Excerpts from
THE CASE AGAINST THE FED
By Murray N. Rothbard
Putting Cartelization Across: The Progressive Line
....It is important to realize that the problem faced by the big bankers was only one facet of a larger problem. Finance capital, led once again and not coincidentally by the Morgan Bank, had been trying without success to cartelize the economy on the free market. First, in the 1860s and 1870s, the Morgans, as major financiers and underwriters of America’s first big business, the railroads; tried desperately and repeatedly to cartelize railroads: to arrange railroad “pools” to restrict shipments, allocate shipments among themselves, and raise freight rates, in order to increase profits in the railroad industry. Despite the Morgan clout and a ready willingness by most of the railroad magnates, the attempts kept floundering, shattered on the rock of market competition, as individual railroads cheated on the agreement in order to pick up quick profits, and new venture capital built competing railroads to take advantage of the high cartel prices. Finally, the Morgan-led railroads turned to the federal government to regulate railroads and thereby to enforce the cartel that they could not achieve by the free market. Hence the Interstate Commerce Commission, established in 1887. (16)
In general, manufacturing firms did not become large enough to incorporate until the 1890s, and at that point the investment bankers financing the corporations, again led by the Morgans, organized a large series of giant mergers, covering literally hundreds of industries. Mergers would avoid the problem of cheating by separate individual firms, and monopoly firms could then proceed peacefully to restrict production, raise prices and increase profits for all the merged firms and stockholders. The mighty merger movement peaked from 1898 - 1902. Unfortunately, once again virtually all of these mergers flopped badly, failing to establish monopolies or monopoly prices, and in some cases steadily losing market shares from then on and even plunging into bankruptcy. Again the problem was new venture capital entering the industry and, armed with up-to-date equipment, outcompeting the cartel at the artificially high price. And once again, the Morgan financial interests, joined by other financial and big business groups, decided that they needed the government, in particular the federal government, to be their surrogate in establishing and, better yet, enforcing the cartel. (17)
The famed Progressive Era, an era of a Great Leap Forward in massive regulation of business by state and federal government, stretched approximately from 1900 or the late 1890s through World War I. The Progressive Era was essentially put through by the Morgans and their allies in order to cartelize American business and industry, to take up more effectively where the cartel and merger movements had left off. It should be clear that the Federal Reserve System, established in 1913, was part and parcel of that Progressive movement: just as the large meat packers managed to put through costly federal inspection of meat in 1906, in order to place cripplingly high costs on competing small meat packers, so the big bankers cartelized banking through the Federal Reserved System seven years later. (18)
Just as the big bankers, in trying to set up a Central Bank, had to face a public opinion suspicious of Wall Street and hostile to Central Banking, so the financiers and industrialists faced a public steeped in a tradition and ideology of free competition and hostility to monopoly. How could they get the public and legislators to go along with the fundamental transformation of the American economy toward cartels and monopoly?
The answer was the same in both cases: the big businessmen and financiers had to form an alliance with the opinion-molding classes in society, in order to engineer the consent of the public by means of crafty and persuasive propaganda. The opinion-molding classes, in previous centuries the Church, but now consisting of media people, journalists, intellectuals, economists and other academics, professionals, educators as well as ministers, had to be enlisted in this cause......
Hence the new alliance of State and Opinion-Molder, an old-fashioned union of Throne and Altar recycled and updated into a partnership of government, business leader, intellectual, and expert. During the Progressive Era, by far the most important forum established by Big Business and Finance which drew together all the leaders of these groups, hammered out a common ideology and policy program, and actually drafted and lobbied for the leading new Progressive measures of state and federal intervention, was the National Civic Federation; other similar and more specialized groups followed. (19)
It was not enough, however, for the new statist alliance of Big Business and Big Intellectuals to be formed; they had to agree, propound , and push for a common ideological line, a line that would persuade the majority of the public to adopt the new program and even greet it with enthusiasm. The new line was brilliantly successful if deceptive: that the new Progressive measures and regulations were necessary to save the public interest from sinister and exploitive Big Business monopoly, which business was achieving on the free market. Government policy, led by intellectuals, academics and disinterested experts in behalf of the public weal, was to “save” capitalism, and correct the faults and failures of the free market by establishing government control and planning in the public interest. In other words, policies, such as the Interstate Commerce Act, drafted and operated to try to enforce railroad cartels, were to be advocated in terms of bringing the the Big Bad Railroads to heel by means of democratic government action.
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16 See Gabriel Kolko, Railroads and Regulation, 1877-1916 (Princeton: Princeton University Press, 1965).
17 See Kolko, Triumph of Conservatism, pp. 1-56; Naomi Lamoureaux, The Great Merger Movement in American Business, 1895-104 (New York: Campbridge University Press, 1985); Arthur S. Dewing, Corporate Promotions and Reorganizations (Cambridge, Mass.: Harvard University Press, 1914) and idem, The Financial Policy of Corporations, 2 vols., 5th ed. (New York: Ronald Press, 1953).
18 On meatpacking, see Kolko, Triumph of Conservatism, pp. 98 -108.
19 On the National Civic Federation, see James Weinstein, The Corporate Ideal in the Liberal State, 1890 -1918 (Boston: Beacon Press, 1968). Also see David Eakins, “The Development of Corporate Liberal Policy Research in the United States 1885 - 1965” (doctoral dissertation, Department of History, University of Wisconsin, 1966).
Tuesday, August 10, 2010
Friday, July 30, 2010
WHERE KEYNES WENT WRONG
Excerpt from Where Keynes Went Wrong by Hunter Lewis
Chapter 14
Government for Sale
In the prior chapter, we considered Keynes’s claim that government could do a better job of investing than private enterprise. We evaluated this in terms of the potential threat that it posed for the economy. We have not yet considered what is arguably more important: The threat posed to our democratic institutions by allowing government to become completely mixed up with the world of money and business.
Historian Doris Kearns Goodwin observed that a degree of financial corruption has always existed in the American government, but that it grew exponentially after the Civil War. (1) Why? Because business and government became so closely involved with each other. Sometimes it was the “hard” corruption of outright bribery. More often, it was the “soft” corruption of selling laws, tax breaks, rules, and decisions for campaign contributions, electioneering help, jobs, or other favors.
Government’s job is to guard and protect us. But who will protect us from the guardians themselves, once they become corrupted? There is no certain recourse against a corrupt government.
In Russia today, a holding company, Basic Element, run by the financial oligarch Oleg Deripaska, owes $650 million to Alfa Bank, led by fellow oligarch Mikhail Fridman. Fridman presses Deripaska for repayment. Deripaska speaks to the Russian president, Dimitry Medvedev. The president calls in Fridman and loan is magically deferred. (2)
Russia, having abandoned Communism, has embraced age-old principles of mercantilism. The state does not own the private sector as it once did. But there are really no boundaries between private and public. When businessmen need political favors, they know whom to call. The crony capitalists and politicians are clever; they keep most of it concealed behind closed door.
The world’s most developed countries have not reached this point--yet. But day by day are edging closer to the Russian model. The United States is a case in point.
In 2008, before the rapid expansion of the federal government by the Bush and Obama administrations, government (both federal and state) represented about a third of the economy. The nonprofit sector represented roughly another 10%. This implied that a (bare) majority of the economy was comprised of private, for-profit concerns, the so called private sector. But taking into account companies that are directly or indirectly controlled by government, perhaps as much as two-thirds of the economy is really in the government sphere.
The term Government Sponsored Enterprise (GSE) is generally used to describe private businesses that have been started by government and that continue to enjoy government support. the preeminent examples over the years have been the mortgage giants Fannie Mae and Freddie Mac. It seems appropriate, however, to apply the term GSE more broadly to describe a large number of private firms, all of which either sell to government (defense), are highly regulated, subsidized, price supported, and cartelized by government (healthcare, drugs, housing, and banking and finance), or are dominated by government in a wide variety of ways (law, education, agriculture, autos, broadcasting, utilities, etc.).
The common theme that runs through all these broadly defined GSEs, apart from their dependence on government, is the large amounts of money they give to politicians of both parties and the large amount they spend on lobbying. In 2008, for example, individuals and political action committees (PACs) connected to the finance, insurance, and real estate industries gave $463 million to politicians, with 51% going to Democrats and 49% to Republicans. (3) That same year, then candidate Obama received more money from this source than any other except for trial lawyers. His take from donors in finance ($37.6 million) far exceeded what the Republican candidate, John McCain, got. (4) This flow of money is extremely important to politicians.
The flow of money is not usually tied to a specific favor. But sometimes the connection is unmistakable. For example, in 2007 Congress threatened to end the tax loophole allowing private investment partnership managers to escape taxation at earned income rates. Senator Charles Schumer (D-NY) immediately took steps to protect the loophole. His Democratic Senatorial Campaign Committee subsequently collected almost $5 million from such funds for the 2008 election, double what the Republican committee got. (5)
Campaign contributions are the main thing that politicians want from Wall Street firms and other GSEs. But there are other financial ties including funds from related foundations and jobs for friends or for the politicians themselves. For example, Rahm Emanuel, between stints in the Clinton White House, in Congress, and then in the Obama White House as Chief of Staff, went to Wall Street. Making use of his government contacts, he earned $18 million in only two and a half years, according to his government disclosure forms. (6)
It is especially ironic that Wall Street is regarded by most people as the epicenter of market capitalism. It is, in reality, the epicenter of government-sponsored enterprise. Where Wall Street stops and Washington begins and vice versa is impossible to say. The current symbiosis was not caused, as many suppose, by the Crash of 2008. Rather the Crash of 2008 was caused by the long-standing Wall Street-Washington symbiosis.
In the balance of this chapter, we will examine three GSE case studies, each of which illustrate different aspects of the problem. The first case study will focus on the housing bubble, which involves the Federal Reserve, Congress, the Bush administration, and the real estate and finance industries. The second will focus on the drug industry and how it interacts with Washington. The third will very briefly look at automobile industry troubles. Although this chapter mainly focuses on government/industry ties, we should not forget the vast sums of money flowing to Washington from labor unions and trial lawyers and other special interests as well as from broadly defined GSE industries.
CASE STUDY ONE: THE U.S. HOUSING BUBBLE
Conventional wisdom blames the housing bubble on Wall Street greed. That is only a half-truth. When government serves free drinks by printing money, driving interest rates down and overspending, Wall Street tends to get drunk. This is very convenient for government because, when the hangover comes, the average person will blame the drunk, not the bartender. This happened each time a bubble popped, at the end of the 1920s, the end of the 1990s, and the end of the recent housing bubble.
Throughout the housing bubble, the government sought to provide cheap mortgages by driving interest rates down. generally with the help of other central banks. When the Fed Funds Rate was held below the rate of inflation for three years, this was virtually giving money away to those with the clout and the collateral to get it. These initial borrowers then make the money available to other borrowers, especially to consumers for housing loans.
The US government had already made mortgage interest tax deductible and eliminated most capital gains taxes on homes. It also provided loan guarantees through the Federal Housing Administration (FHA) and its own cheap mortgages both through the Federal Home Loan Banks and the private/public entities Fannie Mae and Freddie Mac. The government’s Department of Housing and Urban Development did its part by mandating that Fannie and Freddie invest what became 50% of assets in lower-end mortgages, including, if necessary, unqualified mortgages, the ones that later blew up. (7)
By the end of 2007, government-sponsored mortgages accounted for 81% of all mortgage loans made in the US. (8) During 2008, Fannie Mae developed the Home Saver program. This enabled defaulting homeowners to borrow additional money to cover the arrears in their mortgage payments. Although ostensibly designed to help struggling homeowners, the new loans meant that none of the original loans had to be considered in default. More importantly, none of them had to be written off. Many of the new Home loans were written off almost immediately, nearly half a billion worth, but this sum was small compared to the original loans that could be kept on the books for awhile longer. In this and other creative ways, Fannie executives kicked the can (of mortgage defaults) down the road a bit further into the future.
