Rational Politics Chapter 4: Our Democracy And Financial Markets

The news today is dominated by a handful of terms; bailout, financial reform, greed, regulation, crisis, and too big to fail spring immediately to mind. The very existence of the Tea Party movement, or at least the anger being exploited by the organizers of the Tea Party movement, owes itself to the financial meltdown of 2008 and the bailouts that followed. Often called “populist anger”, the emotions are loaded with all the confusion, yelling, and uncontrolled swinging attendant to street fighter losing a brawl.

We are angry at being taken advantage of, and irate about not knowing who to blame. There are two items making this situation even worse; we did this to ourselves, and we are about to do it again. When I wrote of confused and angry populism, I was thinking about the following chain of reasoning ( and I use “reason” in that fragment loosely);

  1. We don’t want the government in our lives (in the form of financial regulations).
  2. We believed in Alan Greenspan (and his savant Ayn Rand) when he repeatedly told us that markets could regulate themselves.
  3. We supported our elected officials (Republican legislators and Democratic President Bill Clinton along with the Alan Greenspan disciples running financial policy, Robert Rubin and Larry Summers) when they dismantled the protections erected under President Franklin Roosevelt.
  4. We spent money hand over fist on the credit in our homes with the help of shady lenders and interest rates kept far below normal by Alan Greenspan and his disciple, Ben Bernanke.
  5. We believed everyone who told us that the growth in home prices, far above historical norms, was proof that they were good investments and not dangerously overvalued.
  6. When Wall Street people did what they were taught to do (do as much as legally allowed in order to make as much money as possible so long as the risk could be hidden, packaged, and sold off to someone else); we screamed at them for taking our economy to the brink.
  7. When our elected officials, led by Republican George W. Bush and a bipartisan group of legislators, passed a $700 billion bailout of the financial industry, we screamed at the politicians, then blamed President Obama.
  8. When President Obama and the Congressional Democrats released the second half of the bailout money passed by President Bush, we screamed at them.
  9. When President Obama and the Congressional Democrats passed a law filling one third of the $2 trillion hole the financial meltdown blew in our economy with tax cuts, extended unemployment benefits, funding for teachers and police officers, and infrastructure spending, we screamed at them.
  10. When President Obama, Congressional Democrats, and some Republicans (notably Chuck Grassley and Bob Corker) try to affect limited re-regulation of the financial marketplace and add consumer protections; well, will we scream at them?

The senior citizen who last year told the President that the government better keep its hands off his Medicare is a perfect example of the confusion. The actions that the government took, Republican and Democrat, led directly to the need for the government to bail out the big banking firms.

The term moral hazard is used to describe a situation in which government action (or inaction) leads directly to the need for more government intervention; or else. Risk, in investment, used to be contained to individual companies. Firms were separated, and financial instruments were traded in regulated markets and easy to understand.

The moral hazard in play now, is that government action (specific deregulation) and government inaction (the failure to regulate and monitor derivatives), have led to a new financial reality. The banks, and the instruments they sell, are so intertwined in our economy that their failure would cripple the country. In the Fall of 2008, the threat of that market failure was so great that the government was forced to act. It is an ongoing hazard because the very action that the government took, in concert with the lack of change to the structure of the markets GUARANTEES that it will happen again. Firms can take on unlimited risk because they know, if they fail, they will be rescued because the government (our democracy), has no choice. So why did it happen?

Clinton wanted to allow greater linkage between Wall Street investment banks and local lenders, in the hope that it would support his goal of expanding home ownership to more Americans by making mortgages more liquid. It worked….the part about mortgages becoming more liquid. Home ownership only expanded by a handful of basis points among the population at large (although the net effect on African-American home ownership was much greater).

Republicans like Phil Gramm wanted to break down barriers between banks and insurance concerns so that they could be free to create new products. This would drive wealth to those firms and reinforce his concept of supply-side economics in which wealth would trickle down to the middle class. It worked…the part about the firms making more products and more money. While Wall Street concerns pocketed huge sums during the first decade of this century, real wage growth and savings rates for normal, everyday, working Americans remained flat. To restate, the economic prosperity of the Bush years missed most of the middle class (the real middle class…you folks out there who team with your spouse to work 100 hours per week and make less than $100,000).

