What Five Hours From Last Thursday Can Tell Us About Dodd-Frank and JP Morgan

May 14, 2012Mike Konczal

In the course of an afternoon, we saw the problems Dodd-Frank is trying to solve, the solutions on the table, and the efforts to roll them back -- not in that order.

Let's take a quick look at a time frame lasting less than five hours from last Thursday, May 10th, 2012.

In the course of an afternoon, we saw the problems Dodd-Frank is trying to solve, the solutions on the table, and the efforts to roll them back -- not in that order.

Let's take a quick look at a time frame lasting less than five hours from last Thursday, May 10th, 2012.

At 12:10 p.m., Martin J. Gruenberg, Acting Chairman of the Federal Deposit Insurance Corporation (FDIC), gave the keynote at the 48th Annual Conference on Bank Structure and Competition held by the Federal Reserve Bank of Chicago. In the long-awaited speech, he outlined the overall vision, as well as the problems and pitfalls, of the FDIC using "resolution authority" to oversee the failure and unwinding of a Too Big To Fail financial firm. These powers were granted to the FDIC in the Dodd-Frank financial reform bill in order to achieve both accountability and stability while avoiding the panic and contagion that occured in the fall of 2008.

At 2:15 p.m., House Republicans passed H.R. 5652, Paul Ryan's Sequester Replacement Reconciliation Act of 2012, by a vote of 218 to 199. This reconciliation act does many things; one is that it takes lots of money from poverty relief programs and gives it to the military, and another is that it renegs on automatic cuts that were agreed to as a result of the Super Committee's failure, which will almost certainly trigger a crisis on the next debt ceiling fight. But for our purposes, one specific thing it does is revoke Title II of Dodd-Frank, which is the resolution authority powers Gruenberg was presenting. It replaces them with nothing.

At 5 p.m., the large, systemically risky firm JP Morgan had a surprise conference call where it announced, following what was disclosed on its 10-Q, that it had a giant loss of $2 billion in the last quarter. This suprised the market and sent analysts running to their phones and computers.

There are two ways to look at the relationship between the Dodd-Frank financial reform framework and JP Morgan's loss disclosure. One is that it shows the need for a strong implementation of Dodd-Frank broadly and the Volcker Rule specifically, which is designed to separate prop trading from large, risky financial firms. Marcus Stanley of Americans for Financial Reform has a great post up discussing what happened, how the principle of the Volcker Rule should work in this situation, and the threats it faces. Dodd-Frank is designed to make the financial markets more transparent and robust to shocks through such mechanisms as expanding clearing requirements for derivatives and reducing interconnectedness between large financial firms. It is also designed to make it less likely that any individual firm will collapse by having stronger capital requirements for larger financial firms and eliminating certain business lines they can participate in through the Volcker Rule. This is crucial for a Too Big To Fail firm like JP Morgan.

But the second is to acknowledge that businesses run profits and they run losses. There is something to a conservative like Kevin Williamson's remark that "The odd thing about this is that it is now considered somehow scandalous when a business loses money. It’s a scandal when banks make profits, and it’s a scandal when they make losses." On a long enough timeline, the survival rate for everyone drops to zero. Though it was clear quickly at 5 p.m. Thursday that JP Morgan wasn't in danger of collapsing, if things had been different it could have failed.

This illustrates the need for a mechanism to allow firms to fail in a way that fairly allocates losses to the right parties. The way corporations fail in this country is a series of legal choices we've made, and we found in the fall of 2008 that the mechanism we have for a shadow-bank financial firm failing -- Chapter 11 bankruptcy -- dragged down the entire system with it. Hence the move to bring in the FDIC to make sure a financial firm fails in a way compatible with fairness. The FDIC has special powers -- advance planning and living wills, debtor-in-possession financing and liquidity, making payments to creditors based on expected recoveries, keeping operations running, the ability to transfer qualified financial contracts without termination, and the ability to turn up or down regulations going into a potential resolution based on prompt corrective action -- appropriate to what our 21st century financial system needs.

Now what did Gruenberg present? The whole speech is recommended, but these goals are worth highlighting:

The second step will be the conversion of the debt holders' claims to equity. The old debt holders of the failed parent will become the owners of the new company and thus be responsible for electing a new board of directors. The new board will in turn appoint a CEO of the fully privatized new company. For a variety of reasons, we would like this to be a rapid transition.

In summary, what we envision is a resolution strategy under which the FDIC takes control of the failed firm at the parent holding company level and establishes a bridge holding company as an interim step in the conversion of the failed firm into a new well-capitalized private sector entity. We believe this strategy holds the best possibility of achieving our key goals of maintaining financial stability, holding investors in the failed firm accountable for the losses of the company, and producing a new, viable private sector company out of the process.
Shareholders are wiped out, the bank is recapitalized through previous debt holders, and the old board is fired. Stability and accountability are both emphasized. This is not simple, and this is where Dodd-Frank hangs together or it falls apart. It is a system of deterrence and detection alongside FDIC resolution. The Volcker Rule is meant to prevent having hedge fund-like gigantic losses out of nowhere, which would allow the FDIC to have some lead time to try to steer a firm back to solvency through prompt corrective action before resolution. Well-capitalized and transparent derivative markets will help with issues of contagion and panic that come with a major financial firm approaching collapse.
 
This isn't perfected yet. The big problems are given special attention in the speech: the international component of these firms, their size and complex corporate structure, their liquidity needs, and the lack of available or appropriate acquisition firms. These are not simple problems to solve, though it is clear that the FDIC wants to solve them. Now is the worst time to pull the plug and replace it with nothing, though that is the course House Republicans are on. Because no matter how many regulations are put in place, firms fail. We need a system that allows that.
 
Mike Konczal is a Fellow at the Roosevelt Institute.
 
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The Dimon Fiasco: A Stark Lesson on Why Finance Needs Government Regulation

May 11, 2012Jeff Madrick

J.P. Morgan Chase's trading losses are a perfect example of why we need increased government regulation of banks.

Many people see the $2 billion in trading losses announced by J.P. Morgan Chase as the quintessential example of why strong regulation is needed. There is a lot of irony in this story. It is a true story about the importance of government.

J.P. Morgan Chase's trading losses are a perfect example of why we need increased government regulation of banks.

Many people see the $2 billion in trading losses announced by J.P. Morgan Chase as the quintessential example of why strong regulation is needed. There is a lot of irony in this story. It is a true story about the importance of government.