Official government propaganda kept touting home ownership as the American dream. No one paid attention to studies showing that countries and regions with the highest home ownership also had the highest unemployment rate. Why? Because home ownership makes it difficult for workers to move to where the jobs are, especially to where the best jobs for their particular skills are. (10) This was finally noticed after the housing crash.
Democratic politicians especially liked Fannie and Freddie. They exempted both from state and local sales tax and some Securities and Exchange Commission (SEC) requirements and also gave them implied government backing for their bonds. They fought off Bush administration efforts to regulate them more, even after it became apparent that both firms had issued false accounting statements. They also saw nothing wrong with Fannie and Freddie borrowing $60 for each $1 of capital, much more leverage than even Wall Street used.
Representative Barney Frank, chair of the US House Financial Services Committee, said that fears of a looming crisis were “exaggerated.” His counterpart in the Senate, Christopher Dodd, chair of the Banking Committee, agreed. (11) As late as July 2008, Dodd said that: “[Fannie and Freddie] are fundamentally sound and strong. There is no reason for the reaction we’re getting.” (12) Before the end of the year, both companies had collapsed and been refinanced by the government. Earlier, Frank was worried that any attempt to reign in Fannie and Freddie would make housing less “affordable,” presumably for people of modest means. He did not explain what Fannie and Freddie government-supported loans of as large as $625,000 had to do with affordability, or how soaring home values made homes more affordable.
By 2006, cheap credit had doubled the price of the average house in less than ten years. (13) By then, the housing bubble had spread round the world and become the largest and most universal bubble in economic history. The 1920s bubble in the US led to a total debt to gross domestic product ratio of 185% in 1928. The housing bubble led to a total US debt to GDP ration of 357% by 2008. (14)
What nobody mentioned throughout the debate about Fannie and Freddie was how convenient their supposedly private but actually public status was for politicians. As private companies, they could make campaign contributions through their employees and their PACs (Political Action Committees). Their “foundations” could also provide “soft” funding for a host of political purposes. As Forbes Magazine publisher Steve Forbes noted in August 2008:
Fannie’s nonpolitical money even went to Acorn, the group charged in 2008 with voter fraud. (16) Altogether, excluding “charitable” gifts, Fannie spent $170 million on lobbying from 1998-2007 and $19.3 million on campaign contributions from 1990. The largest sum during the 2006-2008 electoral cycle went to Senate Banking Committee Chair Dodd, and the second largest to then Senator Obama. (17)
Senator Dodd was also the second largest recipient of funds from a political action committee (PAC) organized by Countrywide Financial, a leading sub prime mortgage lender, as well as recipient of two mortgages from Countrywide’s VIP program that waived points and other fees. Later Dodd stated that he did not realize he was getting special treatment and refinanced the loans elsewhere. The largest recipient of funds from the Countrywide PAC was the then Senator Obama.
As the Crash of 2008 unfolded, the government did not of course just bail out Fannie and Freddie. It bailed out banks and investment banks as well. In early October 2008, the government told nine major banks and investment banks that they must sell the government an ownership stake in their companies even if they did not need the money, just to show that the government stood behind the banks. (19)
In a stroke, banks like Citigroup, JP Morgan Chase, Bank of America, Wells Fargo, Bank of New York, and State Street became full-fledged GSEs, little different than traditional GSEs like Fannie and Freddie. So did investment banks like Goldman Sachs and Morgan Stanley. Shortly thereafter, Barney Frank received $9,500 from Wells Fargo’s and Goldman Sach’s PACs, (20) presumably just a beginning. With tighter controls over the old GSEs and many new ones, the flow of money to Washington would inevitably break all records.
Not surprisingly, Democratic Party leaders selected eleven newly elected Democratic members of the house who had won their races by narrow margins and assigned them to the Financial Services Committee. In this way, they could be sure to raise plenty of money. The money alone might discourage Republican challengers. In this way, control of Congress helps to cement future control of Congress.
During the fall of 2008, leading investment banks such as Goldman Sachs and Morgan Stanley legally became banks. This meant that these firms, essentially giant hedge funds, could enjoy permanent access to newly printed government money offered at the lowest possible rates, rates shortly fell to just above zero. This was deeply ironic. At a time when many sound companies on “Main Street” were struggling to obtain loans at high rates, the leading Wall Street speculators could borrow directly from the government at bargain rates.
At that very moment, the recent head of Goldman Sachs, Hank Paulson, now secretary of the Treasury, was running the government’s Wall Street rescue operation with Ben Bernanke, chairman of the US Federal Reserve. Paulson’s firm directly received $10 billion of TARP bailout money (21) in addition to cheap money from the Fed’s loan window. But that was not all.
The largest single chunk of TARP money, $173 billion, went to American International Group (AIG), a giant insurer. When the company ran into trouble, Paulson selected Edward Liddy, previously a director of Goldman Sachs, to run it. (22) Because AIG owed money to others, much of the bailout flowed through to other firms whose names the government refused to disclose, possibly because some of these firms were foreign. Some of the names leaked, however, and it turned out that almost $13 billion of the AIG bailout money had gone to Goldman Sachs.
AIG, by the way, had been a major source of campaign donations. The number two recipient of these funds for 2003-2008 had been Senator Dodd. The number one recipient had been then Senator Obama. (24)
During the fall of 2008, Secretary Paulson also arranged for Bank of America, a recipient of TARP money, to rescue Merrill Lynch, the giant investment firm. The head of Bank of America later testified that Paulson had directed him to complete the transaction and also asked him not to disclose how bad Merrill’s losses were, which may have been illegal. The then head of Merrill Lynch was a former head of Goldman Sachs and thus a former colleague of Paulson’s.
When the Obama administration came in, Timothy Geithner, the president of the New York Federal Reserve, the operating arm of the US Federal Reserve, took Paulson’s job. A former chief economist of Goldman Sachs, William Dudley, then took Geithner’s New York Fed job. Shortly thereafter, the chairman of the New York Fed, Stephen Freidman, another former Goldman Sachs head and also former chief economic advisor to President George W. Bush, decided to resign because he wanted to be more active at Goldman. (25)
The cozy Wall Street-Washington club described above has many departments. One of them is the leading private securities rating services--Standard and Poor’s, Moody’s, and Fitch. These firms played an important role in blowing up the housing bubble by giving safe ratings to mortgage securities that turned out to be anything but safe.
How did these firms come to hold so much power in the securities market? The answer: government laws and regulations forbid the purchase (by insurance companies, banks, money market funds, et al) of securities not rated by these select firms. In other words, the government has created a protected cartel of raters. Since the cartel was immune from competition, it was easy for Wall Street to win approval for dubious securities, especially since the flood of such securities was generating so much fee income for the raters.
All bubbles eventually pop. The housing bubble was no exception. But why did it pop when it did? A major precipitating factor was an obscure accounting rule applied to banks (but not insurance companies) in 2007 called “mark-to-market.” This rule change (FASB 157) forced many banks to write down the value of their assets, thereby creating insolvency or worries about insolvency, which in turn triggered federal bailouts.
There was a Keystone Cops element about this. Mark-to-market was accurately described by some critics as mark-to-make-believe. When real market prices are not available, often the case with bank assets, the rule essentially makes them up. Auditors implementing the rule operated in an atmosphere of fear created by the federal Sarbanes Oxley Act, and also looked nervously over their shoulder at the threat of lawsuits from trial lawyers. They were naturally more inclined to play it safe by writing down assets, sometimes to zero, even when cash flows from the investments were still entirely positive.
Even Fannie Mae, the most egregiously over leveraged financial firm, never actually ran out of money, the commonsense definition of bankruptcy. The government, acting through the Securities and Exchange Commissions, could have called a “mark-to-market” time out. It could have temporarily or permanently suspended mark-to-market while requiring the same information to be provided as footnotes to accounting statements.
This was not the only instance of misjudgment of Bernanke’s part. It was one of a cascading avalanche of such errors. Both as a governor, and then as chairman of the Federal Reserve, Bernanke had been generally responsible for financing the bubble with cheap debt. He clung to the idea that so long as consumer price increases were restrained, there was no reason to worry about an asset bubble. As the signs of trouble steadily gathered, he said that
He also made one last crucial error, when he drastically cut the Fed Funds rate again in September of 2007.
By this time, no one could claim that consumer price increases were restrained. Even the government’s doctored index showed them advancing at 5% a year. Bernanke cut rates anyway, and his action had the completely unintended consequence of setting off a race out of the dollar and into commodities such as oil. The price of a barrel of oil quickly doubled, which helped to panic consumers and slow business.
In more Keystone Cops fashion, Senator Joe Lieberman blamed the oil price rise, not on Bernanke’s actions, but rather on speculators. He threatened to enact legislation banning large institutional investors from investing in commodities altogether. (28) By the time he spoke, commodity prices had already peaked and were about to free-fall during the Crash.
Bernanke had hoped that his rate cut would help bring down mortgage rates. Instead mortgage rates kept climbing. Meanwhile Wall Street firms responded by taking one last, long gulp of Bernanke’s cheap money-- only to find very shortly that more leverage at very short maturities was the last thing they needed in an imploding economy. And it was not just Wall Street. Ship owners ordered more ships, businesses added to inventory, all just at the wrong time, all prompted by the Fed’s rate cut.
By October 2008, President Bush was spreading panic by saying on television that a failure to pass his TARP (Troubled Assets Relief Program) bill would leave the economy in ruin. Retail sales began to fall dramatically right after the President spoke. (29) So did Republican election prospects.
Seven hundred billion dollars in TARP money was sold as a program to buy troubled mortgages from banks. After passage the treasury secretary agreed (privately, not publicly) that the plan made little sense. There being no market for the mortgages, there was no way to price them. Even if there had been a market, buying them at real market value would not help the banks. Later Tim Geithner, Obama’s new secretary of the Treasury, revived the idea anyway, in the form of a giveaway to Wall Street.
Consider what was happening here. After endless government interference, the price system had broken down in the mortgage field. The most important task was to establish real market prices (not phony “mark-to-market” prices) for mortgages.
The main reason that the mortgage price system had broken down was because of cheap government loan money and loan guarantees. So what does Secretary of the Treasury Geithner decide to do? He decides to offer still more guaranteed government loans, in this case loans intended to convince Wall Street firms to buy the bad mortgages. Result:
What if Geithner’s plan failed? What if Wall Street refused to buy the bad mortgages from the banks or the banks refused to sell them despite the government price subsidies? In that case, said Federal Deposit Insurance Corporation (FDIC) Chairman Sheila Bair, the banks would “need to be told” by the government to sell the mortgages whether they wanted to or not at the government engineered price. (30) That of course would make it even more impossible to discover true market prices for the mortgages, the one step that would really help end the crisis.