Before we go further, let me state very clearly that I am a capitalist. Capital and land should be privately held and traded, but this notion that the democracy (i.e. we the people acting through our government) should not be able to effect the structure of that trade troubles me. The idea that Wall Street business creates wealth is ridiculous; wealth is created when a business employing people sells a product or service to a consumer. Wall Street houses firms whose pure purpose is twofold; to enable business growth by directing funds towards promising concepts, and to facilitate the first aim by generating vehicles for investment that earn more than inflation. When we convince ourselves that firms should be allowed to pursue more aggressive goals at the risk of our entire system, then we become the fools. We have allowed Wall Street to “create wealth” at the expense of workers and consumers. Folks, that is a role-reversal of epic proportions.

The golden rule of finance is risk versus reward. As you take on more risk, the reward (or potential return on investment) should increase. This concept is the reason that a financial adviser will facilitate a portfolio that is a mixture of higher return vehicles and safer low return items. Market deregulation allowed and encouraged the violation of this concept, because risk could easily be passed on while retaining the reward. Big banks and insurance firms were separate, so they couldn’t sell risky instruments and insure themselves against that risk by creating even more risky instruments and selling them. Big investment banks (the ones Wall Street uses), and big commercial banks (the ones you and I use), used to be separate, so the irresponsible risk that one took on couldn’t threaten the entire system.

Finance can be confusing, but this problem isn’t. Take a person with the flu and place them in a subway car; you have just connected the risk to the population at large. That is why there used to be regulations keeping these firms separate. Now, go ask your insurance agent how many different policies he has sold on your car. If he has sold other people insurance on your automobile then he has created his own version of a credit default swap (the really ugly derivative). If he took out a loan secured by your car, then sold an insurance plan against your defaulting on his loan, then he did what Goldman-Sachs thinks is good business.

Unregulated Wall Street types sold trillions of dollars of these things anchored, not by a car, but by trillions of dollars of mortgage based securities. To be specific, they took $8 trillion worth of loans, secured by houses worth less than $8 trillion, and sold $15 trillion worth of insurance…when those folks who bought that insurance came looking for their money (after the U.S. housing market started coming back to Earth in a hurry), the financial system of the entire world was put in jeopardy.

We had no choice on the bailout, because we allowed ourselves to believe that it was wrong to regulate financial markets. The people you see arguing against new regulation are making billions in the unregulated marketplace. I am not suggesting a Robin Hood method here, I have no problem with a world of rich and poor (it is the way of nature…to a point). My suggestion is that it is good and proper that a democracy control the market to the extent that those greedy, self-serving, idiots can’t destroy us all!

The Rational Middle has advocated for a financial reform package before here. The plan contained three simple steps (although you folks pointing to the length of a bill to question its value need to reassess). The plan currently being blocked by Republicans is more complicated in that it tries to directly regulate derivatives, and creates a new consumer protection agency that would streamline financial regulation. I don’t particularly trust Chris Dodd, but the bill has some merit. The Democrats are also trying to strengthen it by breaking up the largest banks in order to end the too big to fail threat permanently. Please note that the Democrats are not trying to nationalize the banks, they are suggesting that anti-trust rules apply (monopolies and cartels are bad for markets friends).

The point of this post, as per usual, is that you take a look at the real story; ignore the cable news spin and read summaries of the bill. Set aside your frustration with the system and take a moment to assess what really happened. Americans, almost universally and completely without regard to party affiliation, feel disconnected from their own government. So we should, because we have allowed wealthy interests to tell us that nameless business is more important than people. Lets practice some real economic populism, and tell our representatives to regulate Wall Street….when regular folks have more money in their pockets, the business owners on Main Street will thank you.

The Rational Middle invites you to comment….