Privatizing Benefits, Socializing Risks: The Roots of our Economic Crisis

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Mon Dec-28-09 10:58 PM
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Privatizing Benefits, Socializing Risks: The Roots of our Economic Crisis

Our nation�s elites have long disparaged the words �Communism� and �Socialism� to such an extent as to make these words almost synonymous with evil. Yet it is only one side of the equation that they hate. They hate the idea of a society or government that provides a safety net to its most vulnerable members, in an attempt to ensure that everyone has access to the basic necessities of life. Yet you don�t often hear them complain when government provides them with benefits, at the expense of the rest of society.

This attitude is the essence of the privatization and deregulation movement that came into full force in our country during the Reagan Revolution of the 1980s. Deregulation is the crux of their philosophy, and it is the very essence of privatized benefits in the face of socialized risks. They equate deregulation with freedom. But their �freedom� comes at a great cost to the rest of society: Deregulation of environmental controls means pollution of our air, water, and soil and putting our planet on the brink of a climate crisis that threatens catastrophe to billions; deregulation in the workplace means threatening the health and safety of our workers; deregulation of prohibitions against monopolies means granting control of huge areas of our economy to the wealthy few, with consequent rising costs and declining quality of goods and services for the average consumer; and deregulation of the financial industry means that our financial elites are granted the �freedom� to operate as they please, amass huge fortunes from irresponsible risky ventures, and then receive huge subsidies from the American taxpayer when things go sour � rationalized with the argument that the �services� they provide are so essential to the economy of our country that we can�t function without them.

A classic example � Robert Rubin and the Citigroup fiasco

A classic example of how privatized benefits combine with socialized risks to create vast fortunes for the few at the expense of the many is seen in the career of Robert Rubin. Rubin was Bill Clinton�s Secretary of the Treasury before he resigned in 1999. Shortly before he resigned he advocated for the repeal of the Glass-Steagall law, which protected the American people against financial fraud by prohibiting commercial banks from taking on the risky role of investment banks. Citigroup is widely considered the greatest beneficiary of the repeal of Glass-Steagall. Charles Gasparino explains the philosophy:

The theory of Citigroup was widely accepted in business circles as the future of the financial business; combining commercial and investment banking services under one roof and allowing firms to sell all sorts of products was a step forward toward "financial modernization."

With Rubin�s backing, Glass-Steagall (which was already severely weakened through years of abuse) was repealed. Within days of the repeal of Glass-Steagall, Rubin joined Citigroup, as a senior executive with the title of �Chairman of the Executive Committee�. In that capacity he strongly advocated for high risk policies which eventually contributed to Citigroup�s downfall. Gasparino describes the sequence of events:

Citigroup, with its mandate now in hand, and with Rubin approving the effort, became one of the biggest creators of mortgage bonds� With Wall Street buying these loans en mass from the banks to pack into their ever-riskier bonds, lending to so-called "subprime" borrowers became an accepted practice fully sanctioned by the federal government. When Citigroup couldn't sell the bonds to investors, it horded them on their balance sheet, earning the high interest rates the bonds threw off.

That is until reality set in, as it did last year when the entire financial system, burdened by investments in these mortgage bonds on their way to default, Wall Street, began to collapse and the economy fell into the Great Recession, now with 10.2% unemployment that shows no signs of letting up. Citigroup was the biggest casualties of the collapse; its risk takers had lost so much money that it needed tens of billions in guarantees and handouts, as well as the government becoming the bank's largest shareholder.

When the dust finally cleared, it became obvious that the demise of Glass-Steagall allowed the risk-taking traders at Citigroup to jeopardize nearly $1 trillion worth of customers� deposits, which is the main reason the feds had to spend so much bailing it out. With that, Bob Rubin's Wall Street career was over. He was forced to resign from the Citi board and the firm itself with his reputation in tatters, but not without earning more than $100 million.

In what kind of a world does massive failure result in �earning� $100 million? Answer: a world in which the game is played with a stacked deck, in which the consequences of failure and massive financial losses are spread out (socialized) so that the American people pick up the tab for the wealthy.

The origins of Glass-Steagall

Nobel Prize winning economist Paul Krugman explains the origins of the Glass-Steagall legislation in his book, �The Return of Depression Economics � and the Crisis of 2008�. Prior to the Great Depression of the 1930s, the United States had experienced periodic severe recessions and depressions, which were due largely to an unregulated financial system. Nothing demonstrated the need for regulation of the financial sector more than the Great Depression. Krugman explains:

Because they were supposed to engage only in low-risk activities, trusts were less regulated� than national banks. However, as the economy boomed during the first decade of the 20th century, trusts began speculating in real estate and the stock market, areas from which national banks were prohibited. Because they were less regulated than national banks, trusts were able to pay their depositors higher returns. Meanwhile, trusts took a free ride on national banks� reputation for soundness� As a result, trusts grew rapidly� and the most severe banking crisis in history emerged in the early 1930s� precipitating a series of loan defaults followed by bank runs� There�s more or less unanimous agreement among economic historians that the banking crisis is what turned a nasty recession into the Great Depression.