The banks originally targeted for President Bush’s TARP funds were those considered “too big to fail.” In most cases, these banks had grown to giant size with government encouragement. Each time a smaller bank is in danger of failing, the usual government response is to try to merge it into one of the banking behemoths. In practice, the TARP funds became a honey pot that firms in a great variety of congressional districts tried to get a through their members of Congress.
Not all the TARP funds were even used for the financial crisis. In order to win passage, it included special provisions for Puerto Rican rum producers, auto race tracks, companies operating in American Samoa (one of which, Starkist, was based in Speaker of the House Nancy Pelosi’s district), tax benefits for various parties, even a requirement that medical insurance companies cover mental health. (31)
Buried deep in the fine print, the Act also vastly expanded the power of the Federal Reserve by allowing it to pay interest on member bank deposits. This was a critically important change in the monetary system, one that would allow the Fed to print much more money. Did members of Congress even know about this provision of the bill? It is doubtful. If they did, they probably had no conception of its purpose or importance.
The housing bubble illustrates how government errors may paradoxically increase government control over large swaths of the economy. Yet in the long run it is not clear who will control whom. Will government keep the upper hand in a government-Wall Street “partnership”? Or will Wall Street eventually take control of government, using its vast powers to restrict competition and create sustainable monopoly pricing?
This is not an idle question. To see how a regulated industry co-ops the regulator and uses the power of government for its own purposes, we need only to turn to our next case study.
CASE STUDY TWO: THE DRUG INDUSTRY
The drug industry at one time was called the patent medicine industry, and this is still the more revealing name.
Drug companies devote themselves to inventing non-natural molecules for use in medicine. Why non-natural? Because molecules previously occurring in nature cannot, as a rule, be patented. It is essential to develop a patentable medicine, because only a medicine protected by a government patent can hope to recoup the enormous cost (up to $1 billion) of taking a new drug through the government’s drug approval process.
Getting a new drug through the US Food and Drug Administration (FDA) is not just expensive. It also requires having the right people on your side. Drug companies know that they must hire former FDA employees to assist with the process. They also hire leading experts as consultants, experts who will probably be called on by the FDA to serve on screening panels. Direct payments must also be made to support the FDA’s budget.
Although the costs are astronomical, the financial payoff from FDA approval is even bigger. Only FDA-approved drugs can be prescribed within government programs such as Medicare. Doctors may prescribe unapproved substances outside of Medicare, Medicaid, or the Veteran’s Administration but by doing so risk losing their license to practice.
The FDA will also discourage, and often ban, substances that might compete with approved drugs. When antidepression drugs (based on extending the life of a hormone, serotonin, inside the body) were approved, the Agency promptly banned natural substance, L-Tryptophan, that increased serotonin, even though the natural substance was much cheaper and had long been available. Many years later, after the antidepression drugs were well established, Tryptophan was finally allowed back, but under restrictions that make it more expensive.
In effect, then, drug companies are not really private companies competing in an open market. They are also government-sponsored enterprises (GSEs) not unlike Fannie Mae or Freddie Mac, and (now) the big Wall Street banks and firms. It should not be surprising therefore that drug companies, like Fannie and Freddie, spend millions on political lobbying and campaign contributions. Many politicians rely on these campaign contributions and thus have a vested interest in maintaining the drug cartel, even though needlessly high drug costs contribute to soaring medical costs.
The government’s share of these soaring medical costs is, in part, financed by borrowing from China and other countries. Too much of the borrowed money is spent making old people miserable in the discomfort of hospitals prior to their deaths. In fact, medical errors and unintended consequences of treatment may be the leading cause of death in the US.
In the US, businesses pay for a great deal of medical care. Consequently, monopoly-driven drug prices also reduce business profits, which in turn leads to fewer raises for existing employees, less hiring, and ultimately to higher unemployment. Higher business costs also lead to fewer export sales, which increases the US trade deficit, and so on it goes, with one undesirable and unintended consequence after another.
The bottom line here is the drug companies, ostensibly regulated by the government, have come to dominate and even control the regulators. the result is a semisocialized drug cartel, enforced by government, whose power is wreaking economic havoc. This is an inherently unstable situation. One possibility is that government will reassert itself through price controls.
Does the drug industry story shed further light on what happened in Wall Street after the housing bubble? It might. In the immediate aftermath of the Crash of 2008, it seemed that government was taking control of Wall Street. But money, power, and control have been flowing back and forth between Wall Street and Washington for years. There is always traffic in both directions. In the short run, Washington is reasserting itself. In the long run, as previously noted, Wall Street may turn a tighter relationship to its own advantage.
CASE STUDY THREE: THE AUTOMOBILE INDUSTRY
Polls consistently showed the bailout of General Motors and Chrysler by the Bush and Obama Administrations to be unpopular with American voters.
Nor can a failing industry contribute large amounts of campaign funds. This is clearly not like finance or drugs, two of the cash cows of American politics.
Why then did the bailouts take place? First, because the employees of these two companies largely live in six Midwestern presidential “swing” states. These are states that typically decide a presidential election. Second, because the United Auto Workers, like other major unions, is an important source of campaign funds and campaign assistance to the Democratic Party.
Ironically, it is wage and benefit concessions to the United Auto Workers over the years that left General Motors and Chrysler unable to compete. Payments to retired workers in particular added thousands of dollars to the cost of each car, expense that Toyota and other competitors did not have to bear. This presented the American companies with what seemed to be an irresolvable conundrum. The only way to escape the burdens of the past was to declare bankruptcy. But a long drawn out bankruptcy process would destroy customer confidence in the value of warranties, the availability of servicing, and related to these, the resale value of the car.
What the Obama administration did in response to these challenges was extraordinary. It provided billions in bailout funds. It fired the chief executive of General Motors and selected his successor. It put the full faith and credit of the government behind auto warranties, an unprecedented step. But that was only the beginning.
The administration knew that the stockholders of the two companies had already lost everything. The remaining financial stakeholders were the secured creditors and the unsecured creditors. Among the unsecured creditors (those without a direct claim on the company’s assets) was the United Auto Workers. According to law, the secured creditors should be paid first, then the unsecured creditors equally. These well established property rights enshrined in bankruptcy law and ultimately guaranteed by the US Constitution. The Obama administration nevertheless developed a plan which, by ignoring these rights, was arguably illegal.
The specifics of the Obama plan called for the secured creditors of Chrysler to receive about 28% of their money back. The major unsecured creditor, the United Auto Workers, would receive a $4.6 billion note equivalent to 43% of its total claim and 55% of the company. Some of the secured lenders were big banks being kept alive by the federal government, and they agreed to the terms. How could they not do what government told them to do? When the other secured lenders initially balked, they were publicly scolded by President Obama and labeled “speculators.” (33) After even more pressure was applied, all the secured lenders reluctantly accepted the government plan.
The plan for General Motors was similar. In this case, unsecured debt holders other than the United Auto Workers would be offered 10% of the company shares, worth no more than 5% of their investment even if the company recovered. The union by contrast would receive $10.2 billion in cash, equivalent to half its claim, and 39% of the company. If the union received the same deal as the other unsecured creditors, it would have no cash and only about 8% of the company shares.
A group representing some of the creditors at one point in the negotiations pointed out that “[This] amounts to using taxpayers’ money to show political favoritism of one creditor over another.” (34) Law school teachers objected that it amounted to a “sub rosa” reorganization prohibited by law, that it violated property rights, and that it represented a very dangerous precedent. (35) Columnist Lawrence Kudlow said that “political decisions are replacing rule of law.” (36)
As more and more industries drift or cascade into the government-sponsored sector of the economy, we need to stop and ask ourselves: what is this doing to American democracy? Our economy may survive; economies are resilient. But will our political life, or democracy, survive? Do we like the new world that we are creating and leaving our children?
This new world is not just about politicians, their financial needs, and businesses whose cash flows they increasingly control. It is also about new men and women, specialists and operatives who live and thrive in the Wall Street-Washington and wider GSE world.
Consider the career of John Podesta. He worked as a Capitol Hill staffer before forming a lobbying firm, Podesta Associates Inc., with his brother Tony in 1988. He then joined the Clinton White House and rose to become chief of staff.
At the end of the Clinton Administration, Podesta returned to lobbying, but a few years later in 2003 founded the Center for American Progress in Washington, which quickly became the pre-eminent Democratic Party think tank. The Center does not reveal its funders, but is believed to be supported by mega hedge fund investor George Soros among others. When Barack Obama was elected president, Podesta was asked to co-chair the presidential transition team.
Meanwhile the Podesta lobbying firm flourishes. Tony Podesta and his wife Heather are considered among the most powerful Capitol Hill lobbyists; they have garnered many new clients since the start of the Obama administration. The firm’s clients include a defense contractor, a drug company, a giant financial firm, and so forth.
The Podestas have brought it all together: power, money, and intellectual firepower. This is truly a Keynesian world, although not, one thinks, what Keynes himself expected from greater government control of the economy.
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CITATIONS
Chapter 14: Government for Sale (A Digression)
1. Goodwin, NPR interview, n.d.
2. Economist (March 21, 2009): 57-58.
3. Center for Responsive Politics, http://www.opensecrets.org.
4. http://www.townhall.com (March 25, 2009)
5. New York Review of Books (April 9, 2009): 20.
6. Fortune (September 25, 2006); http://www.cnnmoney.com.
7. Dick Morris and Eileen McGann, http://www.townhall.com (March 11, 2009).
8. Grant’s Interest Rate Observer (May 30, 2009): 3.
9. David Reilly, Bloomberg News (April 25, 2009).
10. Atlanta (March 2009): 55, re: the work of economist Andrew Oswald.
11. Washington Times (October 6, 2008): 34.
12. Senate Banking Committee (July 11, 2008).
13. Grant’s Interest Rate Observer (April 6, 2007): 10.
14. Grant’s Interest Rate Observer (November 28, 2008): 2.
15. Forbes (August 11, 2008): 19.
16. http://www.archierichards.com (October 1, 2008).
17. Washington Times (September 29, 2008): 34.
18. David R. Sands, Washington Times (September 29, 2008): 34; (February 9, 2009).
19 Washington Post, as reported in Grant’s Interest Rate Observer (October 17, 2008): 1.
20. Washington Times (February 6, 2009): 10.
21. “Treasury Department” reported in Washington Times (January 26, 2009): 7.
22. New Yorker (May 18, 2009): 50
23. Michael Lewis, http://www.bloomberg.com (March 20, 2009).
24. C. Baum, http://www.bloomberg.com (March 26, 2009).
25. Bloomberg News (May 13, 2009).
26. Bloomberg News (October 1, 2008).
27. F. Sheehan, March 28, 2007, in M. Faber, Gloom, Boom and Doom Report (September
2008): 1.
28. New York Times (June 13, 2008): 1.
29. Lawrence Lindsey, Weekly Standard (December 1, 2008): 22.
30. Bloomberg News (May 15, 2009).
31. David Boaz, http://www.realclearpolitics.com (January 29, 2009).
32. Gary Null, et al., Death by Medicine (Mr. Jackson, VA: Praktikos Books, forthcoming
2010).
33. Economist (May 9, 2009): 14.
34. Economist (May 2, 2009): 64-65.
35. Ann Woolner, Bloomberg News (May 6, 2009).
36. Lawrence Kudlow, Washington Times (May 4, 2009): 31.
Chapter 14
Government for Sale
In the prior chapter, we considered Keynes’s claim that government could do a better job of investing than private enterprise. We evaluated this in terms of the potential threat that it posed for the economy. We have not yet considered what is arguably more important: The threat posed to our democratic institutions by allowing government to become completely mixed up with the world of money and business.
