Bubble, Bubble, Toil and Trouble: Rethinking our Foundations

Aug 13, 2010Joe Costello

money-smile-150It's time to rethink the basis of our economy and our politics.

money-smile-150It's time to rethink the basis of our economy and our politics.

Me and my baby gonna get on a train that's gonna take us away,

We're gonna live in a tent, we're gonna pay no more rent, we're gonna pay no more rates,

We're gonna live in a field, we're gonna buy me gun to keep the policemen away.

Gonna pass me a brand new resolution,

Gonna fight me a one man revolution, someway,

Gonna start my rebellion today.

But here come the people in gray,

To take me away.

-- Ray Davies

Bubble, Bubble

Gillain Tett has a must read piece (h/t Yves) in the FT regarding the heart of the past financial bubble: shadow banking. It's based on a good IMF paper, but good information can indeed come from bad sources. The piece is much easier to understand if you replace the term "rehypothecation" with "Ponzi". Here's the nut:

Second, as the IMF paper shows, this rehypothecation [Ponzi] activity can be so frenetic it can significantly affect the overall volume of leverage in the system. The IMF paper calculates that, by 2007, the seven largest US brokers were getting about $4,500bn of funding from rehypothecation [Ponzi] activity, most of which was not recorded in their accounts or the US government's flow of fund data.

That's $4.5 trillion, one third of the entire US economy. And here, dear reader, you see why all the blowing in the world by Mr. Bernanke and every other central banker is not going to reflate the bubble. We have a choice: we can clear the books and get rid of all the bad debt, or we can all spend the next twenty years working in a crippled economy, paying off a bunch of debt that was fraudulent at its foundation.

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The financial press has been gushing this morning with the news that German economy grew, wait for it, a whole 2.2%. That's the largest growth rate in the German economy in twenty years. The FT describes it as "stellar". Phew! Talk about your "new normal". Just think, if the Euro goes down to fifty US cents, or the neo-Deutsche Mark is released at 75 cents, the Germans might reach 3%.

And Trouble

Barbara Ehrenreich has a piece in The Nation in which she states, "the federal government, avatar of liberal hope for at least a century, has become hopelessly undemocratic, poisoned by corruption and structurally snarled by partisan divisions." It even gets better (though there's a gratuitous slam at the Tea Partiers at the end). The final step of a liberal education will be the over-, and too often badly-educated left understanding it does indeed have some common ground with "angry white-boy America." That would be trouble indeed.

Liberals of the United States: run from DC, you have nothing to lose but your chains.

Joe Costello was communications director for Jerry Brown’s 1992 presidential campaign and was a senior adviser for Howard Dean’s effort in 2004.

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How I Learned to Quit Worrying and Love Corporate Globalization

Aug 12, 2010Joe Costello

money-globe-150Corporate globalization is in vogue for politicians, but it benefits no one.

money-globe-150Corporate globalization is in vogue for politicians, but it benefits no one.

General Ripper: It's incredibly obvious isn't it? A foreign substance is introduced into our precious bodily fluids, without the knowledge of the individual, certainly without any choice. That's the way your hardcore Commie works.

Captain Mandrake: Tell me Jack, when did you first develop this theory?

General Ripper: Well, I first became aware of it Mandrake, during the physical act of love. A profound sense of fatigue and feeling of emptiness followed. Luckily, I was able to interpret these feelings correctly...loss of essence.

-- Dr. Stangelove

One interesting thing that has happened over the last several decades is a shift in our elites' view of international conspiracies. If you are unfortunately old enough to remember our existential obsession with "international communism," you will remember for the most part it was party line for both parties to look with suspicion on things labeled "international" or "global." Yet a funny thing happened with the rise of corporate globalization: suddenly "international" not only lost suspicion, but was necessary. It's to the point now where a Democratic administration can cut auto workers' pay in half in the name of international competition, and the move is met not only by complete silence but approval from the workers so-called representatives, the UAW.

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The Washington Post has a story about a report released by the Congressional Oversight Panel on the bank bailouts, bringing to light one of the dirty little not-so-secrets -- a good chunk of the bailout money went to foreign firms:

The federal government's effort to stabilize the financial system in 2008 by flooding money into as many banks as possible resulted in a boon to many foreign firms and left the United States shouldering far more risk than governments that took a narrower approach, according to a new report by a panel overseeing the Treasury's $700 billion bailout fund.

They cite as a case study the bailout of insurance giant American International Group. While the Treasury committed up to $70 billion to AIG through its Troubled Assets Relief Program, the report states, much of that money ended up in the coffers of foreign trading partners in France, Germany and other countries. The cash that the United States poured into AIG alone equaled twice what France spent on its total capital injection program, and half what Germany spent.

AIG was a hole big enough to save the world -- call it "loss of essence". (See good piece on AIG by William Greider.) Corporate globalization's impact on the planet has pretty much been the same as nuclear bombs: it entirely rearranges the globe and is good for neither those "controlling" matters, nor those on the receiving end. It is beneficial only in the short-run for the bomb makers. At some point, we will realize this is simple madness.

Joe Costello was communications director for Jerry Brown’s 1992 presidential campaign and was a senior adviser for Howard Dean’s effort in 2004.

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The Murky Realm of (Derivatives) Clearing

Aug 9, 2010Wallace Turbeville

spending-money-150For clearinghouses to work, we must have regulation that challenges the way we think about them.

spending-money-150For clearinghouses to work, we must have regulation that challenges the way we think about them.

Matt Taibbi's latest article in Rolling Stone appropriately characterized the financial reform act as neither an "FDR-style, paradigm-shifting reform, nor a historic assault on free enterprise." While generally describing the act as a "cop out," he identified the Fed audit requirement and the Consumer Finance Protection Bureau as positive developments. But he viewed the requirement that many derivatives be cleared as "the biggest win of all." Alas, Matt may have been too generous, or at least premature.

Mandating clearing was a convenient and simple approach for Congress. The idea was to shift the basic derivatives trading risks in an appreciable percentage of the market away from the banks to reduce systemic risk. The problem is that very few people are equipped to understand just how the mandate might work in practice.

How much of the market? What are the consequences? I have not seen evidence that anyone on the government's side can answer these questions effectively. This is not intended to demean anyone's intellect. Clearing theory is complicated and arcane. It was always a backwater of finance and was taken care of by people at the clearinghouses and in the back offices of the banks. Clearinghouses were largely allowed to regulate themselves through a process of self certification. This limited the Commodity Future's Trading Commmison's practical involvement with the markets.

Then clearing became the centerpiece of derivatives reform. We decided to concentrate the most dangerous financial risks in the galaxy in a couple of organizations.

