America's Economic Free Fall

By William Greider,

"A generation of conservative propaganda, arguing that markets make wiser
decisions than government, has been destroyed by these events. The
interventions amount to socialism, American style, in which the government
decides which private enterprises are "too big to fail." Trouble is, it
was the government itself that created most of these mastodons --
including the all-purpose banking conglomerates. The mega-banks arose in
the 1990s, when a Democratic President and Republican Congress repealed
the New Deal-era Glass-Steagall Act, which prevented commercial banks from
blending their business with investment banking. That combination was the
source of incestuous self-dealing and fraudulent stock valuations that led
directly to the Crash of 1929 and the Great Depression that followed."

The Nation. Posted August 1, 2008.

In their haste to do anything Wall Street wants, Congress and the
lame-duck President are sowing far more profound troubles for the country.

Washington can act with breathtaking urgency when the right people want
something done. In this case, the people are Wall Street's titans, who are
scared witless at the prospect of their historic implosion. Congress
quickly agreed to enact a gargantuan bailout, with more to come, to calm
the anxieties and halt the deflation of Wall Street giants. Put aside
partisan bickering, no time for hearings, no need to think through the
deeper implications. We haven't seen "bipartisan cooperation" like this
since Washington decided to invade Iraq.

In their haste to do anything the financial guys seem to want, Congress
and the lame-duck President are, I fear, sowing far more profound troubles
for the country. First, while throwing our money at Wall Street,
government is neglecting the grave risk of a deeper catastrophe for the
real economy of producers and consumers. Second, Washington's selective
generosity for influential financial losers is deforming democracy and
opening the path to an awesomely powerful corporate state. Third, the
rescue has not succeeded, not yet. Banking faces huge losses ahead, and
informed insiders assume a far larger federal bailout will be needed --
after the election. No one wants to upset voters by talking about it now.
The next President, once in office, can break the bad news. It's not only
about the money -- with debate silenced, a dangerous line has been
crossed. Hundreds of billions in open-ended relief has been delivered to
the largest and most powerful mega-banks and investment firms, while
government offers only weak gestures of sympathy for struggling producers,
workers and consumers.

The bailouts are rewarding the very people and institutions whose reckless
behavior caused this financial mess. Yet government demands nothing from
them in return -- like new rules for prudent behavior and explicit
obligations to serve the national interest. Washington ought to compel the
financial players to rein in their appetite for profit in order to help
save the country from a far worse fate: a depressed economy that cannot
regain its normal energies. Instead, the Federal Reserve, the Treasury,
the Democratic Congress and of course the Republicans meekly defer to the
wise men of high finance, who no longer seem so all-knowing.

Let's review the bidding to date. After panic swept through the global
financial community this spring, the Federal Reserve and Treasury rushed
in to arrange a sweetheart rescue for Bear Stearns, expending $29 billion
to take over the brokerage's ruined assets so JPMorgan Chase, the
prestigious banking conglomerate, would agree to buy what was left. At the
same time, the Fed and Treasury provided a series of emergency loans and
liquidity for endangered investment firms and major banks. Investors were
not persuaded. Their panic was not "mental," as former McCain adviser Phil
Gramm recently complained. The collapse of the housing bubble had revealed
the deep rot and duplicity within the financial system. When investors
tried to sell off huge portfolios of spoiled financial assets like
mortgage bonds, nobody would buy them. In fact, no one can yet say how
much these once esteemed "safe" investments are really worth.

The big banks and investment houses are also stuck with lots of bad paper,
and some have dumped it on their unwitting customers. The largest banks
and brokerages have already lost enormously, but lending portfolios must
shrink a lot more -- at least $1 trillion, some estimate. So wary
shareholders are naturally dumping financial-sector stocks.

Most recently, the investors' fears were turned on Fannie Mae and Freddie
Mac, the huge quasi-private corporations that package and circulate
trillions in debt securities with implicit federal backing. Treasury
Secretary Henry Paulson (formerly of Goldman Sachs) boldly proposed a $300
billion commitment to buy up Fannie Mae stock and save the plunging share
price -- that is, save the shareholders from their mistakes. So much for
market discipline. For everyone else, Washington recommends a cold shower.

Talk about warped priorities! The government puts up $29 billion as a
"sweetener" for JP Morgan but can only come up with $4 billion for
Cleveland, Detroit and other urban ruins. Even the mortgage-relief bill is
a tepid gesture. It basically asks, but does not compel, the bankers to
act kindlier toward millions of defaulting families.