Historian Doris Kearns Goodwin observed that a degree of financial corruption has always existed in the American government, but that it grew exponentially after the Civil War. (1) Why? Because business and government became so closely involved with each other. Sometimes it was the “hard” corruption of outright bribery. More often, it was the “soft” corruption of selling laws, tax breaks, rules, and decisions for campaign contributions, electioneering help, jobs, or other favors.
Government’s job is to guard and protect us. But who will protect us from the guardians themselves, once they become corrupted? There is no certain recourse against a corrupt government.
In Russia today, a holding company, Basic Element, run by the financial oligarch Oleg Deripaska, owes $650 million to Alfa Bank, led by fellow oligarch Mikhail Fridman. Fridman presses Deripaska for repayment. Deripaska speaks to the Russian president, Dimitry Medvedev. The president calls in Fridman and loan is magically deferred. (2)
Russia, having abandoned Communism, has embraced age-old principles of mercantilism. The state does not own the private sector as it once did. But there are really no boundaries between private and public. When businessmen need political favors, they know whom to call. The crony capitalists and politicians are clever; they keep most of it concealed behind closed door.
The world’s most developed countries have not reached this point--yet. But day by day are edging closer to the Russian model. The United States is a case in point.
In 2008, before the rapid expansion of the federal government by the Bush and Obama administrations, government (both federal and state) represented about a third of the economy. The nonprofit sector represented roughly another 10%. This implied that a (bare) majority of the economy was comprised of private, for-profit concerns, the so called private sector. But taking into account companies that are directly or indirectly controlled by government, perhaps as much as two-thirds of the economy is really in the government sphere.
The term Government Sponsored Enterprise (GSE) is generally used to describe private businesses that have been started by government and that continue to enjoy government support. the preeminent examples over the years have been the mortgage giants Fannie Mae and Freddie Mac. It seems appropriate, however, to apply the term GSE more broadly to describe a large number of private firms, all of which either sell to government (defense), are highly regulated, subsidized, price supported, and cartelized by government (healthcare, drugs, housing, and banking and finance), or are dominated by government in a wide variety of ways (law, education, agriculture, autos, broadcasting, utilities, etc.).
The common theme that runs through all these broadly defined GSEs, apart from their dependence on government, is the large amounts of money they give to politicians of both parties and the large amount they spend on lobbying. In 2008, for example, individuals and political action committees (PACs) connected to the finance, insurance, and real estate industries gave $463 million to politicians, with 51% going to Democrats and 49% to Republicans. (3) That same year, then candidate Obama received more money from this source than any other except for trial lawyers. His take from donors in finance ($37.6 million) far exceeded what the Republican candidate, John McCain, got. (4) This flow of money is extremely important to politicians.
The flow of money is not usually tied to a specific favor. But sometimes the connection is unmistakable. For example, in 2007 Congress threatened to end the tax loophole allowing private investment partnership managers to escape taxation at earned income rates. Senator Charles Schumer (D-NY) immediately took steps to protect the loophole. His Democratic Senatorial Campaign Committee subsequently collected almost $5 million from such funds for the 2008 election, double what the Republican committee got. (5)
Campaign contributions are the main thing that politicians want from Wall Street firms and other GSEs. But there are other financial ties including funds from related foundations and jobs for friends or for the politicians themselves. For example, Rahm Emanuel, between stints in the Clinton White House, in Congress, and then in the Obama White House as Chief of Staff, went to Wall Street. Making use of his government contacts, he earned $18 million in only two and a half years, according to his government disclosure forms. (6)
It is especially ironic that Wall Street is regarded by most people as the epicenter of market capitalism. It is, in reality, the epicenter of government-sponsored enterprise. Where Wall Street stops and Washington begins and vice versa is impossible to say. The current symbiosis was not caused, as many suppose, by the Crash of 2008. Rather the Crash of 2008 was caused by the long-standing Wall Street-Washington symbiosis.
In the balance of this chapter, we will examine three GSE case studies, each of which illustrate different aspects of the problem. The first case study will focus on the housing bubble, which involves the Federal Reserve, Congress, the Bush administration, and the real estate and finance industries. The second will focus on the drug industry and how it interacts with Washington. The third will very briefly look at automobile industry troubles. Although this chapter mainly focuses on government/industry ties, we should not forget the vast sums of money flowing to Washington from labor unions and trial lawyers and other special interests as well as from broadly defined GSE industries.
CASE STUDY ONE: THE U.S. HOUSING BUBBLE
Conventional wisdom blames the housing bubble on Wall Street greed. That is only a half-truth. When government serves free drinks by printing money, driving interest rates down and overspending, Wall Street tends to get drunk. This is very convenient for government because, when the hangover comes, the average person will blame the drunk, not the bartender. This happened each time a bubble popped, at the end of the 1920s, the end of the 1990s, and the end of the recent housing bubble.
Throughout the housing bubble, the government sought to provide cheap mortgages by driving interest rates down. generally with the help of other central banks. When the Fed Funds Rate was held below the rate of inflation for three years, this was virtually giving money away to those with the clout and the collateral to get it. These initial borrowers then make the money available to other borrowers, especially to consumers for housing loans.
The US government had already made mortgage interest tax deductible and eliminated most capital gains taxes on homes. It also provided loan guarantees through the Federal Housing Administration (FHA) and its own cheap mortgages both through the Federal Home Loan Banks and the private/public entities Fannie Mae and Freddie Mac. The government’s Department of Housing and Urban Development did its part by mandating that Fannie and Freddie invest what became 50% of assets in lower-end mortgages, including, if necessary, unqualified mortgages, the ones that later blew up. (7)
By the end of 2007, government-sponsored mortgages accounted for 81% of all mortgage loans made in the US. (8) During 2008, Fannie Mae developed the Home Saver program. This enabled defaulting homeowners to borrow additional money to cover the arrears in their mortgage payments. Although ostensibly designed to help struggling homeowners, the new loans meant that none of the original loans had to be considered in default. More importantly, none of them had to be written off. Many of the new Home loans were written off almost immediately, nearly half a billion worth, but this sum was small compared to the original loans that could be kept on the books for awhile longer. In this and other creative ways, Fannie executives kicked the can (of mortgage defaults) down the road a bit further into the future.
Official government propaganda kept touting home ownership as the American dream. No one paid attention to studies showing that countries and regions with the highest home ownership also had the highest unemployment rate. Why? Because home ownership makes it difficult for workers to move to where the jobs are, especially to where the best jobs for their particular skills are. (10) This was finally noticed after the housing crash.
Democratic politicians especially liked Fannie and Freddie. They exempted both from state and local sales tax and some Securities and Exchange Commission (SEC) requirements and also gave them implied government backing for their bonds. They fought off Bush administration efforts to regulate them more, even after it became apparent that both firms had issued false accounting statements. They also saw nothing wrong with Fannie and Freddie borrowing $60 for each $1 of capital, much more leverage than even Wall Street used.
Representative Barney Frank, chair of the US House Financial Services Committee, said that fears of a looming crisis were “exaggerated.” His counterpart in the Senate, Christopher Dodd, chair of the Banking Committee, agreed. (11) As late as July 2008, Dodd said that: “[Fannie and Freddie] are fundamentally sound and strong. There is no reason for the reaction we’re getting.” (12) Before the end of the year, both companies had collapsed and been refinanced by the government. Earlier, Frank was worried that any attempt to reign in Fannie and Freddie would make housing less “affordable,” presumably for people of modest means. He did not explain what Fannie and Freddie government-supported loans of as large as $625,000 had to do with affordability, or how soaring home values made homes more affordable.
By 2006, cheap credit had doubled the price of the average house in less than ten years. (13) By then, the housing bubble had spread round the world and become the largest and most universal bubble in economic history. The 1920s bubble in the US led to a total debt to gross domestic product ratio of 185% in 1928. The housing bubble led to a total US debt to GDP ration of 357% by 2008. (14)
What nobody mentioned throughout the debate about Fannie and Freddie was how convenient their supposedly private but actually public status was for politicians. As private companies, they could make campaign contributions through their employees and their PACs (Political Action Committees). Their “foundations” could also provide “soft” funding for a host of political purposes. As Forbes Magazine publisher Steve Forbes noted in August 2008:
The two most mammoth political powerhouses in America today are Fannie Mae and Freddie Mac. Their lobbying muscle makes Arnold Schwarzenegger look like a 90-pound weakling. Directly and indirectly they employ legions of ex-pols to help them [and their friends] on the Hill. They hand out largesse of one sort or another to any pol who matters and is willing to take it. Fannie Mae’s “charitable” operations have field people in virtually every congressional district.
These monsters are fiercely resistant to any change affecting their ability to tap Uncle Sam’s ATM at will while privatizing profits and socializing losses. (15)
Fannie’s nonpolitical money even went to Acorn, the group charged in 2008 with voter fraud. (16) Altogether, excluding “charitable” gifts, Fannie spent $170 million on lobbying from 1998-2007 and $19.3 million on campaign contributions from 1990. The largest sum during the 2006-2008 electoral cycle went to Senate Banking Committee Chair Dodd, and the second largest to then Senator Obama. (17)
Senator Dodd was also the second largest recipient of funds from a political action committee (PAC) organized by Countrywide Financial, a leading sub prime mortgage lender, as well as recipient of two mortgages from Countrywide’s VIP program that waived points and other fees. Later Dodd stated that he did not realize he was getting special treatment and refinanced the loans elsewhere. The largest recipient of funds from the Countrywide PAC was the then Senator Obama.
As the Crash of 2008 unfolded, the government did not of course just bail out Fannie and Freddie. It bailed out banks and investment banks as well. In early October 2008, the government told nine major banks and investment banks that they must sell the government an ownership stake in their companies even if they did not need the money, just to show that the government stood behind the banks. (19)
In a stroke, banks like Citigroup, JP Morgan Chase, Bank of America, Wells Fargo, Bank of New York, and State Street became full-fledged GSEs, little different than traditional GSEs like Fannie and Freddie. So did investment banks like Goldman Sachs and Morgan Stanley. Shortly thereafter, Barney Frank received $9,500 from Wells Fargo’s and Goldman Sach’s PACs, (20) presumably just a beginning. With tighter controls over the old GSEs and many new ones, the flow of money to Washington would inevitably break all records.
Not surprisingly, Democratic Party leaders selected eleven newly elected Democratic members of the house who had won their races by narrow margins and assigned them to the Financial Services Committee. In this way, they could be sure to raise plenty of money. The money alone might discourage Republican challengers. In this way, control of Congress helps to cement future control of Congress.
During the fall of 2008, leading investment banks such as Goldman Sachs and Morgan Stanley legally became banks. This meant that these firms, essentially giant hedge funds, could enjoy permanent access to newly printed government money offered at the lowest possible rates, rates shortly fell to just above zero. This was deeply ironic. At a time when many sound companies on “Main Street” were struggling to obtain loans at high rates, the leading Wall Street speculators could borrow directly from the government at bargain rates.
At that very moment, the recent head of Goldman Sachs, Hank Paulson, now secretary of the Treasury, was running the government’s Wall Street rescue operation with Ben Bernanke, chairman of the US Federal Reserve. Paulson’s firm directly received $10 billion of TARP bailout money (21) in addition to cheap money from the Fed’s loan window. But that was not all.
