Sunday, December 12, 2010

Once more into the breach.

The word is out. Wall Street is back. Houses in the Hamptons. High end cars. Manhattan condos. After two years of nervousness, excess may once again trump discretion, or shame.

Soon we will see Goldman CEO and former gold trader Lloyd Blankfein walking the halls of Congress once again, defending his industry's largesse and lucre—though perhaps this time he will have the good grace to forego his prior suggestion that they are doing “God’s work.”

Wall Street’s revival comes even as Citibank CEO Vikram Pandit took time out of the G-20 meetings in Korea to complain about how chilly the climate was for bankers in the U.S., in contrast to the warmth he felt ensconced among his global finance brethren.

Chilly indeed.

Could America conceivably be more accommodating to its major financial institutions, as they prepare to pay out record levels of bonus compensation in the coming weeks?

The myth continues that Wall Street was bailed out with the $700 billion of TARP money. Pushed through a recalcitrant Congress in the wanting months of the Bush administration by Hank Paulson and Ben Bernanke and disbursed over the months that ensued, TARP has become the iconic whipping boy of left, right and center alike.

Ironically, little of the TARP money was actually used to purchase bank “toxic assets,” as originally intended, as most banks refused to sell—fearing the losses that they would be forced to recognize. Instead, TARP funds were provided as equity infusions and asset guarantees that nursed the banks back from the brink of collapse.

Today, the details of the whole episode are receding into memory. Even as films and books have chronicled wide-ranging stupidity, fraud and incompetence, as a matter of public policy bad conduct was occasionally noted, but never pursued. We have moved on.

The boards of the banks remain intact. The CEOs that oversaw the debacle fly off to G-20 meetings in Geneva or Korea to bemoan their fate. To hear them talk, one would think that the banks were incidental to the financial crisis. And in their revision of history, the TARP money was forced upon them. They were doing just fine on their own.

Few recall Hank Paulson and Ben Bernanke viewing the American economy on the verge of collapse. Fewer still give credit to any of the participants—Bush, Paulson, Bernanke, Obama, Geithner—for having stabilized the financial system. That is now deep in the past.

The total cost of the orgy of greed that that surrounded the packaging and trading of complex derivatives and collateralized securities has yet to be fully tallied. Last year, the IMF projected total bank losses at over $4 trillion, with $2.7 trillion of those losses at U.S. banks. Federal Reserve Bank data shows household balance sheet losses from the market collapse reached $15 trillion in 2009—almost 24% of the total net worth of American families—before ebbing to $10 trillion as the equity markets rebounded.

What is lost in the fury over TARP is that it represents only a portion of the federal intervention to support the country’s leading banks, as well as the two largest investment banks, Goldman and Morgan Stanley, which converted into bank holding companies in order to gain access to Federal Reserve support.

The most far-reaching area of federal intervention has been the sustained injection of massive amounts of liquidity (i.e. money) into the banking system by leaving the critical Fed Funds Rate—the interest rate charged on interbank loans among members of the Fed system—at or close to zero.

The effects of a 0% Fed Funds Rate are profound. In a normal time, and in a normal, cyclical recession, lowering the Fed Funds Rate ripples through the economy as a lower cost of capital on prime business loans and other loans. In the current economy, however, little new business lending is taking place.

While Fed data indicates that little commercial banking (lending) is going on, banks are taking full advantage of the availability of zero interest loans, and have borrowed trillions from the Fed. Literally trillions. Goldman: $600 billion. Morgan Stanley: $2 trillion. Citi: $1.8 trillion. Bear Stearns (now J.P. Morgan): $1 trillion. Merrill Lynch (now Bank of America) $1.5 trillion.

The term trillion makes all of this somewhat hard to grasp. But what is easy to grasp is the notion that if someone lends you money at 0%—OK, 25 basis points if you want to be picky—reinvesting it at a positive spread is not hard to imagine. Most Americans would relish the thought of replenishing their depleted retirement savings with zero interest loans, and would find any number of ways to take advantage of the opportunity. Put the money in a bank. Buy treasuries. Buy bonds. Buy commodities. Buy gold. Buy almost anything.

For the banks, free money translates into huge trading profits with no trading risk if they stick to investing in treasuries, and more if the go farther afield. And that is the point. The Fed strategy of keeping the Fed Funds Rate at or near zero provides a back door way of recapitalizing the banks, of rebuilding the balance sheets of financial institutions that lost an estimated $3 trillion and were insolvent. $700 billion of TARP funds was nowhere near enough, and the banks bridled at the constraints on compensation that came as part of the deal. In contrast, the Fed strategy was clean, and for the most part invisible. It required no vote of Congress, no authorization or appropriation of federal funds. There was no public humiliation on Capitol Hill. The only downside—for the public at least—is that before those banking profits reach the bank balance sheets, 40% or so of the trading profits will be paid out as bonuses.

But the Fed strategy has come at a high price. While the zero Fed Funds Rate is great for the banks, it has been a killer for those living off of their savings and for the nation’s pension systems. Senior citizens whose income is derived from rolling over certificates of deposit have seen their interest income decline by as much as 95% as CD yields declined from the 3% to 5% range prior to the economic collapse to recent levels of ¼ to ½ of 1%, according to Fed data.

If much of this seems incomprehensible, the message is simple: The Federal Reserve policy of keeping its target rate near zero is intended to allow banks to recapitalize, but has the effect of taking money from the elderly and others living off their savings, and transferring that money to the banks.

Over the coming weeks, Wall Street banks will pay out an estimated $30 billion in bonuses. These bonuses come on the heels of the second year in a row of record trading profits. Those record profits are not a product of great market insight, but reflect what is possible when money is free.

