Hypothesis #5—The Bad Banking Impediment: From the beginning, the banking system in the United States has limited the capacity of economic freedom to spread wealth and improve lives. Under ultra-capitalism, this impediment has escalated to a force that threatens the world’s economy.
Commercial banks have a simple mission: make high-quality loans in support of the job-growth economy. Government policies, instead, now allow banks at various times and in various ways to provide easy credit to fund excessively speculative and high-risk ventures, to trade in futures, to slow growth during a credit crunch, and to hide total debt through structured finance and securitization. Government policies then insure, subsidize, and bail out the banks, assuring a continuation of bad loans. In a down market, bank policies then deprive credit-worthy businesses of critical funds because the bankers are trying to fix their loan reserve ratios that they screwed up with their bad loans.
Adam Smith predicted that free markets would spread wealth and improve lives through “the natural course of events” and the “invisible hand,” if money were low-cost, ample, non-volatile, and patient. Smith warned particularly that the system could be compromised by the “prodigals and projectors” who would deflect money from the job-growth economy, waste it, and destroy free-market benefits.
In this hypothesis, I affirm that the U.S. government has failed to protect the system from the “prodigals and projectors”; it has, rather, encouraged, funded, insured, subsidized, and bailed them out. Extreme examples of this corruption of free-market principles include LTCM (see chapter 7) and Enron (see chapter 9), but many other cases could be cited. This contradiction of Smith’s free-market philosophy has slowed economic and social progress for two centuries, and the privileges and corruptions have now escalated to a level that deprives the world’s economy of its best opportunity. The global economy cannot function if the speculators on borrowed money have more power than do central bankers, a power that the speculators demonstrated many times during the last quarter of the twentieth century. Leveraged speculation would be purged from the system in a heartbeat if citizens understood the corruption. The way to a world of peace and plenty lies before us, but we cannot follow it until the economic system implements a 21st-century version of the free-market principles proclaimed by Adam Smith and refined by Marx and Mill so long ago.
While Adam Smith and the classical economists believed that the free markets could do most of the job without assistance, that belief was qualified by the expectation that government exercise its responsibility to assure that money remain a neutral medium of exchange, and that capital for investment be patient. The government can fulfill this responsibility either through free banking that is monitored by market disciplines or through government regulation.
The banking system in the United States is the worst of both possible worlds because it has deregulated at the same time that it was suspending the disciplines that free markets depend upon. The result is a banking system that privatizes the profits for the few and nationalizes the losses to the taxpayer. Instead of allowing the market to seek equilibrium, the U.S. government’s policies cause large swings in the economy that are economically and socially damaging.
Since the beginning of the American government, the politicians have experimented with national banks, State banks, private banks, and the present system of half-public/half-private banking. None of these efforts has succeeded in serving the general welfare.
The present banking system in the United States has limited the power of economic freedom to improve lives because it has been cobbled together in pieces, and designed under the influence of Wall Street lobbyists whose mission is to make money on money. No integrated banking policy; no long-term government plan for currency and credit control; and no thoroughly articulated responsibility for fiscal, monetary, and regulatory practice is in place. What does exist is spread among so many governmental agencies that the overlap, confusion, and turf squabbles cause a policy vacuum that is filled by Wall Street lobbying. This approach has limited growth, concentrated wealth for the privileged, slowed the world’s economy, and prevented improvement in the lives of billions of people.
The more recent policies lobbied by the special interests of ultra-capitalism generated the excessive liquidity that funded the bubble economy, lately popped. From one extreme to the other, the policies then switch to a credit crunch just when the economy needs stimulation to regain momentum. Similar policies have been applied around the world by the U.S. dominated IMF with the same boom/bust economic damage, over-funding in the up direction, under-funding in the down.
Adam Smith’s qualification that free markets function only when capital is not deflected to the speculators, has not only been ignored by the American government but has been denied at the highest level. When Chairman Greenspan famously described the “excessive exuberance” in the stock market in the mid-1990s, he not only did not reduce the percentage of money that could be borrowed for speculative purposes but also he advised Congress that no relationship exists between the money available for speculation and the rise in the stock market (see chapter7). In a later speech, Greenspan reviewed the 1990s bubble economy and concluded that if high interest could not prick the bubble, then the Fed had no other tools to do the job. In other words, Greenspan was acknowledging the government’s powerlessness to prevent the boom-and-bust pattern that has caused such enormous social damage over the past two centuries. Greenspan commented:
If low-cost, incremental policy tightening appears incapable of deflating bubbles, do other options exist that can at least effectively limit the size of bubbles without doing substantial damage in the process? To date, we have not been able to identify such policies.
