it."

"We rate every deal," came the response. "It could be structured by cows and we would rate it."

Asked to explain the cow reference, Deven Sharma, S.& P.'s president, told the committee: "The unfortunate and inappropriate language used in these e-mails does not reflect the core culture of the organization I am committed to leading."

Maybe so, but that was a lot for my malarkey meter to absorb.

Then, on Thursday, my meter sputtered as Alan Greenspan, former "Maestro" of the Federal Reserve, testified before the same Congressional questioners. He defended years of regulatory inaction in the face of predatory lending and said he was "in a state of shocked disbelief" that financial institutions did not rein themselves in when there were billions to be made by relaxing their lending practices and trafficking in exotic derivatives.

Mr. Greenspan was shocked, shocked to find that there was gambling going on in the casino.

MY poor, overtaxed, smoke-and-mirrors meter gave out altogether when Christopher Cox, chairman of the Securities and Exchange Commission, took his turn on the committee's hot seat. His agency had allowed Wall Street firms to load up on leverage without increasing its oversight of them. But he said on Thursday that the credit crisis highlights "the need for a strong S.E.C., which is unique in its arm's-length independence from the institutions and persons it regulates."

He said that with a straight face, too.

There was more. Mr. Cox went on to suggest that his hapless agency should begin regulating credit-default swaps.

This, recall, is that $55 trillion market at the heart of almost every big corporate failure and near-collapse of recent months. Trading in these swaps, which offer insurance against debt defaults, exploded in recent years. As the market for the swaps grew, so did the risks - and the interconnectedness - among the firms that traded them.

During the years when these risks were ramping up unregulated, Mr. Cox and his crew were silent on the swaps beat.

How exasperating. After all the time and taxpayer money spent trying to resolve the financial crisis, we're still in the middle of the maelstrom. The S.& P. 500-stock index was down 40.3 percent for the year at Friday's close.

Yes, the problems are global, and made more complex by Wall Street's financial engineers. And a titanic deleveraging process like the one we are in, where both consumers and companies must cut their debt loads, is never fun or over fast.

Still, as the stock market continues to grind lower, something more may be at work. And that something centers on trust and credibility, which have been lacking in corporate and government leadership in recent years.

Like the boy who cried wolf, corporate and regulatory officials have issued a lot of hogwash over the years. Until recently, investors were willing to believe it. Now they may not be so easily gulled.

Companies, even those in cyclical businesses, routinely told investors that the reason they so regularly beat their earnings forecasts was honest hard work - and not cookie-jar accounting. They were believed.

Politicians proclaiming that the economy was strong and that the crisis would not spread kept our trust.

Brokerage firms insisting that auction-rate securities were as good as cash won over investors - and, as we all know now, that market froze up.

Wall Street dealmakers were fawned over like all-knowing superstars, their comings and goings celebrated. No one doubted them.

Banks engaging in anything-goes lending practices assured shareholders that safety and soundness was their mantra. They, too, got a pass.

Directors who didn't begin to understand the operational complexities of the companies they were charged with overseeing told stockholders that they were vigilant fiduciaries. Investors suspended their disbelief.

And regulators, asserting that they were policing the markets, convinced investors that there was a level playing field.

Is it any surprise that virulent mistrust seems to own the markets now?

Janet Tavakoli, a finance industry consultant who is president of Tavakoli Structured Finance, said the stock market's gyrations are a result of a severe lack of confidence in the very officials who are charged with cleaning up the nation's mess.

"It is not enough to throw money at a problem; you also have to use honesty and common sense," Ms. Tavakoli said. "In fact, if you leave out the last two, you are wasting taxpayers' money."

What Ms. Tavakoli means by common sense is a plan that will force institutions to get a fix on what their holdings are actually worth.

"If you are going to hand out capital, you have to first revalue the assets or take over so that you can force a mark to market," she said. "Force restructurings, mark down the assets to defensible levels and let the market clear."

She also suggests that financial regulators impose a form of martial law, allowing them to rewrite derivatives contracts that bind counterparties to terms they may not even comprehend.

"If I were queen of the world, I would wade in there with a small army of people and just start straightening out these books," she said. "Start stripping them down and simplifying contracts so people can start to understand what they own. It would be unprecedented, but so is everything else we are doing."

THAT move, which would begin the much-needed healing process for investors, would be unprecedented in another way. It might get the people who run our companies and our regulatory agencies into the business of telling the truth.

Naïve, I know. But something to wish for - I'd like to give my hypocrisy meter a breather.

What Went Wrong

How did the world's markets come to the brink of collapse? Some say regulators failed. Others claim deregulation left them handcuffed. Who's right? Both are. This is the story of how Washington didn't catch up to Wall Street.

By Anthony Faiola, Ellen Nakashima and Jill Drew
Washington Post Staff Writers
Wednesday, October 15, 2008; A01

A decade ago, long before the financial calamity now sweeping the world, the federal government's economic brain trust heard a clarion warning and declared in unison: You're wrong.

The meeting of the President's Working Group on Financial Markets on an April day in 1998 brought together Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert E. Rubin and Securities and Exchange Commission Chairman Arthur Levitt Jr. -- all Wall Street legends, all opponents to varying degrees of tighter regulation of the financial system that had earned them wealth and power.

Their adversary, although also a member of the Working Group, did not belong to their club. Brooksley E. Born, the 57-year-old head of the Commodity Futures Trading Commission, had earned a reputation as a steely, formidable litigator at a high-powered Washington law firm. She had grown used to being the only woman in a room full of men. She didn't like to be pushed around.

Now, in the Treasury Department's stately, wood-paneled conference room, she was being pushed hard.

Greenspan, Rubin and Levitt had reacted with alarm at Born's persistent interest in a fast-growing corner of the financial markets known as derivatives, so called because they derive their value from something else, such as bonds or currency rates. Setting the jargon aside, derivatives are both a cushion and a gamble -- deals that investment companies and banks arrange to manage the risk of their holdings, while trying to turn a profit at the same time.

Unlike the commodity futures regulated by Born's agency, many newer derivatives weren't traded on an exchange, constituting what some traders call the "dark markets." There were now millions of such private contracts, involving many of Wall Street's top firms. But there was no clearinghouse holding collateral to settle a deal gone bad, no transparent records of who was trading what.

Born wanted to shine a light into the dark. She had offered no specific oversight plan, but after months of making noise about the dangers that this enormous market posed to the financial system, she now wanted to open a formal discussion about whether to regulate them -- and if so, how.

Greenspan, Rubin and Levitt were determined to derail her effort. Privately, Rubin had expressed concern about derivatives' unruly growth. But he agreed with Greenspan and Levitt that these newer contracts, often called "swaps," weren't exactly futures. Born's agency did not have legal authority to regulate swaps, the three men believed, and her call for a discussion had real-world consequences: It would cast doubt over the legality of trillions of dollars in existing contracts and create uncertainty over how to operate in the market.

At the April meeting, the trio's message was clear: Back off, Born.

"You're not going to do anything, right?" Rubin asked her after they had laid out their concerns, according to one participant.

Born made no commitment. Some in the room, including Rubin and Greenspan, came away with a sense that she had agreed to cool it, at least until lawyers could confer on the legal issues. But according to her staff, she was neither deterred nor chastened.

"Once she took a position, she would defend that position and go down fighting. That's what happened here," said Geoffrey Aronow, a senior CFTC staff member at the time. "When someone pushed her, she was inclined to stand there and push back."

Greenspan and Rubin maintained then, as now, that Born was on the wrong track. Greenspan, who left the Fed job in 2006 after an unprecedented three terms, also insists that regulating derivatives would not have averted the present crisis. Yesterday on Capitol Hill, a Senate committee opened hearings specifically on the role of financial derivatives in exacerbating the current crisis. Another hearing on the issue takes place in the House today.

The economic brain trust not only won the argument, it cut off the larger debate. After Born quit in 1999, no one wanted to go where she had already gone, and once the Bush administration arrived in 2001, the push was for less regulation, not more. Voluntary oversight became the favored approach, and even those were accepted grudgingly by Wall Street, if at all.

In private meetings and public speeches, Greenspan also argued a free-market view. Self-regulation, he asserted, would work better than the heavy hand of government: Investors had a natural desire to avoid self-destruction, and that served as the logical and best limit to excessive risk. Besides, derivatives had become a huge U.S. business, and burdensome rules would drive the market overseas.

"We knew it was a big deal [to attempt regulation] but the feeling was that something needed to be done," said Michael Greenberger, Born's director of trading and markets and a witness to the April 1998 standoff at Treasury. "The industry had been fighting regulation for years, and in the meantime, you saw them accumulate a huge amount of stuff and it was already causing dislocations in the economy. The government was being kept blind to it."

Rubin, in an interview, said of Born's effort, "I do think it was a deterrent to moving forward. I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way. My recollection was, though I truly do not remember the specifics of the meeting, this was done in a more strident way."

Rarely does one Washington regulator engage in such a public, pitched battle with other agencies. Born's failed effort is part of the larger story of what led to today's financial chaos, a bipartisan story of missed opportunities and philosophical shifts in which Washington stood impotent as the risk of Wall Street innovation swelled, according to more than 60 interviews as well as transcripts of meetings, congressional testimony and speeches. (Born declined to be interviewed.)

Derivatives did not trigger what has erupted into the biggest economic crisis since the Great Depression. But their proliferation, and the uncertainty about their real values, accelerated the recent collapses of the nation's venerable investment houses and magnified the panic that has since crippled the global financial system.

A New Chain of Risk

Futures contracts, one of the earliest forms of a derivative, have long been associated with big market failures. Harry Truman's father was financially wiped out by agriculture futures, and rampant manipulation by speculators contributed to the market collapses of 1929. Regulators have long known that new trading instruments have a way of giving reassurance of stability in good times and of exacerbating market downturns in bad.

Futures -- essentially, a promise to deliver cash or something of value at a later time -- are traded on regulated exchanges such as the Chicago Mercantile Exchange, regulated by the CFTC. But Born was not questioning bets on pork bellies or wheat prices, the bedrock of futures trading in simpler times. Her focus was the arcane class of derivatives linked to fluctuations in currency and interest rates. She told a group of business lawyers in 1998 that the "lack of basic information" allowed traders in derivatives "to take positions that may threaten our regulated markets or, indeed, our economy, without the knowledge of any federal regulatory authority."

The future that Born envisioned turned out to be even riskier than she imagined. The real estate boom and easy credit of the past decade gave birth to more complex securities and derivatives, this time linked to the inflated value of millions of homes bought by Americans ultimately unable to afford them. That created a new chain of risk, starting with the heavily indebted homebuyers and ending in a vast, unregulated web of contracts worldwide.

By appearing to provide a safety net, derivatives had the unintended effect of encouraging more risk-taking. Investors loaded up on the mortgage-based investments, then bought "credit-default swaps" to protect themselves against losses rather than putting aside large cash reserves. If the mortgages went belly up, the investors had a cushion; the sellers of the swaps, who collected substantial fees for sharing in the investors' risk, were betting that the mortgages would stay healthy.

The global derivatives market topped $530 trillion as of June 30 this year, including $55 trillion in the suddenly popular credit-default swaps; that $530 trillion represents all contracts outstanding. The total dollars at risk is much smaller, but still a hefty $2.7 trillion, according to an estimate by the International Swaps and Derivatives Association.

To make sense of those figures, compare them to the value of the New York Stock Exchange: $30 trillion at the end of 2007, before the recent crash. When the housing bubble burst and mortgages went south, the consequences seeped through the entire web. Some of those holding credit swaps wanted their money; some who owed didn't have enough money in reserve to pay.

Instead of dispersing risk, derivatives had amplified it.

The Regulatory Rift

Born, after 30 years in Washington, found herself on President Bill Clinton's short list for attorney general in 1992. The call never came. Approached about the CFTC job four years later, she took it, seeing a chance to make a public service mark, colleagues say.