So when you see Lloyd Blankfein walking the corridors of power on Capitol Hill, defending the trading profits of his industry and proclaiming once again that they are doing God’s work, give your mom a call, or your great aunt or your elderly neighbor living on a fixed income. Give them a hug, and thank them for their sacrifice for God and country. Apparently, their sacrifice is necessary to rebuild our banking system and our nation.

After all, someone has to pay the price, and God knows its not going to be the people who created the mess to begin with.

Friday, December 10, 2010

Passing moment.

Taken at their word, Tea Party acolytes had among their core message two principles: First, Congress should move quickly to end out of control deficit spending. Second, Congress should stop lying to the American people.

Well, so much for that election.

Over the past few weeks, in short order, Congress swept aside the recommendations of the President’s debt commission, ignored the parallel recommendations of the study committee led by Pete Domenici and Alice Rivlin, and moved to prevent the expiration of the Bush-era tax cuts that are set to expire at the end of this month.

Taken together, these actions reaffirm the principle that one ought to judge people on their actions rather than their words. For all of the words of praise directed at Erskine Bowles and Alan Simpson for putting a credible plan on the table—leading Bowles to foolishly intone that the era of deficit denial is over—Congress moved swiftly to assure jittery financial markets that such denial is still with us, and that any bold or courageous action by the 535 members of Congress to act on our long-term fiscal problems will not happen on their watch.

Or make that 534 members of Congress. Hats off to Kent Conrad, the sole member of the debt commission who will be in office in January who voted in favor of the debt commission recommendations.

To extend the Bush tax cuts is simply wrong.

Little if anything has been said in the public debate about why those tax cuts are set to expire: They expire to comply with the fiscal rules in place when the cuts were enacted into law. Back in 2001, tax legislation was required to meet a ten-year scoring rule, which required that the tax cuts be paid for over a ten-year horizon. The ten-year requirement itself was a liberalization of the earlier, less flexible, “Paygo” rules that required that changes be paid for on an ongoing basis.

These rules are not in the Constitution or some other founding document, but rather are rules Congress sets for itself, as if to guard the nation from Congress’ own penchant for reckless and inappropriate conduct. Congress does not have to approve balanced budgets—as we all know—but in the wake of Reagan-era deficits we saw the rise of legislation such as Gramm-Rudman-Hollings that sought to restrain Congress increasing disregard for fiscal prudence.

Simply stated, the Bush-era tax cut legislation provides for rates to return to the levels in effect in 2001 in order to pay for the largesse that was bestowed upon taxpayers over the ensuing years. Not just taxpayers who earn over $1 million, but all of us.

All those who are clamoring for tax rates to remain at the lower levels are giving the lie to the notion that Congress should be subject to any rules, or that such rules should be followed. The argument that tax rates should not be increased in the face of a recession is utterly disingenuous. Those arguing to gut the 2001 and 2003 tax bills now would be doing so regardless of our economic condition.

Look back at the historical record. Even as the tax cut legislation was being considered, Republican leaders assured their base that by 2010 the cuts would be made permanent, and that those who might seek to let the cuts expire would be attacked for raising taxes. That is to say, even at the moment of the original legislation, those who supported it eschewed any intention of adhering to the fiscal rules that Congress itself had imposed. At the time, the cynicism was breathtaking. But as political calculation, it was prescient.

Today, with the reversion to the pre-tax cut rates looming come January, few if any in Congress are prepared to stand on principle and remind their colleagues that those tax increase are the price that was to be paid for the prior years of reduced taxes. Instead, Congress can point to the economic situation as justification for their collective determination to undermine the fiscal rationale of the law that they are now seeking to upend.

The problem with the argument that this is not the time to “raise taxes” is that this was part of the deal. This was part of the rules—and a very limited set of rules at that—that were set in place to protect Congress from itself, and to protect the rest of the nation from Congress. And this will be no temporary action. By supporting a two-year extension, Republican strategists have made the sound bet that regardless of the financial condition two years from now, making those cuts permanent at that time will be an easy sell. After all, 2012 is an election year.

Perhaps further stimulus over the short-term is warranted, as the Domenici-Rivlin group specifically addressed. But ideally such actions would be targeted to have the greatest economic impact over the near term, while not undermining prospects for addressing the longer-term problems, such as providing a payroll tax holiday to boost domestic spending and addressing a corporate tax structure that inhibits the repatriation of foreign earnings and undermines domestic investment.

But the greatest irony is the support of eviscerating the Bush-era tax legislation coming from those who during the very same week supported the work—if not the specific recommendations—of the debt reduction commission. Both that commission and the Domenici-Rivlin group provided alternatives for balancing the short-term need for economic stimulus with long-term recommendations to address the nation’s fiscal situation. They provided our political leadership with the opportunity to stanch the momentum of a nation heading toward a fiscal train wreck. They provided a moment in which serious leaders could stand up and be counted.

How quickly that moment passed.

Representative Paul Ryan’s dissembling words in dismissing the work of the debt commission on which he served stand as evidence that for all the talk, most in Washington still do not believe that the problems we face warrant any serious consideration.

"I just don't think this thing (the work of the commission) has the ability to last in policy, and it simply buys us time. I'd rather fix the problem, with the Boomers starting to turn 65 this year, fix it once and for all so we can really get this thing fixed."

Ryan, the architect of his own fiscal reform plan, was simply unwilling to step forward and show the courage of his convictions. Imagine if he had said instead.

