Saturday, September 20, 2008

Glass Steagall is not the Issue. Economic Fundamentals are the real story.

There's a lot of talk now about how John McCain is particularly ill-equipped to lead the country out of the current financial melt-down because he and Phil Gramm were proponents of deregulation and deregulation, including Gramm's dismantling of the Glass Steagall act that separated commercial from investment banking, is what got us into this mess. There are two main problems with this argument. First, Wall Street has been highly regulated in the last decade. Eliot Spitzer's prosecutions, Sarbanes Oxley, regulation FD, have left the business neck-deep in red tape. For example, communications between different functions of the firms are tightly constricted, and employees need permission to make personal investments or accept positions on corporate boards. Second, Glass Steagall might have made things worse. Bear could not have jumped into the arms of JPM had Glass Steagall been in place, nor could Merrill have merged with Bank of America. Past mergers may have been responsible for averting other potential crises as well. Could Citi's or UBS's investment banking arms have weathered the storm without their banking parents?

So regulation and oversight sound good (and appear to have worked in the case of commercial banks), but their application doesn't necessarily protect us, as illustrated by the recent crisis.

The problem this time around was really pretty similar to what happened in the dot-com bubble. Investors had a great appetite for a particular category of investment, in this case structured finance including mortgage-backed securities, and so Wall Street provided a great amount of it. The bizarre twist in this case was that a lot of what turned out to be rubbish was not equities, bets on promising technology, but AAA-rated debt. That made this bubble more toxic than the last one. Another realization that didn't really come up in the dot-com era: broker-dealers hold a lot of inventory and can suffer significant losses as a result.

The problems occurred in the unregulated "structured finance" realm rather than in the regulated world of corporate finance. One response would be to demand the kind of transparency and disclosure of structured entities that is demanded of public corporations. After all, if billions of dollars are being invested in them, the cost of disclosure might be worth the benefit. This might help, and we should probably do what we can, but it's safe to say it won't solve the problem. When investor appetites are in play, securities will flow and when the good stuff is gone, the junky stuff will be conjured up. The problems were flawed science, hopeful investing, and old-fashioned spin-meistering. These things can't be stopped.

So what ought to be done? First, a litle more diagnosis.

The root of the problem is the distribution of income. Wealth was quickly accumulating in the newly global investor class and it wound up spilling into these instruments that looked conservative, but in fact relied on a healthy American middle class. This group didn't exist anymore.

The US response to anemic economic growth was to keep interest rates really low. Growth was anemic because the American consumer saw no growth in earnings. Low interest rates permitted borrowing and grew asset prices in real estate, as well as sustaining politically presentable levels of consumption growth. Beggars can't be choosers, and this debt-based economic growth was all the US could muster.

Can anything be done about the skewed distribution of income which is essentially a technological phenomenon? Well, the appropriate public policy response is to recognize that economic growth as well as the basic health of a society depends on broad-based prosperity. If the dollars are flowing to corporations and the wealthy, tax them and make the middle class better off with free popular services that benefit everyone such as education, health care, infrastructure.

Historically, societies marked prosperous times by building great, lasting things, like universities, city boulevards, museums, skyscrapers. The prosperity of the 1990s and the more narrow prosperity of the mid-2000s didn't yield much public manifestation. I think that's the root of the problem here. The wealth wasn't shared. And as Obama says, the poverty trickled up.


Bob said...

Yes, Clinton missed his opportunity to reform health care during his first term was distracted by the impeachment trial to make necessary investments in infrastructure during his second term.

Bush squandered the fiscal legacy of the 1990s, a large surplus, on excessive tax cuts for the top 1% and an unnecessary war in Iraq.

Bush leaves an excessively challenging legacy to his successor. A large deficit, the need for reasonable entitlement reform, two festering foreign policy quagmires, and a financial mess.

ericthefez said...

Great analysis of the situation, Crappie. Any argument that can help turn the tide on wealth distribution is much needed.