For several years before Born's arrival at the futures commission, Washington had been hearing warnings about derivatives. In 1993, Rep. Jim Leach (R-Iowa) issued a 902-page report that urged "regulations to protect against systemic risk" as well as supervision by the SEC or Treasury. Sen. Donald W. Riegle (D-Mich.), while acknowledging that swaps helped manage risk, saw "danger signs, on the horizon" in their rapid growth. He and Rep. Henry Gonzalez, a Texas Democrat, introduced separate bills in 1994 that went nowhere. Mary Schapiro, Born's predecessor, made her own run at the issue through enforcement actions.

In an earlier decade, President Ronald Reagan had described the CFTC as his favorite agency because it was small and it had allowed the futures industry to grow and prosper. Born swept into the agency, the least known of the four major regulators with primary responsibility for overseeing the nation's financial markets, determined to enforce its rules and tackle hard issues.

"One theory at the time was she was so disappointed not to be running Justice -- that she got this tiny agency as a consolation prize and was hell-bent to make it important. I'm not sure that was in her mind, but it was a point of criticism," said John Damgard, president of the Futures Industry Association. Damgard disagreed with Born's approach but said he respected her for fighting for her principles.

Daniel Waldman, Born's law partner at Arnold and Porter and her general counsel at the futures commission, said Born let the industry know she meant business. "She got into a knock-down, drag-out fight with the Chicago Board of Trade over the delivery points for soybean contracts," he recalled. "She believed it was her obligation under the statute to review decisions by the exchanges. If they didn't meet agency requirements, she was going to say so, not look the other way."

Born didn't back off on derivatives, either. On May 7, 1998, two weeks after her April showdown at Treasury, the commission issued a "concept release" soliciting public comment on derivatives and their risk.

The response was swift and blistering. Within hours, Greenspan, Rubin and Levitt cited their "grave concerns" in an unusual joint statement. Deputy Treasury Secretary Lawrence Summers decried it before Congress as "casting a shadow of regulatory uncertainty over an otherwise thriving market."

Wall Street howled. "The government had a legitimate interest in preserving the enforceability of the billions of dollars worth of swap contracts that were threatened by the concept release," said Mark Brickell, a managing director at what was then J.P. Morgan Securities and former chairman of the International Swaps and Derivatives Association.

Although Born said new rules would be prospective, Wall Street was afraid existing contracts could be challenged in court. "That meant anybody on a losing side of a trade could walk away," Brickell said.

He spent months shuttling between New York and Washington, working on Congress to block CFTC action. "I remember getting on an overnight train and arriving at Rayburn by 5:30 a.m.," he said. "I watched the sun rise and then went to work on my testimony without a whole lot of sleep."

Born, who testified before Congress at least 17 times, tried to counter the legal question by saying that regulation would apply only to new contracts, not existing ones. But she relentlessly reiterated her conviction that ignoring the risk of derivatives was dangerous.

In June 1998, Leach, who had become chairman of the House Banking committee, thrust himself into the regulatory rift. He herded Born, Rubin and Greenspan into a small room near the committee's main venue at the Rayburn House Office Building, thinking he could mediate. "This is the most unusual meeting I've ever participated in," Leach recalled. "I have never in my life been in a setting where three senior members of the U.S. government reflected more tension. Secretary Rubin and Chairman Greenspan were in concert in expressing frustration with the CFTC leadership. . . . She felt, I'm confident, outnumbered with the two against one."

Leach thought the futures commission lacked the professional bench to handle oversight. He pressed Born not to proceed until the Treasury and the Fed could agree which agency was best suited to the role. "I tried to take the perspective of, 'I hope we can work this out,' " he said. "Both sides -- neither side, gave in."

Rubin said, in the recent interview, that he had his own qualms about derivatives, going back to his days as a managing partner at Goldman Sachs. He later wrote in a 2003 book that "derivatives, with leverage limits that vary from little to none at all, should be subject to comprehensive and higher margin requirements," forcing dealers to put up more capital to back the swaps. "But that will almost surely not happen, absent a crisis."

Asked why he didn't suggest stricter capital requirements as an alternative in 1998, Rubin said, "There was no political reality of getting it done. We were so caught up with other issues that were so pressing. . . . the Asian financial crisis, the Brazilian financial crisis. We had a lot going on."

Crisis and Ice Cream

When the warring parties faced off next, in the Senate Agriculture committee's hearing room July 30, 1998, it was not a neutral battleground to air their differences. Chairman Richard G. Lugar, an Indiana Republican, wanted to extract a public promise from Born to cease her campaign. Otherwise, Congress would move forward on a Treasury-backed bill to slap a moratorium on further CFTC action.

The committee had to switch to a larger room to accommodate the expected crowd of lobbyists representing banks, brokerage firms, futures exchanges, energy companies and agricultural interests, according to a Lugar aide. A dubious Lugar opened the hearing by telling Born: "It is unusual for three agencies of the executive branch to propose legislation that would restrict the activities of a fourth."

Born would not yield. She portrayed her agency as under attack, saying the Fed, Treasury and SEC had already decided "that the CFTC's authority should instead be transferred to and divided among themselves."

Greenspan shot back that CFTC regulation was superfluous; existing laws were enough. "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary," he said. "Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living."

The stalemate persisted. Then, in September a crisis arose that gave credence to Born's concerns.

Long Term Capital Management, a huge hedge fund heavily weighted in derivatives, told the Fed that it could not cover $4 billion in losses, threatening the fortunes of everyone from tycoons to pension funds. After Russia, swept up in the Asian economic crisis, had defaulted on its debt, Long Term Capital was besieged with calls to put up more cash as collateral for its investments. Based on the derivative side of its books, Long Term Capital had an astoundingly high debt-to-capital ratio. "The off-balance sheet leverage was 100 to 1 or 200 to 1 -- I don't know how to calculate it," Peter Fisher, a senior Fed official, told Greenspan and other Fed governors at a Sept. 29, 1998, meeting, according to the transcript.

Two days later, Born warned the House Banking committee: "This episode should serve as a wake-up call about the unknown risks that the over-the-counter derivatives market may pose to the U.S. economy and to financial stability around the world." She spoke of an "immediate and pressing need to address whether there are unacceptable regulatory gaps."

The near collapse of Long Term Capital Management didn't change anything. Although some lawmakers expressed new fervor for addressing the risks of derivatives, Congress went ahead with the law that placed a six-month moratorium on any CFTC action regarding the swaps market.

The battle left Born politically isolated. In April 1999, the President's Working Group issued a report on the lessons of Long Term Capital's meltdown, her last as part of the group. The report raised some alarm over excess leverage and the unknown risks of the derivative market, but called for only one legislative change -- a recommendation that brokerages' unregulated affiliates be required to assess and report their financial risk to the government.

Greenspan dissented on that recommendation.

By May, Born had had enough. Although it was customary at the agency for others to organize an outgoing chairman's going-away bash, she personally sprang for an ice cream cart in the commission's beige-carpeted auditorium. On a June afternoon, employees listened to subdued, carefully worded farewells while serving themselves sundaes.

In November, Greenspan, Rubin, Levitt and Born's replacement, William Rainer, submitted a Working Group report on derivatives. They recommended no CFTC regulation, saying that it "would otherwise perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States."

Toward Self-Regulation

Throughout much of 2000, lobbyists were flying in and out of congressional offices. With Born gone, they saw an opportunity to settle the regulatory issue and perhaps gain even more. They had a sympathetic ear in Texas Sen. Phil Gramm, the influential Republican chairman of the Senate Banking Committee, and a sympathetic bill: the 2000 Commodity Futures Modernization Act.

Gramm opened a June 21 hearing with a call for "regulatory relief." Peering through his wire-rimmed glasses, he drawled: "I think we would do well to remember the Lincoln adage that to ask a society to live under old and outmoded laws -- and I think you could say the same about regulation -- is like asking a man to wear the same clothes he wore when he was a boy."

Greenspan and Rubin's successor at the Treasury, Larry Summers, still held sway on keeping the CFTC out of the swaps market. But Treasury officials saw an opportunity to push forward on a self-regulation idea from the Working Group's November 1999 report: an industry clearinghouse to hold pools of cash collected from financial firms to cover derivatives losses. But the report had also called for federal oversight to ensure that risk-management procedures were followed.

The swaps industry generally supported the clearinghouse concept. One amended version of the bill made federal oversight optional. Treasury officials scrambled to act, and a provision introduced by Leach requiring oversight prevailed.

The House passed the bill Oct. 19, but then the legislation stalled. Gramm was holding out for stronger language that would bar both the CFTC and the SEC from meddling in the swaps market. Alarmed, SEC lawyers argued that the agency at least needed to retain its authority over fraud and insider trading. What if a trader, armed with inside knowledge, engaged in a swap on a stock? Treasury Undersecretary Gary Gensler brokered a compromise: The SEC would retain its antifraud authority but without any new rulemaking power.

On the night of Dec. 15, with the nation still focused on the Supreme Court decision three days earlier that settled the 2000 presidential election in George W. Bush's favor, the act passed as a rider to an omnibus spending bill. The clearinghouse provision remained. At the time, it seemed like a breakthrough.

A clearinghouse would have created layers of protections that don't exist today, said Craig Pirrong, a markets expert at the University of Houston. "An industry-backed pool of capital could have cushioned against losses while discouraging risky bets."

But afterward, the clearinghouse idea sat dormant, with no one in the industry moving to put one in place.

'An Absolute Siege'

In 2004, the SEC pursued another voluntary system. This one, too, didn't work out quite as hoped.

For years, Congress had allowed a huge gap in Wall Street oversight: the SEC had authority over the brokerage arms of investment banks such as Lehman Brothers and Bear Stearns, but were in the dark about deals made by the firms' holding companies and its unregulated affiliates. European regulators, demanding more transparency given the substantial overseas operations of U.S. firms, were threatening to put these holding companies under regulatory supervision if their American counterparts didn't do so first.

For the SEC, this was deja vu. In 1999, the SEC had sought such authority over the holding companies and failed to get it. Late in the year, Congress passed the Gramm-Leach-Bliley Act, dismantling the walls separating commercial banks, investment banks and insurance companies since the Great Depression. But the act did not provide for any SEC oversight of investment bank holding companies. The momentum was all toward deregulation.

"I remember saying at the time, people don't get it -- the level of missed opportunities to address some of these problems," said Annette Nazareth, then the SEC's head of market regulation. "It was an absolute siege on regulation."

Five years later, the European regulators were forcing the issue again. Restricted by Gramm-Leach-Bliley, the SEC proposed a voluntary system, which the big investment banks opted to join. The holding companies would be permitted to follow their own computer models to assess how much risk they were taking; the SEC would get access to make sure the complex capital and risk-management models were up to the job.

At an April 28 SEC meeting, commissioner Harvey Goldschmid expressed caution. "If anything goes wrong, it's going to be an awfully big mess," said Goldschmid, who voted for the program.

Last month, the SEC's inspector general concluded that the program had failed in the case of Bear Stearns, which collapsed in March. SEC overseers had seen Bear Stearns's heavy focus on mortgage-backed securities and over-leveraging, but "did not take serious action to limit these risk factors," the inspector general's report said.

SEC officials say the voluntary program limited what they could do. They checked to make sure Bear Stearns was adhering to its risk models but did not count on those models being fundamentally flawed.

On Sept. 26, with the economic meltdown in full swing, SEC Chairman Christopher Cox shut down the program. Cox, a longtime champion of deregulation, said in a statement posted on the SEC's Web site, "the last six months have made it abundantly clear that voluntary regulation does not work."

It was too late. All five brokerages in the program had either filed for bankruptcy, been absorbed or converted into commercial banks.