The largest single chunk of TARP money, $173 billion, went to American International Group (AIG), a giant insurer. When the company ran into trouble, Paulson selected Edward Liddy, previously a director of Goldman Sachs, to run it. (22) Because AIG owed money to others, much of the bailout flowed through to other firms whose names the government refused to disclose, possibly because some of these firms were foreign. Some of the names leaked, however, and it turned out that almost $13 billion of the AIG bailout money had gone to Goldman Sachs.
AIG, by the way, had been a major source of campaign donations. The number two recipient of these funds for 2003-2008 had been Senator Dodd. The number one recipient had been then Senator Obama. (24)
During the fall of 2008, Secretary Paulson also arranged for Bank of America, a recipient of TARP money, to rescue Merrill Lynch, the giant investment firm. The head of Bank of America later testified that Paulson had directed him to complete the transaction and also asked him not to disclose how bad Merrill’s losses were, which may have been illegal. The then head of Merrill Lynch was a former head of Goldman Sachs and thus a former colleague of Paulson’s.
When the Obama administration came in, Timothy Geithner, the president of the New York Federal Reserve, the operating arm of the US Federal Reserve, took Paulson’s job. A former chief economist of Goldman Sachs, William Dudley, then took Geithner’s New York Fed job. Shortly thereafter, the chairman of the New York Fed, Stephen Freidman, another former Goldman Sachs head and also former chief economic advisor to President George W. Bush, decided to resign because he wanted to be more active at Goldman. (25)
The cozy Wall Street-Washington club described above has many departments. One of them is the leading private securities rating services--Standard and Poor’s, Moody’s, and Fitch. These firms played an important role in blowing up the housing bubble by giving safe ratings to mortgage securities that turned out to be anything but safe.
How did these firms come to hold so much power in the securities market? The answer: government laws and regulations forbid the purchase (by insurance companies, banks, money market funds, et al) of securities not rated by these select firms. In other words, the government has created a protected cartel of raters. Since the cartel was immune from competition, it was easy for Wall Street to win approval for dubious securities, especially since the flood of such securities was generating so much fee income for the raters.
All bubbles eventually pop. The housing bubble was no exception. But why did it pop when it did? A major precipitating factor was an obscure accounting rule applied to banks (but not insurance companies) in 2007 called “mark-to-market.” This rule change (FASB 157) forced many banks to write down the value of their assets, thereby creating insolvency or worries about insolvency, which in turn triggered federal bailouts.
There was a Keystone Cops element about this. Mark-to-market was accurately described by some critics as mark-to-make-believe. When real market prices are not available, often the case with bank assets, the rule essentially makes them up. Auditors implementing the rule operated in an atmosphere of fear created by the federal Sarbanes Oxley Act, and also looked nervously over their shoulder at the threat of lawsuits from trial lawyers. They were naturally more inclined to play it safe by writing down assets, sometimes to zero, even when cash flows from the investments were still entirely positive.
Even Fannie Mae, the most egregiously over leveraged financial firm, never actually ran out of money, the commonsense definition of bankruptcy. The government, acting through the Securities and Exchange Commissions, could have called a “mark-to-market” time out. It could have temporarily or permanently suspended mark-to-market while requiring the same information to be provided as footnotes to accounting statements.
Why did both the Bush and Obama administrations choose to let what Forbes Magazine publisher Steve Forbes called “accounting asininity” continue unchecked? Perhaps because Fed Chairman Ben Bernanke strongly opposed even a temporary suspension. (26) Perhaps because European governments, partial architects of the rule through the Basle Accords, did not want to admit error. The rule was finally revised, but not until April of 2009.
This was not the only instance of misjudgment of Bernanke’s part. It was one of a cascading avalanche of such errors. Both as a governor, and then as chairman of the Federal Reserve, Bernanke had been generally responsible for financing the bubble with cheap debt. He clung to the idea that so long as consumer price increases were restrained, there was no reason to worry about an asset bubble. As the signs of trouble steadily gathered, he said that
• US households have been managing their personal finances well” (June 13, 2006).
• “We do not expect significant spillovers from the subprime [mortgage] market to
the rest of the economy or to the financial system” (March 28, 2007). (27)
He also made one last crucial error, when he drastically cut the Fed Funds rate again in September of 2007.
By this time, no one could claim that consumer price increases were restrained. Even the government’s doctored index showed them advancing at 5% a year. Bernanke cut rates anyway, and his action had the completely unintended consequence of setting off a race out of the dollar and into commodities such as oil. The price of a barrel of oil quickly doubled, which helped to panic consumers and slow business.
In more Keystone Cops fashion, Senator Joe Lieberman blamed the oil price rise, not on Bernanke’s actions, but rather on speculators. He threatened to enact legislation banning large institutional investors from investing in commodities altogether. (28) By the time he spoke, commodity prices had already peaked and were about to free-fall during the Crash.
Bernanke had hoped that his rate cut would help bring down mortgage rates. Instead mortgage rates kept climbing. Meanwhile Wall Street firms responded by taking one last, long gulp of Bernanke’s cheap money-- only to find very shortly that more leverage at very short maturities was the last thing they needed in an imploding economy. And it was not just Wall Street. Ship owners ordered more ships, businesses added to inventory, all just at the wrong time, all prompted by the Fed’s rate cut.
By October 2008, President Bush was spreading panic by saying on television that a failure to pass his TARP (Troubled Assets Relief Program) bill would leave the economy in ruin. Retail sales began to fall dramatically right after the President spoke. (29) So did Republican election prospects.
Seven hundred billion dollars in TARP money was sold as a program to buy troubled mortgages from banks. After passage the treasury secretary agreed (privately, not publicly) that the plan made little sense. There being no market for the mortgages, there was no way to price them. Even if there had been a market, buying them at real market value would not help the banks. Later Tim Geithner, Obama’s new secretary of the Treasury, revived the idea anyway, in the form of a giveaway to Wall Street.
Consider what was happening here. After endless government interference, the price system had broken down in the mortgage field. The most important task was to establish real market prices (not phony “mark-to-market” prices) for mortgages.
The main reason that the mortgage price system had broken down was because of cheap government loan money and loan guarantees. So what does Secretary of the Treasury Geithner decide to do? He decides to offer still more guaranteed government loans, in this case loans intended to convince Wall Street firms to buy the bad mortgages. Result:
• More taxpayer money dumped into Wall Street pockets.
• Complete frustration of the market price discovery process
What if Geithner’s plan failed? What if Wall Street refused to buy the bad mortgages from the banks or the banks refused to sell them despite the government price subsidies? In that case, said Federal Deposit Insurance Corporation (FDIC) Chairman Sheila Bair, the banks would “need to be told” by the government to sell the mortgages whether they wanted to or not at the government engineered price. (30) That of course would make it even more impossible to discover true market prices for the mortgages, the one step that would really help end the crisis.
The banks originally targeted for President Bush’s TARP funds were those considered “too big to fail.” In most cases, these banks had grown to giant size with government encouragement. Each time a smaller bank is in danger of failing, the usual government response is to try to merge it into one of the banking behemoths. In practice, the TARP funds became a honey pot that firms in a great variety of congressional districts tried to get a through their members of Congress.
Not all the TARP funds were even used for the financial crisis. In order to win passage, it included special provisions for Puerto Rican rum producers, auto race tracks, companies operating in American Samoa (one of which, Starkist, was based in Speaker of the House Nancy Pelosi’s district), tax benefits for various parties, even a requirement that medical insurance companies cover mental health. (31)
Buried deep in the fine print, the Act also vastly expanded the power of the Federal Reserve by allowing it to pay interest on member bank deposits. This was a critically important change in the monetary system, one that would allow the Fed to print much more money. Did members of Congress even know about this provision of the bill? It is doubtful. If they did, they probably had no conception of its purpose or importance.
The housing bubble illustrates how government errors may paradoxically increase government control over large swaths of the economy. Yet in the long run it is not clear who will control whom. Will government keep the upper hand in a government-Wall Street “partnership”? Or will Wall Street eventually take control of government, using its vast powers to restrict competition and create sustainable monopoly pricing?
This is not an idle question. To see how a regulated industry co-ops the regulator and uses the power of government for its own purposes, we need only to turn to our next case study.
CASE STUDY TWO: THE DRUG INDUSTRY
The drug industry at one time was called the patent medicine industry, and this is still the more revealing name.
Drug companies devote themselves to inventing non-natural molecules for use in medicine. Why non-natural? Because molecules previously occurring in nature cannot, as a rule, be patented. It is essential to develop a patentable medicine, because only a medicine protected by a government patent can hope to recoup the enormous cost (up to $1 billion) of taking a new drug through the government’s drug approval process.
Getting a new drug through the US Food and Drug Administration (FDA) is not just expensive. It also requires having the right people on your side. Drug companies know that they must hire former FDA employees to assist with the process. They also hire leading experts as consultants, experts who will probably be called on by the FDA to serve on screening panels. Direct payments must also be made to support the FDA’s budget.
Although the costs are astronomical, the financial payoff from FDA approval is even bigger. Only FDA-approved drugs can be prescribed within government programs such as Medicare. Doctors may prescribe unapproved substances outside of Medicare, Medicaid, or the Veteran’s Administration but by doing so risk losing their license to practice.
The FDA will also discourage, and often ban, substances that might compete with approved drugs. When antidepression drugs (based on extending the life of a hormone, serotonin, inside the body) were approved, the Agency promptly banned natural substance, L-Tryptophan, that increased serotonin, even though the natural substance was much cheaper and had long been available. Many years later, after the antidepression drugs were well established, Tryptophan was finally allowed back, but under restrictions that make it more expensive.
In effect, then, drug companies are not really private companies competing in an open market. They are also government-sponsored enterprises (GSEs) not unlike Fannie Mae or Freddie Mac, and (now) the big Wall Street banks and firms. It should not be surprising therefore that drug companies, like Fannie and Freddie, spend millions on political lobbying and campaign contributions. Many politicians rely on these campaign contributions and thus have a vested interest in maintaining the drug cartel, even though needlessly high drug costs contribute to soaring medical costs.
The government’s share of these soaring medical costs is, in part, financed by borrowing from China and other countries. Too much of the borrowed money is spent making old people miserable in the discomfort of hospitals prior to their deaths. In fact, medical errors and unintended consequences of treatment may be the leading cause of death in the US.
In the US, businesses pay for a great deal of medical care. Consequently, monopoly-driven drug prices also reduce business profits, which in turn leads to fewer raises for existing employees, less hiring, and ultimately to higher unemployment. Higher business costs also lead to fewer export sales, which increases the US trade deficit, and so on it goes, with one undesirable and unintended consequence after another.
The bottom line here is the drug companies, ostensibly regulated by the government, have come to dominate and even control the regulators. the result is a semisocialized drug cartel, enforced by government, whose power is wreaking economic havoc. This is an inherently unstable situation. One possibility is that government will reassert itself through price controls.
Does the drug industry story shed further light on what happened in Wall Street after the housing bubble? It might. In the immediate aftermath of the Crash of 2008, it seemed that government was taking control of Wall Street. But money, power, and control have been flowing back and forth between Wall Street and Washington for years. There is always traffic in both directions. In the short run, Washington is reasserting itself. In the long run, as previously noted, Wall Street may turn a tighter relationship to its own advantage.
CASE STUDY THREE: THE AUTOMOBILE INDUSTRY
Polls consistently showed the bailout of General Motors and Chrysler by the Bush and Obama Administrations to be unpopular with American voters.