As fate would have it, I am one of the few people around who knows something about the clearing business and theory and is not employed by an investment bank or clearinghouse. At the end of my career on Wall Street, I was hired to perform a financial autopsy of the special purpose derivatives clearinghouse set up by California as part of an innovative power market structure. It had failed in the state's power crisis of 2001-02. Observing the tremendous systemic risk generated by using conventional clearing techniques for all but straightforward derivatives, I embarked on a seven year quest. I formed a company that designed a mathematical, IT and legal structure to provide a transparent and orderly system to manage the risks of those derivatives which shouldn't be cleared conventionally.

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Imagine my surprise when the banks decided against using the system. They preferred taking advantage of the opaque and chaotic bi-lateral derivatives market. The profit potential of the shadowy chaos outweighed efficiency, transparency and sensible risk management. At least I can claim to have been ahead of the times.

There are two dangerous forces at work in the endeavor to push derivatives into clearinghouses:

1) Concentrating risks only makes sense if the risks associated with the cleared derivatives can be adequately managed. There is no way to collect enough collateral to cover all potential losses if a derivatives trader defaults. The credit risk embedded in a derivative is, by definition, limitless. Clearinghouses use statistics to measure probable losses. They will require sufficient collateral so long as the statistical analysis reflects reality. The further a type of derivative strays from the standard, liquid markets, the less valid is the statistical measurement of risk. It appears that most people involved with the reform legislation thought "unclearable" transactions were only one-off deals with non-standard contractual terms. The far greater issue concerns commodity classes and financial indices for which statistical risk measurement is unreliable. Historical market data may be too meager or the daily volume may make predicted prices "untransactable." For certain classes of derivatives, statistical risk measurement is simply impossible, not just unreliable.

One might think that clearinghouses would only take on these types of derivatives if the risk of doing so were prudent. One would be wrong. A byproduct of financial deregulation is fierce competition among a handful of clearinghouses. Profit depends on volume. Even before the crisis, competition had already pushed clearinghouses to the edge of prudence and beyond. We cannot assume that clearinghouses will be rational or that the government, so invested in clearing as an answer to the derivatives dilemma, will enforce prudence. Sophisticated and well-capitalized banks recently evaporated because they transacted business that, in retrospect, made no sense. Why not clearinghouses?

The risk is that we revisit the world of "Too Big to Fail."

2) Dealer banks have enormous influence over clearinghouses because they can control volume. Of the two major US clearinghouses, the IntercontinentalExchange (ICE) and Chicago Mercantile Exchange (CME), ICE is more susceptible. After all, the banks created ICE, largely to compete with CME. But CME is under bank influence as well. ICE and CME raced to clear credit default swaps after the market collapse in September 2008. The ICE effort was successful, in part because the special purpose clearinghouse it set up agreed to give the banks a 49.9% share of the revenues. CME naively created a structure with a trading feature attached, assuming that real-time CDS price transparency would be an attractive add-on. The transparency feature angered the dealer banks, which were already inclined to prefer the ICE structure for obvious reasons. The dealers have largely declined to support CME's massively expensive effort. Privately, CME has vowed never again to take on a project that the dealer banks don't support.

Clearinghouses may take on derivatives imprudently, but the banks may use their influence to limit clearing. These do not balance one another. The banks might well support clearing of some risky derivatives and, at the same time, use their influence to resist clearing of other derivatives which should be cleared.

These pitfalls can be avoided. Regulatory implementation and oversight can establish defenses. However, the process must aggressively challenge conventional notions of how clearinghouses work. Most of all, the regulators and proponents of reform have to be aware that the banks and clearinghouses are not necessarily friends. The banks will try to use their superior knowledge, resources and influence to craft a structure that allows them to continue business as usual. I despair that there is no practical counterbalance to the banks, such as AFR and other public interest groups that were so effective during the legislative process.

It turns out that this part of financial reform is a marathon, not a sprint.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

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On Elizabeth Warren, Financial Literacy and Complexity

Aug 5, 2010

The GOP will have a hard time blasting someone who works for financial literacy and against complex products.

The recommendations for Warren keep coming in: The New York Times makes the best case on her credentials, but there are other cases to be made. Matt Yglesias writes that it would rally the base. Noam Scheiber does the math and finds Warren can likely be confirmed.

The GOP will have a hard time blasting someone who works for financial literacy and against complex products.

The recommendations for Warren keep coming in: The New York Times makes the best case on her credentials, but there are other cases to be made. Matt Yglesias writes that it would rally the base. Noam Scheiber does the math and finds Warren can likely be confirmed.

Also 141 academics signed a petition supporting Warren. Notably, the Roosevelt Institute's Make Markets Be Markets conference contributors Michael Greenberger and Richard Carnell signed it. Warren presented the Consumer Financial Protection Bureau at our conference earlier this year in the video above, and it it is difficult to think of a more successful champion for the project.

Some people like Karl Smith aren't convinced: "Is there anyone who disputes that Elizabeth Warren has signaled that she will be a crusader on behalf of consumers; that she views consumers as having gotten a raw deal from the financial system and that she intends to do what she can to change that?...My ideal vision of the government is as an institution that is a fair and neutral arbiter of disputes. One that ensures that fraud, deception, bullying and coercion don't go on." His commenters caught the fact that he's contradicting himself there, and that fighting fraud, deception, bullying and coercion necessitate a role that speaks on behalf of consumers in the same way a lawyer fights for a client.

But let's unpack Warren's writings, as I read them. Others may have a different interpretation. I think there are two main threads in what I've read of Warren's popular work that are relevant, and that is her approach to consumer financial literacy and her arguments about complexity.

Consumer Financial Literacy as a buffer against Shocks

If you look at the final financial reform bill you get this in there:

(d) OFFICE OF FINANCIAL EDUCATION.- (1) ESTABLISHMENT.-The Director shall establish an Office of Financial Education, which shall be responsible for developing and implementing initiatives intended to educate and empower consumers to make better informed financial decisions.

There's growing scholarly evidence that a lack of financial literacy was a contributor to the financial crisis. My suspicion is as people continue to investigate we'll find is that a lack of financial literacy made people vulnerable to fraud.

So it's worth noting that Dr. Phil has endorsed Warren for her efforts, both on her show and in general, at increasing financial literacy. I know Karl Smith really wants to find a proto-Marxist seething with the desire to destroy Wall Street buried here somewhere, but practically speaking Warren does stuff like this: Conducting a Financial Fire Drill. "1. Can your family survive without one income?...2. Can you downshift your fixed expenses?...3. What is your emergency back-up plan?"