“I will support the Commission recommendations not because it is my preferred plan, but because it is the first step to forcing Congress—all of us who are charged to lead the American people—to make the hard choices necessary to chart a new course for our nation. I believe Congress must approve this plan. Then, those of us who believe there is a better way can propose changes to that plan that will improve our situation—bring down healthcare costs, further attack the problem of growing entitlement obligations at the federal and state level, increasing the pro-growth structure of our tax code.

“But all of those changes require first that we achieve balance—or something close to balance—and this plan does that. Those of us who believe further—and better—changes are necessary will make that case, to Congress and to the American people. But if this is the plan that gets is to a balanced starting point, we must all come together and support this as an essential first step.”

Almost 200 years ago, Alex deTocqueville commented that “The American Republic will endure until the day Congress discovers that it can bribe the public with the public’s money.” Paul Ryan, and most others in Congress, will vote soon to bribe Americans one more time, in pursuit of their own narrow political interests.

Shortly thereafter, these same politicians will clamor for deficit reduction and decry the fiscal situation of our nation—a situation that is a product of their own cynicism, self-interest and unwillingness to do the job for which they were elected.

Wednesday, November 10, 2010

Market distortions.

It did not take long for the conflicts to emerge as Republicans struggle to make good on their commitments to reduce federal spending. In the wake of the Republican victory last Tuesday, public comments regarding how to cut the federal deficit followed a familiar line: Across the board cuts in spending, exempting Medicare, Social Security and Defense. Now, just a few short days after John Boehner’s victory lap, this strategy has been kicked to the curb.

The problem is that the math doesn’t work. Since 1980, those sacrosanct programs, Medicare, Social Security and Defense, have grown from 72% of the federal budget to 84%. Based on Congressional Budget Office data, non-defense discretionary spending for 2010 totaled $512 billion, which means that to meet Senator Jim DeMint’s threshold of $300 billion in cuts, one would have to reduce the non-defense discretionary budget by 60%. Despite the urge to point the finger at non-defense discretionary spending as the source of all that ails us, that spending category represented 3.7% of GDP in 2010, down from a quarter century peak of 3.8-3.9% in 2003-05, but up from the low of 3.2% reached in late 1990s.

Senator-elect Rand Paul has challenged the notion of sacrosanct programs, by suggesting instead that a 5% cut should be applied across the board. A 5% cut in the $3.2 trillion federal budget would translate into a $160 billion cut—still well short of DeMint’s threshold—but it puts into play those programs heretofore off limits, though still avoiding specifics of what to cut. Meanwhile, DeMint himself is mired in a battle with Mitch McConnell over the largely symbolic issue of earmarking.

Much has been written about the lack of specific proposals for spending reduction coming from Tea Party candidates during the run-up to the elections, but underlying the movement has been a call for reduced federal regulation and spending, and a return to greater reliance on free markets.

Such a call for the federal government to take its finger off the scale of competition and commerce could be a healthy change for the country, even if a painful one to achieve. Some of the pain would come in the form of economic dislocation, as industries now supported by federal subsidies or favorable tax or other treatment would have to swim in unfamiliar, competitive waters. But the greater pain would be felt by the members of Congress themselves—of every political stripe—who for decades have traded on their ability to tip the scale on behalf of those who support them.

We have all paid a price for the policies and priorities that are now deeply woven into the tapestry that constitutes the federal budget and system of regulation. Consider for a moment the role of federal spending and policies in exacerbating just a few of the problems that we continue to grapple with.

First, federal policy has directly encouraged overleveraging at the corporate and household level.

The 2008 economic collapse followed a period of massive over-leveraging at the corporate and household levels. At the corporate level, debt has been used for the past quarter century as a tool for increasing economic value, by companies, private equity funds and others. This over-leveraging of the corporate sector increases financial risk and vulnerability. Corporate over-leveraging is a specific response to the unequal treatment of debt and equity under the tax code. Simply stated, interest paid on debt is privileged by being deductible, while dividends are paid on an after tax basis. For any company seeking a $1 million investment, this unequal treatment provides a direct inducement to seek debt financing rather than equity investment.

At the household level, the inducements to borrowing are grounded in the tax-deductibility of mortgage payments vs. the payment of rent from after tax dollars, and the stimulation of consumer credit through home equity loans. Home ownership has long been touted as the cornerstone of national social policy, but of late the disadvantages of home ownership have become apparent. As we have built an increasingly dynamic national economy, labor mobility has become an increasing value, both for individuals seeking to optimize their career and educational opportunities, as well as for overall economic growth. Recently, Fed Chairman Bernanke noted the issue of labor immobility as an increasing problem for economic development. This was shorthand for people who cannot move for a job because they cannot sell their home.

Second, federal policy has directly encouraged overspending on medical procedures and pharmaceuticals.

The current structure of health insurance provides direct inducements to overspending on medical care. For example, drug insurance plans—whether private or public—that have the consumer paying a fraction of the price of a drug lead to high consumption based upon the low net price, while leaving the tax or premium paying public absorbing the rest of the cost. The impact of this incentive to overspending can be seen in the rash of commercials for new drugs for every imaginable syndrome from social anxiety disorder to overeating disorder to acne. For a $5 co-pay, there is a market for anything. At the full price of $200 per month, many consumers might choose lifestyle or nutritional solutions instead.

Third, federal policy has encouraged dependency on foreign oil.

Since the creation of CENTCOM by President Jimmy Carter, the United States has affirmed its policy priority of protecting western access to Middle East oil. After decades of failing to enact a federal energy policy, it is high time that we recognize that CENTCOM is our energy policy. If a heavy military presence in the Middle East and in other energy producing regions is part of the price of predictable access to our annual consumption of $400 billion or so of imported crude oil and petroleum productsas reported by the federal Energy Information Agency—then perhaps some share of our $600 billion defense budget should be internalized into the price consumers pay for oil products. Like overspending on drugs for which we only pay a portion of the true cost, our current energy policy has the effect of encouraging spending on oil by having consumers pay only a portion of the true price of delivering gasoline to the pump on a reliable basis.