When Sandy Weill, the rough and tough entrepreneur, ultimately built a financial conglomerate from many pieces—including Salomon, Smith Barney, and Travelers Insurance—into Citigroup, Jamie Dimon, someday to be the outspoken CEO of J.P. Morgan Chase, had always been at his side. A bright and dutiful young man, Dimon stayed with him when Weill was consigned to a number two role at American Express after selling his firm, Shearson Loeb Rhoades, to the credit card giant in the early 1980s. He was with him in San Francisco, when Weill was charged with slimming down American Express’s subsidiary, Fireman’s Fund. Weill’s expertise was making companies lean and mean, which often entailed ruthless lay-offs. Dimon ran the numbers for Weill and participated in the implementation of the lean and mean philosophy.

When Weill finally left American Express, Dimon again went with him. Finally, they found the consumer finance company Commercial Credit Corp, which made high interest loans to low-income consumers, including early subprime mortgages, much like the old Money Store. According to biographers, Dimon liked the industry because it was unregulated. He and Weill took over the company, fired lots of people, issued a stock offering quickly, and used it to rebuild the Weill dynasty, which would soon include Smith Barney, Shearson again, and, the giant Travelers Insurance in 1993.

But Weill still had no serious investment banking presence, so he turned his attention to Salomon Brothers, king of risky bond and currency trading, the birthplace of what later became Long-Term Capital Management, and maker of much money and several major trading losses. How risky was this trading firm?

Dimon was skeptical. But here is the irony. Weill sent Dimon to study how Salomon made its money, and the originally hesitant Dimon said he now believed the risks could be controlled. Immediately after the acquisition in 1997, however, Weill was clobbered by Salomon losses due to the East Asian financial crisis and many more to come. Weill quickly limited trading exposure at Salomon. Dimon must have learned that losses are inherent in such businesses.

Dimon was finally at Weill’s side when Travelers merged with Citicorp to form Citigroup, becoming a massive financial giant. He left soon after in a personal dispute as Citigroup took on more and more risk, more and more debt, and adopted unethical practices that were later unearthed by Eliot Spitzer, which resulted in more fines than for any other company.

Dimon wound up running J.P. Morgan Chase, where he emerged as a hero after limiting mortgage market risks before the crisis that felled so many. He became the most respected of Wall Street’s leaders, and he was arguably the best of them. But Wall Street trading profits are too tempting, and individual Wall Street traders too hard to control. Even with tight oversight, they often go their own way. And they often lose hundreds of millions and sometimes billions of dollars in the process.

Dimon may have known precisely what his London trader, the “Whale,” was doing. I doubt it. But it’s likely the so-called “London Whale” had been making big bucks for the firm for a long while. Giving him more line would only be natural.  

Herb Allison, former president of Merrill Lynch, is a strong skeptic of commercial and investment banks’ trading operations. He even thinks over time they may all lose money. What happens is that they make plenty along the way, then lose it in a big bust.  As author Michael Lewis divulged, a Morgan Stanley trader, Howie Hubler, lost $9 billion in 2007 and 2008. Nevertheless, Hubler left Morgan with millions of dollars, and later returned to work on the Street.

Dimon, among the most cautious of executives, couldn’t control this trading animal with a life of its own, either. That’s the important conclusion. A Volcker rule to limit speculative trading for banks is necessary. They are using federally insured money to finance much of their banking operations, enabling them to leverage other facets of the company. They are using shareholder money, not their own, to take risks, yet they take enormous bonuses when all goes right. And they are implicitly using taxpayer money, because if they lose too much, they will be bailed out by the federal government. They remain too big to fail.

Serious capital requirements must be implemented against such trading, and banks must also change banker compensation procedures further. For traders, it’s a heads I win, tails you lose proposition. And so it is with the bank CEO as the firm’s overall earnings rise and are socked with a blow only every once in a while. These compensation plans have changed under pressure from the federal government to some degree. But probably not enough. The firms’ partners and employees have to be on the line for losses over time.

All this is a case study in why finance needs more government rules and regulations than most other industries. The omnipresent claim that such rules undermine liquidity in markets is almost laughable. In truth, we have a lot of liquidity when we don’t need it and little when we do—such as after the Lehman Brothers catastrophe in the fall of 2008. As regulations were eliminated and weakened after the 1970s, finance became more unstable, crises more frequent, and trillions of dollars were invested down the rat holes of speculation and fantasy, while Wall Street employees made countless millions. Yes, finance is important to economic growth, but only if government controls it properly. Otherwise it can be and has been damaging.       

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

 

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A Visual Guide to the Conflicting Theories About How to Fix the Economy

May 10, 2012Mike Konczal

A map of the contrasts between 2012's different theories of what's ailing our economy and how we can fix it.

A map of the contrasts between 2012's different theories of what's ailing our economy and how we can fix it.

Since there's so much renewed focus on debates between those with a demand-side approach and those with a supply-side approach to what is wrong with the economy, I think it's a useful time to redraw my mapping of all the explanations of our crisis. I did this exercise in 2011, with a focus on different explanations of what is wrong with the economy and ways certain policies overlapped between them. I'm going to redraw this to emphasize the policy as it exists on a spectrum of options and give some new links.

Demand

The first approach is to say that we have a lack of demand in the economy. Those who believe this usually have three sets of policies for dealing with the weak economy: fiscal policy, monetary policy, or (mortgage) debt policy. Here are the three circles with a policy response spectrum for each of the issues. In general, the response on the right side of the arrow is more aggressive.

For those who want an explanation of how the three link together, some explanations include "Debt, Deleveraging, and the Liquidity Trap" and "Sam, Janet and Fiscal Policy," both by Paul Krugman, as well as "Consumers and the Economy, Part II: Household Debt and the Weak U.S. Recovery," by Atif Mian and Amir Sufi.

Some people put more of an emphasis on one circle versus another. Some think one will be the major factor, and some think another has no traction in the economy. In my humble opinion, it is useful to think of this as a three-legged stool. They all hang together, and contraction on any specific part of the three policies will require more expansion on another part to offset it. They are also all different battlefields policy-wise, requiring different agents and different arguments.

Fiscal Policy

For those who would like to see the government run a larger deficit to increase spending, the big question is whether to just give people money (particularly in the form of tax cuts, but also through other means like food stamps and unemployment insurance) or to use the money to invest, hiring people to work on infrastructure and other public works. The multipler is believed to be larger when it comes to hiring people, plus it results in public works and other investments in our economy -- things like roads, bridges, schools, etc. That takes time, though. This debate goes back to the composition of the ARRA stimulus and continues today.