Nor can a failing industry contribute large amounts of campaign funds. This is clearly not like finance or drugs, two of the cash cows of American politics.
Why then did the bailouts take place? First, because the employees of these two companies largely live in six Midwestern presidential “swing” states. These are states that typically decide a presidential election. Second, because the United Auto Workers, like other major unions, is an important source of campaign funds and campaign assistance to the Democratic Party.
Ironically, it is wage and benefit concessions to the United Auto Workers over the years that left General Motors and Chrysler unable to compete. Payments to retired workers in particular added thousands of dollars to the cost of each car, expense that Toyota and other competitors did not have to bear. This presented the American companies with what seemed to be an irresolvable conundrum. The only way to escape the burdens of the past was to declare bankruptcy. But a long drawn out bankruptcy process would destroy customer confidence in the value of warranties, the availability of servicing, and related to these, the resale value of the car.
What the Obama administration did in response to these challenges was extraordinary. It provided billions in bailout funds. It fired the chief executive of General Motors and selected his successor. It put the full faith and credit of the government behind auto warranties, an unprecedented step. But that was only the beginning.
The administration knew that the stockholders of the two companies had already lost everything. The remaining financial stakeholders were the secured creditors and the unsecured creditors. Among the unsecured creditors (those without a direct claim on the company’s assets) was the United Auto Workers. According to law, the secured creditors should be paid first, then the unsecured creditors equally. These well established property rights enshrined in bankruptcy law and ultimately guaranteed by the US Constitution. The Obama administration nevertheless developed a plan which, by ignoring these rights, was arguably illegal.
The specifics of the Obama plan called for the secured creditors of Chrysler to receive about 28% of their money back. The major unsecured creditor, the United Auto Workers, would receive a $4.6 billion note equivalent to 43% of its total claim and 55% of the company. Some of the secured lenders were big banks being kept alive by the federal government, and they agreed to the terms. How could they not do what government told them to do? When the other secured lenders initially balked, they were publicly scolded by President Obama and labeled “speculators.” (33) After even more pressure was applied, all the secured lenders reluctantly accepted the government plan.
The plan for General Motors was similar. In this case, unsecured debt holders other than the United Auto Workers would be offered 10% of the company shares, worth no more than 5% of their investment even if the company recovered. The union by contrast would receive $10.2 billion in cash, equivalent to half its claim, and 39% of the company. If the union received the same deal as the other unsecured creditors, it would have no cash and only about 8% of the company shares.
A group representing some of the creditors at one point in the negotiations pointed out that “[This] amounts to using taxpayers’ money to show political favoritism of one creditor over another.” (34) Law school teachers objected that it amounted to a “sub rosa” reorganization prohibited by law, that it violated property rights, and that it represented a very dangerous precedent. (35) Columnist Lawrence Kudlow said that “political decisions are replacing rule of law.” (36)
As more and more industries drift or cascade into the government-sponsored sector of the economy, we need to stop and ask ourselves: what is this doing to American democracy? Our economy may survive; economies are resilient. But will our political life, or democracy, survive? Do we like the new world that we are creating and leaving our children?
This new world is not just about politicians, their financial needs, and businesses whose cash flows they increasingly control. It is also about new men and women, specialists and operatives who live and thrive in the Wall Street-Washington and wider GSE world.
Consider the career of John Podesta. He worked as a Capitol Hill staffer before forming a lobbying firm, Podesta Associates Inc., with his brother Tony in 1988. He then joined the Clinton White House and rose to become chief of staff.
At the end of the Clinton Administration, Podesta returned to lobbying, but a few years later in 2003 founded the Center for American Progress in Washington, which quickly became the pre-eminent Democratic Party think tank. The Center does not reveal its funders, but is believed to be supported by mega hedge fund investor George Soros among others. When Barack Obama was elected president, Podesta was asked to co-chair the presidential transition team.
Meanwhile the Podesta lobbying firm flourishes. Tony Podesta and his wife Heather are considered among the most powerful Capitol Hill lobbyists; they have garnered many new clients since the start of the Obama administration. The firm’s clients include a defense contractor, a drug company, a giant financial firm, and so forth.
The Podestas have brought it all together: power, money, and intellectual firepower. This is truly a Keynesian world, although not, one thinks, what Keynes himself expected from greater government control of the economy.
___________________________________________________
CITATIONS
Chapter 14: Government for Sale (A Digression)
1. Goodwin, NPR interview, n.d.
2. Economist (March 21, 2009): 57-58.
3. Center for Responsive Politics, http://www.opensecrets.org.
4. http://www.townhall.com (March 25, 2009)
5. New York Review of Books (April 9, 2009): 20.
6. Fortune (September 25, 2006); http://www.cnnmoney.com.
7. Dick Morris and Eileen McGann, http://www.townhall.com (March 11, 2009).
8. Grant’s Interest Rate Observer (May 30, 2009): 3.
9. David Reilly, Bloomberg News (April 25, 2009).
10. Atlanta (March 2009): 55, re: the work of economist Andrew Oswald.
11. Washington Times (October 6, 2008): 34.
12. Senate Banking Committee (July 11, 2008).
13. Grant’s Interest Rate Observer (April 6, 2007): 10.
14. Grant’s Interest Rate Observer (November 28, 2008): 2.
15. Forbes (August 11, 2008): 19.
16. http://www.archierichards.com (October 1, 2008).
17. Washington Times (September 29, 2008): 34.
18. David R. Sands, Washington Times (September 29, 2008): 34; (February 9, 2009).
19 Washington Post, as reported in Grant’s Interest Rate Observer (October 17, 2008): 1.
20. Washington Times (February 6, 2009): 10.
21. “Treasury Department” reported in Washington Times (January 26, 2009): 7.
22. New Yorker (May 18, 2009): 50
23. Michael Lewis, http://www.bloomberg.com (March 20, 2009).
24. C. Baum, http://www.bloomberg.com (March 26, 2009).
25. Bloomberg News (May 13, 2009).
26. Bloomberg News (October 1, 2008).
27. F. Sheehan, March 28, 2007, in M. Faber, Gloom, Boom and Doom Report (September
2008): 1.
28. New York Times (June 13, 2008): 1.
29. Lawrence Lindsey, Weekly Standard (December 1, 2008): 22.
30. Bloomberg News (May 15, 2009).
31. David Boaz, http://www.realclearpolitics.com (January 29, 2009).
32. Gary Null, et al., Death by Medicine (Mr. Jackson, VA: Praktikos Books, forthcoming
2010).
33. Economist (May 9, 2009): 14.
34. Economist (May 2, 2009): 64-65.
35. Ann Woolner, Bloomberg News (May 6, 2009).
36. Lawrence Kudlow, Washington Times (May 4, 2009): 31.
Thursday, April 15, 2010
Why Am I Not Surprised?
The health insurance industry people have already begun their maneuvers to get around some of the restrictions placed on them by the new law.
Many will look at this and say: See you cannot leave them to the “free market”. They will never do the right thing.
In response to this complaint, one of the commentators on the article said what I would have said but much better than I could have said it:
Please we have got to learn what the free market is and what it is not.
http://www.reuters.com/article/idUSTRE63E4QQ20100415?feedType=RSS&feedName=healthNews&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+reuters%2FhealthNews+%28News+%2F+US+%2F+Health+News%29
Many will look at this and say: See you cannot leave them to the “free market”. They will never do the right thing.
In response to this complaint, one of the commentators on the article said what I would have said but much better than I could have said it:
And these are the “honest” corporations that Tea-Party-ers and Republicans want to be left to themselves in a “free-market”, because “unregulated” big business will “benefit” the American people.
Sure, it will (!).
A truly “free” market would have no constraints on medical services, medicines, or licensure.
As soon as a government places restrictions on obtaining medical services, that government has created a restricted market that can be monopolized and leveraged against those who need it. Limiting free access to medicines or procedures naturally turns them into products and excludes segments of the population that cannot afford those products.
It is a governmentally-derived limitation that creates such a market (one which is no longer “free”). Thus, it automatically becomes the obligation of that same government, which created a situation excluding part of its population from access to care, to put into place those mechanisms of regulation that will restore access to excluded populations.
In other words, the medical market ceased to be “free” as soon as care and medicine were regulated in any form. We cannot now pretend that leaving those companies and institutions which provide governmentally authorized medical care to themselves in any way constitutes “free-market” practice, since in reality it is government-enforced “closed market” monopoly commerce.
Presently, before any of this new bill goes into effect, the “free market” medical industry already has to spend upwards of 340 billion per year to comply with government regulations. It has not been a free market for decades. The problems that we now have in accessing cost effective medical care are directly a result of the government already having crippled the market with its restrictions, regulations and price controls.
Please we have got to learn what the free market is and what it is not.
Saturday, April 10, 2010
In Response to Questions 1
My daughter-in-law raised some good questions in her comments to my post- Free Markets - Yes or No (Part 2). Another commentator also had questions regarding similar issues particularly regarding deregulation. It was necessary that I begin another post to try to respond to their questions because of the amount of information. I appreciate the dialogue very much. I think we really need to discuss these issues. They are vital to our future.
Kat said...
Denny said...
To begin with Kat --I was raised in one of the “steel centers” of our country - the Chicago/Lake Michigan area. My dad took care of his family (that’s us) with his 30 plus years at Blaw-Nox Steel Company in East Chicago, Indiana. For us the collective bargaining of the steel unions was essential. This bargaining made what otherwise would have been an unacceptably dangerous job acceptable and profitable for my dad and for us with benefits we all needed. However the danger of unions is critical to understand. Production is a very important factor in the level of wages. If within an industry production is up because of substantial demand for the product, wages also need to rise. For the employers within that industry unless they raise wages they run risk of losing their workers to other employers who see that there is much profit to be made if they can increase their supply of the product. This whole scenario has a tendency to force wages up to market level. The problem comes when some employers find a way to keep their employees but without raising the wages. In such situations collective bargaining is very useful for putting pressure on stubborn employers.
However the danger comes when labor unions become politically powerful enough to force wages above market. This will cause unemployment and other detrimental consequences. Minimum wage laws also increase unemployment. The balancing of wages has to be tied to production and the wage earner’s part of the production. If laws force employers to have to pay more than market or to pay employees above their productivity, they will lay off employees. As I read economists (not government economists) I find that there are many factors contributing to our present situation of persistent unemployment. The factors include the minimum wage requirements. The finger also must point to monetary policy of our government/Fed Reserve. The devaluing of the dollar has contributed to the loss of production which also results in unemployment.
Deregulation is often viewed with suspicion. Like taking controls off of powerful and wealthy folks seems like a dangerous policy. However, removing regulations and restrictions from markets is essential. But it has to be done with a respect for how markets work and has to be done within a market where its functions have not already been disabled. One of the fundamental functions of the market is price control - either up or down. Most people have no idea how powerful those forces are. I know I did not either. These forces are tied firmly to an industry’s participant’s ability to attain and maintain profitability. It is like a balancing act. On one side is the opportunity for increasing revenues and charging what the market will bear. On the other side are the risks. Risks of misunderstanding the market demand and being beaten out by competition. Sears for many years was the king of department stores. However, the company lingered in upgrading its business model. Lo and behold Sears found itself far down the ladder beneath companies like Best Buy, Home Depot and a host of others. Now Sears is having to hustle - innovate- improve service - to try to regain the lost market share. We (the consumers) are the beneficiaries of this situation that produces better products at lower prices.
