Friday, October 17, 2008

Brief History of the US Economy: Bailout Edition

Let's start with "Deregulation". The reason I put it in quotes, as I always do, is that it's a misleading term for something that doesn't really exist. If I was a bit more cynical, I would have to imagine that the reason people use this term is that they maliciously want to defame the very idea of capitalism & more importantly, economic freedom. But I think a lot of people just find it easier to compartmentalize the way they think about some of these issues, so I won't say that is always the case.

(Of course, one doesn't have to be tooo cynical - just have a read into Naomi Klein's new book "The Shock Doctrine: The Rise of Disaster Capitalism", or at least read Johan Norberg's fine article in Reason Magazine defending the late (great) Milton Friedman who quite falsely bears the brunt of her attacks -, to find people blaming "deregulated" or "free" markets for the current situation.)

Anyway, there are some people out there who do deliberately want to mislead people into taking more and more socialist approaches to government though I'm sure most people just haven't really looked into it. The problem is, history doesn't support the idea that "deregulation" even exists, much less even accounts for the current crisis. Let me explain:


It all really starts, as far as people's recent memories are concerned, with the Commodity Futures Modernization Act of 2000 - signed into law in the twilight of Bill Clinton's presidency on December 21st, 2000. Naturally, this legislation was crammed into a spending bill and was never even debated in the House of Representatives. What this Act did, among other things, was allow investment banks to engage in Credit Default Swaps - a "high-risk" (I'll get to why that's in quotations in a minute), and very complex speculative investment structure by which bad debts are sold to 3rd party companies and used as investment collateral - something they had not been able to do since 1982. I don't know if I need to point out that the people often yelling the loudest about "deregulation" are the people who blame Ronald Reagan & other Republicans, yet this little time bomb was made into law by everyone's favorite Democrat... Not that Republican's are in any way innocent here.

But anyway, here we are in the year 2000, going into 2001 and it's suddenly ok for banks to engage in more risky investment activities.

This leads me to two important questions though. First... and important to one of my overall premises, is; does the Commodity Futures Modernization Act really constitute "deregulation"??

Secondly, if things like Credit Default Swaps are so risky, why would a company engage in them?

I mean, we're talking about something that Warren Buffett described (speaking broadly of investment derivatives based on speculation) as "financial weapons of mass destruction", and Buffett's ideas on worthy investments are really not to be taken lightly. P.S. Did anyone else notice that Berkshire Hathaway and Buffett are doing fine throughout all this market madness... turns out Buffett ain't no fool.

Anyway, the answer to question number one is a resounding NO!

Why? Well... because we have a Keynesian economic system - a "mixed-economy". Government may have relaxed regulation in one specific area of the financial markets, but they hold all the other cards. In fact, it is because of the way government ran every other aspect of the market that we're in the mess we're in AND, all that ties directly to the answer to the second question of why investment bankers would do something that "risky".

The overly simplistic (and waste of our time here) answer to No. 2, is: "Greed!!"

The real answer to question No. 2, is: It was a Trick Question!

Credit Default Swaps are NOT risky *if* the company knows that any losses incurred will not be borne by them, but by the American Taxpayer... which takes us right back to why deregulation is a myth.

We have an abundance of financial & economic regulation. The problem (in this instance) is that an awful lot of it helps the specific companies & industries that lobby for it. This is not a free market! In fact, there are two amazing quotes from easily the two most outspoken supporters of freedom & free markets who've ever lived that have really become my favorites over the last several months:
"One of the methods used by statists to destroy capitalism consists in establishing controls that tie a given industry hand and foot, making it unable to solve its problems, then declaring that freedom has failed and stronger controls are necessary."

—Ayn Rand, 1975
"Business corporations in general are not defenders of free enterprise. On the contrary, they are one of the chief sources of danger....Every businessman is in favor of freedom for everybody else, but when it comes to himself that's a different question. We have to have that tariff to protect us against competition from abroad. We have to have that special provision in the tax code. We have to have that subsidy."

--Milton Friedman, 1978
The reality here is not that there's "too little regulation", there's plenty of that. Even the Commodity Futures Modernization Act was barely a blip on the radar for deregulation. The truth is, the Federal Government controls a vast amount of the economic system through the Federal Reserve's ability to set interest rates and increase or decrease the supply of money available in the market - which also means that it sets the pace for inflation (something we should all worry more about). Also, there's the Securities & Exchange Commission, which regulates and interprets legislation for a wide array of financial dealings on more of the executive side. The government is involved in every merger and IPO, it creates international or even interstate tariffs, protecting some companies or industries, limiting competition and in some cases gives outright subsidies to businesses - with strings attached, of course. Likewise, governments control zoning laws, property taxes, corporate taxes (which really just get passed on to consumers, so I'm not sure why we do that at all...), business operating licenses, etc.

So again, there's PLENTY of regulation!

