To paraphrase Winston Churchill, "[capitalism] is the worst form of [economics] except all those other forms that have been tried from time to time."
I subscribe to capitalism with the same sense of faith and irony. As I mentioned in my previous blog post, it is compelling that the financial services industry should be such an incredible example of capitalism's failure. Of course, I do not believe capitalism itself has failed. It hasn't even had a chance to succeed. Bribery (under the guise of campaign contributions), regulatory capture and lobbyist influence -- these noxious forces have corrupted our political and economic system.
Markets are the bedrock of capitalism, theoretically enabling efficient allocation of resources and price discovery. In reality, they have become simultaneously beholden to the manipulation of the Federal Reserve and a veritable casino of poorly regulated (or completely unregulated) gamblers and speculators, with incredible brain power and unprecedented computational resources. While markets yearn to be free, we have long accepted that regulations are necessary to curb market excess and ensure fairness. Matt Taibbi argues: "In a society governed passively by free markets and free elections, organized greed always defeats disorganized democracy."
As such, unregulated markets spin out of control, much in the same way as poorly regulated markets do. We have too much of both today, and it has imperiled our global economic system.
While High-Frequency Trading has (justifiably) been a favorite target, it is only symptomatic of a much larger, more fundamental problem. Other evidence for this include:
- Too Big To Fail Institutions ("TBTF") and the Repeal of Glass-Steagall: TBTF would not exist in a truly capitalist system. They are created through regulatory capture and government subsidies. And yet, our government not only subsidizes these "Systemically Dangerous Institutions" -- as Bill Black so eloquently labeled them -- it has even forced smaller institutions to join forces to become far more systemically dangerous (e.g. Bank of America + Merrill Lynch; JP Morgan + Bear Stearns).
- One cannot meaningfully discuss TBTF without recognizing its relationship to the Glass-Steagall Act. The Glass-Steagall Act mandated a separation between commercial and investment banks; essentially, Congress tried to protect the financial services industry from the weight of its own heft, and this worked for nearly 70 years. For example, as Luigi Zingales points out in a recent Financial Times op-ed, the 1987 stock market crash did not impact the economy, because commercial banks were unaffected. Likewise, Zingales notes, "securities markets helped alleviate the credit crunch (of the early 90s) because they were unaffected by the banking crisis."
- The Financial Crisis of 2008 offered a clear illustration of what happens when investment and commercial banks commingle. Quite simply, TBTF did just that -- the private sector failed, and the public has had to pay the price. The mess has compounded daily since then, with no end in sight.
- The Sheer Size of the Industry: As institutions have grown "too big to fail", the industry itself has taken on a much larger and more concentrated (and therefore more problematic) share of GDP. Our financial services industry has transformed from a capitalist-based survival-of-the-fittest to a moral-hazard-based survival-of-the-biggest.
- A dramatic shift took place starting in the 1990s; Alan Greenspan dropped the Fed Funds Rate and kept it low for an extended period of time. The financial services industry, which had never comprised more than 1.7 percent of GDP (and had averaged just 1.2 percent) from 1929 - 1988 suddenly started growing to peak at an unsustainable 3.3 percent of GDP in 2005.
- New York Times writer Floyd Norris blames excessive risk-taking and an unregulated derivatives market for this concentrated spike in the industry's share of GDP. In this connection, it is hardly a wonder that our outsized financial services industry has pushed society away from fair, orderly markets and into a spiraling series of bubbles and crises.
- Historically extreme compensation. To quote the man of the hour, Jamie Dimon, "They want Wall Street to pay... They think we're overpaid assholes." It's true. And you are. I mean, I know you're doing "God's work" and all, according to Lloyd Blankfein of Goldman Sachs, but your dramatic emphasis on short-term profits over prudent long-term financial stewardship is killing our economy. And you don't care, because you just keep getting your bonuses.