And as for blaming Wall Street for everything, that's not what she writes to consumers. If you read her book All Your Worth, she writes about mental traps that keep people in debt like this:

Finger-Pointing....The trap is in the hidden message: You are telling yourself that you are off the hook. The financial problems you face are someone else's doing, and therefore it's all out of your hands. You are telling yourself there's nothing you can do. And if there is nothing you can do, then you have a free pass to sit on your duff....The truth is that there will always be a reason why you can't balance your money....Move past the blame because it isn't helpful. In fact, it is worse than not helpful; it is downright destructive....Because there is always something you can do. (p. 59-61)

I like the idea of economists, Wall Street, libertarians and bank-friendly democrats terrified by the idea of a person who uses the word "duff", but it's important to think of how much this doesn't sync with where a lot of thinking is. This is an idea that debt could be a trap for consumers, that business models have evolved to make their biggest profits, not by getting repaid, but by keeping people underwater for as long as possible and that customers need to be wary. This goes against both the economic notion of a consumer as a fully-informed consumption smoothing robot and the idea that the financialization of our lives doesn't come with a dark side.

And I'll over-read the other part, the idea that the middle class is facing a new type of economic vulnerability. This one is centered around the rising costs of the bundle of middle class stability goods like transportation, child rearing and health care, and all the cheap stuff you can get at the mall doesn't substitute for that. This calls for a re-commitment to stability and economic security for families that, frankly, centrist aren't willing to fight for. I think this is what is scary to elites, that the system we've built isn't working for a lot of Americans, though it's common sense for most of us out there. Warren advises consumers to be extra conscious of this as they set up their budgets, spending and households, urging people to take responsibility and think like a risk manager.


The other theme is complexity. In the video above, Warren talks about the evolving complexity of credit cards contracts. I'm not sure if people like Smith are concerned about this. If the idea that the financial sector is putting on complexity without adding real value comes across as dangerously radical, then there are a lot of respectable dangerous radicals out there.

Rick Bookstaber, Senior Policy Adviser at the SEC, who has also worked at Bridgewater Associates, ran the Quantitative Equity Fund at FrontPoint Partners and was in charge of risk management at Moore Capital Management, thinks that a lot of the complexity in the derivatives market isn't adding much value, and writes about a flight to simplicity in derivatives.

Kevin Warsh, a member of the Board of Governors of the Federal Reserve System to the New York Association for Business Economics, says that "Asset quality and funding sources for financial firms must be more understandable and readily comparable among peers. Stakeholders can then make better informed judgments of potential risks and rewards." Which is the same exact thing Warren says about consumer financial products like mortgages and credit cards.

American Enterprise Institute Fellow Alex Pollack created a one-page mortgage. (Warren's talk used a two-page mortgage, so Pollack must be twice the radical Warren is.)

More disclosure doesn't always help. This area is where the CFPB could, in theory, make the most difference. Warren likes to quote an AARP poll that asked if people want a two page credit card agreement, no tricks, no traps. 96 percent of Americans said, "That's what I want." 91 percent: "That's what I strongly want."

(If you are the type of person hyperventilating at the idea that a perfect market should have provided this by now, I'd recommend checking out Shrouded Attributes and Information Suppression in Competitive Markets by Gabaix and Laibson.)


I'm not much of a political analyst, but I'd note that I think Republicans would have a hard time going hard against her. I'm not sure if the Republicans could opposed her as a block. Shahien Nasiripour reports about the waffling inside the Republican camp already.

A nomination battle in which the GOP is blasts Elizabeth Warren is going to hurt them with women voters, voters they are looking to test out strategies to reach. For a GOP looking to bring on women voters who like Sarah Palin, the idea of them yelling "who cares about a fee that is only $30?" or "$1,000 in medical costs? That's chump change!" at Warren would probably not work that well with women voters who fight to make sure the budget lasts the whole month.

And remember the Credit Card Bill of early last year passed the Senate 95-to-5. This was May, 2009, so we were already into GOP Waterloo territory on the Obama domestic agenda. That's a lot of votes for the Senate; I think Republicans can't quite defend this part of the financial sector in the same way that they work to get expanded derivatives loopholes.

And the GOP managed to make the financial bill much weaker and then voted against it anyway. And it's not going to cost them anything that they did this. So turning up the heat with this nomination battle has to look good for voters.

Mike Konczal is a Fellow at the Roosevelt Institute.

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The Real Reason Banks Aren't Lending

Aug 4, 2010Marshall Auerback

tim geithner 150Banks won't lend until the American people are creditworthy again -- and that takes full employment.

tim geithner 150Banks won't lend until the American people are creditworthy again -- and that takes full employment.

Our Treasury Secretary has conceded that it is still a "tough economy" for most Americans, and warned it's possible the unemployment rate will go up for a couple of months before it comes down. Given the constellation of recent economic data that has come out, Tim Geithner is probably correct.

The US economy is showing signs of slowing, as the fiscal stimulus is dissipating and spending contractions at the state and local government level increasingly undermine the injections from the federal sphere. Worse, it appears that much of the growth has resulted largely from a replenishment of inventories, a process which largely seems to have run its course. Excluding this inventory re-stocking, underlying growth was a very tepid 1.5% annualised. Fiscal drag from state spending contraction could well reduce overall consumption even further in the quarters ahead, an ominous trend for future growth and employment prospects. While we may not experience a "double dip" in purely technical terms, it will certainly feel like a return to recession for most Americans if Geithner's assessment is anywhere close to being accurate.

At this stage, there is a widespread belief that government fiscal stimulus has run up against its "limits" on the grounds of "fiscal sustainability" and the need to retain "the confidence of the markets". Consequently, goes this line of reasoning, as private credit conditions improve the private sector must pick up the baton of growth where the public sector leaves off. If this proves insufficient, there is room for an expansion of monetary policy via "quantitative easing".

Recent speeches by the Fed suggest that they are indeed laying the groundwork for such a return to quantitative easing, or "QE2" as the markets are now calling it. It's not the name of a ship-liner: quantitative easing essentially means that the central bank buys up high yielding assets and exchanges them for lower yielding assets. The premise is that the central bank floods the banking system with excess reserves, which will then theoretically encourage the banks to lend more aggressively in order to chase a higher rate of return. Not only is the theory plain wrong, but the Fed's fixation on credit growth is curiously perverse, given the high prevailing levels of private debt. More borrowing is the last thing the highly stressed and leveraged American household requires today.

As we have argued many times in the past, credit growth follows creditworthiness, which can only be achieved through sustaining job growth and incomes. That means embracing stimulatory fiscal policy, not "credit-enhancing" measures per se, such as quantitative easing, which will not work. QE is based on the erroneous belief that the banks need reserves before they can lend and that this process provides those reserves. But as Professor Scott Fullwiler has pointed out on numerous occasions, that is a major misrepresentation of the way the banking system actually operates:

In the U. S., when a bank makes a loan, this loan creates a deposit for the borrower. If the bank then ends up with a reserve requirement that it cannot meet by borrowing from other banks, it receives an overdraft at the Fed automatically (at the Fed's stated penalty rate), which the bank then clears by borrowing from other banks or by posting collateral for an overnight loan from the Fed. Similarly, if the borrower withdraws the deposit to make a purchase and the bank does not have sufficient reserve balances to cover the withdrawal, the Fed provides an overdraft automatically, which again the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed.

