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Wall Street, DC, and the New Financial Euphoria

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Talk about premature exaltation.

I spent last week in New York and Washington, speaking with many erstwhile Masters of the Universe and those charged with cleaning up the mess they've created. And in both cities I was stunned by how many Wall Street and political insiders were ready to break out the champagne. Forgive me if I keep the bubbly on the shelf.

The insider consensus seems to be that the worst of the hard times is behind us and that the economy is back on track. Or at least on track to be back on track.

Not even the latest employment stats showing that another 539,000 Americans had lost their jobs dimmed the enthusiasm. Call it The New Financial Euphoria.

Only it's not really new. When I was interviewing Eliot Spitzer last week on Squawk Box, he recommended a book called A Short History of Financial Euphoria by John Kenneth Galbraith, and over the weekend, in between running into more cases studies in financial euphoria, I gave it a read. Kudos to Spitzer, because the book couldn't be more apt to what we're facing today.

Written in response to the stock market crash of 1987, the book is an examination of how economic bubbles start and why we never seem to learn the right lessons when they burst. Starting with the tulip mania in the 17th century and going up to 1987, Galbraith explores the psychology behind the boom/bust cycle and how "the extreme brevity of the financial memory," combined with an ignorance of history, leads to the same reckless mistakes being made again and again and again. Often soon after the last boom/bust go round.

"Financial disaster is quickly forgotten," writes Galbraith. "When the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery."

Sound familiar? Credit default swaps, anyone?

For an example of what Galbraith called "the pathological weakness of the financial memory" and a "mass escape from reality," look no further than Sunday's New York Times, in which a variety of Wall Streeters, asked whether it is "safe to exhale yet," offered up delusional gems such as "I'm of the view that this is a bull market," a bottom "probably has been reached," and this could be a "lasting bull market" that in a few years might hit October 2007 highs.

One of the problems with this happy talk is that it contributes to running out the clock on the narrow -- and narrowing -- window for reform.

Back at the end of 2008, the banking class was terrified by the prospect of serious reform of the financial industry. Populist anger was rising, and it looked like the political will to rein in Wall Street was taking hold. But here we are in May and while we've gotten some impressive talk from Obama's economic team about the need to fix the financial system, there has been no real push for reform -- only the ongoing express delivery of few-strings-attached taxpayer dollars to Wall Street.

Bank bailouts move forward at warp speed while regulatory reform sputters along in the slow lane. Which is just the way Wall Street wants it. Its motto is: if it's broke (but you keep bailing us out), why fix it?

That's where Galbraith's warnings about the ignorance of history come into play. The last thing Wall Street wants is for Congress to take to heart a history lesson like the one Elizabeth Warren offered when I interviewed her on Squawk Box. She explained how, going back to the time of George Washington, "every 10-15 years we had boom and bust, boom and bust, boom and bust... until we hit the Great Depression." At that point, as Warren put it, FDR's economic team decided: "You know what? We can do better than that. We can write a set of rules that are going to make it better than that." And they put in place reforms like the Glass-Steagall Act, and the creation of the FDIC and the SEC. The result, according to Warren: "50 years of security and prosperity."

Then came the push for deregulation -- which gave us the S&L crisis, then Enron/WorldCom/Global Crossing, and now the current economic meltdown, which Nassim Taleb calls "vastly worse" than what happened in the 1930s. "This is the most difficult period of humanity that we're going through today," he told a conference in Singapore last week, "because governments have no control."

And that's just how Wall Street wants to keep it.

So far, Washington seems unwilling to offer much pushback. The problem is that reform is not in the DNA of those in charge of the administration's economic policy. And real systemic change is not going to happen without at least one person on the senior economic team who will single-mindedly make that a priority.

Instead we get Larry Summers (one of the architects of the dismantling of Glass-Steagall) and Tim Geithner, who actually talks the talk of a reformer, but walks the walk of a Wall Street true believer.

There he was last week on Charlie Rose, claiming: "We are being dramatically more aggressive than I believe any serious government has ever been, certainly in generations, in responding to financial crises. So if you look at the scale of action, look at the quality of initiative we've taken, I think it dramatically exceeds even the best-managed crises we've seen before."

And there is no question that he is right in terms of the scale of the administration's response. But all this scale and aggressiveness have been geared towards saving the current system -- not reforming it. The result is that we are on track to return to where we were when all the trouble started -- to the demonstrably flawed status quo.

Back in March, Geithner told Congress that the financial system had failed "in fundamental ways" and that fixing it would be accomplished not by "modest repairs at the margin, but new rules of the game."

But where is the urgency to push through these new rules? Where is the evidence that Geithner and company are willing to go toe-to-toe with those who see regulation as their mortal enemy?

When Rose asked Geithner about the "army full of lobbyists with huge amounts of money" who are determined to undermine what Geithner promised would be the "most sweeping changes in financial regulation that we've seen in decades," the Treasury secretary replied: "It's going to be hard for them, because again the people are watching."

But the people were watching when the Senate voted on cramdown legislation that would have given relief to the millions of Americans who are, or soon will be, facing foreclosure -- and the lobbyists won. As a Times editorial put it: "When the time came to stand up to the banking lobbies and cajole yes votes from reluctant senators -- the White House didn't. When the measure failed, there wasn't even a statement of regret."

This is all the more significant because of the precedent it sets. Wall Street has seen that it can count on enough Democratic Blue Dogs to scuttle even modest, utterly sensible reform. And that the administration won't put up much of a fight to save it.

I am at heart an optimist. But being among the giddy revelers at last week's White House Correspondents' Dinner in DC and the Time 100 party in New York, I felt like a prude at a 60s love in.

Indeed, there is something in the current DC/NY culture that equates a lack of unthinking boosterism with a lack of patriotism. As if not being drunk on the latest Dow gains is somehow un-American. You can see this in the way those who accurately predicted the bursting of the most recent bubble were viewed, branded as "naysayers," and "prophets of doom."

This too is nothing new. In his book on financial euphoria, Galbraith writes about how, in 1955, after offering Senate testimony suggesting toughening stock buying rules, he was inundated with angry responses: "The postman each morning staggered in with a load of letters condemning my comments, the most extreme threatening what the CIA was later to call executive action."

Yes, it's more fun to hop a ride on the Happy Days Are Here Again bandwagon. But it won't be fun when it ends up back in the same ditch -- or, worse, rolling completely over the cliff -- because we didn't make the necessary repairs when we had the chance.

And, yes, it's not fun feeling like Cassandra. But remember: Cassandra turned out to be right and the cheerleading Trojans very seriously wrong. And very seriously dead.

The other problem with "the pathological weakness of the financial memory" is that it causes us to forget, along with the Trojan War and the last economic crisis, all the things we could have done with the massive amounts of money we spent bailing out the banks -- things like foreclosure relief, job creation, infrastructure repair, health care reform, and improving education.

It's time to stop pretending that the Wall Street economy is the same as the real economy. The Wall Street economy may be showing signs of life -- thanks to the hundreds of billions we have poured into it -- but the real economy isn't.

"Don't tell me about the stock market," wrote Bob Herbert last week. "Don't tell me about the banks and their perpetual flimflammery. Tell me whether poor and middle-income families can find work. If they can't, the country's in trouble."

And that trouble is only growing worse, even if the media are full of Wall Streeters over the moon because the Dow just went up 100 points.

There aren't going to be reasons for optimism -- or cause for celebration -- unless "the new rules of the game" Geithner promised are moved from the realm of rhetoric to the arena of action. The window for reform is closing.