So what about the financial markets and the deregulation that Greenspan allowed which resulted in the crisis we now find ours in? NPR covered extensively the recent Senate review/investigation of the financial meltdown we’ve just experienced. They brought in Alan Greenspan to answer some questions. He denied over again that the Fed was any cause of the present situation. He blamed Congress for encouraging Fannie Mae and Freddie Mac to purchase more bundled mortgage securities. They purchased 40% motivating mortgage companies to scramble to find more mortgages to bundle and sell earning significant commissions. In addition Greenspan maintained that the Fed had done everything that experts are suggesting that they should have done. And that because of what they had done, things did not turn out as badly as they could have.
There were comments that Greenspan was warned enough but ignored warnings. Greenspan maintains that the Fed policy of keeping the interests rates low did not encourage risky lending. Others say that this policy was indeed a contributing factor. There are many theories floated as to how this fiasco could have happened and under who’s watch did it occur.
AIG bailed out Goldman Sacks with bailout money orchestrated by the Fed. Goldman Sacks when accused of having a special privileged relationship with AIG enabling them to receive those funds replied that they did not have any such relationship. That their contractual agreement would have resulted in them receiving the funds in any case. Goldman Sacks stated that we should be willing to accept volatility from time to time considering what a valuable service they perform for the country.
All of this discussion, conflict and contradicting opinions among experts in the political and economic fields underscores an aspect of all of this that seems to be constantly overlooked. That is the conflict of interest inherent in the function and mission of the Federal Reserve System. The Fed is chartered as the lender of last resort. That has come to mean that the banking system will always have a way out regardless of any risky activity that backfires. The Fed promotes and supports fractional reserve banking, an age old practice which does not require that adequate reserves be held by any banking institution. When reserves are needed, the banks simply access their line of credit with the Fed.
All of this means that the very existence and mission of the Fed encourages risky behavior. This is clear from the beginning of the Fed. The Fed cannot effectively push for the enforcement of strong regulations without sabotaging its mission to endlessly expand banking, the money supply and credit. So it is clear that there is conflict of interest that cannot be resolved as long as we have our present Federal Reserve System. There is no free market in the banking industry as long as the Fed is there to shield banks from market discipline. Therefore deregulation in this context is suicide. Deregulation can only work when the market participants are fully exposed to risk and have to bear the responsibility for their decisions.
The country of Panama has no central bank. They never have for the 100 years that they have been independent. They have a very successful and stable macroeconomic environment. As s result of having no central bank their money supply has become completely market-driven. They have had some banking problems but nowhere near the crises that we have experienced. They are the only Latin American country that has not experienced a financial collapse or a currency crisis since its independence.
Panama’s inflation is always 1 to 3 points lower than the U.S. And even that inflation is caused by the U.S. Federal Reserve’s effect on world prices. They even have had some years that were deflation years. We have been taught to fear deflation. In reality deflation is a healthy function of the market. It produces adverse correctional activity for the financial markets - they lose profits. But it is good for the rest of us as prices are periodically driven downward. But our Fed manipulates markets in attempts to avoid deflationary cycles. In Panama deflation happens without the terrible consequences predicted by our government Keynesian economists. Presently the Panamanians are in their 4th year of market economic growth well above 7%. Oh well, I can at least dream.
Panama Has No Central Bank
http://mises.org/daily/2533
Regarding booms and busts prior to Great Depression: Yes we had them but I think there is some misunderstanding about them. I am putting together another post to explore our history of bank volatility in more detail.
Kat said...
Hmmm... I'm going to go a little off topic here, but I hope that this will all tie together.
The rise of populist movements can be traced throughout history with the rise and fall of economies. Recessions always bring populist movements. This recession has been very interesting for me in that it has brought up a conservative populist movement when historically those movements have been to the left of center.
I find it intellectually fascinating how the "pendulum" has swung. During the Progressive Era, the populist movements of unions and other labor/political activists brought about some VERY needed changes in the free unfettered markets in this country. While I understand that some people think that unions have outlived their usefulness; at one time they were needed. 40 hour work weeks are a good thing. No child labor is a good thing. A living wage is a good thing. None of these things were even an option during the early years of Industrialism and before government regulation of the markets.
I would like to throw the idea out there that perhaps we are in the mess we are in because of the opening and deregulation of the markets. I don’t believe that the government should control the entire economy, but I do think that some regulation is necessary.
Denny said...
...wasn't there a fairly regular cycle of booms and busts prior to the great depression and the regulatory controls it inspired, followed by decades of relative stability until deregulation started chipping away in the 80's? would i be wrong to associate a cause and effect there? i appreciate youre creating this blog and enjoy reading youre thoughts and comments
To begin with Kat --I was raised in one of the “steel centers” of our country - the Chicago/Lake Michigan area. My dad took care of his family (that’s us) with his 30 plus years at Blaw-Nox Steel Company in East Chicago, Indiana. For us the collective bargaining of the steel unions was essential. This bargaining made what otherwise would have been an unacceptably dangerous job acceptable and profitable for my dad and for us with benefits we all needed. However the danger of unions is critical to understand. Production is a very important factor in the level of wages. If within an industry production is up because of substantial demand for the product, wages also need to rise. For the employers within that industry unless they raise wages they run risk of losing their workers to other employers who see that there is much profit to be made if they can increase their supply of the product. This whole scenario has a tendency to force wages up to market level. The problem comes when some employers find a way to keep their employees but without raising the wages. In such situations collective bargaining is very useful for putting pressure on stubborn employers.
However the danger comes when labor unions become politically powerful enough to force wages above market. This will cause unemployment and other detrimental consequences. Minimum wage laws also increase unemployment. The balancing of wages has to be tied to production and the wage earner’s part of the production. If laws force employers to have to pay more than market or to pay employees above their productivity, they will lay off employees. As I read economists (not government economists) I find that there are many factors contributing to our present situation of persistent unemployment. The factors include the minimum wage requirements. The finger also must point to monetary policy of our government/Fed Reserve. The devaluing of the dollar has contributed to the loss of production which also results in unemployment.
Deregulation is often viewed with suspicion. Like taking controls off of powerful and wealthy folks seems like a dangerous policy. However, removing regulations and restrictions from markets is essential. But it has to be done with a respect for how markets work and has to be done within a market where its functions have not already been disabled. One of the fundamental functions of the market is price control - either up or down. Most people have no idea how powerful those forces are. I know I did not either. These forces are tied firmly to an industry’s participant’s ability to attain and maintain profitability. It is like a balancing act. On one side is the opportunity for increasing revenues and charging what the market will bear. On the other side are the risks. Risks of misunderstanding the market demand and being beaten out by competition. Sears for many years was the king of department stores. However, the company lingered in upgrading its business model. Lo and behold Sears found itself far down the ladder beneath companies like Best Buy, Home Depot and a host of others. Now Sears is having to hustle - innovate- improve service - to try to regain the lost market share. We (the consumers) are the beneficiaries of this situation that produces better products at lower prices.
So what about the financial markets and the deregulation that Greenspan allowed which resulted in the crisis we now find ours in? NPR covered extensively the recent Senate review/investigation of the financial meltdown we’ve just experienced. They brought in Alan Greenspan to answer some questions. He denied over again that the Fed was any cause of the present situation. He blamed Congress for encouraging Fannie Mae and Freddie Mac to purchase more bundled mortgage securities. They purchased 40% motivating mortgage companies to scramble to find more mortgages to bundle and sell earning significant commissions. In addition Greenspan maintained that the Fed had done everything that experts are suggesting that they should have done. And that because of what they had done, things did not turn out as badly as they could have.
There were comments that Greenspan was warned enough but ignored warnings. Greenspan maintains that the Fed policy of keeping the interests rates low did not encourage risky lending. Others say that this policy was indeed a contributing factor. There are many theories floated as to how this fiasco could have happened and under who’s watch did it occur.
AIG bailed out Goldman Sacks with bailout money orchestrated by the Fed. Goldman Sacks when accused of having a special privileged relationship with AIG enabling them to receive those funds replied that they did not have any such relationship. That their contractual agreement would have resulted in them receiving the funds in any case. Goldman Sacks stated that we should be willing to accept volatility from time to time considering what a valuable service they perform for the country.
All of this discussion, conflict and contradicting opinions among experts in the political and economic fields underscores an aspect of all of this that seems to be constantly overlooked. That is the conflict of interest inherent in the function and mission of the Federal Reserve System. The Fed is chartered as the lender of last resort. That has come to mean that the banking system will always have a way out regardless of any risky activity that backfires. The Fed promotes and supports fractional reserve banking, an age old practice which does not require that adequate reserves be held by any banking institution. When reserves are needed, the banks simply access their line of credit with the Fed.
All of this means that the very existence and mission of the Fed encourages risky behavior. This is clear from the beginning of the Fed. The Fed cannot effectively push for the enforcement of strong regulations without sabotaging its mission to endlessly expand banking, the money supply and credit. So it is clear that there is conflict of interest that cannot be resolved as long as we have our present Federal Reserve System. There is no free market in the banking industry as long as the Fed is there to shield banks from market discipline. Therefore deregulation in this context is suicide. Deregulation can only work when the market participants are fully exposed to risk and have to bear the responsibility for their decisions.
The country of Panama has no central bank. They never have for the 100 years that they have been independent. They have a very successful and stable macroeconomic environment. As s result of having no central bank their money supply has become completely market-driven. They have had some banking problems but nowhere near the crises that we have experienced. They are the only Latin American country that has not experienced a financial collapse or a currency crisis since its independence.
Panama’s inflation is always 1 to 3 points lower than the U.S. And even that inflation is caused by the U.S. Federal Reserve’s effect on world prices. They even have had some years that were deflation years. We have been taught to fear deflation. In reality deflation is a healthy function of the market. It produces adverse correctional activity for the financial markets - they lose profits. But it is good for the rest of us as prices are periodically driven downward. But our Fed manipulates markets in attempts to avoid deflationary cycles. In Panama deflation happens without the terrible consequences predicted by our government Keynesian economists. Presently the Panamanians are in their 4th year of market economic growth well above 7%. Oh well, I can at least dream.
Panama Has No Central Bank
http://mises.org/daily/2533
Regarding booms and busts prior to Great Depression: Yes we had them but I think there is some misunderstanding about them. I am putting together another post to explore our history of bank volatility in more detail.
Wednesday, April 7, 2010
Free Markets - Yes or No (Part 2)
Regarding the FDIC I will refer to a quote from Ron Paul in his book “End The Fed”:
Free markets do not require that participants do the right thing -- out of a sense of duty to their fellow man. The free market does, however, put effective pressure on the participants do the right thing in a much more convincing way. If they do not do the right thing, they will lose their shirts. The only way this does not happen is if some entity interferes with the market dynamics in a way that shields some participants from the risk of losing their shirts. Market participants do not have the power or ability to set up devices to shield themselves from market risks. Only government has that kind of power. And market participants constantly seek government involvement (particularly regulations) that will enable them to avoid market risks.
The market is nothing more than a tool. In the right hands (that is the hands of the public with minimal interference by government) it is a useful and beneficial tool for us to live and work and thrive in our nation. In the wrong hands --(the government as it constantly intervenes)-- the market becomes a menace to our welfare.