Chrstina Romer has an overview about what we know on fiscal stimulus. Dylan Matthews reviewed nine studies about the effects of the ARRA stimulus bill that was passed in 2009. On the other hand, as Karl Smith would say,  "Why is the US government still collecting taxes when borrowing is cheaper than free?"

Monetary Policy

For monetary policy, the big debate is whether the Federal Reserve should engage in unconventional monetary policy through monetary instruments or by setting more aggressive targets. Paul Krugman gave a nice overview of the debate between these two approaches here.

Joe Gagnon wrote "The World Needs Further Monetary Ease, Not an Early Exit," justifying further action using monetary instruments. The larger case is that Bernanke can do more by guiding short-term interest rates than he could with the blowback he'd get from doing more aggressive targeting.

For the NGDP target group, Scott Sumner has been the best writer on this: see "Re-Targeting The Fed" and "The Case for NGDP Targeting: Lessons from the Great Recession." (A nice background on this movement is Lars Christensen's "Market Monetarism: The Second Monetarist Counter-revolution.") Brad Delong argues that a 2 percent inflation target is too low. Charles Evans's conditional higher inflation target is first alluded to in this speech of his; Yglesias covers his Brookings paper on his approach versus the instruments/guidance approach here.

Mortgage Debt Policy

For debt relief policy, the godfather of the "balance-sheet recession" view is Richard Koo -- see his "U.S. Economy in Balance Sheet Recession: What the U.S. Can Learn from Japan’s Experience in 1990–2005." To understand how mortgage debt and a balance-sheet recession is different than the wealth effect of people just feeling poorer from losing their housing value, see this interview with Amir Sufi. Adam Levitin has testimony about how to adjust bankruptcy to prevent housing foreclosures and better assign losses. Atif Mian, Amir Sufi, and Francesco Trebbi make the case that foreclosures are having a major real, negative economic impact in "Foreclosures, house prices, and the real economy." R. Glenn Hubbard and Chris Mayer argue for economic stimulus through refinancing here.

Supply

Meanwhile, on the supply side, there tends to be another three sets of policy arguments. One is that government policy is the issue, another is that governement budgets are the issue, and the third is that the labor force is the issue. Again, the issue on the right side of the spectrum should be considered the more aggressive approach in understanding the topic.

Government Budget/Debt

The first major cluster of supply-side arguments focus on the government budget and the deficits the government is running. These usually argue that private capital and job creators are sitting on the sidelines due to worries about government spending, future tax burdens, and/or a potential debt/solvency crisis. "Growth in a Time of Debt" by Carmen Reinhart and Kenneth Rogoff, as well as "Spend and Save" by Noam Scheiber, are places to start. These often go hand-in-hand with philosophical defenses of a program like the Ryan Plan and assaults on the social safety net (e.g. Yuval Levin's "Beyond the Welfare State").

At their most aggressive, these arguments say that short-term consolidation would expand the economy instead of shrink the economy. This "expansionary austerity" is less popular than it was in 2010-2011 (see David Brooks, "Prune and Grow") due to what is happening in Europe, though it still shows up. "A Guide for Deficit Reduction in the United States Based on Historical Consolidations That Worked" by AEI and "Large changes in fiscal policy: taxes versus spending" by Alesina and Ardagna are places to start.

Another aggressive argument is that any increased government spending would have to come at the expense of private capital, crowding out investment by definition. This "Treasury View" was a very common Chicago School argument against expansion in 2009, though is mentioned less now -- see Brad Delong's "The Modern Revival of the 'Treasury View.'"

Goverment Policy

Government policy arguments usually rely on the idea that economic performace is weak because of regulatory decisions made under the Obama administration, especially the passage of health care and financial reforms as well as regulatory decisions by the EPA. Suzy Khimm gives an overview of this argument and its political impact. Alan Greenspan is the most prominent advocate of this argument (see his paper "Activism"). Robert Lucas argues that Obama may have turned America into a social democratic country, which could explain the weak economy, in "The classical view of the global recession."

At the more aggressive end of this argument is the idea that the unemployment rate is high because the government is encouraging the unemployed to go on vacation (i.e. it's not a Great Recession but a Great Vacation). Instead of adding to background uncertainty, the government's policies are actively creating the unemployment they are trying to fix. See "Compassionate, But Inefficient" by Casey Mulligan and "The Dirty Secret of Unemployment" by Reihan Salam.

The other argument at the aggressive end is the idea that the level of GDP in 2007 was in a bubble, unsustainably high as a result of debt and/or bad sectoral allocations to finance and housing (caused solely by government policy, of course). A related argument is that the collapse of the housing bubble has permanently reduced U.S. potential output. See the arguments of James Bullard in the links here or here; it is also part of the main thesis of Raghuram Rajan's Foreign Affairs article.

Labor Productivity

The last cluster of arguments are centered around labor productivity. Some argue that we have an issue of labor mismatch. Our workers lack the skills necessary for high-tech 21st century jobs, or the recession has tossed the lowest productivity workers out of the labor force, or there are geographic and related issues that weaken our ability to match unemployed workers to job openings. See David Brooks here and Narayana Kocherlakota here for job openings, and Tyler Cowen's "10 Percent Unemployment Forever?" for the productivity argument.

The more aggressive version of this argument is that our problems are related to a lack of producitivty gains from so-called "protected" sectors of the economy, and without labor market reforms our economy cannot grow. Usually this is code for public sector workers; sometimes it means various growth-related government policy decisions (immigration, copyright/patents). This should properly be thought of as a long-term growth issue, though it is being folded into our current short-term economy by those who would make these arguments. David Brooks makes the case here; Raghuram Rajan makes a similar case in Foreign Affairs.

In general, the supply arguments have not held up well (remember when U.S. debt rallied on a ratings downgrade? good times), but here they are. Did I miss anything?

Mike Konczal is a Fellow at the Roosevelt Institute.

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Live at the Financial Times: Monetary Policy Response Op-Ed

May 9, 2012Mike Konczal

I have an editorial at the Financial Times online here on monetary policy. It responds to Raghuram Rajan's editorial against "progressive economists" calling for the Federal Reserve to do more (same link, unguarded here.)  The essay is reprinted here, but go check it out at the FT's webpage.  Enjoy!

I have an editorial at the Financial Times online here on monetary policy. It responds to Raghuram Rajan's editorial against "progressive economists" calling for the Federal Reserve to do more (same link, unguarded here.)  The essay is reprinted here, but go check it out at the FT's webpage.  Enjoy!

