The Coming "Conservative" Depression

Economist Paul Krugman warned in early 2009 that if the administration failed to stimulate the economy appropriately and resorted to more politically acceptable half measures instead that we would quickly find ourselves in a depression as fiscal policy became politically impotent. That warning proved prescient.

Tea Party protests across the nation (the photo at right is from Chicago) reflect genuine outrage that the government spent so much with insufficient benefits to ordinary citizens or the economy in general. Nor can the Tea Party be dismissed as a small group of extremists on this issue as most informed analyses of the 2010 mid-term elections now project a decisive GOP victory complete with a transfer of power in the House. Amazingly, one poll found that only 6% of Americans feel the stimulus package helped reduce unemployment.

Krugman is hardly alone among top economists that feel the economy is desperately in need of more stimulus. Another Noble laureate, Joseph Stiglitz, has repeatedly called for more stimulus spending since at least 2009. More recently, Noble economist Robert Solow published an article explaining the need for a second stimulus. The problem is that going forward the original stimulus will expire in the second half of 2010 and in combination with the cutbacks at the state level government spending will shift from stimulating our very weak economy to creating substantial headwinds that will slow growth at the least and tip us into depression at worst. The states are acting like fifty Herbert Hoovers in terms of cutting expenditures in the face of a severe downturn. In fact, government investment and consumption at all levels has actually stagnated or contracted as a percentage of GDP since the onset of the financial crisis in 2008. Most of the increases in government spending have not been due to any massive public works program (a relatively small part of the stimulus package) but rather automatic stabilizers such as unemployment insurance.

Those automatic stabilizers work wonders. For example, in Germany, automatic stabilizers have led to massive increases in government spending that exceed the increases in government spending in the U.S.--and led Germany into positive GDP to the tune of 9% growth. The United States however, suffers from built-in automatic destabilizers--the fifty states with balanced budget mandates and a body politic schooled in macroeconomic mythology.

If so, 2010 and 2011 are likely to see the "conservative" depression--with only tax cuts on the agenda that will further balloon the deficit while offering very little actual stimulus in the present debt-deleveraging context.

The upshot of this "inconceivably ugly" reality is that the economy is almost certain to face severe challenges this year and next with little or no prospect of either further monetary or fiscal support. The elections are likely to result in fiscal gridlock and our broken banking system renders monetary policy impotent.

This entire episode of fiscal policy impotence would have been a great historical example of why fiscal policy requires legal restructuring, including a shift to a depoliticized expert agency, to add to my article, Fear and Social Capitalism.

The Solution Is How They See The Problem

Now that the financial reform bill is in its final state, we finally have a clear look at what lawmakers view as the problems that led to the financial collapse. When the reform process began the approach that would be taken, and which problems in the financial sector would be solved, was far less clear. Essentially there were two options before policymakers, either limit the size and scope of banks or increase regulation and the power of regulators to prevent problems as they occur. The first approach called for hard and clear caps on the size, function, and actions of banks. Paul Krugman called this the “Roman approach”, an approach that would work even without skilled regulators:

“The pre-1980 system was, I’d argue, pretty robust. Bank regulators didn’t have to be all that smart, because the rules were simple — and besides, the large franchise value of banks, the fact that they faced limited competition and were almost guaranteed to be profitable, made bank executives unwilling to take big risks of killing the goose that laid golden eggs.”

This approach highlighted the staggering growth of financial sector profits as part of all profits in the economy, now 41% of domestic profits, and wanted to trim it down to size. Also questioned was the need and usefulness of “financial innovation” that led to ideas like the Credit Default Swap, the Mortgage Backed Security and further back the Long-Term Capital Management failure and the Savings and Loans crisis. Under this approach we have the ideas of capital requirements (not included in the bill but will be dealt with under Basel III), the plain-vanilla mortgage that would have to be offered to all customers (not in the bill), the Volcker Rule or re-imposition of Glass-Stegall (in the bill but in watered down form), and a financial transaction tax (not in the bill).