A generation of conservative propaganda, arguing that markets make wiser
decisions than government, has been destroyed by these events. The
interventions amount to socialism, American style, in which the government
decides which private enterprises are "too big to fail." Trouble is, it
was the government itself that created most of these mastodons --
including the all-purpose banking conglomerates. The mega-banks arose in
the 1990s, when a Democratic President and Republican Congress repealed
the New Deal-era Glass-Steagall Act, which prevented commercial banks from
blending their business with investment banking. That combination was the
source of incestuous self-dealing and fraudulent stock valuations that led
directly to the Crash of 1929 and the Great Depression that followed.

Even before Congress and Bill Clinton repealed the law, the Federal
Reserve had aggressively cleared the way by unilaterally authorizing
Citigroup to cross the line. Wall Street proceeded, with accounting tricks
described as "modernization," to re-create the same scandals from the
1920s in more sophisticated fashion. The financial crisis began when these
gimmicky innovations blew up.

Democrats who imagine they can reap partisan advantage from this crisis
don't know the history. The blame is bipartisan; so also is the disgrace.
In 1980, before Ronald Reagan even came to town, Democrats deregulated the
financial system by repealing federal interest-rate ceilings and other
regulatory restraints -- a step that doomed the savings and loan industry
and eliminated a major competitor for the bankers. Democrats have
collaborated with Republicans on behalf of their financial patrons every
step of the way.

The same legislation also repealed the federal law prohibiting usury --
the predatory practices that ruin debtors of modest means by lending on
terms that ensure borrowers will fail. Usurious lending is now commonplace
in America, from credit cards and "payday loans" to the notorious subprime
mortgages. The prohibition on usury really involves an ancient moral
principle, one common to Judaism, Christianity and Islam: people of great
wealth must not be allowed to use it to ruin others who lack the same
advantages. A decent society cannot endure it.

The fast-acting politicians may hope to cover over their past mistakes
before the public figures out what's happening (that is, who is screwing
whom). But the Federal Reserve has a similar reason to move aggressively:
the Fed was a central architect and agitator in creating the circumstances
that led to the collapse in Wall Street's financial worth. The central
bank tipped its monetary policy hard in one direction -- favoring capital
over labor, creditors over debtors, finance over the real economy -- and
held it there for roughly twenty-five years. On one side, it targeted
wages and restrained economic growth to make sure workers could not
bargain for higher compensation in slack labor markets. On the other side,
it stripped away or refused to enforce prudential regulations that
restrained the excesses of banking and finance. In The Nation a few years
back, I referred to Alan Greenspan as the "one-eyed chairman" [September
19, 2005] who could see inflation in the real economy -- even when it
didn't exist -- but was blind to the roaring inflation in the financial
system.

The Fed's lopsided focus on behalf of the monied interests, combined with
its refusal to apply regulatory laws with due diligence, eventually
destabilized the overall economy. Trying to correct for previous errors,
the Fed, with its overzealous free-market ideology, swung monetary policy
back and forth to extremes, first tightening credit without good reason,
then rapidly cutting interest rates to nearly zero. This erratic behavior
encouraged a series of financial bubbles in interest-sensitive assets --
first the stock market, during the late 1990s tech-stock boom, then
housing -- but the Fed declined to do anything or even admit the bubbles
existed. The nation is now stuck with the consequences of its blindness.

The Federal Reserve's dereliction of duty is central to the financial
failures. It betrayed the purpose for which the central bank was first
created, in 1913, abandoning the sense of balance the Fed had long pursued
and that Congress requires. Most politicians, not to mention the press,
are too intimidated to question the Fed's daunting power, but their
ignorance is about to compound the problem. Instead of demanding answers,
the political system is about to expand the Fed's governing powers --
despite its failure to protect us. Treasury Secretary Paulson proposed and
Democratic leaders have agreed to make the insulated Fed the "supercop"
that oversees not only commercial banks and banking conglomerates but also
the largest investment houses or anyone else big enough to destabilize the
system. This "reform" would definitely reassure club members who are
already too cozy with the central bankers. Everyone else would be left
deeper in the dark.

The political system, once again, is rewarding failure. The Fed is an
unreliable watchdog, ideologically biased and compromised by its
conflicting obligations. Is it supposed to discipline the big money
players or keep them afloat? Putting the secretive central bank in charge,
with its unlimited powers to prop up troubled firms, would further
eviscerate democracy, not to mention economic justice.