The point of all this is that the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank's ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding.

What is required to drive lending is a creditworthy borrower on the other side of the bank lending officer's desk, which means an employed borrower, whose income allows him to sustain regular repayments. Absent that, there will be no lending activity. It is pointless to blame the evil bankers for this of state affairs, since they don't control fiscal policy, which is the remit of the Treasury.

For all the talk from policy makers about not repeating the mistakes of Great Depression, we seem to be perilously close to doing precisely that. This is largely based on a poor understanding of the economic dynamics of that period, even by that noted scholar of the Great Depression, Ben Bernanke.

Most people believe the economy crashed between 1929 and 1932 and then remained depressed until the Second World War, which finally mobilized the economy's idle resources and brought about a full recovery. That's complete bunk if you calculate the unemployment data correctly (see here for an explanation) . Even leaving aside the unemployment calculations, it is abundantly clear that, once the Great Depression hit bottom in early 1933, the US economy embarked on four years of expansion that constituted the biggest cyclical boom in U.S. economic history. For four years, real GDP grew at a 12% rate and nominal GDP grew at a 14% rate. There was another shorter and shallower depression in 1937 largely caused by renewed fiscal tightening (and higher Federal Reserve margin requirements). This second depression has led to the misconception that the central bank was pushing on a string throughout all of the 1930s, until the giant fiscal stimulus of the wartime effort finally brought the economy out of depression.

That's incorrect. The financial dynamics of the huge economic recovery between 1933 and 1937 are extremely striking. Despite their insistence that changes in the stock of money were behind all the cyclical ups and downs in U.S. economic history, even economists Milton Freidman and Anna J. Schwartz in their "Monetary History of the United States" conceded that the money aggregates did not lead the U.S. economy out of the depression in 1932-1933.

More striking, private credit growth seemingly had nothing to do with the takeoff of the economy. Industrial production, off the 1932 low, doubled by 1935. By contrast, bank credit to the private sector fell until the middle of 1935. Because of the collapse in nominal income during the depression, the U.S. private sector was more indebted than ever in the Depression lows. Yet somehow it took off and sustained its takeoff with no growth in private credit whatsoever. The 14% average annual increase in nominal GDP from early 1932 to 1935 resulted in huge private deleveraging, largely as a consequence of aggressive fiscal stimulus.

Tim Geithner should be aware of this, but like his old colleagues at the Fed, his main obsession remains deficit reduction, which is why he is now expending considerable political capital on allowing the Bush tax cuts for the wealthy to expire. Ironically, one of the more amusing aspects of this particular issue is the sight of Republicans such as Mike Pence and Eric Cantor arguing that job creation is more important to Americans than deficit reduction (hence, we should extend the Bush tax cuts for the wealthy, even as their party fought vociferously against extending unemployment insurance benefits for the past several months).

The reasoning of Cantor and Pence is perverse, but on balance -- however disingenuous and politically insincere -- we support the GOP's born again support for job creation over deficit reduction. We just wish they would refocus on something that would really help reduce unemployment, such as a Job Guarantee Program. A disproportionate amount of the stimulus program has been enjoyed by those who least need it. We would like to see the Obama Administration at least begin to make the case that fiscal stimulus, whether via tax cuts or direct public investment, is still required to generate more demand and employment. They should not concede anything in this area to the politically insincere GOP, which never met a tax break for the top 2% of the population that they didn't like.

There might well be very good reasons, on grounds of social equity, to minimize the income gap between the rich and the poor, but Geithner and Obama are not making the case for the elimination of the tax breaks on these grounds. Rather, they continue to do so on the basis that this is the "fiscally responsible" thing to do. This is also consistent with the President's odd championing of a "bipartisan commission" to study entitlement "reform", where the focus appears to be on cutting Medicare and Social Security -- in effect gutting the Democrats most substantial social legacy of 20th century.

The only concern about government deficit spending should be a whether it generates inflation, in which case it should of course be slowed down. None of those critique the ongoing fixation on fiscal sustainability, or "pork", or "entitlement reform", do so on the basis that there are "no limits" on government deficit spending, as has been alleged. What we do argue is that deficit cutting per se, devoid of any economic context, is not a legitimate goal of public policy for a sovereign nation. Deficits are (mostly) endogenously determined by the performance of the economy. They add to private sector income and to net financial wealth. They will come down as a matter of course when the economy begins to recover and as the automatic stabilizers work in reverse (i.e. tax receipts rise and social welfare expenditure comes down). When our policy makers begin to understand this, we can stop with the counsel of despair and actually do something that reduces unemployment today, not years from now -- when it will be far too late.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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Do Deficits Matter? Foreign Lending to the Treasury

Aug 3, 2010L. Randall Wray

money-globe-150How can we reconcile our lending to China with the interests of the United States?

money-globe-150How can we reconcile our lending to China with the interests of the United States?

Deficit hawks raise three objections to persistent federal government budget deficits: a) they pose a solvency risk that could force to government to default on its debt; b) they pose an inflation, or even a hyperinflation, risk; and c) they impose a burden on our grandkids, who will have to pay interest in perpetuity to the Chinese who are accumulating treasuries as well as power over the fate of the dollar.

I have argued that federal budget deficits and debts do not matter so far as national solvency goes (see here). The sovereign issuer of the currency cannot be forced into an involuntary default. I have also dealt with possible inflation effects of deficit spending (see here). To summarize that argument as briefly as possible, additional deficit spending beyond the point of full employment will almost certainly be inflationary, and inflation barriers can be reached even before full employment. However, I argued that the risk of hyperinflation for a country like the US is exceedingly low, and high inflation will be avoided by every stripe of policymaker the US is likely to appoint.

In this blog I will address the connection between trade deficits and foreign accumulation of treasuries, the interest burden supposedly imposed on our grandkids, and the possibility that foreign holders might decide to abandon the dollar.

Let us set out the framework. At the aggregate level, the government's deficit equals the nongovernment sector's surplus. We can break the nongovernment sector into a domestic component and a foreign component. As the US macrosectoral balance identity shows, the government sector deficit equals the sum of the domestic private sector surplus plus the current account deficit (which is the foreign sector's surplus). Let me stress that this is an identity, beyond dispute. Even those who are worried about the sustainability of continued budget deficits recognize the macro accounting identity (see here). We will put to the side discussion about the behaviors that got us to the current reality -- which is a large federal budget deficit that is equal to a (smallish) private sector surplus (spending less than income) plus a rather large current account deficit (mostly resulting from a US trade balance in which imports exceed exports).