This was not the approach that Treasury, the Obama Administration or Congress decided to take. While the bill has received deserved criticism as being insufficient to prevent future crises, this has generally been criticism of the approach taken by the bill not its contents. To analogize to the Health Care debate, there were some who proposed that the only way to reform the system to an acceptable level is to have Single Payer health care, a fundamental change of the system. Instead the Administration took a less radical approach to reform and better the existing system in a less disruptive and conservative way. The less intrusive approach of financial reform relied on empowering regulators and giving the Fed as well as Treasury additional powers to deal with a large bank collapse in a quicker, transparent, and routine fashion. Mike Konzcal describes how this approach looks at the problem:

It’s a story where the regulators just needed a bit more power, a little more legal scope, and a greater extension of what jurisdiction the Federal Reserve has in order to rush in and save the day. A story where the Federal Reserve can successfully carry out prompt corrective action, detecting problems early and guiding banks back to health, on an institution with $2 trillion dollars on its sheet. A story where that institution’s off-balance sheet and the warehouse of derivatives it holds are no match for our regulator’s stare. But more importantly, it is a story where the regulators will be able to sweep in during a moment of crisis and keep the financial sector working no matter what.

Here the bill does well, giving Treasury the power to break up big banks or “resolution authority” that is commonplace under the FDIC and to help avoid situations like the Lehman bankruptcy that lead to panic and the seizing up of credit. There is also language in the bill to limit derivative trading to try to prevent some of the most egregious casino like behavior. It also will require regulators to draft new regulations that more closely fits the intricacies of the financial impact – it’s the use of a scalpel instead of a hammer.

So then what does this bill see as the problems that led to the financial collapse? This bill isn’t a harsh lesson to banks, punishing them for their part in causing the financial collapse only to be bailed out by the taxpayer. The bill doesn’t impose anything like the consequences that would have occurred if these banks had been left to fail on their own. But while not a total change this bill represents an ideological shift away from the culture deregulation that we have seen over the last thirty years. The bill is a clear message that continual deregulation, where the free market (or a market dominated by powerful political and economic actors in a world post-Citizens United) is wholly allowed to govern economic activity leads to inefficient outcomes and poses a systemic risk to the economy.

Dodd-Frank: My Final Take

The Dodd-Frank Act can only be termed an epic failure of policy. The Act includes some positive elements such as the corporate governance reforms and predatory finance prohibitions. Nevertheless, the importance of these reforms pales in comparison to the risks of another financial meltdown as well as deeply impaired macroeconomic performance far into the future. In fact, not only do I share the concerns voiced by Joseph Stiglitz and others regarding the risks of a future crisis, I fear that the Act fails to deal appropriately with the current crisis and instead seems predicated on the erroneous assumption that the subprime debacle and the financial crisis of late 2008 and 2009 are over.

For example, bank capital remains under siege. European debt could explode at any moment and the bailout of last spring appears inadequate. Student loans will inexorably erode bank capital because of the dearth of job opportunities for graduates. The residential real estate market continues to meltdown, with the commercial real estate market now inflicting comparable losses on the financial sector. One trillion dollars of consumer debt suffers from serious delinquency. Consumer deleveraging will continue to suppress demand for quite some time. This will continue to mean employment problems that will lead to more losses on debt. Dodd-Frank does nothing to address any of this and instead reaffirms the lack of real restructuring in the financial sector and virtually zero help for anyone other than the most economically powerful. Without any restructuring in the financial sector expect the same financial elite faced with same financial balance sheets to engage in the same conduct as today—hoarding cash.

The Act allows massive government guarantees to persist and therefore continues the massive subsidies implicit in the TBTF problem. Indeed, the Act directs the FDIC and the Fed to promulgate bailout programs that are “widely available” or that provide “broad-based eligibility” for bailout benefits. The Act formalizes the power of the FDIC and the Fed to bailout systemically critical financial institutions. The implicit guarantee now appears increasingly explicit, under sections 1101 and 1105. Moreover, even if a financially significant firm somehow fails notwithstanding such extraordinary support the orderly liquidation process offers further bailout mechanisms. Dodd-Frank therefore continues the regulatory indulgence, even facilitation, of excessive risk in the financial sector. Creditors have already concluded that Dodd-Frank preserves the too-big-to fail subsidies. In fact, the credit ratings agencies specifically give the mega-banks much higher credit ratings than otherwise due to the presence of government backing notwithstanding Dodd-Frank.