If Congress enacts this concept early next year, the privileged group of
protected financial interests is sure to grow larger, because other
nonfinancial firms could devise ways to reconfigure themselves so they too
would qualify for club membership. A very large manufacturing conglomerate
-- General Electric, for instance -- might absorb elements of banking in
order to be covered by the Fed's umbrella (GE Capital is already among the
largest pools of investment capital). Private-equity firms, with their
buccaneer style of corporate management, are already trying to buy into
banking, with encouragement from the Fed (the Service Employees
International Union has mounted a campaign to stop them). A new President
could stop the whole deal, of course, but John McCain has surrounded
himself with influential advisers who were co-architects of this financial
disaster. For that matter, so has Barack Obama.

The nation, meanwhile, is flirting with historic catastrophe. Nobody yet
knows how bad it is, but the peril is vastly larger than previous
episodes, like the savings and loan bailout of the late 1980s. The dangers
are compounded by the fact that the United States is now utterly dependent
on foreign creditors -- Japan and China lead the list -- who have been
propping us up with their lending. Thanks to growing trade deficits and
debt, foreign portfolio holdings of US long-term debt securities have more
than doubled since 1994, from 7.9 percent to 18.8 percent as of June 2007.
If these countries get fed up with their losses and pull the plug, the US
economy will be a long, long time coming back.

The gravest danger is that the national economy will weaken further and
spiral downward into a negative cycle that feeds on itself: as conditions
darken, people hunker down and wait for the storm to pass -- consumers
stop buying, banks stop lending, producing companies cut their workforces.
That feeds more defaulted loan losses back into the banking system's
balance sheets. This vicious cycle is essentially what led to the Great
Depression after the stock market crash of 1929. I offer not a prediction
but a warning. The comparison may sound farfetched now, but US
policy-makers and politicians are putting us at risk of historic
deflationary forces that, once they take hold, are very difficult to
reverse.

A more aggressive response from Washington would address the real
economy's troubles as seriously as it does Wall Street's. Financial firms
have lost capital on a huge scale -- more of them will fail or be bought
by foreign investors. But Wall Street cannot get well this time if the
economy remains stuck in the ditch. Washington needs to revive the "animal
spirits" of the nation at large. The $152 billion stimulus package enacted
so far is piddling and ought to be three or four times larger. Instead of
sending the money to Iraq, we should be spending it here on getting people
back to work, building and repairing our tattered infrastructure,
investing in worthwhile projects that can help stimulate the economy in
rough weather.

An agenda of deeper reforms can boost public confidence even as it undoes
a lot of the damage caused by the financiers and bankers. Some
suggestions:

a.. Nationalize Fannie Mae and other government-supported enterprises
instead of coddling them. Restore them to their original status as
nonprofit federal agencies that provide a valuable service to housing and
other markets. Make the investors eat their losses. Buy the shares at 2
cents on the dollar. Without a federal guarantee, these firms are doomed
anyway.

b.. Resolve the democratic contradiction of "too big to fail" bailouts by
dismantling the firms that are too big to fail -- especially the newly
created banking conglomerates that have done so much harm. Restore the
boundaries between commercial banking and investment banking. In any case,
market pressures are likely to shrink those behemoths as banks sell off
their parts to survive. For the remaining big boys, revive antitrust
enforcement. Set stern new conditions for emergency lending from
government -- supervised receivership, stricter lending rules to prevent
recidivism and severe penalties for greed-crazed shareholders and
executives.

c.. Assign the Federal Reserve's regulatory role to a new public agency
that is visible and politically accountable. Make the Fed a subsidiary
agency of the Treasury Department and reform its decision-making on money
and credit to restore an equitable balance between competing goals and
interests -- seeking full employment but also stable money and moderate
inflation.

d.. Begin the hard task of re-creating a regulated financial system
Americans can trust, one that recognizes its obligations to the broad
national interest. This requires regulatory reforms to cover moneypots
like private-equity funds and to clear away the blatant conflicts of
interest and double-dealing on Wall Street, and also to give responsible
shareholders, workers and other interests a greater voice in corporate
management and greater protection against rip-offs of personal savings.

e.. Re-enact the federal law against usury. The details are difficult and
can follow later, but this would be a meaningful first step toward
restoring moral obligations in the financial sector. People would
understand it, and so would a lot of the money guys. Maybe in the
deepening crisis, Washington will begin to grasp that money is also a
moral issue.