New Law Review Article re Debt Crises and Dodd-Frank

I recently posted a new article on SSRN lamenting the ineffectiveness of the Dodd-Frank bill to prevent another debt crisis accompanied by a financial sector meltdown. Entitled Dodd-Frank as Maginot Line, my thesis is that the financial reform act changes nothing in any meaningful time frame and that brewing debt crises in Europe and the US will likely trigger another Lehman Brothers type of financial meltdown that may prove more painful than the crash of capitalism in 2008-2009. The article will appear in the Chapman Law Review, and was initially presented at this symposium.

The article seems unfortunately prescient. As we look over the abyss today, and the Eurozone meltsdown before our eyes while the US suffers from a historic breakdown of responsible leadership, we may well learn very soon the deficiencies of the Dodd-Frank Act.

The sad truth is that even after the Act financial elites face every incentive to crash the global economy and pocket billions in profit. A comparison of those who hold credit default swaps on US Treasury debt with the financial supporters of the Tea Party would certainly prove an interesting test case of that central point: the legal system now fails to assure that those with economic power have any interest in the success of our economy.

Here is the abstract:

The Dodd-Frank Act will prevent a future debt crisis arising from subprime mortgage debt. The Act will fail, however, to prevent other future debt crises leading to future financial crises because the Act fails to address the distorted incentives to accumulate excessive debt and the distorted incentives for large financial firms to gamble on debt instruments. The Act preserves the power of the government to bailout financial firms deemed too-big-to-fail. The Act preserves the ability of such firms (at least over the short and medium term) to speculate in debt instruments through derivatives, securities and hedge fund activities. The Act also fails to assure the disruption of CEO primacy, as a matter of corporate governance law. In short, the Act constitutes a limited response to the crisis of 2007-2009, at best. CEOs still retain the power and still face incentives to saddle their firms with excessive risks at the expense of shareholders and society in general.

GDP Report. . .Debt Crisis

The estimated and revised GDP numbers are out today and as the graph above shows its dismal. It turns out the recession was significantly deeper than initial estimates, the recovery was more tepid than initially thought and we are teetering closer to a double dip recession than previously was the case. For purposes of where we are today, the downward revision of GDP in Q1 of 2011 from an initial estimate of 1.9 percent to a revised 0.4 is alarming.

The debt crisis will not help the economy. Its continuation will impair confidence and its resolution will likely impair government spending which in itself will tip the economy into recession just as the election season gets underway. Goldman Sachs found that government spending cuts hurt GDP more in Q1 of this year than any other time since the 1980s. Dramatic government spending cuts right now are economic suicide for the US and political suicide Obama Administration. He will not get reelected if we are in the throes of a recession on election day--even if this coming recession is triggered by the GOP arson squad in the House. As I, and others, have argued many times, the economy desperately needs short term stimulus with long term spending cuts.

Obama has options. As I have previously shown the Treasury holds delegated power from Congress to print money under 31 U.S.C. section 321. As Professor Timothy Canova recently highlighted to me it holds express power to mint platinum coins without limitation. Therefore, the President could resolve this debt impasse now by announcing that the Treasury will not allow default and will provide sufficient legal tender to pay all of its obligations in a timely fashion. The Fed would doubtlessly follow with an announcement that it stands ready to neutralize this monetary expansion as needed through the sale of bonds. It would be a fatal blow politically and economically to the folly of the far right extremists now in control of the House. More importantly, Obama is Constitutionally bound to avert default and make lawfully authorized disbursements.

ADDENDUM: For a similar analysis of the power of the Treasury from Professor Jack Balkin see http://www.cnn.com/2011/OPINION/07/28/balkin.obama.options/index.html?hpt=hp_c1

Letting Bankers Walk

While the Wall Street banking industry bears enormous responsibility for the financial market collapse of 2008, which continues to plague our nation (and global economies), Wall Street executives and the banking industry appear to remain “untouchable.” The Obama administration has been reticent to force responsibility onto the industry (perhaps due in part to massive campaign contributions), and U.S. financial policy now seems to have evolved into a “letting bankers walk” position. This policy position avers that cracking down on banks would either slow a recovery of the housing market or would undermine the broader prospects of national fiscal recovery. Nobel Prize winning economist Paul Krugman argues however, that these banker-friendly policies are not the answer to resolving the banking industry’s past indiscretions, and neither will this policy assist in healing the U.S. housing condition. Per Krugman “Ever since the current economic crisis began, it has seemed the five words sum up the central principle of United States financial policy: go easy on the bankers.”