In 1926, John Maynard Keynes attacked socialist ideas for being “little better than a dusty survival of a plan to meet the problems of fifty years ago, based on a misunderstanding of what someone [Karl Marx] said a hundred years ago.” Right now the monetary policy debate in the US is centered on answering the problems of 30 years ago – when inflation and unemployment were both at high levels – based on a misunderstanding of what someone said 50 years ago: Milton Friedman.

The problem at the core of the US economy is that interest rates have been too high since the recession started. However, the Fed is not in a straightjacket. It has the tools to get the economy going again and must put them to use. The absence of pressure on the Fed, which has received only one dissenting vote demanding more stimulus but several to tighten earlier, to do more to reduce unemployment speaks to an intellectual paralysis as challenging as the orthodoxy of the gold standard and balanced budgets in the Great Depression.

The Fed uses monetary policy to balance unemployment and inflation. It has typically done this with an inflation “target”. But the target metaphor is inaccurate; it functions far more like a “ceiling.” People aim for targets but can go over them. Yet what we’ve seen over the last five years is that rather than a balance between its two goals, the Federal Reserve supports the economy up until the point where it is near the inflation target, and thereafter backs down from monetary stimulus. The market understands this and output remains equivalently depressed.

The Fed is fighting the last war: against 1970s stagflation. It is of course essential that the Fed maintains its hard-won credibility against runaway inflation. But the best way to do so isn’t to keep the economy in a perpetual state of high unemployment. It is to be explicit in what it wants to see accomplished and what it is willing to tolerate in order to get it. As Charles Evans, President of the Chicago Federal Reserve, recently pointed out, the Fed could “make a simple conditional statement of policy accommodation relative to our dual mandate responsibilities.” An “Evans Rule” would mean the Fed would agree to keep interest rates at zero and tolerate 3 per cent average inflation until unemployment went down to 7 per cent, setting market expectations in such a way that would allow aggregate demand to surge.

If conventional monetary policy was available – if interest rates were at 1 per cent instead of zero per cent – Mr Rajan’s argument suggests he wouldn’t lower interest rates further. Even though inflation has been lower than the target for several years, and unemployment is significantly higher than it should be, his editorial suggests he believes interest rates are already too low. Lower rates will not help the unemployed, since unemployment is localised. As he puts it, people are out of work in Las Vegas, but lower interest rates will increase demand in New York. So we won’t see increased employment, just savers “coerced” into buying risky bonds.

Contrary to Mr Rajan’s argument, the crisis is a national one. The median state’s unemployment rate is 1.65 times higher than it was before the recession began. New York has an unemployment rate of 8.5 per cent, up from its pre-recession rate of 4.7 per cent. Meanwhile, as Edward Luce wrote in the Financial Times yesterday, “risk capital is far harder to come by”. If lower rates would, as Mr Rajan says, increase demand for riskier assets, that’s exactly what the economy needs.

This would help with our current dilemma, but the Fed must also change its future approach to monetary policy. It has failed to balance inflation and growth, especially in periods of low inflation. Our low inflation target doesn’t work precisely at the moment when we most need it. Changing the target to inflation and growth added together, or what economists call NGDP (nominal gross domestic product), would better balance these goals. Alternatively, moving to a higher inflation target, say 4 per cent a year, would give the Fed much more room to fight recessions. Four per cent was the average annual rate during much of the past 30 years. The costs of a higher target would be minimal. Given that the cost of the current recession is in the trillions of dollars, this demands serious reconsideration.

It seems like a radical statement to some to note that the Fed has the ability to bring us closer to full employment with little risk and is simply choosing not to do it. They believe the Fed is full of disinterested technocrats doing the best they can. No doubt those at the Fed believe they are trying hard, but if the situation was reversed, with unemployment at ultra-low rates and inflation well above what anybody could possibly want, they would be working overtime to try and fix the problem. Chairman Bernanke, when he was a scholar of Japan, understood that a central bank could end up in a situation of “self-induced paralysis,” like where our current Federal Reserve is. And Milton Friedman himself, who people arguing against looser monetary policy would like to invoke, also understood that the Bank of Japan had “no limit” on closing output gaps if “it wishes to do so.”

Commentators would like to argue that monetary policy rewards some people over others, forgetting that mass unemployment is the most regressive policy imaginable. But beyond that, monetary policy is not a morality play, and it’s not about rewarding the good people and punishing the bad ones. It’s about stabilising growth, prices and maximum employment without overheating the system or letting it choke to death from a lack of oxygen. Now, more than ever, a commitment to both goals is necessary for the good of our economy.

 

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A Message to World Leaders: Ignore the Financial Markets

May 7, 2012Jeff Madrick

A solution for the eurozone? Listen to the people, not to the markets.

For 40 years, there has been a tug of war between government in democracies and what we may call “the other government.” By the latter I mean, of course, the financial markets. James Carville highlighted his concerns when he announced that in the next life he would want to be a bond trader. Alan Greenspan followed the bond markets religiously for signs of increased or reduced inflationary expectations.

A solution for the eurozone? Listen to the people, not to the markets.

For 40 years, there has been a tug of war between government in democracies and what we may call “the other government.” By the latter I mean, of course, the financial markets. James Carville highlighted his concerns when he announced that in the next life he would want to be a bond trader. Alan Greenspan followed the bond markets religiously for signs of increased or reduced inflationary expectations.

Now Europe faces the threat of a financial market rebellion. Democracy has spoken loudly in this weekend’s elections on the Continent and in England. Voters said, "We have had all the austerity economics we can take."  They threw over Sarkozy in France and many Conservative and Liberal candidates in England. In Greece they ran for the extremes. The moderate liberal Pasok party won the least votes in memory, but it may yet form a coalition to run a new government. Italian election results will be in soon.

And democracy is working! The instinct among those in the financial markets is that democracy usually reflects the weak-willed demands of the public. But the public is generally right this time, and it has been many times before. Austerity economics is self-destructive when economies are so weak.   

Yet of course the financial markets’ initial reaction to the European elections was to sell, as if austerity economics was actually working to make nations' bond payments easier to handle. It was not! But the markets fear that a new strategy will make matters worse.