There is a positive relation between budget deficits and the current account deficit that goes behind the identity. All else equal, the government budget deficit raises aggregate demand so that US imports exceed US exports (American consumers are able to buy more imports because the US fiscal stance generates household income used to buy foreign output that exceeds foreign purchases of US output.) There are other possible avenues that can generate a relation between the US government deficit and the current account deficit (some point to effects on interest rates and exchange rates), but they are at best of secondary importance. To sum up: a US government deficit can prop up demand for output, some of which is produced outside the US-so that US imports rise more than exports, especially when a budget deficit stimulates the American economy to grow faster than the economies of our trading partners.

When foreign nations run trade surpluses (and the US runs a trade deficit), they are able to accumulate dollar denominated assets. A foreign firm that receives dollars usually exchanges them for domestic currency at its central bank. For this reason, a large proportion of the dollar claims on the US end up at foreign central banks. Since international payments are made through banks, rather than by actually delivering federal reserve paper money, the dollars accumulated in foreign central banks are in the form of reserves held at the Fed-nothing but electronic entries on the Fed's balance sheet. These reserves do not earn interest. Since the central banks would prefer to earn interest, they convert them to US treasuries-which are really just another electronic entry on the Fed's balance sheet, albeit one that periodically gets credited with interest. This conversion from reserves to Treasuries is akin to shifting funds from your checking account to a certificate of deposit (CD) at your bank, with the interest paid through a simple keystroke that increases the size of your deposit. Likewise, treasuries are CDs that get credited interest through Fed keystrokes.

In sum, a US current account deficit will be reflected in foreign accumulation of US Treasuries, held mostly by foreign central banks. The figure below displays the top foreign holders of US treasuries. While most public discussion has focused on Chinese holdings, Japanese holdings are of a similar size.graph-l-randall

(Seen here)

While this is usually presented as foreign "lending" to "finance" the US budget deficit, one could just as well see the US current account deficit as the source of foreign current account surpluses that can be accumulated as treasuries. In a sense, it is the proclivity of the US to simultaneously run trade and government budget deficits that provides the wherewithal to "finance" foreign accumulation of treasuries. Obviously there must be a willingness on all sides for this to occur-we could say that it takes (at least) two to tango-and most public discussion ignores the fact that the Chinese desire to run a trade surplus with the US is linked to its desire to accumulate dollar assets. At the same time, the US budget deficit helps to generate domestic income that allows our private sector to consume-some of which fuels imports, providing the income foreigners use to accumulate dollar saving, even as it generates treasuries accumulated by foreigners.

In other words, the decisions cannot be independent. It makes no sense to talk of Chinese "lending" to the US without also taking account of Chinese desires to net export. Indeed all of the following are linked (possibly in complex ways): the willingness of Chinese to produce for export, the willingness of China to accumulate dollar-denominated assets, the shortfall of Chinese domestic demand that allows China to run a trade surplus, the willingness of Americans to buy foreign products, the (relatively) high level of US aggregate demand that results in a trade deficit, and the factors that result in a US government budget deficit. And of course it is even more complicated than this because we must bring in other nations as well as global demand taken as a whole.

While it is often claimed that the Chinese might suddenly decide they do not want US treasuries any longer, at least one, but more likely many, of these other relationships would also need to change.

For example it is feared that China might decide it would rather accumulate euros. However, there is no equivalent to the US treasury in Euroland. China could accumulate the euro-denominated debt of individual governments-say, Greece!-but these have different risk ratings and the sheer volume issued by any individual nation is likely too small to satisfy China's desire to accumulate foreign currency reserves. Further, Euroland taken as a whole (and this is especially true of its strongest member, Germany) attempts to constrain domestic demand to avoid trade deficits-meaning it is hard for the rest of the world to accumulate euro claims because Euroland does not generally run trade deficits. If the US is a primary market for China's excess output but euro assets are preferred over dollar assets, then exchange rate adjustment between the (relatively plentiful) dollar and (relatively scarce) euro could destroy China's market for its exports.

I am not arguing that the current situation will go on forever, although I do believe it will persist much longer than most commentators presume. But changes are complex and there are strong incentives against the sort of simple, abrupt, and dramatic shifts often posited as likely scenarios. I expect that the complexity as well as the linkages among balance sheets ensure that transitions will be moderate and slow-there will be no sudden dumping of US treasuries.

Before concluding, let us do a thought experiment to drive home a key point. The greatest fear that many have over foreign ownership of treasuries is the burden on our grandkids-who, it is believed, will have to pay interest to foreigners. Unlike domestically-held treasuries, this is said to be a transfer from some American taxpayer to a foreign bondholder (when bonds are held by Americans, the transfer is from an American taxpayer to an American bondholder, believed to be less problematic). So, it is argued, government debt really does burden future generations because a portion is held by foreigners. Now in reality, interest is paid by keystrokes-but our grandkids might decide to raise taxes on themselves to match interest paid to Chinese bondholders and thereby impose the burden feared by deficit hawks. So let us continue with our hypothetical case.

What if the US managed to eliminate its trade deficit so that it ran a perpetually balanced current account? In that case, the US budget deficit would exactly equal the US private sector surplus. Since foreigners would not be accumulating dollars in their trade with the US, they could not accumulate US treasuries (yes, they could trade foreign currencies for the dollar but this would cause the dollar to appreciate in a manner that would make balanced trade difficult to maintain). In that case, no matter how large the budget deficit, the US would not "need" to "borrow" from the Chinese to finance it.

This makes it clear that foreign "finance" of our budget deficit is contingent on our current account balance-foreigners need to export to us so that they can "lend" to our government. And if our current account is in balance then no matter how big our government budget deficit, we will not "need" foreign savings to "finance" it-because our domestic private sector surplus will be exactly equal to our government deficit. Indeed, one could quite reasonably say that it is the budget deficit that "finances" domestic private sector saving.

Yet, the deficit hawks believe the federal budget deficit would be more "sustainable" if foreigners did not accumulate treasuries that supposedly burden future generations of Americans.

OK, how could we eliminate the current account deficit that allows foreigners to accumulate treasuries? The IMF-approved method of balancing trade is to impose austerity. If the US were to grow much slower than all our trading partners, US imports would fall and exports would rise. In fact, our current "great recession" did reduce our trade deficit-although only moderately and probably temporarily. In order to eliminate the trade deficit and to ensure that we run balanced trade, we are going to need a much deeper, and permanent, recession. By reducing American living standards relative to those enjoyed by the rest of the world, we might be able to eliminate our current account deficit and thereby ensure that foreigners do not accumulate treasuries said to burden future generations of Americans.

Now, can the deficit hawks please explain why we should desire permanently lower living standards on their promise that this will somehow reduce the burden on our grandkids?