This Act’s approach to securities and derivatives trading exacerbates this fundamental distortion towards risk. The exceptions to the prohibition of derivatives trading within banks swallow the rule. The Act allows banks to trade securities and invest in hedge funds into the next decade. Thus, the Act gives large banks a subsidized cost of capital while largely preserving their ability to gamble in the derivatives and securities markets. CEOs and other senior bank managers therefore face the identical incentives to gorge on risk that they faced before 2008 to ring up short profits without regard to future losses that may come to fruition only after the payment of incentive based compensation. Even if the firm approaches insolvency the payment of golden parachute arrangements further blunts the disincentives senior managers face for excessively risky conduct.

The orderly liquidation regime under Title II of Dodd-Frank could operate to dissuade mangers from excessive risk, but most firms will never enter that process. No firm enters that regime without a recommendation of the Treasury and 2/3 majority votes of the Fed and the FDIC. Only the FDIC, under the admirable leadership of Sheila Bair, seems likely to have the fortitude to pull the trigger, and then probably only on the eve of a major meltdown, under the plain language of the statute. The gross negligence standard for director and officer liability for firms entering the regime precludes the applicability of insulating statutes like Delaware General Corporation Act section 102 (b) (7), but the FDIC historically displays a reluctance to pursue such claims although that may be changing. If a firm should find itself in the orderly liquidation regime senior managers will lose their jobs and their employment contracts and benefits (including severance payments) will generally be paid out last.

The Act mitigates these negative elements through the possibility of corporate governance reform. Unfortunately, the Act offers a package of reforms on this front that will likely prove too little too late. For example, non-binding shareholder resolutions seem exceedingly unlikely to stop the runaway executive compensation train. There is no shareholder say on golden parachute payments except for merger and acquisition shareholder votes. In 2011 we may look forward to independent compensation committees but in the past definitions of independence proved inadequate to actually stem CEO autonomy. The SEC holds the keys to major reform through their now explicit power to reform corporate democracy, combined with an immediately effective ban on broker votes. Unfortunately, the SEC traditionally failed to embrace shareholder suffrage.

So, the upshot of Dodd-Frank is that it continues and even formalizes massive subsidies for the largest financial firms (at the expense of smaller competitors as well as the economy) regardless of the recklessness (or worse) of their conduct. It continues CEO primacy and permits continued enrichment of managers for reckless (or worse) risk taking. This is a deeply suboptimal economic outcome and we as a society will pay the costs implicit in allowing capitalism to continue to degenerate into a rigged game in favor of those controlling the most vast amounts of wealth. Dodd-Frank may well entrench this pernicious economic reality by allowing it to fester within a more stable financial context. By outlawing consumer predation and exploitative finance future financial crises are unlikely to be as painful as the subprime debacle. A leveraged asset bubble that derails both the financial sector as well as the consumer base of our economy may be forestalled in the long run by Dodd-Frank’s outlawing of abusive consumer loans. It is difficult to oppose these regulatory improvements.

Nevertheless, Dodd-Frank may well operate to transmogrify a reform moment into an opportunistic and cynical effort to slowly bleed the American economy through the overweening power of a narrow and backward political and financial elite that is ever more divorced from concerns about the general economic well-being of the United States. If Dodd-Frank operates to prevent major financial cataclysms at the cost of subpar macroeconomic performance stunted by an entrenched elite that saps our collective economic strength in the name of short term wealth, then it may prove to be more costly than if Congress had done nothing. Whether Dodd-Frank is thus worse than nothing is still to be determined. But, by any measure it preserves the power and economic prospects of the very financial elites whose misconduct caused the crisis in the first instance. In my view, the estimated $591 million invested in lobbying (since January of 2009) and the $112 million invested in campaign contributions to the members of the conference committee (since 1989) yielded precisely the returns expected and demanded by our financial elite: the ability to play in the high risk securities and derivatives markets with continued government backing, without any prospect of being broken up. Moreover, Dodd-Frank encourages more lobbying by punting many issues to regulators and financial elites are already greasing the revolving door for a massive new lobbying blitz.