Banks, pharma and oil are just three industries that have effectively used the federal government to enhance their competitive position and support or protect the markets for their products. And each of the practices that has been implemented to support and protect those industries—deductibility of debt, copayments for drugs and medical treatments, defense protection of oil supply lines—have encouraged patterns of over-consumption by masking the true price from the consumer and contributed directly to bubbles that we often discuss but rarely diagnose or address: Overleveraging, excessive societal spending on medical care and growing reliance on foreign oil.

In each case, addressing the incentive structure and effectively taking the federal finger off the scale could ameliorate these problems of over-consumption for which we have paid and continue to pay a heavy price: Reduce the bias toward debt in corporate finance and reduce financial risk. Increase individual incentives to make good health decisions through lifestyle changes and nutritional choices. Provide a more level playing field for non-oil based energy sources.

“The government is promoting bad behavior,” marked the opening salvo of Rick Santelli’s rant in the opening moments of the Tea Party movement. “How many of you people want to pay for your neighbor’s mortgage…?” Yet while Santelli focused on the bank bailouts, the larger problem stemmed from years of federal programs that promoted low cost mortgages—to support both home ownership and the building trades—that promoted a culture of over-borrowing and over-building.

There is no end to ways that we subsidize bad behavior, only to pick up the back end costs that ensue. To extend Santelli’s point, how many of us want to pay for agricultural subsidies and marketing programs to promote sales of cheese, corn syrup and sugar, and then pay for the skyrocketing health costs that stem from our poor nutrition habits? In Santelli's world of free markets and free choice, would not farmers live or die based on demand for their products—rather than their state's role in presidential primariesand the customers bear the consequences of their own nutritional choices?

Today, we live in a world where prices have been distorted, often as a direct product of federal policies. And those distortions come with a price. We are now paying a high price for the collapse of an artificially induced housing boom. We pay through taxes, premiums and public debt for that portion of drug prices that are hidden from the consumer. And we pay the hidden cost of delivering oil to the pump through taxes, debt and war.

The question for Republicans as they seek to reduce the federal budget is not just whether they are prepared to cut discretionary military spending and tackle entitlement reform, but whether they are prepared to go farther and confront the complex system of subsidies, protections and regulations now built into the federal budget that distort free markets and lead to adverse outcomes that, as Rick Santelli noted, none of us want to pay for.

The free market aspirations of the Tea Party should not be silenced or dismissed, but instead should engender a much-needed reevaluation of federal fiscal, tax and regulatory policies. The question for Tea Party acolytes will be whether they are prepared to walk the walk and push to cleanse the federal budget of all manner of pork and privilege, or if theirs is a partisan battle that only aims to cut the federal budget on the backs of their political adversaries.

Saturday, October 30, 2010


In a fit of self-importance—or perhaps it is despair—the media has pounced on Jon Stewart for stepping out of the studio and into the public square. Some veil their criticism as concern for Stewart’s career. Others savage him for crossing the line between news and entertainment.


Like some rendition of Brigadoon, one has to wonder what world these critics are living in. Twenty years ago—give or take a decade—Ted Koppel interviewed Rush Limbaugh on Nightline. In response to Koppel questioning whether he—like Steward today—was crossing a sacred line, El Rushbo retorted, Ted, let’s remember, you and I, we’re in the entertainment business now.

Religion. Politics. News. Entertainment. If the line was blurred for Rush a few decades ago, it is now gone. When Glenn Beck stood on the Washington Mall in August and pronounced the next Great Awakening, he was bringing all four together, with himself firmly placed at the epicenter. Those who suggest that Jon Stewart crossed a line should open their eyes and behold the new world.

No one questions whether Glenn Beck is in the business of entertainment. Or politics. Or news. Nor should one question the same for Sarah Palin. Beck and Palin stand at the cutting edge of a democracy that is being subsumed into popular culture, and they understand well the seamless flow between news and entertainment, religion and politics. Beck has been in the ratings game for longer than Sarah. She spins one-liners with the best of them—her riff, How’s that hopey, changey thing workin’ out for ya? is viscous and humorous at the same time—but Beck has a trained ear for when one argument has run its course and it is time to develop new material.

The ones who don’t learn and adapt are the ardent followers. Whether in the guise of Reagan Democrats of the 1980s, the Perot voters of the 1990s or the Tea Party acolytes today, disaffected American voters are easily seduced by politicians who channel their anger and provide succor through promises of lower taxes and easy fixes. The rhetoric of false prophets and entertainers alike can lure them into the public square, ready to point fingers at all the sources of their pain.

But they never want to look into the mirror.

Check the record. With promises of cutting waste, fraud and abuse, and pointing the finger at welfare cheats, Ronald Reagan offered the promise of cutting taxes and reducing the size of the federal government. The Reagan administration succeeded in cutting taxes, but never introduced a budget to Congress that reduced spending. Despite all of the familiar arguments about the revenue growth that ensued, the greatest legacy of the Reagan years was the political lesson that tax cuts buy votes, while there is no meaningful constituency for cutting budgets beyond old school Republican bankers sipping a single malt at the New York Athletic Club.

In the three decades since the Gipper recast the rules of the game, the Republican Party has become the party of tax cuts and the Democrats the party of spending increases as the key argument to their constituencies. But neither party feels any obligation to take the painful steps necessary if they are to pay for the promises that they aim to deliver.