Political leaders should ignore the financial markets in the short run, pure and simple. This may drive up financing costs for a while, but the eurozone should absorb those and adjust policies. The European Central Bank (ECB) ought to accommodate its needs. The right policies are stimulus from the current account countries and the end of extreme austerity in the periphery. Wages should rise in the eurozone core and stabilize in the periphery; they can even rise from their current lows in places like Greece. The 17-nation Eurozone or the 27-nation EU should issue jointly backed bonds to provide social safety net support to the financially weak nations, to raise demand for them and get their economies going, while reducing the extreme financial pain and sacrifice that now jeopardize social stability. As examples, the Greeks voted for extremist parties, the Le Pen party did well in France, and the Tea Party runs amok in the U.S. Austerity fever even grips Washington, which makes the November election especially important.

What the crisis requires is elected government, not bond trader government. Any idea that the financial markets are rational should have been discarded four years ago. They have been absurdly wrong for decades. In the U.S., they persistently overestimated future inflation by driving interest rates too high compared to the CPI and the GDP deflator. Greenspan treated them as the height of rational forecasting, when indeed they were simply following the latest conventional wisdom. In my informal opinion, he used long-term rates as a guide to policy. Now the ECB remains too tight as well. In the U.S., the “rational” bond traders actually traded what they thought the market would think, rather than what rational foretellers of the future would think. It was Keynes’ beauty contest analogy—choose the woman you think others believe is beautiful. The belief that the markets were right was the fallout of extreme efficient markets theory.

The media too often treated the markets as rational as well. Bond traders implicitly endorsed austerity economics until fairly recently, and the media usually reported them as being right. The supposedly sophisticated financial media (with some noted columnists as exceptions) wondered what could possibly work if not austerity. Now there are signs that the press is waking up to reality and realizing that it, along with the financial markets, is not working.

There are some signs of the ice breaking. The German finance minister announced it was okay for German wages to rise. They have actively restrained wage growth to make their exports more competitive for over ten years. The main sources of their demand were the European periphery, where wages were rising a bit due to a property bubble caused by irrationally low interest rates offered in the financial markets. But there are still signs of backward thinking. Many in Europe think of growth policies as nothing more than making labor markets more competitive through deregulation and reduced wages. As if the more flexible labor markets in the U.S. are leading to rapid recovery.

In sum, what’s needed in Europe is fiscal stimulus, a more accommodative ECB, social transfers from rich states, higher wages in many nations, a change in the silly EU agreement to keep deficits absurdly low, and industrial policy to gear capital investment across the continent, free of prejudice and nationalistic tendencies. The elections may bring some of this about. Then, once policies are working to support growth and reduce financial burdens as tax revenues rise, the financial markets will at last respond constructively. They must be waited out for now.

To put it most simply, what’s needed is the will of the government of the people to ignore the financial markets and stop treating them like a more rational government than democracy itself.   

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

Banner image courtesy of Shutterstock.com.

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Matt Stoller: Romney Could Be Better Than Obama for Wall Street Reform

Apr 27, 2012

Roosevelt Institute Fellow Matt Stoller joined Cenk Uygur last night on Current TV's

Roosevelt Institute Fellow Matt Stoller joined Cenk Uygur last night on Current TV's Viewpoint with Eliot Spitzer, where they discussed the presidential race and how it may effect efforts to end financial fraud and crack down on Wall Street. Surprisingly, Stoller thinks Wall Street reformers might have more success with Mitt Romney in the White House than they would if Barack Obama wins a second term. In the video below, he argues that "if you look at Mitt Romney's career, it's been about moving where the political winds are, and the interesting thing is that Barack Obama is far less flexible in terms of his policy approach than Mitt Romney has been." 

Matt says that there would be no surprises in Obama's second term when it comes to his relationship with the big banks. "We know what Barack Obama's policy architecture is, and it's to perpetuate these sort of fraud machines and to help them and to bail them out and to overrule and steamroll anyone in office who wants to take them on." He explains that while he doesn't believe Romney's policies would be any better, "I'm putting my hope in the public. The public has shown an unwillingness to take on Barack Obama. I think the public is far more willing to take on Mitt Romney, because Mitt Romney looks like a plutocrat, and they may say 'No, you have to justify your policies.'" In other words, while Romney might be naturally inclined to support his friends on Wall Street, he's also far more likely to bend to the will of the outraged electorate or pragmatic advisors. Matt argues that by contrast, Obama is "unwilling to be pushed in the right direction by people who know what they're doing" because he's "a neoliberal ideologue. He has a strong, rigid view on what is right, and he doesn't move, evidence be damned."

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Representative Bachus, FDIC and Voting Down Dodd-Frank's Resolution Authority

Apr 20, 2012Mike Konczal

So the House Republicans on the Financial Services Committee just voted to repeal "resolution authority."  What does this mean, and how can we compare it to previous actions by House Republicans?

So the House Republicans on the Financial Services Committee just voted to repeal "resolution authority."  What does this mean, and how can we compare it to previous actions by House Republicans?

A useful way of understanding both the financial crisis of 2008 and Dodd-Frank's response to it is through the idea of a "shadow banking system."  We have a set of regulatory rules, laws, practices and institutions from the New Deal that does well with the regular banking sector.  Over the past thirty years, a set of institutions started acting like banks without calling themselves banks, and thus did not have the same set of rules, laws and practices in place to regulate them as such.  Dodd-Frank's goal was to extend this regulatory framework to all "systemically risky financial institutions," or shadow banking institutions.

One of the main pillars of this is "resolution authority," which allows FDIC to takeover and wind-down a failing shadow bank.  Since the New Deal the FDIC can wind down a failing commercial bank without the system collapsing.  We found that putting commercial banks through bankruptcy was a disaster, so we created FDIC to allow a firm to fail and allocate losses in a way that mitigated panics and contagion.  Now the FDIC can use those powers on firms acting like banks but that are not hanging a "bank" sign on their window.  These powers include the ability to force big financial firms to write "living wills" to help with taking them down.

The FDIC has been making progress in formulating these powers.  They released a major report, The Orderly Liquidation of Lehman Brothers Holdings under the Dodd-Frank Act, which walks through how they would have handled 2008.  They've also answered conservative think tank critiques of resolution authority in what I think are correct and persuasive.

So when you hear people, especially on the right, criticizing Dodd-Frank's resolution authority your first step should be to analyze what they think of the FDIC more broadly.  Do they view it as a statist boot stamping on a human face forever?  Here's a Cato Handbook for Congress from 1997 arguing for the privatization of FDIC and mandating banks purchase private deposit insurance (perhaps from an exchange?).  Cato's 2001 call for privatizing FDIC is amazing for how disastrous every one of their assumptions and calls turned out to be in light of the financial crisis.  But, as they say, at least it's an ethos.