Second Thoughts

On Sept. 15, 2005, Federal Reserve Bank of New York president Timothy F. Geithner gathered senior executives and risk-management officers from 14 Wall Street firms in the Fed's 10th-floor conference room in lower Manhattan for another discussion about a voluntary mechanism. Also arrayed around the wood rectangular table, covered by green-felt tablecloths, were European market supervisors from Britain, Switzerland and Germany.

E. Gerald Corrigan, managing director of Goldman Sachs and one of Geithner's predecessors at the New York Fed, had reported in July that the face value of credit-default swaps had soared ninefold in just three years. Without an automated, electronic system for tracking the trades or collateral to back them, the potential for systemic risk was increasing. "The growth of derivatives was exceeding the maturity of the operational infrastructure, so we thought we would try to narrow the gap," Geithner said in an interview.

Talks have continued on a range of issues, including how to set up a clearinghouse with reserves in case of default -- the same concept in the 2000 legislation -- and what kind of government oversight would be allowed. But three years later, there is no system in place. Some major dealers have preferred to go it alone, and no one in the government told them they couldn't.

With last month's death spiral of American International Group, the world's largest private insurance company until it was seized by the government, regulators saw their fears play out. AIG had sold $440 billion in credit-default swaps tied to mortgage securities that began to falter. When its losses mounted, the credit-rating agencies downgraded AIG's standing, triggering a clause in its credit-default swap contracts to post billions in collateral that it didn't have. The government swooped in to prevent AIG's default, hoping to ward off another chain reaction in the already shaky financial system.

The economic crisis has added momentum to the Fed's attempts to organize a voluntary clearinghouse. Geithner held two meetings last week with several firms and major dealers interested in setting up such a mechanism. Last week, the Chicago Mercantile Exchange announced it would team with Citadel Investment Group, a large hedge fund, to launch an electronic trading platform and clearinghouse for credit-default swaps. Other private companies and exchanges are working on their own systems, seeing opportunities for profit in becoming a shock absorber for the system.

The crisis has prompted second thoughts. Goldschmid, the former SEC commissioner and the agency's general counsel under Levitt, looks back at the long history of missed opportunities and sighs: "In hindsight, there's no question that we would have been better off if we had been regulating derivatives -- and had a clearinghouse for it."

Levitt, too, thinks about might-have-beens. "In fairness, while Summers and Rubin and I certainly gave in to this, we were not in the same camp as the Fed," he said. "The Fed was really adamantly opposed to any form of regulation whatsoever. I guess if I had to do it over again, I certainly would have pushed for some way to give greater transparency to products which turned out to be injurious to our markets."

Researchers Brady Dennis and Robert Thomason contributed. - Columnists - Martin Wolf - Why financial regulation is both difficult and essential

Nice try; no cigar. That was my reaction to the attempt of the banking community to forestall additional regulation, by recommending "a suite of best practices to be embraced voluntarily". It was also the reaction of the policymakers meeting in Washington over the weekend. More regulation is on its way. After frightening politicians and policymakers so badly, even the most optimistic banker must realise this. The question is whether the additional regulation will do any good.

In an interim report on "market best practices", the Institute for International Finance, an association of bankers, offers devastating self-criticism.* Here then are some of the weaknesses it identifies: "deteriorating lending standards by certain originators of credit"; a "decline of underwriting standards"; an "excessive reliance on poorly understood, poorly performing and less than adequate ratings of structured products"; and "difficulties in identifying where exposures reside". Would you buy a voluntary code from people who describe their own mistakes in this brutal manner? I thought not. There are two powerful additional reasons for not doing so.

First, in such a fiercely competitive business, a voluntary code is almost certainly not worth the paper it is written on. When they can get away with behaving irresponsibly, some will do so. This puts strong pressure on others. That is what Chuck Prince, former chief executive officer of Citigroup, meant when he told the FT that "as long as the music is playing, you've got to get up and dance". So, as Willem Buiter of the London School of Economics remarks: "Self-regulation stands in relation to regulation the way self-importance stands in relation to importance."

Second, the industry has form. The IIF itself was founded in 1983 in response to the developing country debt crisis. At that time, big parts of the west's banking system were in effect bankrupt. Now, many upsets later, we have reached the "subprime crisis". The IIF was created not only to represent the industry, but to improve its performance. It is clear that this has not worked.

Do not just take my word for it. Last month, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard published an extraordinary paper on the long history of financial crises.** The chart shows that the incidence of banking crises (measured by the proportion of countries affected) has been as high since 1980 as in any period since 1800; that the incidence of crises is correlated with liberalisation of capital flows; and that there was, until 2007, a decline in the incidence of crises in the 2000s.

Yet why, I ask, should this industry have apparently failed to improve its standards of performance over the past century? After all, almost every other industry has done so. Consider how confident we are that the food we buy will not poison us. Yet adulterated food was once a threat.

Consider, by those standards, the failures of the banking industry, as admitted by the IIF itself. Its purely operational performance is now impressive. But competition does not work well in finance. The "product" of the financial industry is promises for an uncertain future, marketed as dreams that can readily become nightmares. Customers are readily swept away by exaggerated promises, irrational beliefs, misplaced trust and sheer skulduggery. So, too, are practitioners: basing risk management on limited data and inadequate models is a good example. Emotions count wherever uncertainties loom.

Boeing would not survive if the aircraft it built fell out of the sky. Yet in the financial industry, huge blunders are also almost always made in common. If everybody is in the dance nobody is to blame and, in any case, governments, horrified by the consequences of a collapsing financial system, will come to the rescue.

Until last August, I comforted myself with the thought that many of the crises of the past quarter-century occurred in relatively backward financial systems, even if institutions of the first world played a part in "seducing minors". So things might, I hoped, be getting better.

That is no longer a plausible view. Once the US itself ran a large current account deficit the concomitant accumulations of internal debt generated huge losses, as the excellent new Global Financial Stability Report from the International Monetary Fund points out. The one good thing is that estimated losses of close to $1,000bn are widely distributed (see charts). That makes today's situation less transparent, sadly. But it also means that the pain is more widely, and so much more safely, shared.

What then is to be done now? Interestingly, there is substantial convergence on the substance between the IIF and the authorities, as shown in a devastatingly critical recent report from the Financial Stability Forum on "enhancing market and institutional resilience".*** Both agree, for example, that structures of compensation matter, as both I and others have argued. Both agree, too, that risk management was appalling.

The agenda laid out in the official report is lengthy. It includes: strengthening prudential oversight of capital, liquidity and risk management; enhancing transparency; changing the role and uses of credit ratings; strengthening the authorities' responsiveness to risk; and improving arrangements for dealing with stress. But, it should go without saying, policymakers also believe regulation must be tougher. Given the damage done and the extent of the safety net provided, no alternative exists.

Yet I am not that optimistic about regulation either. Regulators are doomed to close the stable doors behind financial institutions that always find new and more exciting ways of losing money. It is, for this reason, crucial that the institutions, and unsecured creditors, feel some pain: the burned child fears the fire; singeing is less effective. Yet the fire must never burn too far, since that might destroy the entire economy.

If regulation is to be effective, it must cover all relevant institutions and the entire balance sheet, in all significant countries; it must focus on capital, liquidity and transparency; and, not least, it must make finance less pro-cyclical. Will it ever work perfectly? Certainly not. It is impossible and probably even undesirable to create a crisis-free financial system. Crises will always be with us. But we can surely do far better than we have been doing. In any case, we are doomed to try.

Sarah "Frodo" Palin and The Cancer School of Economics

Both Democrats and Republicans want America atop the world's economic food chain. After all, it's better to be the Great White Shark than the seal. They differ on what to do to keep us there, of course. Generally, Republicans want businesses operating free of taxes and government intervention, while Democrats believe certain limits on businesses and our financial markets are necessary to keep Americans safe and prosperous.

Republican economic policy is based on the Theory of Natural Law first advanced by Aristotle. Since nature doesn't make intellectual decisions intellectualism is considered artificial, or unnatural. Regulation is an intellectual act, so it's not natural and therefore doomed to fail. Therefore our economy, Conservatives believe, if free of any regulation, will naturally fall into a stable balance of permanent prosperity. Regulations and intervention, they claim, are wholly unnatural and illegitimate.

Conservatives have been working for decades to deregulate markets and businesses. In 1999 they succeeded in removing important regulations set up after the Great Depression to ensure market safety. So why did the markets crash?

Because Natural Law economic theory never existed.

Nature, in fact, places the most severe limits on animals and their behavior to make sure they stay balanced. Sharks don't have a "stop eating" mechanism in their biological blueprint. Under normal conditions sharks can't catch food fast enough to do themselves damage from over-eating. Nature has limited their ability to catch food. A shark in a feeding frenzy, however, given enough food, will eat until it quite literally bursts open like an overstuffed sausage. Its guts just explode out into the water. In some cases crazed, gut-busted sharks eat their own entrails, unable to distinguish between their innards and their kill.

A shark is just a dumb beast driven by a killer instinct. If nature's limits break down, so does the shark. The only thing keeping sharks from eating themselves to death are the physical limits nature places on all apex predators. Because nature has perfected the art of limitation, a shark eating itself to death is extremely rare, and usually occurs only when humans get involved and temporarily throw food supplies out of balance. Nature is nothing if not a series of carefully orchestrated restrictions. True Natural Law economics is not laissez faire it is structured guidance, like the rules in a football game. It's a bad idea to give 22 men pads, helmets and a football and say laissez faire, unless you want every one to get killed.

Animals have a complex system of internal and external limits to make sure they don't outgrow their eco-system either in body or population. In Aristotle's day nature had total control over human beings. His people could only move so quickly, gather and grow only so much food, and had only rudimentary tools. These and other physical limits contained human population growth for millennia. Human economic activity required minimal governmental oversight if any at all, so laissez faire seemed natural.

Today huge groups of human beings are largely free of nature's constraints. We, as a race, can, and will, apparently, out grow our eco-system- something Aristotle did not consider in his extensive writings on natural law. Given the political freedom 21st century human beings could and would extract every fish in the ocean in a few years time. But for nature's limits sharks would, too. Soon genetic engineering breakthroughs will clear away whatever constraints nature has left over humanity. Conservative economic theory, which depends entirely on constraints provided by nature, is fantasy.

Out growing nature's restraints means nature can no longer stop us from destroying ourselves if we get off track. With nothing to contain us we have to assume nature's former corrective role in all our endeavors and provide necessary limits ourselves.

We should not be afraid of limits. Everything growing thing in nature is limited in some way except cancer. Limitless, unregulated growth is disease, not freedom. If we strip our markets of all restrictions and let the sharks go into frenzy we will create cancer not growth.

In 1999, what I call the Cancer School of Economics succeeded in removing entrenched banking regulations created after the 1929 belly burst that triggered the Great Depression. Stripped of structure, predictably, America's powerful economic killer instinct has run amok ever since. America's economic sharks have gorged on fossil fuels, unfettered financial predation, incomprehensible budget deficits and Keating/Enron style corruption. They ate more than their eco-system allows and busted open yet again. Today America is no longer an apex predator in a sustainable food chain but a cancerous tumor on the world's economy.

A few months ago as the world's economic waters began running cloudy with America's guts, Bush, McCain and Fed Chairman Bernanke said the fundamentals of our economy were sound and strong. What else would a dumb beast say with a mouth full of its own entrails? A dumb beast only knows one thing: if it is eating its happy.

And just like a simple, natural, not at all pointy-headed or intellectual shark eating its own entrails, the Republicans and hapless Democrats are incapable of stopping their self destruction. They passed a bail out/rescue package with toothless over sight provisions that ignores the causes of the meltdown and is funded by borrowed money and a massive cash infusion from the treasury created out of thin air by printing dollars. Apparently they believe self cannibalization will stop us from eating ourselves to death. How very dumb beast of them. In effect we now have a bubble propped up by a bubble, or The Weimar Republic.