This view is not only unacceptable and dangerous but also incorrect. Many options are available to a government willing to follow its Constitutional mandate to control currency and credit for the general welfare, and these options await only an aroused citizenry that will demand their implementation. This, however, is the same chairman that helped repeal the Glass-Steagall Act and helped prevent regulation of derivatives, and, oversight of hedge funds like LTCM and Enron. This type of powerful support from top government officials has led to a fundamental error in government economic policy, namely the deregulation of finance capitalism, with a claim that unregulated finance capitalism constitutes the “free market”. This wrong turn was taken at the same time that the market disciplines that could have kept the market free were being suspended.
Many tools are available to prevent the boom/bust cycle. For example, if bank examiners can come in after the bubble has burst and make matters worse by tightening credit, then why can they not come in earlier and raise reserves, limit the availability, and raise the cost of money for speculation that causes asset inflation in the stock market and real estate in the first place? Reserves must be increased when the stock market rises beyond improvement in corporate earnings, and reserves must be increased when real-estate values grow at a rate faster than inflation. Following this protocol will require determined democratic support because reserves are increased only by a reduction of profits, which affects the price of the bank’s stock and the value of bankers’ stock options.
Whether the problem is the over-funding of Enron or Southeast Asian countries, another control tool is the reintroduction of the debt-to-equity ratio discipline. The relationship of short-term hot money and other debt to long–term patient capital, whether in a company or a country, must be subject to regulation. When hot money becomes disproportionate to long-term equity, the risk goes up; therefore, the availability of money should go down, and the cost of money should go up. An accurate debt/equity comparison, however, depends on full disclosure of all off-balance-sheet debt, but disclosure has been so corrupted under ultra-capitalism that both the lenders’ and borrowers’ balance sheets are works of fiction. International bankers chasing profits through hot money need to be disciplined simply by requiring that a portion of their money invested in emerging economies be in the form of long-term debt or equity, or, in a crisis, a requirement that hot money be cooled by automatic conversion to long-term debt or equity.
The mission of commercial bankers ought to be to make good loans to help the economy grow. Ultra-capitalist bankers, however, are motivated and rewarded based on deal-making, short-term earnings, and stock options that are incongruent with the mission of making good loans. Bankers’ compensation over a period of years should be penalized by write-offs for bad debts. The all-important sensitivity to making good loans will come back only after the insurance, subsidies, and bailouts are eliminated. Deposit insurance, for example, must be returned to the original intention of protecting the small depositor in a single banking location.
William Isaac, former chair of the FDIC (Federal Deposit Insurance Corporation), warned about the potential damage to the economy from the “too big to fail” policy (see chapter 7, DC, Vol I). He pointed out that bankers would be convinced by a bailout that they could make stupid loans for short-term gain and be protected from punishment. Fed Chairman Volcker ignored Isaac’s warning in 1984 and bailed out the Continental Illinois Bank. In 1991, the Bank of New England, the third largest bank-holding company in the Northeast, failed. The FDIC, under new leadership, then demonstrated how far it had gone in protecting bad loans by paying off not only the insured deposits, the limit of which had been raised from $40,000 to $100,000 in the 1982 S&L bailout law, but also all depositors. As the abrogation of market disciplines became steadily worse, so also did the quality of bankers’ loans.
How could this Constitutional contradiction persist while democratic power was growing in a country “of the people, by the people, and for the people?” The answer to this question is that the people’s elected representatives have not been reflecting the will and wisdom of the people; instead, the politicians have been influenced by the lobby power of Wall Street and the banking interests. Liberal Democrats have also ignored the will and wisdom of the majority, and instead of reforming ultra-capitalism, they have concentrated political power to micromanage commerce and redistribute wealth. Hypothesis #6 is about the resulting political gridlock that impedes appropriate reforms.