Representative Spencer Bachus (R - AL) is the current Chairman of the House Financial Services Committee, and just lead the Committee in a vote that, among many other things, repealed this resolution authority powers.  Bachus has argued "This authority is not a death panel for failed institutions...It is taxpayer-funded support for their creditors and counterparties.”

So where does Bachus stand on FDIC more broadly?  Here's the fascinating part: he lead a major 2002 move that expanded deposit insurance.  Bachus was the chief sponsor of the Federal Deposit Insurance Reform Act of 2002 which increased "the standard maximum amount of deposit insurance coverage from $100,000 to $130,000" and also adjusted it for inflation.

It's not clear why he supports FDIC when it comes to commercial banks but not shadow banks.  It's also not clear why, if he is so concerned about even the potential for moral hazard and taxpayer-funding being at risk (remember: FDIC recoups any expenses from fees on shadow banks, so taxpayers are always paid back), he took the bizarre step of expanding the amount of coverage FDIC gives to depositors (or the "creditors and counterparties" he rails about).  Did he feel creditors in the form of depositors weren't protected enough?

I've been reading about this 2002 bill, and if Bachus showed any concern about FDIC as an institution and a preference for putting commercial banks through bankruptcy instead of an orderly winddown I can't find it.  I'm trying to get a comment from the House Financial Services Committee on this but it certainly seems like a complete about face.  So one has to ask - if FDIC is a useful and appropriate way of allowing firms that hang a "bank" sign on the window to fail, why isn't it appropriate when a firm functions exactly like a bank?

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A Tale of Two Smiths: What Capitalism's Founder Would Think of Goldman's Greed

Apr 20, 2012John Paul Rollert

money-and-greed-150Adam Smith made a distinction between self-interest and selfishness -- and he knew that too much of the latter would lead a nation to ruin.

money-and-greed-150Adam Smith made a distinction between self-interest and selfishness -- and he knew that too much of the latter would lead a nation to ruin.

It has been over a month since Greg Smith’s letter of resignation sent Goldman Sachs into full PR panic mode. Since then, the firm has completed its great “muppet” sweep, Mr. Smith has secured a blockbuster book deal, and Lloyd Blankfein has found himself fighting off stories of a growing power struggle at the top of Goldman high command.

All of this makes for good copy, but it risks obscuring the enduring moral dilemma at the heart of the original letter. Namely, when it comes to doing business, can we make a meaningful distinction between self-interest and selfishness? Or, apropos of Mr. Smith, should a place like Goldman ever hold itself to a higher standard than “How much money did we make off the client?”

Another Smith certainly thought so: Adam Smith, the founding father of modern economics. He first made his name as a moral philosopher with The Theory of Moral Sentiments, a careful diagnosis of the concern we have for others, the attention we show ourselves, and how the tension between the two underwrites a common code of ethics.

One of the principal villains of Smith’s work was Bernard Mandeville, an occasional philosopher who impishly elided fine-grained distinctions. His scandalous work,The Fable of the Bees, was an allegorical poem involving a thriving beehive that bore more than passing resemblance to 18th-century England. Accounting for the affluence and ease the bees enjoyed, Mandeville made two contentions sufficient to give any high-minded economist heartburn. 

First, he claimed there was no essential difference, morally speaking, between the con man and the merchant. Both were driven by selfish instincts to get the better of their fellow man (or bee), and to that end, both trucked in deceit. Yes, the con man broke the law, but the merchant hid behind it.

Mandeville’s second claim was even more scabrous: So be it. Vice, not virtue, kept the wheels of commerce turning, with the benefits shared by all:

Thus Vice nurs’d Ingenuity,

Which join’d with Time and Industry,

Had carry’d Life’s Conveniences,

It’s real Pleasures, Comforts, Ease,

To such a Height, the very Poor

Liv’d better than the Rich before,

And nothing could be added more.

If these lines sound a little bit like "greed is good," then you get Mandeville’s point. Human beings are selfish, and thank goodness for it. Otherwise, we might end up like the bees, who are nearly wiped out after a spell of virtue saps their ambition, spoils their economy, and exposes them to outside attack.

When he stepped forward to challenge these views, Smith knew that he had to provide a compelling distinction between pursuits that are self-interested and those that are merely selfish. He granted Mandeville that there was “a certain remote affinity” between them insofar as both are motivated by a concern for personal well-being, but he appealed to common sense in saying that that we don’t view all human desires equally. My interest in having a clean shirt is not only legitimate, it's laudable, whereas my longing for a panda skin sportcoat is not only illegitimate, it’s an outrage.

Fair enough. But how exactly do we make these distinctions? Smith says we come by them naturally, by engaging others and discovering where our desires echo, overlap, and, finally, are at odds with one another. This process, iterative and ongoing, defines our moral sentiments, the felt necessities of right and wrong that shape and restrain our actions. It also defines for us what Smith called “a fair and deliberate exchange,” the very type of interaction at the heart of a commercial enterprise. 

When he turned his attention to economics, Smith did not think of himself as devising a system that was antagonistic or even alien to the one he had already developed. A free market provided individuals a space to engage each other in the pursuit of their own private interests, but that realm was not free from moral sentiments, nor should it be. Engaging in business was no less a part of human interaction than raising children or making friends, and the idea that a commercial sphere dominated by the grossest behavior would not contaminate the rest of society was not only silly, it was dangerously naive.  

This was Smith’s greatest difference with Mandeville: He did not believe that a nation in which people pursued their interests irrespective of one another would be affluent. It wouldn’t even be stable. Riven by “hostile factions,” society would seethe with conflict, for people with different interests would view each other with “contempt and derision.” In such an environment, Smith observed, “[t]ruth and fair dealing are almost totally disregarded,” for the interests of others have no moral claim on us.

Is Goldman Sachs such an environment? Greg Smith says so, but only the people who work there know whether the culture is as “toxic and destructive” as his letter claims. Yet to the degree that clients are viewed with contempt and derision, especially by leadership, Adam Smith would say that we should hardly be surprised, as the other Mr. Smith seems to be, by “how callously people talk about ripping their clients off.” This is to be expected. The line between selfishness and self-interest, in business as in all human pursuits, appears only when we feel that the interests of others occasionally require us to restrain our own. When we stop caring, that line disappears, and with it some very worthy things — personal integrity, self-respect, professional pride — that money can’t buy.

John Paul Rollert is an Adjunct Assistant Professor of Behavioral Science at the University of Chicago Booth School of Business.

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Does Expansionary Monetary Policy Primarily Benefit Finance and Rentiers?