- A complete lack of criminal enforcement. Capitalism depends on the rule of law to function. Instead of prosecuting criminals this time (as they did during the Great Depression) the government is instead bailing them out (and reaping the campaign donations). In fact, the government has taken a number of recent steps to loosen the prosecution of white-collar crime. For example, in 2008, the U.S. Dept. of Justice implemented a policy allowing for the deferral of prosecutions for corporations that show self-investigation and reporting. Great timing, DOJ! With the SEC also adopting this policy, you have tremendous accounting control and institutional fraud from the mortgage crisis going largely unpunished or simply wrist-slapped. Nobody goes to jail.
- The unregulated shadow banking system. The previous symptoms were all within a supposedly "well regulated" market. There exists a much more insidious example of a market that has remained unregulated -- the shadow banking system and the unregulated derivatives market. This market encompasses both derivatives instruments such as mortgage-backed securities, credit default and interest rate swaps, and other such instruments that are "too exotic" to be understood, let alone regulated. This is a complex subject that is difficult to tackle in a bullet point. This chart from Reggie Middleton's BoomBustBlog.com should suffice as it demonstrates that in 2008 (the numbers are worse now) the notional value of JP Morgan's derivatives portfolio was six times US GDP and larger than Global GDP by $21 billion. Of course, I'm sure they know what they're doing, and would never endanger the global economic system by managing that risk recklessly. Banking used to be a boring business -- our economy would be much more stable and our country much wealthier (with a more even distribution of wealth) if it headed back in that direction.
Of course, this post is really just a tip-of-the-iceberg treatment of a topic that has been covered extensively. Unfortunately, movements to reduce partisanship and the influence of money on the financial services system are met with tremendous resources -- political, financial and media -- that also seek to preserve the status quo. I am not suggesting that we seek an alternative to capitalism, as we've seen that other economic systems fare as badly or worse (see: USSR, Europe). But we do need to refom our government and regulators, starting with the two-party duopoly and the campaign finance system. These dramatic reforms might give capitalism a chance to function.
In my next blog post, I'd like to delve deeper into some proposed reforms for financial services in our continuing search to create a more just and equitable economic system. As I've mentioned, I believe economic and political reforms must go hand-in-hand. It does us no good to attack the squid when it's feasting on an unending food supply of corruption that will just spawn another in its place.
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Since we don't know all of the securitized instruments & their "backing," do we even know if they have separate "witching" dates from the known derivatives in the open markets?
If sovereign debt derivatives, foreign MBSs, etc. are timed to the witching, double witching & quarterly triple (or more) witching trading days, things could get very interesting very quickly + High Speed Trading.
A few points:
(a) Mr. Taibbi, and you, are right, ‘In a society governed passively by free markets and free elections, organized greed always defeats disorganized democracy.’ And I agree with this, how else do explain the organized greed of the elderly through the AARP, or the organized greed of the unions that allow them to monopoly powers in a country where price collusion and monopolies are illegal for economic interests…as the unions are. So why signal out the banks? Go after all these sleazy institutions if that is the case.
(b) Glass Steagall: What in Glass Steagall would have prevented too big to fail? It did not prevent Continental Illinois, the Mexico Debt Bailout and LTCM. In addition there was nothing in it that would have prevented the housing crisis and the follow-on financial crisis.
(c) Size? 1.2% v 3.3%. #1, what is the right size. There are countries with much bigger financial industries or similar size that had no problem with a financial crisis. #2, 3.3% is most probably a function that other industries, say manufacturing, has shrunk. #3, other industries, like healthcare, have also exploded in size…is that a problem? Finance is a great industry to have…would prefer it to manufacturing, which is being disintermediated by robotics and going the way of the dodo as an employer, any day.
b) Glass Steagall would have prevented the ownership of the MBS derivatives by the commercial banks. The investment banks would have been able to fail without impacting the economy at large. I think I make the argument quite clearly. You should also read the linked op-ed.
c) I'm trying to say that since the repeal of Glass-Steagall, financial services has gotten much bigger than it has been historically. During the same period, our country has become less wealthy and prosperous. Something seems wrong.
d) There's no envy here. I was in the industry. There's disappointment, that capitalism doesn't seem to be allocating resources efficiently. The compensation structure is also highly skewed to short-term profits, something that has not historically been the case.
e) I agree that we must let banks fail. But are you trying to tell me that the crisis brought about by a collapse in the housing market wasn't caused by extreme over-securitization of mortgages in an unregulated derivatives market? There's a general consensus that it was. Banks were leveraged to the hilt (and in some cases still are) because the shadow banking system is not monitored or regulated.