Finally, additional concerns should be raised, beyond macroeconomic costs and benefits. Government guarantees of the most powerful financial interests in our society simultaneously violate any norm of moral propriety as well as economic logic. If I am correct about the net effect of Dodd-Frank, then it raises red flags about our society that transcend mere economics. When a people in a democratic republic allow themselves to be milk cows for the very wealthy there is something wrong beyond the economic structure of that society. The ultimate irony may well prove to be that the pervasive loss of empathy for the disempowered ultimately empowers a small elite to exploit an entire society. When we lose suspicion of concentrated power and blame the weakest among us for our plight we are surely lost as a people. A people that are convinced that their plight is caused by the powerless in our society rather than those who control our society have lost the ability to hold power to account and to hold power in check. Dodd-Frank raises precisely this specter. Dodd-Frank evinces a near total void of suspicion with regard to concentrated economic power.

So, in the end, the most optimistic thing I can say about Dodd-Frank, is perhaps very pessimistic. It is so radically incomplete that it will surely spawn more financial and economic costs that could well support more appropriate reform efforts. Other than that ray of sunshine, Dodd-Frank proves the problem of allowing excessive concentration of economic resources to persist: regulatory and legal subversion in favor of entrenching the powerful at the expense of sound policy and the general welfare. Dodd-Frank stands as a monument to a deeply misguided, if not actually corrupt, political and economic elite.

Financial Reform: True Change?

Steve Ramirez has provided an excellent assessment of the Dodd-Frank Financial Reform Bill over the past several weeks as he has gone through the legislation by section and provided terrific insight and forecast. By my reading, Professor Ramirez suggests that the new legislation is a mixed bag, with some potential for real reform and thus guarded optimism, but Ramirez remains dubious, even extremely dubious, that the bill will prevent another meltdown and laments the lost opportunity (along with Joseph Stiglitz) to transform Wall Street culture and U.S. capitalism as currently practiced.

In addition to Professor Ramirez' critical insights, I have read two additional works that I recommend as crucial for appreciating and understanding the financial market crisis and the way too tepid legislative response, in my view.

First, I just finished reading Simon Johnson and James Kwak's book "13 Bankers" which is a tour de force in connection with situating the financial market crisis and describing the thoroughly sloppy and irresponsible governmental and regulatory embrace of Wall Street's laissez faire mantra and "smartest guys in the room" culture. That Dodd-Frank did nothing to sever this relationship continues to stun and discourage. Read 13 Bankers for a complete extrapolation of the run-up to the financial market meltdown.

Then, second, I just read Matt Taibbi's recent Rolling Stone Magazine article investigating the internal operations and negotiations in getting the Dodd-Frank bill passed, called "Wall Street's Big Win." Taibbi's sometimes crude, but stark assessment of the bill and the diluting compromises literally required by Wall Street, various Senators and the Obama Administration to get it passed, simply supports Johnson and Kwak's assessment that Wall Street, Pennsylvania Avenue and Capitol Hill all share the same mindset and commitment to investment banks and Wall Street executives as "the Way." Nothing (or very little) in Dodd-Frank will curtail the dizzying excess and reckless decision making by private bank executives that took the global economy to the brink of collapse.

Both 13 Bankers and "Wall Street's Big Win" paint a devastating picture for the future economy.

Per Taibbi:

"All of this is great, but taken together, these [Dodd-Franks] reforms fail to address even a tenth of the real problem. Worse: They fail to even define what the real problem is. Over a long year of feverish lobbying and brutally intense backroom negotiations, a group of D.C. insiders fought over a single question: Just how much of the truth about the financial crisis should we share with the public? Do we admit that control over the economy in the past dec­ade was ceded to a small group of rapacious criminals who to this day are engaged in a mind-­numbing campaign of theft on a global scale? Or do we pretend that, minus a few bumps in the road that have mostly been smoothed out, the clean-hands capitalism of Adam Smith still rules the day in America? In other words, do people need to know the real version, in all its majestic whorebotchery, or can we get away with some bullshit cover story? In passing Dodd-Frank, they went with the cover story."

See "Wall Street's Big Win" here.

Dodd-Frank X: Finally Doing Something About Race?

