Obama and Volcker: Economic Solutions, Good; Summers and Geithner: Financial Solutions, Not Good.

There is a basic economic perspective in Obama and Paul Volcker when they speak about the crisis and what we need to do. It is still somewhat inexplicable to me how Obama could chose Larry Summers and Timothy Geithner as his two top "economic" czars, they of the House of Rubin.

As head of the NY Fed, Geithner could have been far more on top of matters. For instance, he could have done some investigating into the rapid growth of the shadow banking system which is about 70% of global finance. It was the Financial Times that did some of the best investigating, not the Fed! (SeeFinancial Times on the City of London; see also generally Jeff Madrick in the current New York Review of Books; and, on Larry Summers, I just heard Madrick on NPR New York's Leonard Lopate's program, say that Summers is trying to catch up with the new views that Obama seeks to develop, but will be "behind the fact" as he is so deeply rooted in Rubinomics.)

The shadow banking system is not informal, illegal, or clandestine. Not at all: it is in the open, but it has thrived on the opaqueness of the investment instruments, partly facilitated by their complexity. Eventually this meant that nobody knew exactly or could understand the composition of their investments, not even those who sold the instruments.

One key component of the shadow baking system are credit-default swaps. This graph shows the extremely sharp growth over an extremely short period of time. While much attention has gone to subprime mortgages as causes of the financial crisis, the 60 trillion in swaps in mid-2008 is what really got the financial crisis going. The high rate of foreclosures alerted investors that something was not right, and hence a growing demand to cash in the swaps. The banking and financial system did not have those 60 trillion. This is more than global GDP.

There is no way that Geithner could not have noticed this sharp growth in only 5 years. He could have investigated this, even as a research project. Geithner was also part of the bailout which opted for pouring what is a lot of tax payers money into the financial system. How could our taxpayers' billions solve the 60 trillion root cause of the crisis. (See my earlier post on this "A Bad Idea: A Financial Solution to the Financial Crisis.")

In what ways are these swaps part of the shadow banking system?
This shadow banking system has thrived on the recoding of instruments, which, at the limit, allowed illegal practices to thrive. For instance, it is now clear that credit-default swaps are a type of insurance, but rather than selling them as such they were sold as derivatives. Why? Because if they were sold as insurance the law requires they be backed by capital reserves and be subject to considerable regulation. Making them into derivatives was a de facto deregulation and eliminated the capital reserves requirement. Credit-default swaps could not have grown so fast and reached such extreme values if they had been sold as insurance, which would have been the lawful way. None of the financial firms had the capital reserves they would have needed to back 60 trillion in insurance. Because they were recoded as derivatives, they could have an almost vertical growth curve beginning as recently as 2001.

This is a moment for radical departures form the old ways. We need to definancialize the economy: for instance, before the current "crisis" the value of financial assets in the US had reached 450% to GDP (McKinley Report 2008). We all need debt, whether we are a firm, a household, or a country. But do we need this level of debt? No. We need to expand and strengthen regulated banking and make finance less invasive and aggressive. And we need to grow jobs. That is why I put my hopes in Obama's intelligence and common sense and in Volcker's complex and multifaceted economic perspective rather than merely a narrow financial perspective. But I still wish Joseph Stiglitz was part of the team. (On the political aspects of all of this see the 09 issue of Dissent magazine).

Comments

[thesocialistidealist]

Volcker is not a good cabinet pick. His attempts to fight inflation led to economic problems both in the U.S. and globally, that were known as the "Volcker Shocks." On a global level, countries could not pay off their debt because of soaring interest rates. At home, he helped create a recession. All of this with the intent of serving the financial elite. Asking someone who in essence created economic hardship on purpose to "fix the economy" is absurd.

We need to stop thinking in terms of "fixing the economy" and start thinking in terms of class. While the stimulus package may focus on the "real economy," it still does not do nearly enough to help the working class. While "the economy" has had boom times as well as recessions during the last 30 years, working class wages have continued to decline. It should be about distributing wealth more equally, not just about "fixing the economy."

[Saskia Sassen - Huffpost Blogger]

this is an important angle into the whole question. thanks for raising it. i agree with a lot of what you say. i did not raise it because it does take us to a different level of analysis... if you see what i mean. In a book i did recently i tried to recas the question of class to account for th especifics of the current eara 9see my a Sociology of globlaization, Norton 2007)

[Saskia Sassen - Huffpost Blogger]

i do think both Summers and Geithner are getting a kind of public disciplining that might alert them they have some homework to do. : )
Summers, is being criticized for some of the items in the recovery plan--he had a big hand (including putting in money only for roads on the trasnport part, and far less for rapid rail.
Geithener becasue of his taxes and becasue it is becoming clear that he was deeple entrenched while the financila leveraging climbed and then with the give-away to the big fin services firms (they did not even think of distributing those funds among the hundreds of small town banks)

[joebhed]

whoa !