Thanks or the response.
a) You state, ‘Well, I think the financial services industry has a much greater impact on our day-to-day lives than the elderly.’
I would disagree. The intergenerational ponzi scheme known as Social Security and Medicare are far more dangerous to the economy and the health of the US than banks. The elderly are wealth dilutive as a special interest….banks are wealth accretive.
b) But was ownership of MBS derivatives by commercial banks a problem? #1, There is nothing in glass Steagall that stops commercial banks from owning MBS, which is why the commercial banks had lots of ‘em prior to its repeal in 1999. #2, The failure of banks due to MBS were all monoline banks, meaning either investment banks or commercial banks, bear stearns, etc., not both so it is not due to that fact that banks merged businesses. #3, even if condition #1 and condition #2 could have prevented commercial banks from merging and owning MBS, investment banks alone could have more than met demand for MBS…which was substantial, especially from Freddie and Fannie, who were the buyer and insurer of last resort for much of the housing CDO’s. Goldman Sachs and MS had their own origination businesses as well as their own services…they did not need the commercial banks to provide the loans that would be packaged and sold to meet Freddie and Fannie’s gluttonous appetitive for them.
c) OK…they are getting bigger…great…so are competing banks in other countries. Nothing wrong with big banks, per se. That being said….JPM was getting big BEFORE the repeal of G-S not because of it…they bought a series of other commercial banks and their investment arm is not the reason for their growth. Even monoline banks like Goldman and Morgan Stanley have gotten bigger…again, this is because they went public in the early 90’s and this allowed them to grow internationally. If you are going to write about banking you should at least take a history class in banking. There is nothing in G-S, as it existed in the 1980’s and 1990’ss, that stops banks from becoming big. Their growth was a natural offshoot of being successful and buying out less successful banks. Even today, JPM bought Bears, WaMu, and several other banks. We should send them a thank you note.
(e) Unregulated? What about the shadow market caused crisis. If anything it was the overregulated aspects of the market in housing that got us into trouble. The banking industry si subject to more regulation than ever. It is ridiculous. Reduce it and let banks fail.
Kai
As a civilian apart from Wall St., my reaction to Joe Nocera's editorial & Kotlikoff's post, my response was similar to yours:
Bulls-eye !!!!
We haven't found out everything that the banksters have securitized & double-hedged, we don't know the counter-parties and their hedged positions, & we don't know when every deal has to unwind.
Add in the multi-state problem of illegal MERS real property transfers, failures to pay state & local real property transfer fees + the necessary "independence" by licensing law of local foreign national offices of Chase, Goldman, etc. & it could wind up that our securitized credit card debt, housing MBSs & securitized student loan debt could wind up being the least of our problems.
Since the news media continues the trope of "unexpected collateral damage that no one could have foreseen," life could become far more interesting than anything the "experts" have predicted.”
It is meaningless to compare the notional value of derivatives against the actual value of US or Global GDP. Notional means not evident in reality; hypothetical or imaginary. What is the notional amount at risk if all life insurance policyholders died tomorrow? Certainly, you could calculate some total value; but what would it mean? Derivatives bring together a party who believes that “X” will happen with a counterparty who believes that “X” will not happen. When events prove which one is right; then the loser pays off the winner. Sometimes, a party takes both sides on an outcome. If your business would be hurt equally by a 20% rise or a 20% fall of the Euro; then you might buy derivatives to protect you against both events. Derivatives are a zero sum exercise (apart from fees) - they just shuffle money from the counterparty who was stupid/unlucky to the party who was smart/lucky.
http://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporation
A quote: ““The FDIC insures deposits only. It does not insure securities, mutual funds or similar types of investments that banks and thrift institutions may offer.”
AIG was unable to pay what it owed - this is the same problem arises with people who:
- buy stocks on margin
- are unable to make their mortgage payments
- fail to make their credit card payments