"Deregulation" would really imply a free market. But a free market of the variety always described by Friedman, F.W. Hayek, Ludwig von Mises, Murray Rothbard, and even Adam Smith - has to be free from government intervention. And when government is capable of giving $700 Billion dollars to the nation's largest banking institutions, I hope we can all see how far from "free" that really is.

Anyway - the term "deregulation" is such a pet peeve of mine, because there really isn't such a thing, and it's always used to imply that economic freedom is bad, when in reality, there is no such thing and that has nothing to do with the answer to my earlier Question No. 2...

"RISK"... but not really

Why would investment bankers engage in "Risky" speculative behavior, thus contributing significantly to the current market crisis and subsequently the $700 Billion bailout? Again, if you want a mindless answer, say "greed" and just quit thinking about it... but if you're interested in how these things happen for real... let's start with:

The Glass-Steagall Act of 1933, which created the FDIC (

I suppose I could start with how the depression was largely caused by the disastrous policies of the Federal Reserve (circa 1913) but this is becoming less brief by the paragraph, so I'll skip all that and just talk incentives.

The FDIC, and then later, 1950s Federal Deposit Insurance act, were the basis for what we now come to call the US Government's de facto "Too Big to Fail" policy. In case anyone who reads this has been living under a rock the last few months, TBTF is a concept which basically asserts that a major company within a "major" industry (i.e. the financial industry) which goes bankrupt, could cause a ripple effect through the entire economy and negatively affect everyone. Thus, instead of "allowing" that to happen (which a free market would do) we instead use taxpayer money to bail-out the distressed industry. But (1) what does this say to major companies? And (2) what does this do to the market??

As economist Bill Stughart wrote for the Independent Institute;
"The record of government bailouts of private financial institutions in the 1930s, of Continental Illinois Bank in 1984 (which cost $8 billion) and of the entire U.S. savings & loan industry in the late 1980s and early 1990s (which cost $125 billion) teaches that emergency loans keep weak institutions alive just long enough for their problems to increase.

Bailouts encourage more risk-taking and eliminate the freedom to fail that is just as essential to a free-market economy as the freedom to succeed."
I'm inclined to whole-heartedly agree!

Companies know they will get bailed out by the American Taxpayer if they go bankrupt - this encourages them to take so-called "risks" that they could never take if their bankruptcy would actually destroy their companies. Remember, it's not just one rogue CEO here, but boards of directors and upper management of an entire industry! "Greed" simply isn't going to cut it as a reason why the major investment banks were doing these Credit Default Swaps... if the companies these people ran, invested in and sometimes even started from scratch, are going to go bankrupt because of the Credit Default Swap nonsense - then these CEO's don't do it. They stand to gain what, at the high end, $20,000,000 in severance pay? As opposed to losing BILLIONS (as well as seeing the dollar so inflated, $20 mil won't buy you a house)!? Come on... that's not "greed" that's just retarded.

No... no... the reason they took the risks in the first place was because they were NOT RISKS!

The FDIC made damned sure of that.

Wild investment schemes galore existed in the years leading up to this crisis, not because "oh hey, that speculation market isn't illegal anymore, let's do it risks be damned!", they came about because they weren't risks. They were a very predictable means of making a ton of money, right off the backs of the American Taxpayer. (P.S. FDIC *is* regulation).


Real Causes

Yeah.... the next question of course, is how could these Credit Default Swaps have been so prominent anyway... they're based on defaulted debts - so, why were there so many people unable to pay?

Again... the simplistic answer is, "greedy" loan officers (you know, the ones at the local Wells Fargo, making $60k a year who don't get a commission for making you a loan...?) and realtors wanted to just get everyone into a home to make a quick buck.

And ok... the realtors.... well.... maybe ;)

But aren't we forgetting something?? Why would banks have any interest in high-risk borrowers, and how did we get to a point where money was so freely available to give to everyone who wanted a no-money-down house?

So now, I have to point out, the Community Reinvestment Act of 1977 ( - which deliberately ENCOURAGED banks to loan money to high-risk debtors, in the vain hope that home ownership alone would improve the quality of "blighted" neighborhoods. Government's social engineering at it's best!!

And of course, way back in 1938, FDR created everyone's favorite government-run banking timebombs, Fannie Mae & Freddie Mac. "Fannie Mae", is a cute name right? Well, it's actually based on the acronym, FNMA... know what that stands for?

"Federal National Mortgage Association"

That's right... as far back as 1938, the government was using taxpayer dollars (which it had to borrow as it was still in a depressed economy thanks to all the wonderfully socialist bad math of FDR), to buy mortgages for people who could not afford them on their own.

Sure seeeeeems like deregulati... wait... no... as it turns out, Government has been heavily involved in the financial sector for the past 80 years, and just as involved in housing!

The "free market" was so far out of the picture by 2008, that people like Naomi Klein make me want to punch things. Far from being a "deregulated" free-for-all, we have a ridiculously complex system which as been favoring banks, supplying cash at incredibly cheap interest rates to people who make poor decisions, and encouraging bankers to take risks with no concerns for losses and encouraging realtors and the public at large to live well beyond their means.