Conservatives see a Democrat in the character Quint from Steven Spielberg's still excellent 1975 blockbuster Jaws. Quint was a shark hunter. He shot little steel harpoons tied to big, buoyant barrels into sharks which severely reduced their ability to swim. Conservatives see every regulation as just another barrel slowly killing American business.

The Cancer School of Economics doesn't get that forcing Detroit to make cars safer back in the 50's and 60's through Government intervention in the market place made the auto industry more profitable. They can't see that safe cars increased the market for cars and increased dependence on cars which helped create a pervasive car culture and increased sales. That kind of thinking is for pointy-headed intellectuals, not simple, natural folk. All they can see is "bigguvment" got on the backs of poor, poor businessmen and tried to choke the auto industry. They still think we'd all be better off without brake lights, seat belts and turn signals waiting for Detroit to make safe cars.

Republicans don't see health and prosperity in regulation. They see Democrats and their regulations as another kind of shark competing for living space and fish- a smaller, less aggressive, toothless kind of shark who deserves to die, who unfairly restricts stronger sharks who should be allowed to run free and rule the seas. They don't see Democrats as noble or compassionate or evolved or helpful in the least. They see them as whiny, traitorous runts who have turned themselves into un-natural parasites who leech off of their larger, stronger brethren and therefore need to be wiped off the face of the earth lest everything die.

Anyone who wants no rules at all is an adolescent. Like a bratty teenager caught up in a rebellious tantrum, Republicans can't see any limit as healthy. Conservatives point to people who truly are parasitic runts and claim they were created by healthy limits which keep our economy from bursting.

All these Cancer School of Economics financial experts swimming around with their guts hanging out argue the finance, credit, loan and banking system is already the most heavily regulated industry in the nation. Governments don't heavily regulate the greeting card industry. Everything depends on financial stability, confidence, fairness and predictability. The financial markets need intelligent, tough, strictly enforced regulation so our nation's super sharks can do what they were born to do without bursting. Obviously it is the quality of regulation not the quantity that is the issue at hand. Funny -- with all the regulations on the financial industry conservatives targeted just the ones that if removed would cause a meltdown. Weren't interested in all the others, were they?

Republicans, like troubled teenagers, are unable to understand their own behavior is the problem. Conservatives look at the deregulation disaster that is the last eight years of Republican rule and have come to the conclusion that they were corrupted by eight years of power. Power doesn't corrupt. Washington is a petri dish for all one's latent dysfunction. Power revealed who Republicans truly are. They came to Washington and did exactly what they wanted to do and they destroyed themselves. Self knowledge is a bitch.

For all the evil Washington has done to Republicans, they sure don't want to leave. They most definitely want to stay despite the horrible things power does to one's conservative credentials.

To convince Americans they have learned their lesson and should be given the reigns of all-corrupting power one more time, conservatives have brought forward Sarah Palin, someone they advertise as too simpleminded to be affected by Washington's irresistible evil, like some kind of Alaskan version of Frodo Baggins. Basically, Republicans are promising Americans they'll be dumb as hell if we give them another chance in 2008.

The biggest problem Conservatives face right now is that no one has faith in unfettered predation anymore. America's corporate sharks are gut busted and floating belly up. Sarah Barracuda is meant to prove conservative economic ideology is still healthy, wholesome, natural and as dumb as a big fish. Conservatives think just by letting Sarah "Frodo" Barracuda swim into the White House our nation will return to prosperity.

Republicans don't understand there is no Quint slowing them down. Market regulations are not the equivalent of a barrel tied to a shark. The life sustaining financial regulations they greedily stripped away in 1999 were a positive structural force that provided stability, scale, security and confidence. Massive exploitation of resources coupled with an unrestricted financial system is not economic freedom. It is unbalanced, unstructured and un-natural. It is cancerism, not natural law. Limits on risking other people's money is not un-Godly interference, or the life sucking evil of parasitic runts, its protecting the human eco-system, which humanity must do for itself, because, after all we're not dumb beasts. Acting like one won't help anybody, Sarah.

Pressured to Take More Risk, Fannie Hit a Tipping Point - Series - By CHARLES DUHIGG

Almost no one expected what was coming. It's not fair to blame us for not predicting the unthinkable."- Daniel H. Mudd, former chief executive, Fannie Mae

When the mortgage giant Fannie Mae recruited Daniel H. Mudd, he told a friend he wanted to work for an altruistic business. Already a decorated marine and a successful executive, he wanted to be a role model to his four children - just as his father, the television journalist Roger Mudd, had been to him.

Fannie, a government-sponsored company, had long helped Americans get cheaper home loans by serving as a powerful middleman, buying mortgages from lenders and banks and then holding or reselling them to Wall Street investors. This allowed banks to make even more loans - expanding the pool of homeowners and permitting Fannie to ring up handsome profits along the way.

But by the time Mr. Mudd became Fannie's chief executive in 2004, his company was under siege. Competitors were snatching lucrative parts of its business. Congress was demanding that Mr. Mudd help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall Street unless Fannie bought a bigger chunk of their riskiest loans.

So Mr. Mudd made a fateful choice. Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more treacherous corners of the mortgage market, according to executives.

For a time, that decision proved profitable. In the end, it nearly destroyed the company and threatened to drag down the housing market and the economy.

Dozens of interviews, most from people who requested anonymity to avoid legal repercussions, offer an inside account of the critical juncture when Fannie Mae's new chief executive, under pressure from Wall Street firms, Congress and company shareholders, took additional risks that pushed his company, and, in turn, a large part of the nation's financial health, to the brink.

Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers - more than three times as much as in all its earlier years combined, according to company filings and industry data.

"We didn't really know what we were buying," said Marc Gott, a former director in Fannie's loan servicing department. "This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through the gears."

Last month, the White House was forced to orchestrate a $200 billion rescue of Fannie and its corporate cousin, Freddie Mac. On Sept. 26, the companies disclosed that federal prosecutors and the Securities and Exchange Commission were investigating potential accounting and governance problems.

Mr. Mudd said in an interview that he responded as best he could given the company's challenges, and worked to balance risks prudently.

"Fannie Mae faced the danger that the market would pass us by," he said. "We were afraid that lenders would be selling products we weren't buying and Congress would feel like we weren't fulfilling our mission. The market was changing, and it's our job to buy loans, so we had to change as well."

Dealing With Risk

When Mr. Mudd arrived at Fannie eight years ago, it was beginning a dramatic expansion that, at its peak, had it buying 40 percent of all domestic mortgages.

Just two decades earlier, Fannie had been on the brink of bankruptcy. But chief executives like Franklin D. Raines and the chief financial officer J. Timothy Howard built it into a financial juggernaut by aiming at new markets.

Fannie never actually made loans. It was essentially a mortgage insurance company, buying mortgages, keeping some but reselling most to investors and, for a fee, promising to pay off a loan if the borrower defaulted. The only real danger was that the company might guarantee questionable mortgages and lose out when large numbers of borrowers walked away from their obligations.

So Fannie constructed a vast network of computer programs and mathematical formulas that analyzed its millions of daily transactions and ranked borrowers according to their risk.

Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged to handle it. In theory, those high fees would offset any losses.

With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from low-income, minority and risky borrowers by 2010.

All this helped supercharge Fannie's stock price and rewarded top executives with tens of millions of dollars. Mr. Raines received about $90 million between 1998 and 2004, while Mr. Howard was paid about $30.8 million, according to regulators. Mr. Mudd collected more than $10 million in his first four years at Fannie.

Whenever competitors asked Congress to rein in the company, lawmakers were besieged with letters and phone calls from angry constituents, some orchestrated by Fannie itself. One automated phone call warned voters: "Your congressman is trying to make mortgages more expensive. Ask him why he opposes the American dream of home ownership."

The ripple effect of Fannie's plunge into riskier lending was profound. Fannie's stamp of approval made shunned borrowers and complex loans more acceptable to other lenders, particularly small and less sophisticated banks.

Between 2001 and 2004, the overall subprime mortgage market - loans to the riskiest borrowers - grew from $160 billion to $540 billion, according to Inside Mortgage Finance, a trade publication. Communities were inundated with billboards and fliers from subprime companies offering to help almost anyone buy a home.

Within a few years of Mr. Mudd's arrival, Fannie was the most powerful mortgage company on earth.

Then it began to crumble.

Regulators, spurred by the revelation of a wide-ranging accounting fraud at Freddie, began scrutinizing Fannie's books. In 2004 they accused Fannie of fraudulently concealing expenses to make its profits look bigger.

Mr. Howard and Mr. Raines resigned. Mr. Mudd was quickly promoted to the top spot.

But the company he inherited was becoming a shadow of its former self.

'You Need Us'

Shortly after he became chief executive, Mr. Mudd traveled to the California offices of Angelo R. Mozilo, the head of Countrywide Financial, then the nation's largest mortgage lender. Fannie had a longstanding and lucrative relationship with Countrywide, which sold more loans to Fannie than anyone else.

But at that meeting, Mr. Mozilo, a butcher's son who had almost single-handedly built Countrywide into a financial powerhouse, threatened to upend their partnership unless Fannie started buying Countrywide's riskier loans.

Mr. Mozilo, who did not return telephone calls seeking comment, told Mr. Mudd that Countrywide had other options. For example, Wall Street had recently jumped into the market for risky mortgages. Firms like Bear Stearns, Lehman Brothers and Goldman Sachs had started bundling home loans and selling them to investors - bypassing Fannie and dealing with Countrywide directly.

"You're becoming irrelevant," Mr. Mozilo told Mr. Mudd, according to two people with knowledge of the meeting who requested anonymity because the talks were confidential. In the previous year, Fannie had already lost 56 percent of its loan-reselling business to Wall Street and other competitors.

"You need us more than we need you," Mr. Mozilo said, "and if you don't take these loans, you'll find you can lose much more."

Then Mr. Mozilo offered everyone a breath mint.

Investors were also pressuring Mr. Mudd to take greater risks.

On one occasion, a hedge fund manager telephoned a senior Fannie executive to complain that the company was not taking enough gambles in chasing profits.

"Are you stupid or blind?" the investor roared, according to someone who heard the call, but requested anonymity. "Your job is to make me money!"

Capitol Hill bore down on Mr. Mudd as well. The same year he took the top position, regulators sharply increased Fannie's affordable-housing goals. Democratic lawmakers demanded that the company buy more loans that had been made to low-income and minority homebuyers.

"When homes are doubling in price in every six years and incomes are increasing by a mere one percent per year, Fannie's mission is of paramount importance," Senator Jack Reed, a Rhode Island Democrat, lectured Mr. Mudd at a Congressional hearing in 2006. "In fact, Fannie and Freddie can do more, a lot more."

But Fannie's computer systems could not fully analyze many of the risky loans that customers, investors and lawmakers wanted Mr. Mudd to buy. Many of them - like balloon-rate mortgages or mortgages that did not require paperwork - were so new that dangerous bets could not be identified, according to company executives.

Even so, Fannie began buying huge numbers of riskier loans.

In one meeting, according to two people present, Mr. Mudd told employees to "get aggressive on risk-taking, or get out of the company."

In the interview, Mr. Mudd said he did not recall that conversation and that he always stressed taking only prudent risks.

Employees, however, say they got a different message.

"Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little," said a former senior Fannie executive. "But our mandate was to stay relevant and to serve low-income borrowers. So that's what we did."

Between 2005 and 2007, the company's acquisitions of mortgages with down payments of less than 10 percent almost tripled. As the market for risky loans soared to $1 trillion, Fannie expanded in white-hot real estate areas like California and Florida.

For two years, Mr. Mudd operated without a permanent chief risk officer to guard against unhealthy hazards. When Enrico Dallavecchia was hired for that position in 2006, he told Mr. Mudd that the company should be charging more to handle risky loans.