I think my grandkids would prefer a higher growth path both now and in the future, so that we can leave them with a stronger economy and higher living standards. If that means that thirty years from now the Fed will need to stroke a few keys to add interest to Chinese deposits, so be it. And if the Chinese some day decide to use dollars to buy imports, our grandkids will be better situated to produce the stuff the Chinese want to buy.

L. Randall Wray is Professor of Economics at the University of Missouri-Kansas City.

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Credit Card Debt and Subprime Mortgages: Who’s to Blame?

Aug 2, 2010Bryce Covert

credit-card-fees-150Are you in the 'sweat box', the place where credit card companies make money off of your misery?

credit-card-fees-150Are you in the 'sweat box', the place where credit card companies make money off of your misery?

A few weeks ago I wrote a post about my personal decision to stay away from credit cards and my struggle with a society that is rigged in favor of them. The post didn't advocate getting rid of credit cards; it advocated getting rid of a credit score system and other incentives that make it difficult not to have one.

The comments section for the post on reddit had a variety of opinions in response, both positive and negative. But many of them used the words "dumb," "idiot," "lazy," "stupid." They used words such as "responsibility" and "discipline" and "self-control." The crux of these arguments is that those who get into heavy credit card debt are financially illiterate (or just plain naive). This viewpoint rests the blame of soaring American credit card debt on those who get the cards, rather than the companies who issue them. There is of course a grain of truth in this -- many people who have credit card debt spend beyond their means. And there are ways to be savvy about credit cards and not run up a balance.

But that is not what a credit card company wants, and you may in fact find yourself rejected from getting a card if you are that responsible. You are far outside the sweet spot, or what Ronald J. Mann, a professor of law at UT Austin, calls the "sweat box":  "the spectrum from those who carry balances, to those who routinely make minimum payments, to those who miss payments altogether... [where] the interest rates that borrowers pay...greatly exceed the cost of the lender's funds." Mann wrote a paper in 2006, right after Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act. Proponents of the act relied heavily on a moral argument: that it is shameful Americans could ‘easily' walk away from their debt by filing for bankruptcy. Those pushing the reforms were concerned that consumers used bankruptcy as a convenient part of financial planning, not as a last resort. Thus the rules for filing had to be tightened.

But Mann smelled something fishy: the credit card companies had lobbied heavily and expensively with this bill. But the bill was unlikely to return enough income through increased bankruptcy payouts to justify the expense of lobbying. In fact, it had none of the effects you might think credit card companies would want: deterring risky borrowing, increasing bankruptcy payouts, or lowing bankruptcy filing rates. So why did they do it? It turns out that the major outcome of this bill, and all that lobbying, was to delay consumers from filing for bankruptcy. The credit card companies weren't worried about losing money when a customer defaulted; they were worried that too many defaults too early led to lower profits. This is where credit card companies make their money. Not off of customers who are so irresponsible as to default right away, not off of customers who are so responsible that they pay their bills on time. Rather, off of those who are just bad enough to drag out their balances for a long period of time. And that's where they want to keep you -- in the sweat box.

Credit cards have evolved along the same path as mortgages. As Elizabeth Warren, tireless consumer advocate, puts it: "The financial industry has perfected the art of offering mortgages, credit cards, and check-overdrafts laden with hidden terms that obscure price and risk." Need proof? The average credit card contract has bloated up to 30 pages, from a page and a half in the early 1980s. Issuers advertise a single interest rate and then bury the real details in the contract. (It's no coincidence that the landmark Marquette Nat. Bank of Minneapolis v. First of Omaha Service Corp. case was decided in 1978, which said that states could no longer regulate interest rates on nationally-chartered banks, leading them to easily find the laxest state laws and regulators.) Similarly, to quote Elizabeth Warren again, "More than half of the families that ended up with high-priced, high-risk subprime mortgages would have qualified for safer, cheaper prime loans." Wonder why that is. Maybe all those families were interested in high-stakes gambling with their houses? "A recent Federal Trade Commission survey found that many consumers do not understand, or can even indentify, key mortgage terms." Hmm, maybe not.

The responses to my credit card post mimic the response to the subprime mortgage catastrophe, which placed the blame on homeowners who got mortgages without the adequate funds to pay them back. Again, there is truth in this viewpoint. It is true that many people with little to no income bought houses that they couldn't afford. But why were so many of these mortgages given out? Who gave them? And what were their motives?

Gary Rivlin may answer some of these questions in the chapter "The Birth of the Predatory Lender" in his book Broke USA. He writes about the early 1990s, when nonbank lenders started to realize that there were profits to be made from low-income neighborhoods. They preyed upon the poor, as "the typical customer...didn't feel ripped off paying interest rates of 20% or more but instead felt grateful that finally, someone was saying yes." A lawyer working to help some of these customers climb out of their debt "suspected that the lender was more interested in seizing homes through judgments of default than in accruing steady profits through regular monthly payments." And indeed, Fleet, one of the first large banks get into the business, "lost $17,000 per home on the 101 homes it sold at a loss, [but] it made an average of $32,000 per home on 194 homes." Again the story of relaxed regulation in the 80s comes to play: the state caps on interest rates banks could charge on mortgages were barred in 1980. Two years later, Reagan went further and gave lenders the ability to sell creative home loans, including balloon mortgages and adjustable-rate mortgages. A whole new lingo emerged: "packing" a loan, in which a salesperson was able to load it up with points and fees and credit insurance; "flipping," in which a broker could convince customers to refinance loans again and again, each time adding more points and fees; and all of these practices falling under "equity stripping," in which banks siphoned off the equity customers had in their homes. The cards were stacked against mortgage customers so that banks could profit. By the turn of this century, "Increasingly, mainstream banks were revving up profits by purchasing or starting a subprime subsidiary," Rivlin recalls. And we all know how that turned out.

It's tantalizingly easy to place the blame for huge problems like credit card debt and subprime mortgages on individual consumers. The solution to that is for them to "just man up," as one of the reddit readers suggested. And as I said above, individual responsibility will always be a factor when it comes to these issues. In Elizabeth Warren's words: "Nothing will ever replace the role of personal responsibility. The FDA cannot prevent drug overdoses, and the CFPA cannot stop overspending. Instead, creating safer marketplaces is about making certain that the products themselves don't become the source of trouble." And therein lies the rub. It is far more difficult to think and talk about the system in which so many of these decisions are taking place.

The flood of comments and reactions to my piece heartens me, however, for two reasons. One is that people who had similar stories to mine came out of the woodworks. Friends, family, coworkers, strangers all started telling me how they either stayed away from credit cards for similar reasons or got into debt early on, found a way out, and then stayed away. The second heartening thing is that clearly this is something that people care about. President Obama just signed sweeping financial regulation into law, and whether or not it's strong enough to prevent another crisis, the new Consumer Financial Protection Bureau promises to right many of the wrongs listed above. Contracts will become clearer. Regulators will do a better job of regulating these products. Consumers will actually be able to compare credit products, because they will really understand them, and innovation and competition can come back to the market. But none of this will deal with the problem my original post addressed, which is the way our society tethers its people to debt products. If so many people care, so many people wish to be credit card-free, maybe this can change too.