To suggest that Republicans have abandoned their brand is not an idle claim. Since 1980, Republicans have controlled the White House for 20 of 30 years. During that time, Republicans have routinely cut taxes, while never once proposing a budget that would pay for them. The Congressional Budget Office recently observed that the Medicare Part D program passed by George W. Bush will add more to the federal deficit over the next decade than the combined cost of the stimulus, healthcare and TARP legislation—to say nothing of the wars and tax cuts—yet the power of brand still leaves Republicans as the party of fiscal conservatism.

The past three decades offer ample evidence that there are no pure players in this debate. Not the Republican Party that lost its fiscal bona fides decades ago. Not the Democrat Party that in pursuit Wall Street largesse became the handmaiden of accelerating financial deregulation that culminated in financial chaos. And certainly not the American Family, those of all faiths and political persuasions who bought into the silly shibboleths of the new economy, and chose to lever up rather than hunker down as they faced stagnating real incomes.

Yet Tea Party acolytes remain enthralled by those who are selling them a bill of goods to build their own ratings, their electoral prospects or their speaker fees—with little regard for whether they are leading America further down a path of cynicism, and contributing to the further dysfunction of a political system that seems incapable of addressing the real and deepening problems that we face. The plaintive cry “Don’t let the Government get its hands on my Medicare,” might be apocryphal, but it highlights the vacuousness of a political movement that is built on deliberate denial by Americans of their own responsibility for the straits in which we find ourselves. As Pogo said, We have met the enemy, and he is us.

Today, as the economy lies in tatters in the wake of financial crimes and misdemeanors from Wall Street to Main Street, Americans remain reluctant to confront and admit their own complicity in the mess. It was tens of millions of average Americans who violated every rule they were supposed to have learned in kindergarten about living within their means and not borrowing too much. Today, these same Americans who bought too much house and borrowed against too many cards, now want to point the finger at the politicians and decry their profligacy.

The anger and fear that Americans feel as they gather to protest the unfairness of the world should be tempered by their own complicity in buying the same bill of goods, year after year. The truth is that we did not hold our politicians accountable because we did not want to have to choose between consumption and savings. We wanted more now and more in the future.

And compounding that anger and that fear must be a healthy dose of shame for what we have wrought. But rather than facing up to our own culpability, we have become even more determined to lash out at the other that must have created this mess.

After all, it can’t be our fault, because we are Americans. We are the noble citizens of the greatest nation in history. Our ethical conduct and fiscal prudence is beyond reproach. We know this to be the true because Glenn Beck and Sarah Palin and a raft of other politicians and pundits tell us so.

And we are too happy to believe them, because to do otherwise, and to accept some measure of responsibility for the world of our making would too hard. And for that, we should feel undying shame.

Saturday, October 23, 2010

Working class hero.

The Delaware Senate race may not be close in the polls, but people in Delaware are nervous. Despite an apparent 15 point lead for the Democrat, Chris Coons, the palpable anger on the streets of the long-time patrician state of the Dupont family leads many to believe that the outcome of the race remains uncertain.

Delaware is a small state of less than one million people. With the industrial north and rural, agricultural south, it has its own political culture and history. While viewed by many as a Democrat, blue state, its statewide office-holders have flipped from D to R with regularity. And its politics have always had a certain genteel character—with each Election Day followed by Return Day, a public festival of reconciliation culminated by a parade honoring the winners and losers together.

But this year emotions are running high, as they are nationally. At the most recent debate, Republican Christine O’Donnell quizzed Chris Coons on the Constitutional basis of the separation of church and state. The Constitution has carried iconic status among right wing insurgencies over the years—though their affection has tended to focus on a few amendments of choice while ignoring those that less suit their purposes—and O’Donnell was quick to expand her query to whether there was any federal authority that should rightfully bind the choices of a free people. Perhaps unwittingly, her stance in defense of radical federalism recalled Delaware’s history as among the last states to abolish slavery, almost a full decade after the Emancipation Proclamation.

But despite being ridiculed in the national media for her apparent ignorance of the First Amendment, O’Donnell seemed quite pleased with her performance. Indeed, she appeared nothing short of gleeful during the exchange, as she egged Coons on, goading the Yalie into a brief discourse on the Establishment Clause.

In her view, O’Donnell won the moment—evidenced by her joy and the hoots from her supporters—as she had succeeded in stripping the veneer off of the generally unflappable Coons, exposing his essence as a high-brow elitist. You could almost read her thoughts: You see! Listen to him! Thinks he’s the smartest guy in the room, and that he can shame me with that little lecture on the Constitution. But he just doesn’t get it—this race is not about how smart he is; it is about deep and undying anger of Main Street Americans at all of those who for so long have pulled the levers of power, and seen fit to tell the rest of us how much smarter they are than we are.

O’Donnell got this far by bringing down the old school patrician Republican Mike Castle, who in her mind was not one whit better than Coons. Yet many still refuse to take her seriously and suggest that her goal is simply to garner the national stage for a bit and perhaps land a reality show on Fox. But the fact that her numbers remain north of 40% even after her First Amendment performance speaks to the depth of the anger and resentment Delawareans feel toward Washington, D.C., and support her belief that with strong turnout on Election Day she can ride that wave to public office.

O’Donnell’s rhetoric of resentment toward elites has been central to the Republican Party narrative for decades. In prior incarnations, the Party leveraged those resentments to build its base—from Nixon’s Southern Strategy, the Reagan Democrats and Pat Buchanan Peasants with Pitchforks to Lee Atwater and Karl Rove’s success in co-opting the evangelical Christian community.