In the following months to come, Mr. Dallavecchia warned that some markets were becoming overheated and argued that a housing bubble had formed, according to a person with knowledge of the conversations. But many of the warnings were rebuffed.

Mr. Mudd told Mr. Dallavecchia that the market, shareholders and Congress all thought the companies should be taking more risks, not fewer, according to a person who observed the conversation. "Who am I supposed to fight with first?" Mr. Mudd asked.

In the interview, Mr. Mudd said he never made those comments. Mr. Dallavecchia was among those whom Mr. Mudd forced out of the company during a reorganization in August.

Mr. Mudd added that it was almost impossible during most of his tenure to see trouble on the horizon, because Fannie interacts with lenders rather than borrowers, which creates a delay in recognizing market conditions.

He said Fannie sought to balance market demands prudently against internal standards, that executives always sought to avoid unwise risks, and that Fannie bought far fewer troublesome loans than many other financial institutions. Mr. Mudd said he heeded many warnings from his executives and that Fannie refused to buy many risky loans, regardless of outside pressures .

"You're dealing with massive amounts of information that flow in over months," he said. "You almost never have an 'Oh, my God' moment. Even now, most of the loans we bought are doing fine."

But, of course, that moment of truth did arrive. In the middle of last year it became clear that millions of borrowers would stop paying their mortgages. For Fannie, this raised the terrifying prospect of paying billions of dollars to honor its guarantees.

Sustained by Government

Had Fannie been a private entity, its comeuppance might have happened a year ago. But the White House, Wall Street and Capitol Hill were more concerned about the trillions of dollars in other loans that were poisoning financial institutions and banks.

Lawmakers, particularly Democrats, leaned on Fannie and Freddie to buy and hold those troubled debts, hoping that removing them from the system would help the economy recover. The companies, eager to regain market share and buy what they thought were undervalued loans, rushed to comply.

The White House also pitched in. James B. Lockhart, the chief regulator of Fannie and Freddie, adjusted the companies' lending standards so they could purchase as much as $40 billion in new subprime loans. Some in Congress praised the move.

"I'm not worried about Fannie and Freddie's health, I'm worried that they won't do enough to help out the economy," the chairman of the House Financial Services Committee, Barney Frank, Democrat of Massachusetts, said at the time. "That's why I've supported them all these years - so that they can help at a time like this."

But earlier this year, Treasury Secretary Henry M. Paulson Jr. grew concerned about Fannie's and Freddie's stability. He sent a deputy, Robert K. Steel, a former colleague from his time at Goldman Sachs, to speak with Mr. Mudd and his counterpart at Freddie.

Mr. Steel's orders, according to several people, were to get commitments from the companies to raise more money as a cushion against all the new loans. But when he met with the firms, Mr. Steel made few demands and seemed unfamiliar with Fannie's and Freddie's operations, according to someone who attended the discussions.

Rather than getting firm commitments, Mr. Steel struck handshake deals without deadlines.

That misstep would become obvious over the coming months. Although Fannie raised $7.4 billion, Freddie never raised any additional money.

Mr. Steel, who left the Treasury Department over the summer to head Wachovia bank, disputed that he had failed in his handling of the companies, and said he was proud of his work .

As the housing crisis worsened, Fannie and Freddie announced larger losses, and shares continued falling.

In July, Mr. Paulson asked Congress for authority to take over Fannie and Freddie, though he said he hoped never to use it. "If you've got a bazooka and people know you've got it, you may not have to take it out," he told Congress.

Mr. Mudd called Treasury weekly. He offered to resign, to replace his board, to sell stock, and to raise debt. "We'll sign in blood anything you want," he told a Treasury official, according to someone with knowledge of the conversations.

But, according to that person, Mr. Mudd told Treasury that those options would work only if government officials publicly clarified whether they intended to take over Fannie. Otherwise, potential investors would refuse to buy the stock for fear of being wiped out.

"There were other options on the table short of a takeover," Mr. Mudd said. But as long as Treasury refused to disclose its goals, it was impossible for the company to act, according to people close to Fannie.

Then, last month, Mr. Mudd was instructed to report to Mr. Lockhart's office. Mr. Paulson told Mr. Mudd that he could either agree to a takeover or have one forced upon him.

"This is the right thing to do for the economy," Mr. Paulson said, according to two people with knowledge of the talks. "We can't take any more risks."

Freddie was given the same message. Less than 48 hours later, Mr. Lockhart and Mr. Paulson ended Fannie and Freddie's independence, with up to $200 billion in taxpayer money to replenish the companies' coffers.

The move failed to stanch a spreading panic in the financial world. In fact, some analysts say, the takeover accelerated the hysteria by signaling that no company, no matter how large, was strong enough to withstand the losses stemming from troubled loans.

Within weeks, Lehman Brothers was forced to declare bankruptcy, Merrill Lynch was pushed into the arms of Bank of America, and the government stepped in to bail out the insurance giant the American International Group.

Today, Mr. Paulson is scrambling to carry out a $700 billion plan to bail out the financial sector, while Mr. Lockhart effectively runs Fannie and Freddie.

Mr. Raines and Mr. Howard, who kept most of their millions, are living well. Mr. Raines has improved his golf game. Mr. Howard divides his time between large homes outside Washington and Cancun, Mexico, where his staff is learning how to cook American meals.

But Mr. Mudd, who lost millions of dollars as the company's stock declined and had his severance revoked after the company was seized, often travels to New York for job interviews. He recalled that one of his sons recently asked him why he had been fired.

"Sometimes things don't work out, no matter how hard you try," he replied.

[Oct 5, 2008] Economic View - Pursuit of an Edge, in Steroids or Stocks -


... ... ...

It isn't simply "Wall Street greed," which Senator John McCain has blamed for the crisis. Coming from Mr. McCain, a longtime champion of financial industry deregulation, it was a puzzling attribution, squarely at odds with the cherished belief of free-market enthusiasts everywhere that unbridled pursuit of self-interest promotes the common good. As Adam Smith wrote in "The Wealth of Nations," "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."

Greed underlies every market outcome, good or bad. When important conditions are met, greed not only poses no threat to Smith's "invisible hand" of competition, but is an essential part of it.

The forces that produced the current crisis actually reflect a powerful dynamic that afflicts all kinds of competitive endeavors. This may be seen clearly in the world of sports.

Consider a sprinter's decision about whether to take anabolic steroids. The sprinter's reward depends not on how fast he runs in absolute terms, but on how his times compare with those of others. Imagine a new drug that enhances performance by three-tenths of a second in the 100-meter dash. Almost impossible to detect, it also entails a small risk of serious health problems. The sums at stake ensure that many competitors will take the drug, making it all but impossible for a drug-free competitor to win. The net effect is increased health risks for all athletes, with no real gain for society.

This particular type of market failure occurs when two conditions are met. First, people confront a gamble that offers a highly probable small gain with only a very small chance of a significant loss. Second, the rewards received by market participants depend strongly on relative performance.

These conditions have caused the invisible hand to break down in multiple domains. In unregulated housing markets, for example, there are invariably too many dwellings built on flood plains and in earthquake zones. Similarly, in unregulated labor markets, workers typically face greater health and safety risks.

It is no different in unregulated financial markets, where easy credit terms almost always produce an asset bubble. The problem occurs because, just as in sports, an investment fund's success depends less on its absolute rate of return than on how that rate compares with those of rivals.

If one fund posts higher earnings than others, money immediately flows into it. And because managers' pay depends primarily on how much money a fund oversees, managers want to post relatively high returns at every moment.

One way to bolster a fund's return is to invest in slightly riskier assets. (Such investments generally pay higher returns because risk-averse investors would otherwise be unwilling to hold them.) Before the current crisis, once some fund managers started offering higher-paying mortgage-backed securities, others felt growing pressure to follow suit, lest their customers desert them.

Warren E. Buffett warned about a similar phenomenon during the tech bubble. Mr. Buffett said he wouldn't invest in tech stocks because he didn't understand the business model. Investors knew him to be savvy, but the relatively poor performance of his Berkshire Hathaway fund during the tech stock run-up persuaded many to move their money elsewhere. Mr. Buffett had the personal and financial resources to weather that storm. But most money managers did not, and the tech bubble kept growing.

A similar dynamic precipitated the current problems. The new mortgage-backed securities were catnip for investors, much as steroids are for athletes. Many money managers knew that these securities were risky. As long as housing prices kept rising, however, they also knew that portfolios with high concentrations of the riskier assets would post higher returns, enabling them to attract additional investors. More important, they assumed that if things went wrong, there would be safety in numbers.

PHIL GRAMM, the former senator from Texas, and other proponents of financial industry deregulation insisted that market forces would provide ample protection against excessive risk. Lenders obviously don't want to make loans that won't be repaid, and borrowers have clear incentives to shop for favorable terms. And because everyone agrees that financial markets are highly competitive, Mr. Gramm's invocation of the familiar invisible-hand theory persuaded many other lawmakers.

The invisible hand breaks down, however, when rewards depend heavily on relative performance. A high proportion of investors are simply unable to stand idly by while others who appear no more talented than them earn conspicuously higher returns. This fact of human nature makes the invisible hand an unreliable shield against excessive financial risk.

Where do we go from here?

Many people advocate greater transparency in the market for poorly understood derivative securities. More stringent disclosure rules would be good but would not prevent future crises, any more than disclosing the relevant health risks would prevent athletes from taking steroids.

The only effective remedy is to change people's incentives. In sports, that means drug rules backed by strict enforcement. In financial markets, asset bubbles cause real trouble when investors can borrow freely to expand their holdings. To prevent such bubbles, we must limit the amounts that people can invest with borrowed money.

Paulson-Bernanke Steps Created `Big Ripples,' Leading to Rescue

Oct. 3 (Bloomberg) -- The $700 billion rescue that the U.S. House considers today reflects the unintended consequences of decisions made by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke since March.

Beginning with the orchestrated purchase of Bear Stearns Cos. by JPMorgan Chase & Co., each step was a bold effort to forestall a collapse of the financial system. The economy grew in the first two quarters of this year, and financial distress eased for a while after the Bear Stearns rescue. Still, each decision to bail out or not created more instability, leading to further runs on securities firms, banks and insurers.

``Every time you tinker with this delicate system even small changes can create big ripples,'' said Dino Kos, former head of the New York Fed's open-market operations and now a managing director at Portales Partners LLC in New York. ``This is the impossible situation they are in. The risks are that the government's $700 billion purchase of assets disturbs markets even more.''

Paulson and Bernanke insist that the program to buy troubled mortgages and other securities is needed to revive lending and restore stability to markets. What they haven't discussed is the risk that they inadvertently make matters worse. By creating a government pool of distressed real-estate and bad debt, they could depress the housing market further. Risk may become even more concentrated through a wave of bank mergers that, if unsuccessful, would stick taxpayers with an even higher bill.

Conference Call

The decision to launch the biggest bailout in history came on a Sept. 17 conference call, when Bernanke and Paulson pulled the trigger on a proposal etched out over several months. Over the previous two days, they let Lehman Brothers Holdings Inc. fail and seized American International Group Inc. The reaction to their visible hand: a rout in financial stocks, paralysis in the trillion dollar inter-bank loan market, and flight from money market mutual funds.

Treasury and Fed officials had long been uncomfortable with the way the safety net had to be expanded to catch Bear Stearns. Not a single creditor had suffered a default as the company was swept into JPMorgan Chase & Co. with the help of a $29 billion Fed loan. Stock investors received about $10 each.

Their decision to pull back and let shareholders get wiped out in Fannie Mae, Freddie Mac, and then Lehman ``sent shivers through investors,'' said Peter Kovalski, who oversees financial-services stocks for Alpine Woods Capital Investors LLC's $12 billion portfolio. ``Everybody kind of backed off and said if this is the way the government is going to play the game, we don't want to risk our capital.''