As the above chart from United for a Fair Economy shows, even high income minorities are much more likely to end up with high-cost, subprime mortgages than low income whites. The full report entitled State of the Dream 2008: Foreclosed is available here. This report is consistent with overwhelming evidence that minority borrowers were too often steered into subprime mortgages even though they qualified for less costly prime mortgages. As the National Coalition for Community Reinvestment found in a recent report, blacks are 80 percent more likely to end up in a subprime loan than whites, and Latinos 70 percent more likely, even after controlling for credit score, income, loan-to-value ratios and neighborhood characteristics. This racial steering dynamic, so central to the entire crisis, has also been detected in carefully structured audit studies. Indeed, Illinois Attorney General Lisa Madigan (and Loyola University Chicago alumnae) recently filed a massive lending discrimination lawsuit against Countrywide Financial alleging precisely this kind of massive and systematic steering after an exhaustive investigation based upon interviews with former employees, borrowers and a review of nearly 100,000 loan files. Many other such suits are now pending or have settled. As Cheryl Wade highlights, this racial steering has devastated communities of color.

So what does Dodd-Frank do to address this thorny problem?

Section 1403 simply provides: "For any residential mortgage loan, no mortgage originator shall receive from any person and no person shall pay to a mortgage originator, directly or indirectly, compensation that varies based on the terms of the loan (other than the amount of the principal)."

Section 1404 then creates a broad private action for violation of this provision: "The maximum amount of any liability of a mortgage originator. . . to a consumer for any violation of this section shall not exceed the greater of actual damages or an amount equal to 3 times the total amount of direct and indirect compensation or gain accruing to the mortgage originator in connection with the residential mortgage loan involved in the violation, plus the costs to the consumer of the action, including a reasonable attorney's fee."

This simply eliminates any incentive for steering, racial or otherwise.

But, Dodd-Frank does more. Section 917 requires a study regarding financial literacy. Section 1021 requires the new Consumer Financial Protection Bureau to conduct financial education programs. More education for consumers and the investing public in a true capitalist economy makes good sense. Markets pervaded by ignorant market actors are bound to spin into dysfunction.

More importantly, in a nation pervaded by tacit acceptance of white supremacy or widespread delusions regarding our so-called post-racial society, it is rather refreshing to see some reforms that could actually mitigate continued racial oppression, albeit in a facially non-racial way.

Combined with the near abolition of predatory lending, this near abolition of steering in mortgage lending holds the promise (much depends upon regulatory follow-up) of never permitting the subprime debacle to recur.

Dodd-Frank IX: The Abolition of Predatory Lending?

If President Obama is serious about financial reform going forward then he will appoint Elizabeth Warren to head the new Consumer Financial Protection Bureau. She has consistently been a non-partisan voice of reason throughout this entire crisis, and before.

Aside from this outstanding issue, however, I would argue that the Dodd-Frank approach to abusive and predatory lending is one of the great strengths of the bill, and that this strength has generally been overlooked in the media.

For example, section 1411 requires mortgage lenders to make a good faith determination, and to verify, that a borrower has the ability to repay the mortgage loan. Certain "qualified mortgages" enjoy a safe-harbor from this provision under section 1412 which will operate to encourage plain vanilla loans instead of predatory loans. Section 1413 permits the victim of a predatory loan to raise a violation of section 1411 as a defense (in the nature of recoupment or set off), even against subsequent assignees, and even after the expiration of any statutue of limitations. The amount of the defense included costs and attorney fees. Moreover, section 1416 enhances damages available against predatory lenders in a class action from $500,000 to $1,000,000 and extends the statutue of limitation from one year to three years. Even prior to Dodd-Frank section 130 of the Truth in Lending Act authorized civil remedies, including recovery of twice the finance charge paid, actual damages or a statutory amount. In any event, the apparent expansion of liability to assignees means that the market for securitized predatory home loans is very likely to evaporate.

Even beyond these sections the creation of a Consumer Financial Protection Bureau under sections 1011-1014 is another huge step forward. The Bureau is housed within the Fed and self-funded through the Fed, but insulated from interference from the Fed. This is an innovative and likely effective legal structure. Under section 1031 the Bureau will have power to stop "unfair, deceptive or abusive" consumer credit transactions. Sections 1052-1056 give the Bureau subpoena power, the ability to issue cease and desist orders, the ability to enjoin violations, the power to seek civil penalties of up to $1,000,000 per day (for knowing violations) and the ability to make criminal referrals.

Which brings us back to Elizabeth Warren. It is no doubt true that others may be able to do as good a job as Elizabeth Warren in running this new and powerful agency. But why risk it?