But this time, the Republican Party apparatchiks have lost control of the narrative, and Tea Party leaders have wasted no words in asserting their willingness to tear the party apart if it does not follow their lead. They understand all too well that the anti-Washington movements of the past foundered quickly, and saw their leaders compromised and their energies dissipated as the rise of federal power and spending continued unabated.

The irony, of course, is that the Tea Party is a movement without any internally consistent principles. The anti-tax core of the message loses its coherence when combined with the parallel anger over deficit spending. And for all the rhetoric about deficits and healthcare reform, no serious Republican candidate who has embraced the Tea Party talking points believes that deficits were the cause of the housing bubble and ensuing collapse or that our continuing economic problems will be cured by eliminating deficits or repealing healthcare reform.

Instead, rage against the machine is the underlying theme. Christine O’Donnell is not running for office because she believes that she has a better idea about how to fix the economy, or anything else for that matter. Hers is a platform of platitudes and resentments against all those smartest-kids-in-the-class who have been running things all these years and treating the rest of the country like second-class citizens. And she hopes there are enough Delawareans who share her disdain and anger.

But while O’Donnell is unlikely to win on November 2nd, the Republican Party and House Speaker-in-Waiting John Boehner are in for a rough ride. After 40 years of service as the tip of the Republican spear on Election Day, this crowd of angry, resentful Main Street Americans may not be willing to fade away as they have in the past, as the election fades and Washington returns to business as usual. This time, the Republican Party may have to make good on its promises, and John Boehner et al will be hard pressed to construct a legislative agenda and budget that delivers on the disparate slogans they have endorsed and promises they have made.

But it sure will be interesting to watch.

Sunday, October 10, 2010

They're mad as hell, but so easy to manipulate.

Today’s Tea Party has a point. The political progeny of George Wallace Democrats, Richard Nixon’s Silent Majority, the Reagan Democrats, supporters of Ross Perot, and Pat Buchanan’s Peasants with Pitchforks—largely white, working and middle class—are very pissed off. And for good reason. The American middle class that was once the envy of the world has taken an economic beating.

Since 1970, the middle class’ share of national income in the United States has steadily declined. Based on U.S. Census date, over the past 40 years, the middle class—as represented by the middle quintile of households—has improved its share of nation income in only four years, 1990, 1995, 2002 and 2007, and in aggregate saw a decline of 16% over the four decades. By way of comparison, the top quintile improved its share of national income by 17% over the same time period, and the top 5% of families by 31%.

The relative and absolute economic decline of the American middle class has accelerated. Back in the Mad Men years of the 1950s and 1960s, when the American middle class was the envy of the world, real household incomes grew by 35% and 35% in the respectively. Since then, real income growth has moderated, with growth rates of 6% in the 1970s and 1980s, before a brief uptick to 10% in the 1990s. Then the hammer fell, as over the past decade, real incomes for the middle quintile of American families declined by 6%.

So it is no surprise that, in Paddy Chayefsky’s words from the 1976 film Network, middle class Americans are mad as hell and aren’t going to take it any more.

What is surprising—and disappointing—is how easily manipulated the Tea Party movement has been, and how willing its followers seem to be to have their rage channeled against the chosen targets of self-interested and opportunistic leaders.

Socialism. Deficit spending. Healthcare reform. Barack Obama.

The current plight of the middle class had unfolding—and accelerating—for four decades, and this is the best Dick Armey and Sarah Palin and Glen Beck can come up with? And the millions of people embracing the Tea Party creed are willing to accept such blatantly shallow explanations for their plight?

The truth is that the plight of the middle class is a product of the triumph of capitalism, and is the direct product of deliberate national policies that have reflected the consensus of the American political and corporate establishment. Since the end of the Second World War, America has pursued national economic and foreign policies that have purchased world peace—such as it is—at a price of providing our former military and ideological adversaries with largely unfettered access to our markets. Free trade and the opening of world labor markets has supported dramatic growth in standards of living first in Japan and German in the wake of the Second World War, and then in China, the states of the former Soviet Union, India, and other smaller proxy states such as Vietnam as we “won” the Cold War.

Simply stated, we sought to create a world where the dominant world powers would compete in the economic marketplace rather than on the battlefield. Opening our markets brought billions of workers from the nations of our adversaries into direct economic competition with American workers. The impact of our integrated economic and foreign policies first emerged in the 1970s as Japan changed the landscape of the world auto industry and began an economic onslaught from which the American industrial heartland has never recovered.

The ensuing deterioration in the economic outcomes for middle class and working class Americans, and ultimately the decline in family incomes of the past decade, were masked by the steady declines in interest rates from their peak in the early 1980s and the growth in consumer and mortgage debt, which exploded over the past decade even as incomes declined in real terms. The now-familiar adage of the house-as-ATM-machine was very real, and sustained the illusion of growing disposable income until the music came to an abrupt halt in July 2008 when consumer debt peaked.

Real incomes across the American industrial heartland were doomed from the moment America chose to pursue its policy of open markets as a foreign policy tool. Competition with foreign workers depressed American real incomes as open markets pushed real wages toward a new equilibrium that would bring up living standards first in Germany, Japan and East Asia, and then across the globe. Flows of capital investment into new markets raised real incomes in these new markets, while the pressure on the American middle class continued unabated. While global economic growth ameliorated the depressing effect on wages in high-income countries, and technology and capital investment has maintained the level of productivity of American workers, it has done so at the expense of reducing employment levels, even as it increased aggregate output.