Assumptions Thrown Out

Lehman's bankruptcy toppled other assumptions that investors had made. Bear Stearns, deemed too big to fail by the Fed and Treasury, had $399 billion in total assets. Lehman Brothers had $639 billion in total assets, possibly posing a bigger systemic risk than Bear.

``There was a perception, right or wrong, that after Bear Stearns, that in any firm as big, the senior debt holders would be okay,'' said Karl Haeling, head of debt distribution at Landesbank Baden-Wuerttemberg, New York, Germany's largest state-owned bank. ``Obviously, that was the wrong bet.''

Bernanke and Paulson began their discussions at the end of the day on Sept. 17, when the Standard & Poor's 500 Financials Index fell 8.9 percent.

Investors concluded after the AIG takeover -- the price of an $85 billion loan -- that any future federal aid would come at a similar cost, and they fled.

`Oh, My God'

``Are we imploding right here?'' Joseph Saluzzi, co-head of Themis Trading LLC in Chatham, New Jersey, and his colleagues asked each other on Sept. 17. Shares of Goldman Sachs Group Inc. were down 21 percent at noon and Morgan Stanley lost 36 percent. ``People thought, `Oh, my God, if Goldman's going out, we've got a real problem.'''

Lehman's collapse caused the Reserve Primary Fund, the oldest U.S. money-market fund, to write off $785 million of debt issued by the investment bank, forcing the fund to break the buck, meaning its net asset value fell below $1 a share.

The run on money funds, prompted in part by the government's decision to let Lehman fail, caused yet another extension of the safety net by the Treasury and Fed.

On Sept. 19, invoking Depression-era authority, the Fed's Board of Governors authorized its Boston branch to provide emergency loans to commercial banks to purchase asset-backed commercial paper from money mutual funds to help them meet shareholder redemptions.

Paulson's Goal

The Treasury is gambling that the $700 billion plan now being debated in Congress will kick-start capital markets and lending. If the government is a buyer of mortgage securities, they will trade higher, Paulson told Congress. If the banks are cleansed of bad assets, they will find new capital and the cycle of lending will start again.

Investors say once again the government's big-footing in the financial markets could create more problems than it solves.

Officials ``have designed a financial bailout plan that is not only misdirected, but may further exacerbate problems in the housing market,'' says Eric Hovde, chief investment officer at Hovde Capital LLC, which manages $1 billion in financial services stocks. ``Just as foreclosure sales are pressuring housing prices today, government sales will only make matters worse.''

To contact the reporters on this story: Craig Torres in Washington at [email protected]; Eric Martin in New York at [email protected].

"We have a good deal of comfort about the capital cushions at these firms at the moment." - Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.

As rumors swirled that Bear Stearns faced imminent collapse in early March, Christopher Cox was told by his staff that Bear Stearns had $17 billion in cash and other assets - more than enough to weather the storm.

Drained of most of its cash three days later, Bear Stearns was forced into a hastily arranged marriage with JPMorgan Chase - backed by a $29 billion taxpayer dowry.

Within six months, other lions of Wall Street would also either disappear or transform themselves to survive the financial maelstrom - Merrill Lynch sold itself to Bank of America, Lehman Brothers filed for bankruptcy protection, and Goldman Sachs and Morgan Stanley converted to commercial banks.

How could Mr. Cox have been so wrong?

Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency's failure to follow through on those decisions also explains why Washington regulators did not see what was coming.

On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.

A lone dissenter - a software consultant and expert on risk management - weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington.

One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told - those with assets greater than $5 billion.

"We've said these are the big guys," Mr. Goldschmid said, provoking nervous laughter, "but that means if anything goes wrong, it's going to be an awfully big mess."

Mr. Goldschmid, an authority on securities law from Columbia, was a behind-the-scenes adviser in 2002 to Senator Paul S. Sarbanes when he rewrote the nation's corporate laws after a wave of accounting scandals. "Do we feel secure if there are these drops in capital we really will have investor protection?" Mr. Goldschmid asked. A senior staff member said the commission would hire the best minds, including people with strong quantitative skills to parse the banks' balance sheets.

Annette L. Nazareth, the head of market regulation, reassured the commission that under the new rules, the companies for the first time could be restricted by the commission from excessively risky activity. She was later appointed a commissioner and served until January 2008.

"I'm very happy to support it," said Commissioner Roel C. Campos, a former federal prosecutor and owner of a small radio broadcasting company from Houston, who then deadpanned: "And I keep my fingers crossed for the future."

The proceeding was sparsely attended. None of the major media outlets, including The New York Times, covered it.

After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The Times, the chairman, William H. Donaldson, a veteran Wall Street executive, called for a vote. It was unanimous. The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.

With that, the five big independent investment firms were unleashed.

In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms' own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.

Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio - a measurement of how much the firm was borrowing compared to its total assets - rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly.

The 2004 decision for the first time gave the S.E.C. a window on the banks' increasingly risky investments in mortgage-related securities.

But the agency never took true advantage of that part of the bargain. The supervisory program under Mr. Cox, who arrived at the agency a year later, was a low priority.

The commission assigned seven people to examine the parent companies - which last year controlled financial empires with combined assets of more than $4 trillion. Since March 2007, the office has not had a director. And as of last month, the office had not completed a single inspection since it was reshuffled by Mr. Cox more than a year and a half ago.

The few problems the examiners preliminarily uncovered about the riskiness of the firms' investments and their increased reliance on debt - clear signs of trouble - were all but ignored.

The commission's division of trading and markets "became aware of numerous potential red flags prior to Bear Stearns's collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain" capital standards, said an inspector general's report issued last Friday. But the division "did not take actions to limit these risk factors."

Drive to Deregulate

The commission's decision effectively to outsource its oversight to the firms themselves fit squarely in the broader Washington culture of the last eight years under President Bush.

A similar closeness to industry and laissez-faire philosophy has driven a push for deregulation throughout the government, from the Consumer Product Safety Commission and the Environmental Protection Agency to worker safety and transportation agencies.

"It's a fair criticism of the Bush administration that regulators have relied on many voluntary regulatory programs," said Roderick M. Hills, a Republican who was chairman of the S.E.C. under President Gerald R. Ford. "The problem with such voluntary programs is that, as we've seen throughout history, they often don't work."

As was the case with other agencies, the commission's decision was motivated by industry complaints of excessive regulation at a time of growing competition from overseas. The 2004 decision was aimed at easing regulatory burdens that the European Union was about to impose on the foreign operations of United States investment banks.

The Europeans said they would agree not to regulate the foreign subsidiaries of the investment banks on one condition - that the commission regulate the parent companies, along with the brokerage units that the S.E.C. already oversaw.

A 1999 law, however, had left a gap that did not give the commission explicit oversight of the parent companies. To get around that problem, and in exchange for the relaxed capital rules, the banks volunteered to let the commission examine the books of their parent companies and subsidiaries.

The 2004 decision also reflected a faith that Wall Street's financial interests coincided with Washington's regulatory interests.

"We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing," said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox).

"Letting the firms police themselves made sense to me because I didn't think the S.E.C. had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We've all learned a terrible lesson," he added.

In letters to the commissioners, senior executives at the five investment banks complained about what they called unnecessary regulation and oversight by both American and European authorities. A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso, Ind., who said the computer models run by the firms - which the regulators would be relying on - could not anticipate moments of severe market turbulence.

"With the stroke of a pen, capital requirements are removed!" the consultant, Leonard D. Bole, wrote to the commission on Jan. 22, 2004. "Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?"

He said that similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.

Mr. Bole, who earned a master's degree in business administration at the University of Chicago, helps write computer programs that financial institutions use to meet capital requirements.

He said in a recent interview that he was never called by anyone from the commission.

"I'm a little guy in the land of giants," he said. "I thought that the reduction in capital was rather dramatic."

Policing Wall Street

A once-proud agency with a rich history at the intersection of Washington and Wall Street, the Securities and Exchange Commission was created during the Great Depression as part of the broader effort to restore confidence to battered investors. It was led in its formative years by heavyweight New Dealers, including James Landis and William O. Douglas. When President Franklin D. Roosevelt was asked in 1934 why he appointed Joseph P. Kennedy, a spectacularly successful stock speculator, as the agency's first chairman, Roosevelt replied: "Set a thief to catch a thief."

The commission's most public role in policing Wall Street is its enforcement efforts. But critics say that in recent years it has failed to deter market problems. "It seems to me the enforcement effort in recent years has fallen short of what one Supreme Court justice once called the fear of the shotgun behind the door," said Arthur Levitt Jr., who was S.E.C. chairman in the Clinton administration. "With this commission, the shotgun too rarely came out from behind the door."

Christopher Cox had been a close ally of business groups in his 17 years as a House member from one of the most conservative districts in Southern California. Mr. Cox had led the effort to rewrite securities laws to make investor lawsuits harder to file. He also fought against accounting rules that would give less favorable treatment to executive stock options.

Under Mr. Cox, the commission responded to complaints by some businesses by making it more difficult for the enforcement staff to investigate and bring cases against companies. The commission has repeatedly reversed or reduced proposed settlements that companies had tentatively agreed upon. While the number of enforcement cases has risen, the number of cases involving significant players or large amounts of money has declined.

Mr. Cox dismantled a risk management office created by Mr. Donaldson that was assigned to watch for future problems. While other financial regulatory agencies criticized a blueprint by Mr. Paulson, the Treasury secretary, that proposed to reduce their stature - and that of the S.E.C. - Mr. Cox did not challenge the plan, leaving it to three former Democratic and Republican commission chairmen to complain that the blueprint would neuter the agency.

In the process, Mr. Cox has surrounded himself with conservative lawyers, economists and accountants who, before the market turmoil of recent months, had embraced a far more limited vision for the commission than many of his predecessors.

'Stakes in the Ground'

Last Friday, the commission formally ended the 2004 program, acknowledging that it had failed to anticipate the problems at Bear Stearns and the four other major investment banks.

"The last six months have made it abundantly clear that voluntary regulation does not work," Mr. Cox said.

The decision to shutter the program came after Mr. Cox was blamed by Senator John McCain, the Republican presidential candidate, for the crisis. Mr. McCain has demanded Mr. Cox's resignation.

Mr. Cox has said that the 2004 program was flawed from its inception. But former officials as well as the inspector general's report have suggested that a major reason for its failure was Mr. Cox's use of it.

"In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the S.E.C. didn't oversee well enough," Mr. Goldschmid said in an interview. He and Mr. Donaldson left the commission in 2005.

Mr. Cox declined requests for an interview. In response to written questions, including whether he or the commission had made any mistakes over the last three years that contributed to the current crisis, he said, "There will be no shortage of retrospective analyses about what happened and what should have happened." He said that by last March he had concluded that the monitoring program's "metrics were inadequate."

He said that because the commission did not have the authority to curtail the heavy borrowing at Bear Stearns and the other firms, he and the commission were powerless to stop it.

"Implementing a purely voluntary program was very difficult because the commission's regulations shouldn't be suggestions," he said. "The fact these companies could withdraw from voluntary supervision at their discretion diminished the mandate of the program and weakened its effectiveness. Experience has shown that the S.E.C. could not bootstrap itself into authority it didn't have."

But critics say that the commission could have done more, and that the agency's effectiveness comes from the tone set at the top by the chairman, or what Mr. Levitt, the longest-serving S.E.C. chairman in history, calls "stakes in the ground."

"If you go back to the chairmen in recent years, you will see that each spoke about a variety of issues that were important to them," Mr. Levitt said. "This commission placed very few stakes in the ground."

"Free our oil, Mr. President," said House Speaker Nancy Pelosi in a recent House debate. That gambit so far hasn't won White House backing.

Now some Bush regulatory appointees are moving aggressively to take charge. For more than a year, FDIC Chairman Sheila Bair used the bully pulpit to encourage lenders to act more forcefully to help home owners avoid foreclosure. Her speeches had little effect -- but the recent failure of IndyMac Bank is now giving her the power to carry out her ideas.