A free market does not mean that the participants are “free” to do what ever they want to do to unwary consumers. Quite the contrary. A free market means there are little or no barriers to those wishing to enter the market in order to compete. And competition forces the participants to “court” consumers in order to acquire and maintain market share. This “courting” of consumers means supplying what the consumers demand at prices controlled by competition. This includes any demands --goods and services --at competitive prices. A major force in the market are the demands of the consumers. Market participants have to pay close attention to this demand and craft their products and services accordingly. There is a critical difference between "real demand" and perceived demands like "demands" that are more about political expedience than about what consumers are really seeking.
AIG should have been allowed to lose its shirts. The market was “demanding” a correction as a result of risky behavior that backfired. The correction would have included the liquidation of AIG’s toxic assets as it went into bankruptcy. Instead we bailed them out and absorbed their toxic assets (paid full face value money for worthless assets). The government interfered with a necessary market function. The general public would not have been hurt as was stressed by government officials if AIG had been allowed to go bankrupt like Lehman Brothers who somehow did not rate the good graces of the government and was not bailed out. There would have been pain but it would have been limited to the financial sector and it would have been temporary. Historically, bankruptcies do very little (if any) harm to the overall economy. Instead we bailed them out and they are back to business as usual --re-inflating the bubble with the same risky financial devices to continue sucking wealth out of our economy -- heading us toward another meltdown.
Transferring that sum of money to failed institution only hurt our economy as a whole. The present level of unemployment is linked by economists to these recent and earlier redistributions of wealth by our government.
I am not an economist --not by a long shot. But some of these things are painfully obvious as long as you resist accepting the distorted information given to us by a government intent on proving that it is succeeding in its policies when in fact the opposite is true.
Our government (both Democrat and Republican) through misinformation does a good job of demonizing the market so that they can maintain a justification to continue their manipulations for the benefit of some and the detriment to many. The open and free market works best for the many. A controlled market works for those to whom the wealth is funneled as we have blatantly seen with Bear Stearns, AIG, et al. But it also happens (continually) in ways that are not so obvious but just as damaging to the over all economy. And as I have mentioned before, the Federal Reserve System is a pivotal player in this redistribution scheme.
There is so much to say about all of this. But I would rather wait to respond to what others have to say.
There are many programs similar to the CRA (The Community Reinvestment Act of 1977) that add fuel to the fire of waste, fraud, debt, and malinvestment. Significantly contributing to he moral hazard, that is, the bad judgment, have been the FDIC, SEC, Fannie Mae and Freddie Mac, HUD rules and regulations, court orders, the IRS, and a credit card mentality (of the government) of no limits.In one way or another so many of these efforts by government to control economy and minimize risk create situations that cause more damage to the ones they are designed to help than was anticipated. Everything needs to be evaluated not just in terms of the benefit they may bring to a few but to the over all effect including collateral damage and other unintended consequences.
Free markets do not require that participants do the right thing -- out of a sense of duty to their fellow man. The free market does, however, put effective pressure on the participants do the right thing in a much more convincing way. If they do not do the right thing, they will lose their shirts. The only way this does not happen is if some entity interferes with the market dynamics in a way that shields some participants from the risk of losing their shirts. Market participants do not have the power or ability to set up devices to shield themselves from market risks. Only government has that kind of power. And market participants constantly seek government involvement (particularly regulations) that will enable them to avoid market risks.
The market is nothing more than a tool. In the right hands (that is the hands of the public with minimal interference by government) it is a useful and beneficial tool for us to live and work and thrive in our nation. In the wrong hands --(the government as it constantly intervenes)-- the market becomes a menace to our welfare.
A free market does not mean that the participants are “free” to do what ever they want to do to unwary consumers. Quite the contrary. A free market means there are little or no barriers to those wishing to enter the market in order to compete. And competition forces the participants to “court” consumers in order to acquire and maintain market share. This “courting” of consumers means supplying what the consumers demand at prices controlled by competition. This includes any demands --goods and services --at competitive prices. A major force in the market are the demands of the consumers. Market participants have to pay close attention to this demand and craft their products and services accordingly. There is a critical difference between "real demand" and perceived demands like "demands" that are more about political expedience than about what consumers are really seeking.
AIG should have been allowed to lose its shirts. The market was “demanding” a correction as a result of risky behavior that backfired. The correction would have included the liquidation of AIG’s toxic assets as it went into bankruptcy. Instead we bailed them out and absorbed their toxic assets (paid full face value money for worthless assets). The government interfered with a necessary market function. The general public would not have been hurt as was stressed by government officials if AIG had been allowed to go bankrupt like Lehman Brothers who somehow did not rate the good graces of the government and was not bailed out. There would have been pain but it would have been limited to the financial sector and it would have been temporary. Historically, bankruptcies do very little (if any) harm to the overall economy. Instead we bailed them out and they are back to business as usual --re-inflating the bubble with the same risky financial devices to continue sucking wealth out of our economy -- heading us toward another meltdown.
Transferring that sum of money to failed institution only hurt our economy as a whole. The present level of unemployment is linked by economists to these recent and earlier redistributions of wealth by our government.
I am not an economist --not by a long shot. But some of these things are painfully obvious as long as you resist accepting the distorted information given to us by a government intent on proving that it is succeeding in its policies when in fact the opposite is true.
Our government (both Democrat and Republican) through misinformation does a good job of demonizing the market so that they can maintain a justification to continue their manipulations for the benefit of some and the detriment to many. The open and free market works best for the many. A controlled market works for those to whom the wealth is funneled as we have blatantly seen with Bear Stearns, AIG, et al. But it also happens (continually) in ways that are not so obvious but just as damaging to the over all economy. And as I have mentioned before, the Federal Reserve System is a pivotal player in this redistribution scheme.
There is so much to say about all of this. But I would rather wait to respond to what others have to say.
Tuesday, April 6, 2010
Free Markets - Yes or No (Part 1)
My daughter-in-law posted an article on her Face Book page about the devastation wreaked on the city of Birmingham by an out of control, predatory banking establishment.
The following is a discussion resulting from reading the article. The article is in Rolling Stone magazine and I recommend reading it before reading through the following Face Book posts.
http://www.rollingstone.com/politics/story/32906678/looting_main_street/print
The discussion turned into an interchange of ideas about our banking system, the Federal Reserve and free markets, whether or not they work in our favor. I decided to transfer the discussion to this blog to be able to more easily go into the kind of depth necessary to properly address the questions associated with this topic.
I will respond to Kat's questions in the next blog entry.
The following is a discussion resulting from reading the article. The article is in Rolling Stone magazine and I recommend reading it before reading through the following Face Book posts.
http://www.rollingstone.com/politics/story/32906678/looting_main_street/print
The discussion turned into an interchange of ideas about our banking system, the Federal Reserve and free markets, whether or not they work in our favor. I decided to transfer the discussion to this blog to be able to more easily go into the kind of depth necessary to properly address the questions associated with this topic.
Tiny
wow. "low finance" indeed. i feel this way about my student loans, in a way, when i took them out, the federal cap was set, then years later, changed by another president. my interest seems...biblical...in how i owe MORE every year no matter what i pay. gah.
April 3 at 9:45am
Larry Enge
The large banking establishments(ie. JP Morgan et al) are out of control. They got this way by virtue of the protection they’ve had and continue to have from the Federal Reserve System. They constantly employ credit swaps, currency swaps and many other risky though lucrative money manipulations. Within the banking system is bread an attitude of invincibility and arrogance since they know they can buy their way around any restrictions and have the backing of the Fed. It is absolutely positive that they could not get away with this debauchery without the backing of the Fed. They would have to face a real market which would end the risky behavior and arrogance.
The life of our nation has always been threatened by the banking establishment. A push for a federal reserve-type central bank began immediately after our country was established. Thomas Jefferson and James Madison strongly opposed this. In spite of their opposition we finally got a central bank for a few years until it’s charter ran out. Another effort was made for a private central bank. And after much opposition another charter was granted. By the time of Andrew Jackson it was clear how dangerous it was to have central bank. So when the charter was up, Jackson vetoed the charter renewal at great personal and political expense. In 1830 Jackson prevailed and we did not have another central bank until 1913, the birth of the Federal Reserve System which is actually part of an international banking cartel.
The international “banksters” pushing for us to have central bank again finally succeeded in 1913 with the passage of the Federal Reserve Act. This bill, previously orchestrated by Nelson Aldrich, was soundly defeated under President Taft. In order to defeat Taft, the banking community backed Woodrow Wilson, and, to ensure his victory, encouraged ex- President Teddy Roosevelt to run again in order to siphon votes from the popular Taft. Wilson won by 42%, then slipped the Act through a bare quorum of Congress on December 23, 1913 after most of the opposition had gone home for the holidays. ... See More
A couple of quotes from Jefferson:
I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing
power should be taken from the banks and restored to the people, to whom it properly belongs.
—Thomas Jefferson, 1802
“The banks… have the regulation of the safety-valves of our fortunes, and…condense and explode them at their will.” –Thomas Jefferson to John Adams, 1819.
As a result of the Fed the environment of the banking establishment is toxic to regular folks. Notice how Wall street (where the banking establishment lives) got the big bail outs in spite of the fact that the rest of us Americans knew it was a bad idea to bail them out. The wall street bubble is being reinflated by massive infusions through the Federal Reserve System. Yet in the rest of the world, business failure rate continue unabated. Cities, counties and states are particularly hard hit since these local businesses are a main source of revenue for these local governmental institutions. Nearly all 50 states have fallen deeply into the red over the past 5 years. The Wall Street bailouts and infusions are costing us more than we realize. They are adding greatly to the weakening of our economy as well as subjecting us to the predatory arrogance of the banking establishment.
Please do not consider what’s happening in the banking industry as an example of free market gone berserk. The banking establishment has rarely been a free market and not at all been a free market since the Federal Reserve took over the nations banking system.
Sun (4/4/10) at 2:33am
Kat
Didn't Alan Greenspan admit not too long ago that he had based everything on crazy Ayn Rand. Now he says he was wrong... about everything.
Monday (4/5/10) at 4:26 pm
Hey Kat, thanks for responding.
Alan Greenspan was conflicted -- and rightfully so. During most of his tenure he favored free markets. And yes he was greatly influenced by the Objectivism of his long time associate Ayn Rand. His conflict, however, was inevitable. He favored free markets for good reason yet he was chairman of the very institution that by its existence suspended the dynamics of the free market. The Fed’s mission as lender of last resort - in essence a safety net for the banking industry -- cancels out the major function of a free market. That function being to punish risky behavior.
It puts the Fed in a catch 22. Risky behavior in the market can be very lucrative --and it is especially attractive when you know that if you fail you will be bailed. So the Fed in order to control the risky behavior (its presence encourages) presses for regulation in the financial markets (at least so they appear to do so). Greenspan at least tried to be true to his beliefs in a free market. But deregulating a market that is handicapped, that is minus its main control apparatus ( exposure to risk) is suicide as we have seen. The problem is the existence of the Fed.
The banking industry has always wanted a central bank with the power to expand the monetary supply endlessly. During the years that we did not have one, the banks pushed very hard for a central bank because they did not like the market limitations they were exposed to.
Tuesday (4/6/10) at 12:14 am
Kat
But do you think that everyday investors are protected in a free market? How do we protect what little we have from unscrupulous bankers? (But the FDIC is different from the Federal Reserve. Do you believe in one and not the other?)
I think we've discussed this before - but I think that free markets require a certain faith in humanity that I just don't have.
Tuesday (4/6/10) at 7:50 am
I will respond to Kat's questions in the next blog entry.
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