Bryce Covert is Assistant Editor at New Deal 2.0.

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Elizabeth Warren to Netroots Nation: We Have the Tools; Let's Use Them

Jul 30, 2010

netroots-nation-150At last weekend's sizzling Netroots Nation conference in Vegas, strategist Jen Ancona gathered a group of economic luminaries on stage to discuss a progressive vision of our economic future.

netroots-nation-150At last weekend's sizzling Netroots Nation conference in Vegas, strategist Jen Ancona gathered a group of economic luminaries on stage to discuss a progressive vision of our economic future. ND20 contributor Elizabeth Warren started her speech off with the story of her grandmother. This woman drove a wagon full of younger siblings to Oklahoma during the land rush, after her own mother died and her father had already ridden ahead. After she married Warren's grandfather, they built one-room schoolhouses and modest homes, and "stretched and scratched" to put away some money. That money got wiped out in 1907. So they stretched and scratched again, only to be wiped out one more time in the Great Depression. Such was the boom and bust cycle of the turn of the century.

But three laws that came out of the Great Depression helped to build a strong middle class that lasted for 50 years: FDIC insurance, Glass-Steagall, and SEC regulations. It wasn't until a few years after her grandmother died that the regulations were thrown out. Productivity and wages, which had been rising in tandem, began to diverge, and middle class families were spending more on core necessities while making less. Credit companies saw an opportunity to make money off of this problem -- and that led to the "tricks and traps" business practices that they employ today.

But now FinReg has been signed into law. "We have now the tools on the table to make significant change...but we've got to pick up the tools and use them. [The CFPB] must be built," Warren says. As the bureau is her brainchild, she is perhaps the best person to come up with suggestions for how it should be done. She has four: 1) it must stand for families, 2) it must be reality-based, 3) it has to be able to grow and change, and 4) it should make use of our wired world, involving consumers in its research.

The fight is clearly not over, nor will it be an easy one, she reminded the crowd. But, she says, "Remember, Franklin Roosevelt faced his economic royalists. Remember, it took him years to get his entire economic package into place. It was tough, but it paid off." It's time to pick up the "unused tools" of the financial reform bill and put them to good work.

Watch the full speech here.

And check out Warren's pieces on ND20:

The Fight for Vital Consumer Protections

Feminomics: Women and Bankruptcy

New Agenda for America: The Great Lesson

Real Change: Turning up the heat on non-bank lenders

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Deregulated Energy Trading: Uncompetitive Competition

Jul 28, 2010Wallace Turbeville

earth-150The accidental protection of end user activity will ensure toxic energy trading.

earth-150The accidental protection of end user activity will ensure toxic energy trading.

In an earlier article, I described the so-called "Enron Loophole" in the Commodities Futures Modernization Act of 2001.  Deregulation of energy derivatives trading via the Loophole was touted as a way to lower cost through the efficiency of competition.  In reality, the markets are not competitive.  They are dominated by an oligopoly of banks which profits at the public's expense.

The Enron Loophole has been partially closed, but a large portion of the energy market remains unregulated.  The new financial reform legislation permits bilateral (i.e., un-cleared) hedging transactions in which one party is an "end user." Congress failed to consider the level of market abuse in these transactions. It was mesmerized by huge volumes in other transaction types, ignoring the fact that volume is only one factor in measuring the amount of systemic risk.

End users are companies who produce or purchase energy as an integral part of their business and use derivatives to hedge price risk.  They wanted the exemption primarily to avoid having to post collateral to cover credit exposures, as required by regulated clearinghouses.  All end users transact some business on exchanges and these transactions are all cleared.  So end users have systems in place to post collateral.  Their concern was that they would have to post more collateral unless exempted from the law's general requirement that derivatives be cleared.

This concern is curious. End users trade mostly with banks and a few of the large oil and gas companies.  They receive special deals in which the banks and oil companies extend credit in lieu of requiring the posting of collateral. These deals are, in all relevant aspects, the same as extending a loan to the end user in the amount of the foregone collateral - except that no cash changes hands.  The deals are like unconditional letters of credit in which a bank will pay an amount if the account party fails. A letter of credit is treated like a loan by the bank and account party on their respective books.

If a special collateral deal is just like a loan or letter of credit, why don't end users simply clear their trades and borrow money as needed for collateral?  It is because these special deals are not recorded the same way as loans and letters of credit on the books of the end users. End users wanted the exemption to preserve the opaque trading credit deals so that their debt appears to be smaller than it should.

These special credit deals are much riskier for the end users than conventional loans. They routinely include "triggers," requiring that collateral must be funded immediately on occurrence of specified events (e.g., a credit rating downgrade). This means that cash is required at the precise time when it is hardest to come by. Credit rating agencies are put under immense pressure because well-deserved, modest downgrades could induce a death spiral and bankruptcy. Such liquidity events laid low AIG, Enron and many other firms engaged in bilateral trading. End users are exposed to liquidity risks that well capitalized financial institutions can scarcely deal with.

The banks were also keen on the end user exemption.  The special credit deals are useful to entice end users to trade with the banks.  A bank can extend only a finite amount of credit to a company. Allocating credit to a company for trading reduces a bank's capacity to lend for purposes like capital investment. It is well known that the banks make far more money using credit capacity assigned to a company in their trading activities, rather than using it for conventional corporate lending. If the banks are profiting more tying credit to trades, the end users are paying more than they need to for the credit in order to obscure their indebtedness.

The special credit deals are not merely sweeteners for the end users; they are often crucial to the end user's share value. Banks use them to capture and control end user business.  Sometimes this is done with great fanfare, such as a deal in which Pepco transferred all of its hedging activity to Morgan Stanley.  Sometimes it is less formal. I have been told of a major energy producer which shockingly does more than 80% of its business with a single bank. These are not characteristics of open and competitive markets.

End user energy trading volume is not as large as the volume in credit default, currency and interest rate swaps. However, it is extremely profitable for the banks.  They charge a lot for the special credit deals, in effect profiting from the end user's reporting advantage. But the strategic value for the banks is even greater. It allows banks to dominate markets and become sole sources of hedges which can be priced accordingly.

The peculiar nature of the energy markets is at the root of this strategy.  It is useful to look at the power markets, the most extreme example, to understand the strategic play. The general principles apply to all energy markets.

The central dynamic is that power cannot be stored in any practical sense.  Its economic value is fleeting.  A quantum of power only has value at an instant in time and at a particular location where it is needed to fill a demand.