Immediately after the FDIC took control of IndyMac on July 11, she suspended all foreclosures-in-progress for the $15 billion mortgage portfolio directly controlled by the bank. Now she is trying to modify the terms by moving adjustable-rate loans into fixed-rate mortgages.

With many other banks expected to fail because of mortgage defaults, she's likely to have other chances to put her ideas in practice. She also hopes other banks will follow the FDIC's prescription themselves, if necessary. "I think we can lead by example," says Ms. Bair, a Republican who was nominated by President Bush to a five-year term in 2006.

Accumulation of Power

The Fed itself has seen the biggest accumulation of power, as Fed Chairman Bernanke and Treasury Secretary Hank Paulson, two Republicans, try to cope with the deepening economic problems. In mid-March, The Federal Reserve put $29 billion on the line to support the sale of Bear Stearns Cos., a huge investment bank that had begun to collapse and was forced into a shotgun marriage with J.P. Morgan Chase & Co.

The Fed is also lending money to four large investment banks. It has placed people inside those banks to scrutinize their holdings and capital -- an extraordinary step, given that the Fed doesn't have direct authority over the companies. On July 13, the Fed also agreed to lend money to Fannie and Freddie Mac, the two biggest mortgage-finance companies, prompting lawmakers to push for a bigger Fed role in monitoring the companies' soundness.

Though the steps have been viewed as temporary, Mr. Bernanke said this month that the central bank's lending powers to investment banks could last more than the six months originally envisioned.

Other government agencies are playing expansive roles, too. The Treasury Department is seeking Congressional approval to buy equity stakes in Fannie Mae and Freddie Mac and offer them unlimited lines of credit to prevent the companies from collapsing. The Federal Housing Administration has eased standards for government-insured mortgages.

Critics warn that turning power over to technocrats can lead to trouble. "The best and the brightest" of the Kennedy and Johnson administrations escalated, and then lost, the war in Vietnam. Federal and state officials still haven't rebuilt New Orleans and the surrounding area three years after the hurricane struck.

The Fed's reputation for independence could suffer if it is handed a larger regulatory role over banks and could produce a conflict of interest. If economic conditions call for the Fed to, say, raise interest rates to control inflation, would the Fed hold off because those higher rates could hurt the banks it regulates?

Short-Lived Surge?

Former House Republican Speaker Newt Gingrich, who captained the Republican takeover of Congress in 1994 on a "small-government" platform, figures that any surge in government activism is bound to be short-lived because bureaucrats will blunder. "It's very dangerous to assume that some skill at managing the money supply (as the Fed has done) will lead to bureaucratic skills greater than any country possesses," he says.

Dealing with global warming may augur a further expansion of government power. The leading proposal in Congress would cap emissions of greenhouses gases by industries and allow them to buy and sell emission permits.

The legislation garnered 48 votes in the Senate in a June procedural measure, leaving it a dozen short of the 60 needed to get a vote on the bill. Both presidential candidates have made emissions-trading systems a centerpiece of their environmental platforms, all but assuring another Congressional effort after the election.

"Markets are groping" for guidance, says Fred Morse, a senior adviser to the U.S. solar-power subsidiary of Spanish utility Abengoa S.A. "You need government to lay out a policy."

Tyler Cowen Directs Us to John Cochrane by Brad DeLong

July 31, 2008 | Grasping Reality with Both Hands The Semi-Daily Journal Economist Brad DeLong

John Cochrane has things to say about many of his colleagues at the University of Chicago. As far as polemic goes, I don't think I will ever see a better one:

Comments on the Milton Friedman Institute Protest letter:

As usual, academics need to waste two paragraphs before getting to the point, which starts in the first bullet. To really enjoy this delicious prose you have to first read it all in one place. * Many colleagues are distressed by the notoriety of the Chicago School of Economics, especially throughout much of the global south, where they have often to defend the University's reputation in the face of its negative image. The effects of the neoliberal global order that has been put in place in recent decades, strongly buttressed by the Chicago School of Economics, have by no means been unequivocally positive. Many would argue that they have been negative for much of the world's population, leading to the weakening of a number of struggling local economies in the service of globalized capital, and many would question the substitution of monetization for democratization under the banner of "market democracy." Yes, there are people left on the planet who write and think this way, and no, I'm not making this up. Let's read this more closely and try to figure out what it means.

Many colleagues are distressed by the notoriety of the Chicago School of Economics, especially throughout much of the global south, where they have often to defend the University's reputation in the face of its negative image. If you're wondering "what's their objection?", "how does a MFI hurt them?" you now have the answer. Translated, "when we go to fashionable lefty cocktail parties in Venezuela, it's embarrassing to admit who signs our paychecks." Interestingly, the hundred people who signed this didn't have the guts even to say "we," referring to some nebulous "they" as the subject of the sentence. Let's read this literally: "We don't really mind at all if there's a MFI on campus, but some of our other colleagues, who are too shy to sign this letter, find it all too embarrassing to admit where they work." If this is the reason for organizing a big protest perhaps someone has too much time on their hands. Global south I'll just pick on this one as a stand-in for all the jargon in this letter. What does this oxymoron mean, and why do the letter writers use it? We used to say what we meant, "poor countries. " That became unfashionable, in part because poverty is sometimes a bit of your own doing and not a state of pure victimhood. So, it became polite to call dysfunctional backwaters "developing." That was already a lie (or at best highly wishful thinking) since the whole point is that they aren't developing. But now bien-pensant circles don't want to endorse "development" as a worthwhile goal anymore. "South" – well, nice places like Australia, New Zealand and Chile are there too (at least from a curiously North-American and European-centric perspective). So now it's called "global south," which though rather poor as directions for actually getting anywhere, identifies the speaker as the caring sort of person who always uses the politically correct word. The effects of the neoliberal global order that has been put in place in recent decades… Notice the interesting voice of the verb. Let's call it the "accusatory passive." "Has been put in place..." By who, I (or any decent writer) would want to know? Unnamed dark forces are at work. Many would argue that they have been negative for much of the world's population... weakening … struggling local economies I can think of lots of words to describe what's going on in, say, China and India, as well as what happened previously to countries that adopted the "neoliberal global order" like Japan, Hong Kong, and South Korea. Billions of people are leading dramatically freer, healthier, longer and more prosperous lives than they were a generation ago. Of course, we all face plenty of problems. I worry about environmental catastrophes, and their political, social and economic aftermath. Many people are suffering, primarily in pockets of kleptocracy and anarchy. Life's pretty bleak about 5 blocks west of the University of Chicago. In my professional life, I worry about inflation, chaotic markets, and their possible death by regulation. There is a lot for thoughtful economists and social scientists to do. But honestly, do we really yearn to send a billion Chinese back to their "local economies," trying to eke a meager living out of a quarter acre of rice paddy, under the iron grip of some local bureaucrat? I mean, the Mao caps and Che shirts are cool and all, but millions of people starved to death. This is just the big lie theory at work. Say something often enough and people will start to believe it. It helps especially if what you say is vague and meaningless. Ok, I'll try to be polite; a lie is deliberate and this is more like a willful disregard for the facts. Still, if you start with the premise that the last 40 or so years, including the fall of communism, and the [economic] opening of China and India are "negative for much of the world's population," you just don't have any business being a social scientist. You don't stand a chance of contributing something serious to the problems that we actually do face. the service of globalized capital.. was wondering who the subject of all these passive sentences is. Now I'm beginning to get the idea. This view has a particularly dark history. I'll give you a hint: "Globalized capital" has names like Goldman and Sachs. many would question the substitution of monetization for democratization under the banner of 'market democracy.' What a doozy! What can this actually mean? Given the counterpoint "market democracy" (what we live in, I presume) I suspect "democratic" here means "democratic" as in "people's democratic republic", i.e. the government runs everything. Monetization is democratization; it means things are accessible to anyone, not just the politically connected. That observation was, among many other things, Milton Friedman's genius. Once again, the verb tenses and subjects are telling. "The substitution." Who did this substitution? Maybe globalized capital, or the international banking conspiracy? Maybe it's the trilateral commission. The closing bullet point is fun as a reminder of how petty academic squabbles can be after we strip off all the big words, fancy pretentions and meaningless jargon. * In the interests of equity and balance, many of us feel that the University ought to reconsider contributing to the proposed Milton Friedman Institute, which will inevitably be a powerful magnet for scholars and donors who share a specific set of interests and values to the exclusion of others, whether this is openly acknowledged or not. Translation: we publicly charge the faculty committee who put this thing together, and promise a non-partisan non-directed research institute (me included), with lying through their teeth. This sentence adds a – well let's be polite and call it a "factual inaccuracy." The whole point is not "University contribution." The whole point is to try to get private donors who see the benefits of Milton Friedman's legacy to support economics research here. If the writers understood the first thing about money, that it is fungible, they might understand which side of their bread is buttered. Still others believe that, given the influx of private contributions to the MFI, the University now has the opportunity to provide roughly equivalent resources for critical scholarly work that seeks out alternatives to recent economic, social, and political developments. Finally, we get to the point! We can get over our "distress" at admitting where we work, but what we want is to do some of our own "substitution of monetization for democratization." And with none of the niceties about non-partisan, non-ideological, open-minded research in the Milton Friedman founding documents either – this money is reserved for people who can get the right answers and belong to the right clubs. And we're not planning to ask our sympathizers to pony up money either. Basically, we want the Friedman Institute money. Virtually all of us are distressed by the position the University has taken and by the process through which decisions have been made. And we end with good old "process." When you can't really complain on the merits, you can always gum up the works by complaining about "process." Now you know why it takes so long for a university ever to do anything. If it's sad to see what 101 professionally distinguished minds at the University of Chicago think about free markets at all, it is to me sadder still how atrociously written this letter is. These people devote their lives to writing on social issues, and teaching freshmen (including mine) how to think and write clearly. Yet it's awful. The letter starts with two paragraphs of meaningless throat-clearing. ("This is a question of the meaning of the University's investments, in all senses." What in the world does that sentence actually mean?) I learned to delete throat-clearing in the first day of Writing 101. It's all written in the passive, or with vague subjects. "Many" should not be the subject of any sentence. You should never write "has been put in place," you should say who put something in place. You should take responsibility in your writing. Write "we," not "many colleagues." The final paragraphs wander around without saying much of anything. The content of course is worse. There isn't even an idea here, a concrete proposition about the human condition that one can disagree with, buttress or question with facts. It just slings a bunch of jargon, most of which has a real meaning opposite to the literal. "Global South," "neoliberal global order," "the service of globalized capital," "substitution of monetization for democratization." George Orwell would be proud. I'm not a good writer. I admire great prose, and I attempt to fill the spaces between equations of my papers with comprehensible words. But even I can recognize atrocious prose when I see it. Really, guys and gals, if a Freshman handed this in to one of your classes, could you possibly give any grade above C- and cover it with red ink? I was quoted as saying "drivel," and I meant it, not as an insult but as a technically correct description of a piece of prose. We can – and should – happily disagree on all sorts of matters of fact and interpretation, clearly stated, and openly discussed. But there's nothing here to discuss, it's just mush. The saddest aspect of this whole sorry affair is that 100 faculty at such a distinguished institution can sign their names – and with them their intellectual reputations and their sacred honor -- to such utter drivel. Milton Friedman stood for freedom, social, political, and economic. He realized that they are inextricably linked. If the government controls your job or your business, dissent is impossible. He favored, among other things, legalizing drugs, school choice, and volunteer army. To call him or his political legacy "right wing" is simply ignorant, and I mean that also as a technically accurate description rather than an insult. (Of course, he also has a legacy in the economics community as a first-rate researcher, which is what the MFI will do and honor.) So here's my question: If you're embarrassed by this legacy, if you worry that it will tarnish the University's reputation, just what is it that you good-thinking guys and gals have against human freedom?