Apr 17, 2012Mike Konczal

Joe Weisenthal calls it the Biggest Myth in Monetary Policy Today, and recently there's been a wave of posts about it.  Would another round of expansionary monetary policy at this point - in either a QE3, a conditional higher inflation target or NGDP targeting - primarily benefit the financial sector, rentiers and the wealthy?

Joe Weisenthal calls it the Biggest Myth in Monetary Policy Today, and recently there's been a wave of posts about it.  Would another round of expansionary monetary policy at this point - in either a QE3, a conditional higher inflation target or NGDP targeting - primarily benefit the financial sector, rentiers and the wealthy?

Here are Daron Acemoglu and Simon Johnson at Economix, making the case in Who Captured the Fed?:

Thus was born the idea of independent central bankers, steering the monetary ship purely on the basis of disinterested, objective and scientific analysis. When inflation is too high, they are supposed to raise interest rates. When unemployment is too high, they should make it cheaper and easier to borrow, all the while working to make sure that inflation expectations remain under control.

Increasingly, however, it seems that technocratic policy-making is just a myth. We have come full circle, and the Wall Street banks are calling the shots again...

Monetary policy has an impact on inflation, output and employment. But it also has a major impact on stock market prices. Any central banker raising interest rates is reducing stock market values and thus eroding the bonuses of top bankers and other chief executives....

Those people will lobby, asserting that higher interest rates will undermine the economy and cause us to plummet into recession, or worse....

We have lost track of the number of research notes from major banks pleading for easier credit, lower capital requirements, delay in implementing financial reforms or all of the above...

As the American economy begins to improve, influential people in the financial sector will continue to talk about the need for a prolonged period of low interest rates. The Fed will listen.

I'm a huge fan of both Daron Acemoglu and Simon Johnson (I'm about to start each of their books, Why Nations Fail and White House Burning), so I want to take this argument carefully.  How to approach it?

First off, it isn't just the financial sector calling for low rates (if they are, in fact, calling for it, as we'll see in a second).  A generic Taylor Rule, as Paul Krugman recently pointed out, calls for low rates until 2015.  Mess with the rule and the data a bit to adjust that date at the margins, but generic macroeconomic stabilization rules still see low rates for quite some time as necessary.

I always find the following to be a useful thought exercise: imagine we wake up and find that interest rates aren't set at zero but instead at one percent.  Whoops!  Should we turn around and have the Federal Reserve lower interest rates?  Those who think that Taylor Rule is correct and that the zero lower bound is blocking monetary policy from being effective would say yes; so would people who think the Federal Reserve isn't out of ammunition at the zero lower bound, people like Christina Romer and Charles Evans.

The post argues the Federal Reserve should, when unemployment is high, "make it cheaper and easier to borrow, all the while working to make sure that inflation expectations remain under control."  The post seems to concede that monetary policy works as normal, and unemployment is high and inflation expectations are, if anything, lower than what we want.

But I feel the entire vibe of the article is wrong. The financial sector is calling for higher interest rates.  This is why Carmen Reinhart told Institutional Investor that “Financial repression is manifesting itself right now” alongside the notion that financial repression is like “the rape and plunder of pension funds.”  Members of the financial community complain to reporters about "low interest rates that have been 'artificially manipulated' by the Federal Reserve."

Or take Brad Delong's six minute debate about QE with Jim Grant from last year.  As Delong summarized it (my bold):

I found it depressing because the major unfairness Grant focused on is that, because of the Federal Reserve, investors in money market funds can get only one basis point of interest. The 9% unemployed: they are not the victims. Those who cannot sell their houses because of the foreclosure overhang: they are not the victims. Those whose businesses crash because of slack aggregate demand call they are not the victims. The real victims are the rentiers who have a right to a nice solid well above inflation safe return, and from whom the Federal Reserve is stealing that right.

And I found what I could gauge of Jim Grant's worldview depressing as well. He seemed to be selling rentier-populist ressentiment. Grant's world is full of "takers"--and the Federal Reserve is helping them. And the biggest takers in Jim Grant's mind are the hedge fund operators of Greenwich, Connecticut. Why are they the biggest takers? Because they can borrow cheap, at low interest rates, and put the money they borrow to work making fortunes. If only the Federal Reserve would shrink the money stock and raise interest rates! Then the hedge funds would have to pay healthy interest rates for their cash! Then the profits would flow to the truly worthy: the rentier coupon-clippers now suffering with their one basis point yields.

Never mind what a policy of monetary restraint to "normalize" interest rates would do to the unemployed...

You can read that in the recent statement by Mohamed A. El-Erian of Pimco, who, as Karl Smith noted, wants the Federal Reserve to focus on microeconomic goals instead of the macroeconomic problem of full employment.  This isn't new.  As Keynes noted, "the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners."

The implicit argument is that the interest rate compatible with full employment is too low for financial investors to accept.  Do we then just accept mass unemployment and the subsequent hysteresis-induced slowing of growth and human potential so Jim Grant and Pimco can make a profit they feel is worthy of their financial talents?  Of course not.

Now if you check out Jim Grant's argument to Brad Delong, there's an argument that we should split finance in two sectors - an established one that is hurt by low interest rates and one that is more focused on intermediation and/or trading for themselves, which could benefits from low rates and bubbles is stock prices and assets.

The stock market is following unemployment claims pretty closely, so it isn't clear to me that the stock market is broken from its function as a prediction of future economic activity (i.e. in a bubble).  I like two MIT economists arguing that we should disconnect stock prices from the real economy, but I think that requires an additional layer of explanation.  For instance, if monetary policy was constant and we passed another round of deficit-funded fiscal stimulus to rebuild infrastructure and employ people, I would expect the stock market to increase because the economy would be stronger.

If that's the case, that there's two financial sectors and one of them benefits from monetary expansion we have to ask - so what?  If monetary policy is working, and bringing us closer to full employment, and some hedge funds and Wall Street traders make some money off of it, why should that impact our commitment to using all levers for full employment?  Monetary policy is not a morality play, and it's not about rewarding the good people and punishing the bad ones.  It’s about stabilizing growth, prices and maximum employment without overheating the system or letting it choke to death from a lack of oxygen.

As Josh Mason's great guest post here mentioned, if we are worried about where the financial sector channels money, that's an argument for regulation instead of mass unemployment and scarce liquidity.  We should commit to better regulations as well as progressive taxes and/or financial taxes.  If those aren't in place (and I don't believe they sufficently are), those shouldn't be attempted with monetary policy, and they absolutely must not distract us from taking our eye off the goal - full employment in the wake of the Great Recession.