Krugman argues that in bailing the banks out of the mortgage crisis quickly (and letting reckless executives off unencumbered), the country has seen an increase in foreclosures, creating more available homes on the market, and with the increased supply the housing market will see lower prices. A market stabilization is unlikely in such a scenario. Further, Krugman asserts that the banking industry has recovered since the scare of 2008-09, based in part on its hoarding of capital, and with the banking industry recovered, it makes little sense to continue to treat the banks with kid gloves, rather than making them responsible for their roles in the meltdown. The economy continues to falter based on the massive amount of mortgage debt that continues to emanate from the housing bubble.

Rather than adopt policies that offer significant mortgage relief in an effort to correct the continuing housing crisis, the Obama administration instead follows a policy that refuses to make bankers responsible for their complicity in the continuing malaise. Krugman believes that the recovery will remain elusive if these policies continue.

GOP Arson Squad Assumes Control

On July 15, 2011, a commentator for the New York Times reported that: "Not only is Michele Bachmann, a leading Republican presidential candidate, saying a government default is nothing to worry about, but a core group of 59 House Republicans have indicated they will not raise the debt ceiling under any circumstances, according to House Speaker John Boehner." Right now, however, it appears that there may be even more votes in favor of default. Speaker Boehner has his hands full getting any plan to raise the debt ceiling through the GOP controlled House. So, yesterday Boehner was forced to withdraw his plan to raise the debt ceiling for lack of support from his own party in the House which he nominally leads. This morning, Boehner was supposed to present a new modified plan that could attract more support. As of now, Boehner has failed to put together any debt ceiling proposal that can pass the House. There are 100 votes in the House that appear determined to induce default and throw the economy into chaos. These 100 votes want to amend the Constitution as a condition to averting default!

Conservatives will come to regret the rise of this extremist even nihilistic wing of the GOP. Their investment portfolios will get hammered if the government defaults, by a far greater amount than their precious tax cuts. Market instability is just beginning to take hold and over the next few days more people will come to realize the magnitude of the budget impasse and the huge error of ever tying such massive issues to the heretofore formalistic debt ceiling increase. Our global economy is in a very fragile state (the Eurozone is facing a debt calamity right now) and a U.S. government that is incapable of rational fiscal policy would be a serious setback. But the arsonists threaten far more vast economic pain. Even beyond the carnage coming from instability in financial markets, the loss of demand from dramatic government spending cuts would alone tip our economy into a recession. In sum, this crisis could make the Lehman event look like a cakewalk. (Especially since we failed to enact meaningful financial reforms after the last laissez faire market meltdown).

It may be impossible to avert such a meltdown today, as no lawmaker yet has proposed simply increasing the debt limit and decoupling budget talks (much less a Constitutional amendment) to avoid a default.

Federal Reserve Hits Wells Fargo With $85 Million Fine for Predatory Lending

The Federal Reserve finally imposed penalties on the banking industry for its role in predatory lending practices that enabled the housing bubble to expand prior to the market crash of 2008. In particular, the Fed fined Wells Fargo $85 million for its role in writing and pushing predatory subprime loans. Further, even though Wells Fargo did not admit wrongdoing, it agreed to pay back those borrowers who were steered into expensive subprime loans, but qualified for prime loan rates.

The Fed found that between 2004 and 2008, Wells Fargo Financial, a subsidiary that went bankrupt last year, swindled as many as 10,000 borrowers. Wells Fargo employees were falsifying income statements in order to increase their own commissions, despite the fact that borrowers should not have qualified for the subprime loans written and approved by the bank. Wells Fargo will be working with the Fed to pay back those deceived homeowners, but it was quick to state that the fault came at the hands of just a few loan officers. Still, "[t]he Fed blamed compensation and sales quota policies at Wells Fargo Financial for encouraging employees to falsify documents. It also faulted the bank for having inadequate controls in place to manage risk." Wells Fargo did significant damage to each effected homeowner, with the Fed estimating that compensation for the 10,000 borrowers will range from $1,000 to $20,000 each.