The response was the creation of a system with many more safe guards. The Glass-Steagall Act separated banks into two kinds; commercial banks, which accepted deposits, and investment banks, which didn�t. Commercial banks were sharply restricted in the risks they could take; in return, they had ready access to credit from the Fed� their deposits were insured by the taxpayer. Investment banks were much less tightly regulated, but that was considered acceptable because as non-depository institutions they weren�t supposed to be subject to bank runs.

This new system protected the economy from financial crises for almost seventy years.

The deregulation craze of the 1980s and the initial efforts to repeal Glass-Steagall

The presidency of Ronald Reagan ushered in the era of privatization and deregulation. Another way of saying this is that the Reagan administration ushered in the era of favoritism towards wealthy corporations and individuals at the expense of everyone else, which began a trend towards a disappearing middle class and the greatest level of incomeand wealth inequality ever seen in this country. William Kleinknecht describes what this process meant in terms of financial deregulation, in his book, �The Man Who Sold the World � Ronald Reagan and the Betrayal of Main Street America�:

The Reagan administration�s zest for financial deregulation was responsible for the boom-and-bust cataclysms of the 1980s and 1990s, the obscene inflation of executive compensation; the corporate scandals and stock market meltdown of 2000-2001; and innumerable crises in international finance, including the most devastating of them all: the subprime mortgage scandal. Deregulation corrupted financial institutions at the same time that it made them the lords of the world economy and allowed their proxies, people like Robert Rubin and Alan Greenspan, to dictate the policies of the federal government. History will marvel that these two standard-bearers of Reaganism � Greenspan and Rubin � were lionized as geniuses and visionaries at the very time they were steering the nation toward disaster�.

Reagan�s plan for deregulation of the financial sector would take years to come to full fruition � what was finally left of Glass-Steagall would not finally be repealed until 1999 � but the processes he and his Republican colleagues set in motion in 1981 were the genesis of so much that is wrong with the U.S. economy in the 21st century.

Reagan didn�t have the votes in Congress to repeal Glass-Steagall. So he attacked it the same way that he attacked everything else he didn�t like about our system of government: by executive fiat. He simply neglected to fulfill his responsibility as a U.S. president to enforce our existing laws and regulations. As Kleinknecht explains:

Reagan changed the role of government from that of watchdog to lapdog without even bothering to consult the Congress. He also gave a potent political voice to the backlash against regulations, ensuring that the movement would continue to burgeon after he left office� The Reaganites went after regulatory agencies with relish, starving them of resources and staffing them with officials committed to their destruction�The S&L mess worked out well for the new class of robber barons that emerged in the Reagan years. A small group of rich business types went on a spending spree, and the public picked up the $150 billion tab. Privatize the wealth and socialize the risk.

Reagan�s Treasury Secretary, Donald Regan, drafted legislation in 1983 to repeal Glass-Steagall, but it was defeated in the Democratic House of Representatives. With the help of his newly appointed chairman of the Federal Reserve, Alan Greenspan, Reagan tried again in 1988, but the effort was again defeated in the House. Nevertheless, Reagan put Glass-Steagall on life support through his continuous refusals to enforce the terms of the law.

President Clinton�s about-face

Thom Hartmann explains in his book, �Threshold � The Crisis of Western Culture�, that Bill Clinton campaigned for the presidency as an unabashed FDR style liberal. In a speech at Georgetown University on October 23, 1991, he declared:

We need a new covenant, a solemn agreement between the people and their government to provide opportunity for everybody, inspire responsibility throughout our society, and restore a sense of community to our great nation � a new covenant to take government back from the powerful interests and the bureaucracy, and give it back to the ordinary people of our country�

More than 200 years ago, our founding fathers outlined our first social compact, between government and the people, not just between Lords and Kings� More than 60 years ago, Franklin Roosevelt renewed that promise with a New Deal that offered opportunity in return for hard work. Today we need to forge a new covenant that will repair the damaged bond between the people and their government, restore our basic values, embed the idea that a country has the responsibility to help people get ahead� And most important of all, that we�re all in this together�

Clinton was elected President on that promise. Hartmann points out that:

A majority of voters in 1992 were old enough to remember what America was like under the 1940-1981 New Deal era, when a single worker with a good job had health care, a pension, and could raise a family and buy a home� And they noticed that the twelve years of Reagan and Bush had begun the process of shattering that historic era; that the middle class was slipping away; that government had become remote and hostile rather than protecting the rights of workers and the middle class�

But something happened before Clinton was inaugurated. Hartmann continues:

A few weeks before Bill Clinton was to be sworn into office as president of the United States, he was visited by Goldman, Sachs CEO Robert Robin and Alan Greenspan. Rubin and Greenspan sat the young new president down and told him the facts of life as they saw them. Clinton would not govern as an FDR liberal; instead he must cut government, �free� trade, and reduce regulation of business� Clinton complied� In his second inaugural address, he declared, �The era of big government is over.�

I would love to know how a �visit� from Greenspan and Rubin so changed the course of our country. Did they threaten him, bribe him, or just convince him? I guess we�ll never know. Anyhow, Kleinknecht describes how Clinton�s thinking changed:

Bill Clinton� ended up buying into the Reagan mantra of deregulation and continued efforts to undermine Glass-Steagall� He made his chief economic adviser Robert Rubin, the former cochairman of Goldman Sachs and Company, a man who saw the world through the prism of Wall Street� The two men (Greenspan and Rubin) ensured that Clinton stayed the course of Reaganism on economic matters, much to the chagrin of administration liberals like Labor Secretary Robert Reich and Joseph Stiglitz, chairman of the Council of Economic Advisers�

Final repeal of Glass-Steagall

In 1999, Congress passed the Financial Services Modernization Act, commonly known as the Gramm-Leach-Biley Act, which repealed Glass-Steagall. Kleinknecht describes the effects of that:

It was no surprise that the conflicts of interest and sleazy behavior that Glass-Steagall was designed to prevent quickly reappeared once the law was shelved� There were enormous sums of money to be made on Wall Street, and some of that wealth would be plowed into political campaign funds� Within two years after the repeal of Glass-Steagall, companies were inflating their earnings by billions of dollars�

This was the dawn of the George W. Bush era, when the ethos of Reaganism was once again enshrined as holy writ, so the stock market implosion of the millennium would not give rise to new banking regulation. Instead, the financial press continued to deify Greenspan, Rubin, and Reagan, and the country plunged headlong into the subprime mortgage scandal.

One bubble on top of another

Paul Krugman describes the two nation-wide financial bubbles leading up to our current crisis. The first was the stock market bubble, which peaked in the summer of 2000 and then burst, leading to a 40% decline in the stock market over the next two years. Krugman notes that Alan Greenspan received high praise for the fact that the recession that resulted from the bursting of the stock market bubble of 2000 was so short-lived and mild. But that praise was misplaced. The reason that the recession was short-lived and mild was deceptive. The fact of the matter was that the deflating stock market bubble was replaced by the housing bubble. Therefore the recession wasn�t cured by anything Alan Greenspan did, but rather it was interrupted and delayed by the occurrence of another bubble � a much more dangerous one. Krugman explains what an asset bubble is:

An asset bubble is a sort of natural Ponzi scheme in which people keep making money as long as there are more suckers to draw in. But eventually the scheme runs out of suckers, and the whole thing crashes.

As for the housing bubble:

What justified a bubble in housing? � Americans have long been in the habit of buying houses with borrowed money, but it�s hard to see why anyone should have believed, circa 2003, that the basic principles of such borrowing had been repealed. From long experience, we knew that home buyers shouldn�t take on mortgages whose payments they couldn�t afford, and that they should put enough money down so that they can sustain a moderate drop in home prices and still have positive equity� What actually happened, however, was a complete abandonment of traditional principles� It was driven to a greater extent by a change in lending practices. Buyers were given loans requiring little or no down payment and with monthly bills that were well beyond their ability to afford�

Why did lenders relax their standards? � The lenders didn�t concern themselves with the quality of their loans because they didn�t hold on to them. Instead, they sold them to investors, who didn�t understand what they were buying�.

As for Greenspan�s role:

As long as housing prices kept rising, everything looked fine and the Ponzi scheme kept rolling� Some economists warned that there was a major housing bubble� But authoritative figures declared otherwise. Alan Greenspan, in particular, declared that any major decline in home prices would be �most unlikely.�� But there was, and it began deflating in 2006 � slowly at first, then with increasing speed. By that time Greenspan was no longer chairman of the Fed�

Krugman sums up the recession of the early 21st Century:

Officially the recession was short, but the job market kept deteriorating long after the recession had officially been declared over� The unemployment rate rose steeply during the recession but continued to rise in the months that followed. The period of deteriorating employment actually lasted two and a half years, not eight months.