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For Capitalism to Survive, Crime Must Not Pay

Apr 12, 2012Bruce Judson

money-justice-scalesUnequal enforcement of the law will distort and destroy any capitalist society, and we may be witnessing just such a downward spiral in the financial sector.

money-justice-scalesUnequal enforcement of the law will distort and destroy any capitalist society, and we may be witnessing just such a downward spiral in the financial sector.

Capitalism is not an abstract idea. It is an economic system with a distinct set of underlying principles that must exist in order for the system to work. One of these principles is equal justice. In its absence, parties will stop entering into transactions that create overall wealth for our society. Justice must be blind so that both parties — whether weak or powerful — can assume that an agreement between them will be equally enforced by the courts.

There is a second, perhaps even more fundamental, reason that equal justice is essential for capitalism to work. When unequal justice prevails, the party that does not need to follow the law has a distinct competitive advantage. A corporation that knowingly breaks the law will find ways to profit through illegal means that are not available to competitors. As a consequence, the competitive playing field is biased toward the company that does not need to follow the rules.

The net result of unequal justice is likely to be the destruction of the overall wealth of our society. I don’t mean the wealth of individuals; I mean the total wealth of goods and services that are the benefits of healthy competition. To the extent that unequal justice prevails, entities that are exempt from the laws will, in all likelihood, be more profitable than law abiding competitors. Then they use their profits to further weaken competitors by using their illegal profits to further build their businesses at the expense of competitors. All of this business building activity is based on a foundation of sand, and ultimately the entire industry — or even the larger economy — becomes distorted. The “rogue” company gains power, changes markets, and destroys direct and indirect competitors because it is playing by different rules.

The above scenario is not simply a hypothetical example. It is exactly what happened at Worldcom. As the company succeeded because of its then-unknown illegal activities, it grew, managed to take over MCI (one of the true innovators in the industry), and weakened competitors who could not match its profitability. Ultimately the whole edifice collapsed, causing massive wealth destruction in the telecommunications industry and the economy as a whole.

In the WorldCom example, appropriate legal enforcement and prosecution did not occur until the accounting fraud and other crimes were detected. Thus, while it is more an example of undetected accounting fraud than unequal justice, the results are illustrative. In a society with unequal justice, the appropriate laws are never enforced, so entities acting outside the law continue to grow more profitable and powerful (as compared to everyone operating according to the rules). Moreover, the profits from illegal activities can be used to subsidize competition across the spectrum of business activities of companies acting outside the law — which further enforces the competitive advantage, and possible hegemony, of entities operating on a different playing field.

Now, here’s why the above discussion is so important if we hope to return our economy to the dynamo of wealth creation for the entire society that is, in part, what made America a great nation. As economic inequality increases, two sets of laws implicitly develop: one set for powerful members of society and another set for the weaker. These two sets of laws are often defined by a single question: who is prosecuted for crimes and who is not. When powerful members of society can break the law without fear of prosecution, they will inevitably exploit this competitive advantage by engaging in profitable (but illegal) activity. At the same time, the weaker members of society can’t compete; they are shackled by the need to follow the laws of the land. Meanwhile, everyone loses as the profits of companies violating the law distort the competitive playing field and the activities of everyone in it and divert societal activity from the creation of real wealth.

Join the conversation about the Roosevelt Institute’s new initiative, Rediscovering Government, led by Senior Fellow Jeff Madrick.

In effect, equal enforcement of the law is not simply important for democracy or to ensure that economic activity takes place, it is fundamental to ensuring that capitalism works. Without equal enforcement of the law, the economy operates with participants who are competitively advantaged and disadvantaged. The rogue firms are in effect receiving a giant government subsidy: the freedom to engage in profitable activities that are prohibited to lesser entities. This becomes a self-reinforcing cycle (like the growth of WorldCom from a regional phone carrier to a national giant that included MCI), so that inequality becomes ever greater. Ultimately, we all lose as our entire economy is distorted, valuable entities are crushed or never get off the ground because they can’t compete on a playing field that is not level, and most likely wealth is destroyed.

The central question for the nation right now is whether we are, in fact, in the middle of the dire and dangerous cycle described above. Washington insiders have reportedthat the Justice Department is explicitly choosing not to prosecute seemingly illegal bank activities. Indeed, in my previous column I noted that the audits released by the Office of the Inspector General of the Department of Housing and Urban Development detailed activities by senior banking officials associated with the robo-mortgage scandal that seem to constitute clear evidence of multiple federal felonies, and most likely violated state laws as well. Yet no one has been indicted.

In an entirely different sector of financial services, the venerable American Banker just completed a three-part series on past credit card debt collection practices. Many of these activities are now under investigation by the Office of the Comptroller of the Currency. But if the past is prologue, it’s unlikely that any criminal indictments will result, no matter what these investigations uncover.

Indeed, as has been repeatedly documented, when illegal activity is detected, the SEC settles with the banks in civil lawsuits for sums that, while appearing to be large, are a pittance compared to the profits of the institutions involved. While these same activities would in many cases constitute criminal violations, no prosecutions have occurred. The bankers who operate our largest financial institutions can rightfully assume that they are above the laws that constrain everyone else.

The evidence that crime does, in fact, pay is perfectly clear. Before the 1990s, the total profits of the financial services sector rarely accounted for more than 20 percentof the total corporate profits of the nation’s economy. By 2005, they averaged aboutone-third of all corporate profits. After sinking as a result of the crash, they rebounded dramatically. By early 2011, the sector once again accounted for about 30 percent of total corporate profits. As The Wall Street Journal noted, “That’s an amazing share given that the sector accounts for less than 10 percent of the value added in the economy.”

Finance serves a valuable function. Its principal role is to ensure that capital is most efficiently allocated in a society. However, financial services are also an intermediate good. They grease the wheels, through capital allocation, so that real goods and services that people consume or experience can be created. Yet, as the Journal noted, the sector’s profits are far in excess of the value the sector adds to the overall economy. At the same time, recent academic research has suggested that the financial sector has become less efficient over time, with the gains from information technology cancelled out by increases in trading activity (whose social value is certainly open to question).

This will ultimately lead us in a downward spiral: A few large powerful entities and people operate above the law, inequality is extreme, citizens have lost faith in their political systems, real societal wealth is not created, and political instability becomes a potential reality. John Adams held that “We are a nation of laws, not men” for a valid reason. Now, we need those charged with enforcing our laws to do their job.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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