Thank you so much for pointing out the differences that exist between team members.
There is so little analysis being done on the relationship between Obama's team members and what has gone on, and is going on, in the economy.
When Paulson walked in with the 3-page "Give me $750 Billion and no one gets hurt" action, it was Volker who early on said that any position taken by the Treasury in any bank should be on the basis of all the rights possible with that position in protecting the rights of the taxpayers.

Like it was taxpayers' money.

Geithner and Summers are in the coulda, shoulda, woulda known what has been going on for years, with little to show in the way of any attempt at prevention.

Thanks again.

[kenstremsky]

Thank you

[usna73]

Quite right on all accounts. My suspicion is that President Obama will in fact have Mr. Volcker in charge, while Mr. Geithner will be the "front man."

We will nationalize the banks, at least for a few years, becuse there is no alternative.

Mr. Soros proposed this at the very early stages of the crisis.

There is private capital, Think Wilbur Ross, et al; that can come in once we have stabilized the system.

There is no qucik cure for a disasster that was over a decade in the making.

[Saskia Sassen - Huffpost Blogger]

yes, i agree completely. if only more of our legislators and much of the media could have caught on. some did, but somehow their voices were drowned. Obama actually did not want to accept the first TARP (the first phase of the bailout, when no accountability was asked from bankers). all these missed opportunities. I do think it is critical for legislators and citizens to do their homework on this stuff. we should have put a stop on this long ago.

[Callinda]

Summers and Geithner worry me, too. I wish Stieglitz and Krugman were on the team instead. Good post.

[Saskia Sassen - Huffpost Blogger]

on derivatives: outstanding derivatives before the value devaluation of the last few months stood at 640 trillion! this is not money. this is a kind of transactivity.

impressive financial engineering. What if these minds applied themselves to fixing some of the real challenges we face.

Yes, agree on Clinton--in many ways a great prez, but fell for the financializing of the economy, But how could Obama fall for it, at least with Summers and Giethner. The only hope with Geithner is that he is actually not trained as an economist but as a devleopment economist (that is a very different type of econ). And perhaps the recession and obama wil get him to go back to development econhem:

[Mildmannered]

how could the/our economic minds/watchdogs, e.g., Bernanke, Cox, Paulson, Geithner, etc., have not seen this tsunami coming?

[Siryn]

Although I like the Geithner choice, this is why I preferred Volcker for Sec Treas.

[Mildmannered]

As head of the NY Fed, Geithner has been part of our economic problem. As a watchdog why didn't he see this meltdown coming and if not stop it or minimize it, at least warn us?

[argyle]

well said

[kennethjkranz]

ah yes derivatives. I was a derivative neophyte til January of 2008. I happened to glance at the asset backed commercial paper outstanding and noticed it had doubled and continued to rise even though foreclosures were rising.

Then I spent a few months milling through the mortgage and debt derivative market to get an idea of how it worked. In theory, it looks great. Risk is spread out hedged in every differnet fashion and served up to the Insurance industry ala carte. Just what they wanted. But since it skirts regulation (It took down AIG) lots of dollars flowed in. Thats really the problem. Good old fashion too much money inflation. Credit default swaps were sold. the revenues came in and got invested instocks other derivative or plowed back into the already overheated mortgage market.

and the rating agencies of course only get good reviews when they give questionable credit tranches a pass. Question the mortgage and it doesnt get securitized. you wont get asked back to rate the next one. Just Turn it and Burn it. Hedge it and Pledge it!

[StephCaster]

The Guardian (UK newspaper) just did an article on the people most responsible for the financial crisis and Bill Clinton managed to finish just ahead of W. That's because of his collaboration with Congressional Republicans to kick off the deregulation malfeasance that made the whole mess possible. Summers and Geithner aided and abetted.

Clinton was a fine president in many ways, but this was not one of them. Obama must not fall prey to the failed ideology of the DLC Democrats.

[RoloTomassi]

Not to put too fine a point on it, but it was the failed ideology of the GOP that the DLC Democrats bought into....

[lizr]

And I wish smart women like you were working in the Admin. ANd I hope you are posting on

Whitehouse.gov.

[olephart]

There are plenty of smart women in Obama's administration it's men like Summers and Geithner that I worry about.