There is no single power market. Value depends on local supply and demand. There is very little relationship between the market value of power in California and the same power in Pennsylvania. This is because power transmission is constrained. There are absolute engineering constraints over great distance; and even over short distances there are "line losses" of the amount of power generated and fed into the grid.  Regionally, the market values of power at nearby points are usually correlated, but congestion on a transmission path can destroy these correlations, especially at times of high volume each day. Weather is a major factor, but congestion can be as unpredictable as a truck backing into a transformer, storm damage to lines or a generation plant outage

The power market is really a collection of thousands of delivery points, each with unique factors governing valuation.

Power at each delivery point is not monolithic.  Grid operators run day-ahead auctions to secure predictable supplies for forecasted demand. But they also run same day auctions to fine tune supply and demand during the day of delivery.  So there are separately priced day-ahead and real time markets for each delivery point. There are corresponding separate derivative instruments traded for each of these markets.  There is even a derivative for the difference between the two markets at a given delivery point and time.

The value of the transmission between two delivery points is defined by the price differential between the points.  Derivatives transactions for this value are called "basis trades."

Power price is a composite of two values.  The grid operator's ability to access power if required has a value since actual demand and supply can never be known in advance. This is known as "capacity" value. Capacity derivatives are traded.  The difference between capacity value and the actual value of delivered power is referred to as "energy," also a traded derivative.

Most of the value of a power plant is the difference between the price of power it produces and the cost of the fuel required to produce it. For natural gas this is known as the "spark spread," and for coal it is known as the "dark spread." Both are traded as derivatives.

Finally, as demand increases, grid operators call on increasingly less efficient generating resources to supply power and to meet demand.  "Heat rate" swaps are derivatives based on the efficiency of the marginal assets called on at a given time. A heat rate swap is a derivative of a spark spread derivative.

This all means that the power market is really thousands of small markets which are separately priced.  Each delivery point is a "mini-market" which represents multiple potential derivative contracts for trading. Sometimes prices in nearby markets are related, and sometime they are not.

Each end user has regional strengths.  Since markets are really very small, a bank can easily become a dominant force in targeted "mini-markets," effectively "cornering" strategically enabling it to dictate price. Any trader who wants to do business in one of these markets has to deal with that bank.  That is why trading under the end user exemption is so very profitable for the banks.

This all means that the end users' cost of doing business is higher than makes sense in a truly competitive market.  As a result, consumer energy prices are higher than they should be. It also means that the cost of producing almost everything in the economy is too high.

Unregulated energy derivatives have allowed the financial sector to extract extraordinary value from the rest of the economy. It is one reason that the sector has increased dramatically as a percentage of the GDP.  There is no justification for this related to the well-being of the public and the health of the economy.  The end user exemption was misguided.  Other ways to curb these unhealthy practices through regulation must be explored, perhaps focusing on energy policy rather than financial reform.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

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Which is the Bigger Threat: Terrorism or Wall Street Bonuses?

Jul 26, 2010Wallace Turbeville

stockmarket-1500001The current system of trader compensation will continue to decay the heart of Wall Street.

stockmarket-1500001The current system of trader compensation will continue to decay the heart of Wall Street.

Which is a greater threat to the nation -- terrorism or the relentless decline of middle income families? Unless we abandon our core values out of unwarranted fear, terror cannot fundamentally change our way of life. The number of people affected by growing income disparity is vast. When I was a student, income disparity was indicative of an underdeveloped and unstable society.

The government appropriately devotes enormous resources to protect our lives and property from terrorism.  It is unthinkable that a leader would display any weakness opposing this threat.  Politicians have stiff backbones when it comes to terrorism.

In contrast, the government is timid and half-hearted in its approach to the system which perversely rewards a few Wall Street traders with billions of dollars of bonuses, yet allows the foundation to decay.

Kenneth Feinberg issued his report identifying outrageous Wall Street compensation of executives despite their role in the financial disaster and bail out. He proposed that the banks voluntarily adopt "brake provisions" that permit boards of directors to nullify bonuses in the event of a new financial crisis.

He might have more success asking the lions of the Serengeti to give the wildebeests a sporting chance of making an escape.

Over the last fifteen years, the financial sector's percentage of GDP has increased dramatically.  At the same time, the median family income stagnated and then declined.  I do not believe that this is a coincidence.

The large banks have changed. They slice and dice the constituent elements of a stagnant economy, squeezing value out in ever more sophisticated ways.  Wall Street has turned away from its roll as the financial backer of industry and commerce. In the short term, it is more profitable for them to use their capital for trading. Newfangled software and MIT "quants" allow the traders to "rip the faces off" of corporate counterparties and investors which were once trusted clients.

These young traders are simply doing what America has told them to do.  They are allowed to earn obscene amounts of money using the advantageous information, technology and capital of their employers. Making money from less powerful counterparties is like shooting fish in a barrel.  The banks make so much money that they have no problem shoveling it out to the traders.

The alternative careers for these talented young people offer upside which is modest by comparison.  Besides, the trading world, in which the law of the jungle prevails, appeals to youthful aggressiveness.  Michael Lewis expected that college students would be appalled by the amoral environment he described in "Liar's Poker." Instead, the overwhelming response he received from students was a desire to get in on the action. The draining of talented and energetic young professionals away from corporate America where they could help create jobs by the millions may be as damaging as the new allocation of wealth.

The government's flaccid approach to Wall Street compensation, embodied in the Feinberg report, is appalling.  Geithner and Bernake appear intimidated by Wall Street, yet intent on its approval.  Why do they guilelessly buy into the notion that giant, multi-purpose banks dominated by trading are essential to America's competitiveness in the world? Smaller, less risky institutions aligned with economic growth would seem to be a better idea for the vast majority of Americans.

Greenspan and his progeny, including Geithner and Bernake, are enthralled by financial innovation. Innovation, by itself, can be good or bad. Innovation does not fall into the "good" category if it corrupts the home mortgage market, siphons off business productivity and the jobs and wages of employees and unfairly enriches the few at the expense of the many. It is good if it creates jobs and enriches the public as a whole.

Trader compensation is at the heart of the problem. It encourages behavior that is inconsistent with Wall Street's most important function: raising capital for industry and commerce. The banks and the government are afraid that the traders will desert the banks and move to hedge funds if their compensation is reduced. If they do jump ship, it is all the better for America. At least hedge funds can blow themselves up without crippling the US economy in the process.

Former traders now run most of the financial sector.  They believe that the traders somehow deserve compensation at the prevailing levels. The system will not change unless it is forced to do so. The restrictions in the financial reform legislation only inhibit specific abuses.  The banks will concoct new ways to trade risk. It is the only way to maintain their unconscionable profits (that is, until the next bubble bursts and we are in an even worse predicament).  The only way to really change the system is to reduce short term incentives, that is to say limit bonuses.  The government needs the kind of resolve it uses when fighting terrorism.  After all, the stakes are actually higher.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

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