While the fine of Wells Fargo represents an appropriate, albeit late, exercise of Fed power, will an $85 million fine motivate a company like Wells Fargo to forego reckless profit grabs like its predatory loan writing practice between 2004 and 2008, particularly when it made almost $4 billion in the last quarter?

Dodd-Frank Rollback Underway: A Snapshot of an Irresponsible Governing Elite III

The SEC lost a big one today. In Business Roundtable v. SEC, the D.C. Circuit invalidated the Commission's proxy access rule promulgated under section 971 of the Dodd-Frank Act. If you are interested in assessments of the court's reasoning and the outcome generally, I would refer you here, here, here, and here for varying perspectives on the decision. While the original adoption of the proxy access rule enjoyed broad academic support, few voices are today critical of the D.C. Circuit opinion. I will leave the legal analysis to administrative law experts (but admit to a high level of skepticism that the opinion reflects sound legal formalism rather than ideological favor of the corporatocracy).

Macroeconomically, the case will prove catastrophic. When the next financial meltdown takes hold and the ability of CEOs to opportunistically abuse the public corporation for their great profit at the expense of both the corporation and society generally takes center stage yet again we will regret the long delay of shareholder power to nominate and elect directors of their own corporation. This opinion will not age well.

Dodd-Frank Rollback Underway: A Snapshot of an Irresponsible Governing Elite II

It what can only be termed a historic bow to the banks over policy the Obama Administration announced yesterday that Elizabeth Warren will not be the head of the Consumer Financial Protection Bureau. Professor Warren essentially invented the CFPB and its creation was one of few bright spots to emerge from Dodd-Frank, as I have discussed here, here, here, here and here. Instead of a tireless academic workhorse intensely focused on the policy implications of exploitative debt from an outsider's perspective President Obama selected a politician from Ohio. Warren terrified the banks and they simply refused to accept Warren so President Obama obliged them. Unfortunately, with an election ahead, the President is more intent on raising funds from the banks instead of battling them over Warren. While Cordray may well be a solid appointment, President Obama's long delay and ultimate refusal to appoint the best candidate signals yet another retreat from sound financial regulation by this administration.

The CFTC announced another such retreat late last week when it delayed derivatives regulation by up to 5 additional months--up until December 31, 2011. This delay arises from the continued starvation of our regulatory agencies by those in Congress who wish to denude financial reform. The SEC currently suffers similar budgetary starvation. Without proper regulatory funding we will continue to face the same financial risks that caused the global financial sector to crater in 2008.

Finally, it appears more litigation challenges will bedevil Dodd-Frank, and at least one high profile scholar predicts the SEC will lose the shareholder proxy access litigation.

Overall, as two debt crises plague global financial markets, the markets seem as vulnerable to a Lehman-style meltdown as in 2008, from a legal and regulatory perspective, and yet all the political pressure favors more dilution of Dodd-Frank. If we tip into the abyss we can blame our dysfunctional money-driven political system, for what that is worth.

It is a Crisis of Political Maturity, not a Fiscal Crisis

The Republicans do not care about the budget deficit or the national debt, they only care about their precious Bush Tax Cuts. How else to explain this report that Eric Cantor (House Majority Leader) will only agree to close tax loopholes if offset by tax cuts. The GOP would rather default than raise taxes precluding any bipartisan agreement to tackle the debt.

The childish behavior of the GOP appears to amount to political suicide, as only 20% of Americans and 26% of the GOP base supports their illogical obstinance to tax hikes. The GOP appears deaf to a slew of polls suggesting that Americans want the debt impasse resolved through a mixture of tax hikes and spending cuts. If the GOP insists on a debt default in defense of their tax cuts it will ruin their party for decades to come, as Sen. Mitch McConnell keeps trying to communicate to the fanatical wing of the party.