Unless Robert Rubin is literally pulling President Obama's strings, he will appoint Elizabeth Warren. And the Democrats generally should help force the President's hand; after all, they finally surged in polls only after they passed Dodd-Frank. Prior to that they were facing extinction in November largely for their inability to tame Wall Street and their cozy Wall Street connections.

Dodd-Frank VIII: Reimposing Rational Incentives Thru Private Actions?

The recent announcement of the $600 million settlement of the shareholders' action against Countrywide managers and directors should be put into perspective. The CEO of Countrywide Financial, Angelo Mozilo, garnered over $470,000,000 in compensation between 2001 and 2006, according to the Wall Street Journal. During that period shareholders lost 91% of their investment. Mozilo was named the second worst CEO of all time, right up there with Ken Lay and Dick Fuld. Nevertheless, on June 17, 2010 a securities fraud lawsuit against Mozilo and others was dismissed with prejudice before any discovery. And, the $600 million settlement just announced requires no payment whatsoever from Countrywide's former management.

Nor is this case alone in failing to meet subprime conduct with meaningful legal sanctions, as the LA Times reports that "nearly all" of a recent $90 million settlement of claims against New Century's management also was paid for by insurers. Delaware courts used the business judgment rule and Delaware General Corporation Law section 102(b)(7) (which authorizes directors of public firms to be infinitely careless) to insulate both Citigroup management and AIG management from accountability for the huge losses those firms sustained. While the massive Citigroup securities litigation is still pending, it appears that "courts are showing more evidence of subprime fatigue and a greater willingness to grant motions to dismiss even in cases that do not require proof of scienter" in the private securities litigation realm.

The upshot is that senior managers may profit mightily from precisely the conduct that caused the subprime debacle with apparent impunity in terms of their own monetary interests. After all, as I have previously shown Countrywide, AIG and Citigroup were at the very center of the storm. Courts are strongly and clearly affirming the misconduct that got us into this mess. We should not be surprised to see the misconduct at the center of the crisis to repeat itself, as courts have essentially broadcast to senior managers that may continue to profit from crashing capitalism.

The judiciary simply seems determined to let agency costs run amok in the American publicly held corporation. There is no case, economically or legally, for failing to rein in agency costs through sound corporate governance standards. For sixty years after the Great Depression bank managers were held accountable for losses due to negligence and directors of ordinary corporations could face liability for gross negligence. Law provided rational economic incentives for board directors and we lived in a prosperous and stable economy. Further managers faced the prospect of jury trials for allegations of securities fraud under the federal securities laws, a prospect that frequently led to settlements on the eve of trial on the courthouse steps. Securities fraud therefore resulted in monetary sanctions and our securities markets worked well.

So does Dodd-Frank do anything on this score to return us to a rational corporate and financial marketplace like that which prevailed from 1933 through the 1990s? Not really, is the disappointing answer.

Section 929Z requires the GAO to study the problem of secondary liability and the "types" of cases decided under the PSLRA.

Section 933 clarifies that credit rating agencies may be held liable for securities fraud on the same basis as accounting firms and securities analysts, and clarifies and apparently eases scienter pleading requirements.

Section 210(f) allows the FDIC to pursue gross neglignece claims against directors and officers of firms placed in the orderly liquidation process, apparently statutorily abrogating Delaware section 102(b)(7) provisions (as well as similar provisions from other states).

Certainly, it is helpful that managers of firms that are too-big-to-fail understand they could face massive liability for gross negligence if their firm is taken into the orderly liquidation process of Title II. But, much depends upon the regulators to enforce this liability. Overall, given the catastrophic track record of corporate governance in America after the onset on the PSLRA and 102(b)(7) provisions, Dodd-Frank only nibbles around the edges and kicks the can down the road to the regulators.

As I have previously argued, "the benefits [of private litigation] include the following: the creation of private “incentives to ferret out” fraud that public investigators miss; private enforcement immunity from political influence; the probability that investor remedies are more likely to repair investor confidence than mere criminal or administrative remedies; and the lack of any public financing requirement for enforcement efficacy." The beauty of private litigation is that it restores market incentives without costing the government a dime. Moreover, private litigation regulates markets without political interference as private litigants are first and foremost concerned with acheiving recovery of losses and could not care less about the political clout of defendants--like that of Bernie Madoff. Dodd-Frank, I fear, will prove to be a lost opportunity to restore rational market incentives for fraud and ineptitude through costless private actions.