Prelude to depression � The shadow banking system

Krugman explains that in ordinary times it would likely have been possible for our country to have survived the bursting of the housing bubble without too much difficulty. However, the combination of high unemployment and a dysfunctional financial system was more than we could bear. Our financial system was (and is) dysfunctional in ways that the previously existing Glass-Steagall legislation was meant to prevent. But it wasn�t simply the demise of Glass-Steagall that was responsible for the problem. Rather, it was the whole deregulatory atmosphere under which our country has operated since the onset of the Reagan presidency. And more specifically, it was the taking on of investment bank functions by financial entities that were not formally labeled as banks but which actually were banks, in that they functioned as banks. Glass-Steagall wouldn�t have covered these entities even if it had still existed, because they were not �banks�. Krugman explains that the solution to this confusing situation is that:

Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank�

Krugman singles out for discussion one particular financial tool, known as the �auction-rate security�:

The idea of an auction-rate security was that it would reconcile the desire of borrowers for secure long-term funding with the desire of lenders for ready access to their money. But that�s exactly what a bank does. Yet auction-rate securities seemed to offer everyone a better deal than conventional banking. Investors in auction-rate securities were paid higher interest rates� while the issuers of these securities paid lower rates than they would have on long-term bank loans. There�s no such thing as a free lunch� yet auction-rate securities seemed to offer just that. How did they do that?

Well, the answer seems obvious in retrospect: Banks are highly regulated (even without Glass-Steagall)� By raising funds via auction-rate securities, borrowers could bypass these regulations and their attendant expense. But that also meant that auction-rate securities weren�t protected by the banking safety net. And sure enough, the auction-rate security system collapsed in early 2008. One after another, auctions failed, as too few new investors arrived to let existing investors get their money out� And each auction failure led to another; having seen the perils of these too-clever investment schemes, who wanted to put fresh money into the system? What happened to auction-rate securities was, in all but name, a contagious series of bank runs.

Today, the set of institutions and arrangements that act as �non-bank banks� are generally referred to either as the �parallel banking system� or as the �shadow banking system.� Conventional banks operate more or less in the sunlight, with open books and regulators looking over their shoulders. The operations of non-depository institutions that are de facto banks, by contrast, are far more obscure. Indeed, until the crisis hit, few people seem to have appreciated just how important the shadow banking system had become.

The roots of economic catastrophe

Krugman sums up the anti-regulatory craze that led to our current crisis:

As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that we were re-creating the kind of financial vulnerability that made the Great Depression possible � and they should have responded by extending regulation and the financial safety net to cover these new institutions.

But this warning was ignored, and there was no move to extend regulation. On the contrary, the spirit of the times � and the ideology of the George W. Bush administration � was deeply anti-regulation. This attitude was symbolized by a photo-op� in which representatives of various agencies� used pruning shears and a chainsaw to cut up stacks of regulations. More concretely, the Bush administration used federal power� to block state-level efforts to impose some oversight on subprime lending�

So the growing risks of a crisis for the financial system and the economy as a whole were ignored or dismissed. And the crisis came.

This should not be surprising. Why should we expect that the results of deregulating financial institutions � or any corporate sector of our economy � should be any different than deregulating organized crime (i.e. doing away with all laws used to control it), for example? Both organized crime and corporate America are focused primarily on a ruthless pursuit of profits and power, and neither is particularly concerned about who gets run over in the process. So when the barriers are purposely removed we should not be too surprised to see lots of people get run over.

It is inevitable when the wealthy few are given huge advantages over vast masses of people. What we have seen in this country since the Reagan presidency is vast expansion of the income and wealth gap in our country, and consequently the accumulation into the hands of the wealthy few vast powers to shape national legislation to their advantage.

Privatizing benefits while socializing the responsibility for the consequences of risks should strike us as the most obvious of frauds. Yet those in power have managed to bamboozle millions of Americans into thinking of it as �throwing off the restraints on free enterprise�. James Galbraith explains the whole concept in a nutshell, with regard to Treasury Secretary Geithner�s plan for bailing out Wall Street:

The plan is yet another massive, ineffective gift to banks and Wall Street. Taxpayers, of course, will take the hit� The banks don't want to take their share of those losses because doing so will wipe them out. So they, and Geithner, are doing everything they can to pawn the losses off on the taxpayer�. In Geithner's plan, this debt won't disappear. It will just be passed from banks to taxpayers, where it will sit until the government finally admits that a major portion of it will never be paid back.