There are many obvious solutions to our long-term debt problem. According to the Financial Times if we had allowed the Bush Tax Cuts to expire we would have saved $9 trillion through 2024--proving that the largest problem with the debt is the Bush Tax Cuts. Raising the retirement age to 67 right away (then gradually to 68) while adjusting the cost of living increases saves $900 billion from Social Security and $300 billion from Medicare. Accelerating our withdrawal from Iraq and Afghanistan saves $1.229 trillion. Elimination of farm and ethanol subsidies saves $500 billion. Attacking global warming through a carbon tax and a ten cent per gallon gasoline tax would raise another $1.154 trillion. This package of cuts and tax increases reduces the deficit by 75% under the Financial Times approach. The New York Times has a budget calculator that yields very similar results, as does the Center for Economic Research and Policy.

But they all take the same position: it is very difficult to solve the long-term debt problem without any tax increases at all. Our leaders should be negotiating a package of spending and tax measures to address our fiscal position, not threatening default by using the debt ceiling for leverage to jam an ideological agenda down the throats of the American people. I question whether the GOP has the maturity to understand they are playing with economic fire.

Law and the so-called Debt Ceiling III

The above chart shows the historic accumulation of excess reserves in the banking system. Today excess reserve accumulation stands at an unprecedented$1.6 trillion. In addition the largest firms in America are hoarding another $2 trillion, a record high. Further, Treasury Securities still yield essentially zero as far out as 3 months on the yield curve and last week 4 week notes auctioned off at exactly zero yield. All of this hoarding is a rational response to a sick financial system that has not been repaired and the chronic lack of effective demand in our economy. Deleveraging is destroying confidence precipitating a classic liquidity trap. In fact, but for the government backing of our largest banks, most of them have weak or very weak financial structures. And the most recent jobs report shows just how weak the economy is--unemployment went up, wages went down and hours worked went down. Indeed, the employment ratio, the broadest gauge of employment and unemployment rested at 58.2 percent, the lowest since 1983, matching the 2009 crisis low:
More and more economists (such as Nouriel Roubini, Laura Tyson, Brad Delong and Paul Krugman) therefore recognize the obvious: the U.S. desperately needs more fiscal stimulus, in the short term. Government stimulus is the only thing keeping the economy afloat. Unfortunately, it was too small and is now running out.

Moreover, if President Obama agrees to further fiscal austerity, the economy will most certainly crater. Even Fed Chair (and Bush appointee) Ben Bernanke warns against rapid withdrawal of fiscal stimulus. Some market pundits even warn of tipping the economy into a severe contraction through excessive austerity--which has now already failed in Greece, Ireland, and the UK. As the Economist puts it: "cutting back spending viciously in the short term at a time of private-sector retrenchment would be a mistake." If President Obama agrees to trillions in spending cuts along with tax increases, he should insist upon real economic stimulus or face the political consequences of a stagnant economy in 2012 that could seal his fate as the Herbert Hoover of his time.

On the other hand, should the GOP force the Administration's hand and refuse to increase the debt ceiling, then the Treasury would be obliged to print money to pay its bills. Any inflationary threat generated by the expanding money supply could be neutralized by the sale of bonds by the Fed as needed in its judgment. But this process will directly stimulate the economy without relying on our dysfunctional banking sector to stop hoarding cash and actually make loans. As shown in the FDIC Quarterly Bank Profile Report, bank lending is still contracting rapidly:


Being forced to print money could well turn out to be the most effective government stimulus yet, in terms of putting real money in the hands of those most likely to spend (about 50% would go to people unlikely to save much), with little real threat of inflation in the short term. I the medium term, the Treasury could simply issue bonds to mop up the new liquidity once the GOP comes to its senses and unemployment plunges. Thus, the course of action I argued for in prior posts on this blog (and as originally articulated by Peter Morici) could stimulate the economy, save the US from default, and inflict political pain upon the GOP for their reckless misadventure.

Law and the so-called Debt Ceiling II

Congress holds the power to limit Treasury Secretary Timothy Geithner's ability to issue more debt, and he only has a small amount left before he hits the debt ceiling. Under the Constitution, Article I, section 8, only Congress has the power to "To borrow Money on the credit of the United States." Congress has exercised this power to authorize borrowing up to $14, 294,000,000.00.

At the same time, as noted in my prior blog entry, obligations of the United States cannot even be "questioned" under the 14th Amendment, meaning that if Congress allows a default it has breached the Constitution. But, if the Treasury continues to issue debt in defiance of Article I, section 8, it would act outside of its authority under the Constitution. Thus, this debt crisis, if permitted to fester, will lead to a Constitutional crisis of the first order.