And yet politicians are blaming the market, and using it as an excuse to get even MORE involved.

Scroll up and read what Ayn Rand wrote back in 1975 again... and the government hasn't just done this with housing & investment banking. It's given bailouts to auto manufacturers, airlines, trains, energy companies... farms... you name it! But it's all a perversion of the most fundamental ideas of capitalism.



Here's the timeline:

Federal Reserve is created and starts controlling interest rates and printing money... though thanks to a gold-standard, currency remained somewhat stable until we went full on fiat in 1976.
FDIC created with Glass-Steagall Act, starting the trend for banks to make bigger and more catastrophic bad decisions only to be bailed out when they came whining to Uncle Sam.
FNMA (Fannie Mae) created to start offering loans to anyone who couldn't really afford one in order to get people back into houses that no sane private company would loan them money to buy (because at that time they would have still actually taken the loss when the people defaulted!)
Federal Deposit Insurance Act solidified the FDIC, and established the Too Big To Fail concept as we know it today... banks start taking more risks.
Community Reinvestment Act starts encouraging banks to loan to higher-risk debtors because the government wants people to be home owners real bad... thinking that they'll clean up their neighborhoods that way.
Bailouts of dozens of banks, securities & loans, automobile manufacturers, airlines, Amtrak, etc... Pretty much everyone EXCEPT the tech industry in the late 90s (guess which one of those industries is healthy now...?)
President Clinton pushes hard via Fannie Mae to start offering sub-prime loans to low income families. "No down payment" coupled with higher interest rates/variable interest rates being the primary means of making said mortgages available. with banks secure in the knowledge that they can expand and do otherwise stupid things without worrying about consequences, and with significant governmental pressure to make shady loans... comes...

Commodity Futures Modernization Act, which freed up banks who had been largely hamstrung from taking big risks (and who were losing money they shouldn't have been losing by being forced via government policy to loan to people they shouldn't have loaned money to) to get some cash back from all the ridiculous defaults that had been accruing... makes sense though doesn't it? If you were a bank and the gov't told you to keep loaning money to people who kept defaulting, wouldn't you lobby for relaxed legislation on getting something back from the defaults? Thus: Credit Default Swaps and variable rate home loans sweep the financial community!
Sarbanes-Oxley Act: Created in the wake of Enron and other financial scandals to "reform" the financial sector created a number of large increases in cost to doing business, which did not successfully prevent scandals or accounting fraud (obviously), but which did favor large companies at the expense of new competitors and IPO's. At the time, Ron Paul noted: "These regulations are damaging American capital markets by providing an incentive for small US firms and foreign firms to deregister from US stock exchanges. According to a study by a researcher at the Wharton Business School, the number of American companies deregistering from public stock exchanges nearly tripled during the year after Sarbanes–Oxley became law, while the New York Stock Exchange had only 10 new foreign listings in all of 2004. The reluctance of small businesses and foreign firms to register on American stock exchanges is easily understood when one considers the costs Sarbanes–Oxley imposes on businesses. According to a survey by Korn/Ferry International, Sarbanes–Oxley cost Fortune 500 companies an average of $5.1 million in compliance expenses in 2004, while a study by the law firm of Foley and Lardner found the Act increased costs associated with being a publicly held company by 130 percent." And the Wall Street Journal pointed out:  "For all of this, we can first thank Sarbanes–Oxley. Cooked up in the wake of accounting scandals earlier this decade, it has essentially killed the creation of new public companies in America, hamstrung the NYSE and Nasdaq (while making the London Stock Exchange rich), and cost U.S. industry more than $200 billion by some estimates."
9/11, Iraq War, Afghanistan War, MASSIVE increases in government size & power, combined with Ben Bernake's Federal Reserve holding interest rates to insane lows and flooding the market with free or cheap money devalues US currency while simultaneously, the housing market goes nutso with a feedback loop of cheap money leading to higher housing prices which sparks the need for bigger loans, and subsequently larger defaults on those loans....
BUBBLE BURSTS!!! Suddenly... people (except the free market guys who predicted this forever) are caught by surprise and the "solution" is, KEEP DOING EXACTLY WHAT WE'VE BEEN DOING, only instead of $8 Billion or $125 Billion... it's now $700 Billion - in money taken upon penalty of jail or theft, from the American people.

***(PS. I took the liberty of converting all this into 1980 dollars, so the other bailouts were $8, $78, and $281 billion respectively - including this one... but then, as my friend Bill pointed out to me the other day, the history of these bailouts tends to suggest a trend where the actual cost is something like 4x the listed cost that government has told us it'd be.)

And here we are today. Blaming a few years of policy for precedents that started 80 years ago. Scratch that... no one in the media or government is really blaming the actual policy... just "deregulation" and "the free market" - neither of which things exist.

So there it is...

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