Socialism, deficits and healthcare are fine targets for bumper stickers and partisan finger pointing, but they have little to do with the plight many Americans face, but it has been capitalism, not socialism that has led to the dramatic changes in the world economy that have pressured American real incomes and brought middle class America to where it is today. And these changes have been the product of Democrat and Republican administrations alike. Similarly, while today’s deficits may loom as the next threat to our economic future, today they are neither crowding out investment in the private economy nor a plausible cause for the deterioration of middle class incomes over the past several decades.

Absent a more robust economic and political assessment of the state of our nation and the decline of the middle class, the Tea Party movement will lose its moment and leave us with nothing other than a few members of Congress who lack any meaningful platform that offers hope for a future that is different from the past. And the followers of Glen Beck, Sarah Palin and the rest will wonder what happened as they are reduced to just one more political constituency, complaining about their plight, claiming their entitlements, but doing little to build a brighter future for themselves or for the nation.

Saturday, April 17, 2010


Goldman Sachs is robustly protesting their innocence. The SEC accusations—that Goldman is guilt of fraud and duplicity—are “completely unfounded in law and in fact.”

But even if Goldman is proven right, that does not make the SEC wrong.

As the old saw goes,

When the law is against you, pound the facts.

When the facts are against you, pound the law.

When both the law and the facts are against you, pound the table.

It is table pounding time.

In essence, the SEC is raising the question as to whether Goldman created synthetic collateralized debt obligations (CDOs) for the purpose of allowing one group of investors to short the subprime market, while not disclosing this activity to other clients holding or purchasing those same bonds. The SEC is asking whether Goldman benefitted from both sides in a manner that violated their fiduciary obligation to their clients.

And the simple answer is, of course they were.

This is not a legal conclusion, but rather a systemic one. Given the size and scale of its operations, Goldman—like the rest of the financial Goliaths that have emerged from the global financial crisis—cannot help but be on both sides of almost any trade, and ultimately be in a position of advising different clients in opposite directions. But most importantly, Goldman is a trading firm, whose activities inevitably lead them to be putting their own considerable capital to bear against their client’s own interests.

Trading has become the most profitable activity in banking institutions, and derivatives trading—including synthetic CDOs and credit default swaps—has magnified potential profitability by allowing firms to realize nearly unlimited leverage as they position their bets in the global markets. While in years past, Goldman had a far smaller share of the market and prospered through a client-centric culture, that was then and this is now. Today, in a world of previously unimaginable trading profits and bonus payouts, concerns for clients and firm culture have been rendered quaint.

The blinding allure of trading profits has replaced raising and lending capital for the real economy as the singular focus of banking industry. This was evident last month when RBS—Royal Bank of Scotland, the largest bank in the world before the crisis that is now 84% owned by the British taxpayers—decried any limits on its trading activities. Trading profits, RBS asserted, were the key to rebuilding its balance sheet.

That RBS would publicly embrace the view that it intended to trade its way to prosperity begged the question of whether there aren’t any losing sides of any of these trades. Barely a year has passed since the low moments of the financial collapse—a collapse characterized by highly leveraged bets gone wrong—and dementia has truly set in.

As Congress considers major financial system reform, it is increasingly apparent that what emerges will be far from a stringent restructuring of the financial system that is warranted. Wall Street leaders have made no bones over the fact that they intend to protect their own interests in any legislation that emerges, and in particular will fight any efforts to curtail the highly profitable derivatives trading.

That we have reached a table-pounding moment should have been evident to all on February 7th when, in a front page story in the New York Times, Wall Street publicly expressed its “buyer’s remorse” with the Democrats, and now looked to shift their political contributions to Republicans, who eagerly sought to offer Wall Street contributors a more appreciative home for their largesse.

Back in the day, political contributions in exchange for governmental action was viewed as the essence of corruption, and contributors and recipients went to great lengths to deny linkages between the money and legislative outcomes. But apparently there is no longer any shame in—or prohibition against—the buying and selling of political influence.

Today, regulatory reform is being debated publicly between the two largest recipients of banker largesse: Senators Christopher Dodd and Mitch McConnell. Accordingly, instead of focusing on issues of the size and capitalization of banks, the role of deposit insurance, and limitations on derivatives that provide no social utility, debate has focused on consumer protection and the locus of dissolution authority for failed institutions. These may be important questions, but they are predicated on doing nothing to curtail the massive aggregation of financial and political power within the banking sector. Wall Street, it would appear, has spent its money well.

While the debate among Wall Street and Congress continues, others suggest that the issues are not so complicated. One week after the story about Wall Street’s buyer’s remorse, a clique of octogenarians gathered around former Fed Chairman Paul Volker to support his call for more stringent restrictions on the trading activities of commercial banks.

Standing with Volker were former Citigroup chairman John Reed, Bush 41 Treasury Secretary and Dillon Read Chairman Nicholas Brady, Wall Street legend and former SEC Chairman Bill Donaldson, Vanguard founder John Bogle, among others. For these men, whose days in the trading pits and positions of power were behind them, the answers were simple. As Nick Brady intoned: “If you are a commercial bank and you wish the government to guarantee your deposits and bail you out if necessary, then you can’t be involved in speculative activity.”

Arguing that the lure of excessive profits and bonuses had undermined the core values of the banking system, Brady pushed back on those who argued that trading and derivatives were important to the banking system and dismissed self-serving the arguments for preserving the status quo. “You draw a line that is too tight, that doesn’t bother me a bit.”

Volker and his old friends were sending a simple message: Like it or not, we have not yet come close to a real discussion of effective, systemic financial reform. Self-interest—of bankers and politicians alike—stands firmly in the way.