But, perhaps more seriously, Friedman ducked the big questions regarding the relationship between economic freedom and political liberty, and he was completely incapable of seeing that political liberty is both a negative and a positive liberty: freedom from tyranny and oppression but also the freedom and power to decide on and accomplish our common purposes. These are the master questions of history and moral philosophy, and for all his brilliance and hard work, Friedman is of absolutely no help in answering them. As Posner says, Friedrich Hayek's Road to Serfdom "flunks the test of accuracy of prediction … [The] view that socialism of the sort that Britain embraced under the old Labour Party was incompatible with democracy [is] extreme and inaccurate." Yet Friedman bought into that Hayekian view. And in so doing, he ultimately led his followers, and tried to lead the rest of us, down a false path.

Hey, Friedman's feeding us corvids! No complaints here. But for hominids, he did work for they tyrannical Pinochet who is hated in Latin America and provided rhetorical cover for many other tyrants. But no complaints here--keep those dead bodies coming!


[Mar 4, 2008] Free Markets vs. Cronyism

March 4, 2008 | Sudden Debt

I will be on a short trip, so posting will be sporadic for the next few days. Before I go, I want to clear something up, concerning my views on extremism in free markets and their zealot acolytes.

Free markets (in this case financial markets, since they are my area of expertise) without tight regulation to even out the playing field as much as possible, rapidly deteriorate towards crony capitalism, i.e. a particularly virulent form of junglenomics. US financial markets were the envy of the world because a whole array of professional regulators (SEC, NASD, NYSE, FRB, etc) stood ready to send in the feds and bodily carry out manacled perps, in full view of their co-workers and the cameras.

No, it didn't always work out as it should have and many a big fish swam away leaving the minnows to fry in the pan. But mostly it worked, and the markets were the better for it. This is no longer the case and dominant positions now exist (or existed) unchecked in most markets and crony capitalism makes itself evident in many aspects of the US economy (Enron, for example).

Some people sadly still confuse freedom with total lack of regulation, thinking oversight interferes with a "natural" right to do as they please. In that case, their proper place is up in the mountains with the rest of the wild animals (Aristotle had something to say about them, people who do not wish to participate in a cohesive society and be bound by its rules). Others place absolute faith in the invisible hand, thinking it will even out everything all by itself. To my mind, they belong to the Flat Earth Society.

No doubt, they in turn will paint me a "commie", showing a complete lack of understanding about what communism is all about. Well, both communism and absolute laissez-faire don't work - in practice - because they both disregard human nature: man is no saint. He will no more gladly share everything he has with his fellow than he won't fall prey to unfettered greed for individual gain.

Free market capitalism is not antithetical to the common good - quite the contrary; it is just that human nature will always be governed by extremes of fear and greed and behavior must be governed by checks and balances, for everyone's benefit. Likewise for democracy, which can all too easily deteriorate towards mob rule or fascism, a fact understood very well by the writers of the Constitution. It is extremism that I rail against, not freedom.

Bottom line: excellence in market regulation leads to better and freer markets. And please... do not confuse quality with quantity, from either perspective: more is not better, but neither is less. Smarter, more effective, more efficient... that's better.

See you all soon.

[Feb 23, 2008] Crony Capitalism Comes (Returns?) to America By Menzie Chinn

"privatizing profits and socializing losses is crony capitalism, pure and simple."

Or, who will be the Keating 5 of the 2000's? Perspectives from those of us who remember the East Asian crises of the 1990's.

From the NYT:

News Analysis

A 'Moral Hazard' for a Housing Bailout: Sorting the Victims From Those Who Volunteered


Published: February 23, 2008

WASHINGTON -- Over the last two decades, few industries have lobbied more ferociously or effectively than banks to get the government out of its business and to obtain freer rein for "financial innovation."

But as losses from bad mortgages and mortgage-backed securities climb past $200 billion, talk among banking executives for an epic government rescue plan is suddenly coming into fashion.

A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government -- now that it is in trouble.

The proposal warns that up to $739 billion in mortgages are at "moderate to high risk" of defaulting over the next five years and that millions of families could lose their homes.

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.

"We believe that any intervention by the federal government will be acceptable only if it is not perceived as a bailout of the bond market," the financial institution noted.

In practice, taxpayers would almost certainly view such a move as a bailout. If lawmakers and the Bush administration agreed to this step, it could be on a scale similar to the government's $200 billion bailout of the savings and loan industry in the 1990s. The arguments against a bailout are powerful. It would mostly benefit banks and Wall Street firms that earned huge fees by packaging trillions of dollars in risky mortgages, often without documenting the incomes of borrowers and often turning a blind eye to clear fraud by borrowers or mortgage brokers.

A rescue would also create a "moral hazard," many experts contend, by encouraging banks and home buyers to take outsize risks in the future, in the expectation of another government bailout if things go wrong again.

If the government pays too much for the mortgages or the market declines even more than it has already, Washington -- read, taxpayers -- could be stuck with hundreds of billions of dollars in defaulted loans.

But a growing number of policy makers and community advocacy activists argue that a government rescue may nonetheless be the most sensible way to avoid a broader disruption of the entire economy.

... ... ...

One paragraph in the article I find quite amusing is this one:

Surprisingly, the normally free-market Bush administration has expressed interest. Treasury officials confirmed that several senior officials invited Mr. Taylor to present his ideas to them on Feb. 15. Mr. Taylor said he had also received calls from officials at the Office of Thrift Supervision and the Office of the Comptroller of the Currency, which is part of the Treasury Department.

To me, it is completely unsurprising that the Administration should be willing to bail out financial institutions. They are well connected in the way that the unemployed [1] or the uninsured [2] are not.

However, this is not a rationale for not intervening. As I've said before, "Just say 'no'" is not a viable policy. The key point is to realize that, just like some of the East Asian economies in 1997, we are well past the point about worrying about the impact of current policies on "moral hazard" (see this analysis [pdf]). We needed prudential regulation in the period leading up to the housing boom (sadly, policy makers failed in that respect). That is when contingent liabilities built up (see these posts on "looting" [3], [4]). Now, it is not possible for the government to credibly commit to not intervene, when the financial system's operation is at stake (i.e., as Krugman has said, the horse is out the barn door).

And make no mistake -- the financial system is to some degree already frozen, and there is little prospect for a complete unfreezing of the system without substantial government intervention. From Deutsche Bank Economics/Strategy Weekly (Feb. 22):

...Taking MBS spreads as an example, spreads have now widened beyond the levels reached in the convexity episode of 2003, and is approaching the highs of the LTCM crisis of 1998. We emphasize that it is important for the market not to anticipate the kind of mean reversion that occurred in those previous widening episodes. In 1998, the spread widening wasn't a result of a systemic problem (at least in the principal developed economies), but rather was narrowly addressed with the unwinding of LTCM's positions. Spreads moved back relatively quickly on GSE buying, as GSE’s then were a reasonably large part of the mortgage market at that time, unlike the current moment, when the GSE's have been and are still hampered by regulatory and competitive restrictions, and thus are too small to serve as a stabilizing force.

In this sense, the current crisis is very much like the S&L crisis. And as it looks more and more likely that the government will have to spend billions of dollars bailing out investors, banks, and households, it seems to me that accountability is required. Who in the Administration pushed to prevent regulatory oversight? Who in Congress pushed the interests of the banks?

And we should look very carefully at the proposals that are being pushed by the financial industry, even as we acknowledge that laissez faire is not tenable, and we seek to establish procedures and institutional reforms that will prevent a replay. In particular, thinking about a well-funded, integrated, regulatory system that is insulated from political pressures would be a good place to start.

This post was by Menzie Chinn

The Big Picture Housing Impact on GDP

It's apparent to the people who actually read through and interpret data and articles in there own way. A post asks why can't it be said what is really going on with inflation......because as BR knows it is career suicide to go against the normal channels of media and it's spin on any negative news that does't support the current administration's agenda.

Whether we like it or not (or want to admit it) our gov't is engaged in one of the largest frauds and financial chicanery that we've ever been witness to. Remember what happned in Hungary last year???

It will most likely never be exposed as the fraud it is however if it were it would make Watergate look like a children's picnic.

Remember inflation is not a problem if you do not drive anywhere or eat anything......just ask our gov't they'll tell you.

Sheeple in full effect


Posted by: michael Schumacher | May 16, 2007 1:16:06 PM

This fraud has been ongoing. So, although I consider the current adminstration to be far (far, far) worse than its predecessor, we need a mechanism to help us break the two-party duopoly. Indeed, the methodology of "choosing the lesser of two evils" does not guarantee that the *baseline does not get worse*!

We need competition in the political marketplace. Instant run-off voting would eliminate the concern -- "I don't want to waste my vote" -- people have for voting for 3rd party candidates.

We should also have redistricting done by algorithms that don't attempt to control the political makeup of those districts. (Ahnuld said he wanted to do this. I wish he had turned this into one of his propositions. I haven't read anything on it in years.)

Without systemic changes, we seem to be going from bad to worse.

[Oct 4, 2005 ] There is No 'New Deal' in Today's America by Anatol Lieven, New America Foundation

October 4, 2005 | The Financial Times

Serious reformist thinking is largely absent -- not only from the political parties but also from the mainstream media and most think-tanks.

The last existential crisis of the US political and economic system was the Great Depression from 1929. That crisis was overcome thanks to President Franklin Roosevelt and the New Deal. But the intellectual underpinnings of the New Deal had been developed by progressive thinkers in America over the previous 40 years. In Germany or France today, serious reform at present may be politically unfeasible--but at least the issues have been debated and solutions will be at hand if circumstances change. In the US, by contrast, serious reformist thinking is largely absent not only from the political parties but also from the mainstream media and most think-tanks. Of course, it exists, but mostly in politically powerless journals and institutes, not places that really help form elite opinion and state policies. The parties are paralysed by the influence of powerful groups devoted to defending the status quo.

The media and think-tanks are also largely disabled by their links to political and economic interests. In the wake of Katrina, the mainstream US media won praise for finally daring to criticise the Bush administration. But there is little sign of their readiness to analyse deep flaws in the US system. The exceptions are race and poverty, issues raised so glaringly by Katrina that only a totalitarian system could avoid mentioning them.

Among the fundamental issues absent from public discussion is the political patronage system, in the areas of jobs and financial allocations. Strong criticism has been directed at the Bush administration, quite rightly, for its appointment of unqualified political cronies to senior posts. What no one asks is why the US, alone among developed countries, has such an extensive system of political appointments to vital and highly technical government jobs. Such questions would be considered to reflect lack of patriotism. More importantly, the political parties cannot raise this issue as they are both dependent on patronage to raise funds and gain support. The think-tanks cannot discuss it because too many of their members dream of becoming assistant deputy something or other after the next elections. But at least the media should be able to talk about this.

Similarly, both Congress and the Democratic politicians of Louisiana have been criticised, quite rightly, for senators' colossal diversion of scarce federal funds to pork-barrel projects in their states--something that contributed directly to the disaster in New Orleans. But no one asks why the US system allows opportunities for pork-barrel politics on this scale.

US inability to compare itself to other countries also applies to discussion of global warming and energy conservation. After Katrina, these issues cannot be ignored. But the US public cannot be told how isolated internationally America is on this question. Media discussion too often takes the form of a rigged debate in which scientific evidence for global warming is set against scientific opponents of this thesis--despite the fact there is broad international support for the first position while the second is held essentially by isolated individuals.

If a crisis on the scale of 1929-32 strikes the US now, the country would not find an FDR with a New Deal programme to run against the Republican's Herbert Hoover.

It would have a timid, ineffective Hoover for the Democrats running against a Republican Calvin Coolidge, a hidebound defender of the worst aspects of the existing system. If that had been the choice in 1932, the very foundations of the American state would have been in peril



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