Some suggest that because of the 14th Amendment the Administration may ignore the debt limit. But these commentators fail to address Article I, section 8. Therefore I find their position ill-founded, at least in part, and at least as articulated, here, here, and here. However, Jack Balkin has a thorough post on this issue, here.

Balkin argues correctly that the debt limit ceiling is constitutional. Nevertheless, due to the 14th Amendment, he argues that the Obama Administration must exhaust all possible options to avoid default.

I argue that if Congress fails to raise the debt limit it breaches the Constitution and puts the President in a no-win situation: he either breaches the Constitution by ignoring the debt limit; or he breaches the Constitution by defaulting on debt under the 14th Amendment or failing to execute laws (appropriations) that are validly enacted by Congress. It is at this point that the Treasury must print money as argued by economist Peter Morici and myself in my prior post.

Law and the so-called Debt Ceiling

The above image should appear odd to you. First, the red ink does not appear on Federal Reserve Notes, our usual form of money. Second, the bill is denominated a "United States Note" not a Federal Reserve Note. The difference is that the United States Notes are issued by the US Treasury (rather than the Fed under section 11 and section 16 of the Federal Reserve Act) as legal tender--that is as money. The Treasury issued currency like this for over 100 years and placed the last US notes in circulation in 1971.

This power to issue money gives the Obama Administration the perfect response to the GOP's power play to threaten default on US obligations. Essentially the GOP is using the debt ceiling to jam its ideology down the throats of the American people by holding our nation's credit rating and ultimately entire economy hostage, as discussed in greater detail by Paul Krugman, here. Economists generally agree that the GOP's game-playing with the debt ceiling risks huge economic costs for the entire nation.

But GOP recklessness and irresponsibility (making the government default on bills is simply inexcusable) need not cause financial catastrophe. Economist Peter Morici proposes that the government--specifically the Treasury--simply issue more currency to pay its bills. He correctly points out that the Fed could easily prevent this method of paying our bills from becoming inflationary through off-setting sales of its $2.6 trillion of government bonds. However, the Administration and the Fed could simply decide to use the opportunity to stimulate the economy through a kind of fiscal stimulus/QE III. From a political perspective issuing US Notes in mass quantities one year before the election certainly would not harm President Obama's prospects because the economy would no doubt respond positively to additional money in circulation.

Congress already delegated the power to both "manage the debt" and "print currency" to the Treasury in 31 U.S.C. section 321. This power is not reduced by the concurrent power of the Federal Reserve to issue Federal Reserve Notes, and both currency issued by the Fed as well currency issued by the Treasury are deemed legal tender in 31 U.S.C. section 5103. This can hardly be termed a debt obligation, as the only obligation assumed from the issuance of such notes is to maintain their status as legal tender which section 5103 does by force of law. Thus, the GOP could only fulfill their dreams of economic suicide by amending existing law, which would have to clear the Senate and be signed by President Obama. Let me be clear: under existing law the Treasury can simply expand the money supply to avert the debt ceiling.

I would take this position one step further: Secretary Geithner is legally obligated to print money if necessary to avoid default on any federal obligation. The 14th Amendment of the Constitution requires that the validity of all US government obligations "not be questioned." Thus, the Treasury Secretary must use all his powers to assure the payment of all US government obligations under the Constitution.

This point is crucial because technically the issuance of "United States currency notes" is limited by 31 U.S.C. section 5115 to $300,000,000. Unfortunately, Congress left the meaning of "United States currency notes" unclear at best. 31 U.S.C. section 5119 appears to limit the term to currency issued under certain statutory sections. Apparently there is no specific statutory limitation applicable to anything denominated United States Notes (or a similar denomination), like that pictured above. Clear judicial authority holds that statutes should be construed to avoid a conflict with the Constitution.

In ordinary times, the Treasury Secretary would not be well advised to exploit this clear seam in the statutory scheme governing his conduct. The reckless GOP stratagem to pursue ideological goals that they cannot achieve through normal democratic channels has taken the nation to extraordinary times. In order to avoid a default, as commanded by the Constitution, Secretary Geithner would be well advised to print United States Notes as needed.