The SEC charges against Goldman may or may not stick, but it should be clear to all that, as Jack Bogle observed, the system has gone badly awry and needs massive reform. That Goldman Sachs has become the poster child for all that ails us is its own fault. Like its banker brethren, Goldman has used the global financial crisis to its own advantage—gathering tens of billions of public dollars as AIG was unwound and gaining access to the Fed window—and has made effective use of political money and influence to perpetuate a system that assures Wall Street freedom to pursue massive profits, while the public continues to bear the risk.

Shame on Goldman Sachs if they have committed fraud. But shame on us if we do nothing to change the rules of the game.

Saturday, February 20, 2010

Just a glimmer.

For a brief moment, listening to Alan Simpson talk about the work to come of the Debt Commission, I was seized by a moment of optimism. Perhaps there is a glimmer of hope that the cascading problem of debt and entitlements might be honestly and openly discussed, and then addressed, before the weight of our collective irresponsibility collapses around us.

As Simpson noted bluntly, there is not a person within the political establishment in the nation’s capital that does not know the depth of the problem. It is notable, then, how little s actually has been done to address the problems, particularly given the amount of hubris, hot air, and sound bites that focus on the problem.

In many respects, the challenges are simple. With respect to the operations of the Federal government, we spend more than we take in. Compulsively. Collectively.

In some respects, operating deficits as an ongoing problem was exacerbated by two political moments, one by each party. Ronald Reagan fundamentally changed the relationship between the political parties with his embrace of supply side economics, and the articulation of the notion that tax cuts are a politically and morally self-justifying imperative, without little regard to fiscal consequences.

While Reagan took office at a time of very high marginal tax rates, and the salutary a affect on economic output of reductions in rates was clear, Reaganomics came to represent the view simply that economic output is improved with lower taxes—a premise that surely remains true all the way down to a tax rate of zero. But the obligation of governance remains the balancing of revenues and expenditures, and the premise argued by David Stockman, Grover Norquist and others that lower revenues will lead to lower spending proved to be manifestly false when put to its test in the ensuing quarter century.

At the end of the day, the miracle of the Reagan Revolution was that it effectively ended the power of conservatism as a force for fiscal rectitude in American politics. In the succinct words of Pete Petersen, the Republic Party fell prey to the unholy alliance of tax-cutting Republicans and big-spending Republicans.

If Ronald Reagan ended the Republican Party’s stance as a force for fiscal responsibility in the 1980s, Bill Clinton matched his contribution a decade later. Just as the large share of Republicans who admire President Reagan in unblemished terms will take umbrage at this assessment of his contribution to our problems, so too will many Democrats point to President Clinton positive contributions, as the one who left George W. Bush with balanced budgets.

But Bill Clinton also brought to the Democrat Party a commitment to build a fundraising apparatus to match the Republican Party’s fundraising prowess within corporate America. After years of watching the tireless efforts of Peter Terpeluk and Wayne Berman and the other titans of the Republican Party fundraising community develop teams of Eagles and Pioneers, with assurances of access to the top and throughout the bureaucracy, Clinton built a Democrat commitment to a kinder and gentler relationship with the for-profit community.

Clinton’s greatest success in his transformation of the Democrat Party’s relationship with corporate America came in Wall Street. Formerly the heart of the Grand Old Party, the Clintons built a foundation of support for the Democrat Party in lower Manhattan. And by the end of Clinton’s presidency, his administration matched the zeal of the Republicans in promoting the deregulation of the banking industry, ending Glass Steagall restrictions, and fending off regulation of the growing derivatives markets, even in the face of serial financial crises that would have deterred a less determined leader.

The past decade has been a golden age for corporations seeking to access the power and the purse of the federal government in the pursuit of corporate interests and the generation of private wealth. In addition to the financial reforms at the end of the Clinton Presidency, the banking industry pursued and won comprehensive bankruptcy reform several years later, with broad and bipartisan support from willing and well-compensated Congressional supporters on both sides of the aisle.

In terms of accessing the purse of the federal government, the success of the pharmaceuticals industry in passing the Medicare Part D reforms provided a nearly uncapped access to the federal treasury, and again won willing support on both sides of the aisle, with only lip service paid to the massive fiscal consequences of such an open-ended money grab.

In terms of harnessing the power of the federal government in pursuit of corporate goals, bankruptcy reform is one example, while a more interesting example was the near-decade long support of FDA regulation of tobacco products by Philip Morris. While FDA regulation was a long-held goal of health advocates, Philip Morris understood that FDA regulation—and the strict limitations on advertising that would ensue—would effectively lock in Philip Morris’ dominant market share in that industry, reducing advertising costs, increasing profitability and elevating its share price.

Alan Simpson’s challenge is to stare down his long-time Congressional colleagues, and demand that they finally accept that their overriding responsibility is to tend to the long-term health of our nation. It is not about their own reelection or the success of one political party on another. Not in this matter.

But each Senator—with the possible exception of Scott Brown, who may not have been there long enough—probably firmly believes that every vote they cast is made with conviction and integrity. They believe the spin that is wrapped artfully around each vote. Bankruptcy reform is about consumer protection and personal responsibility, not about bank power and profitability. Financial reform was about economic growth and efficiency, not about the accumulation of power and profitability on Wall Street. Medicare Part D was about improving the health and well-being of seniors—on whose comfort we can place no price—not about creating massive new markets for a dizzying array of new drugs for newly minted syndromes.

But whatever they might believe about how they vote, Alan Simpson understands what has increasingly become clear across the political spectrum—from tea partyers and CPAC members on the right to those on the left who watched their dreams of single payer healthcare swiftly subordinated to the interests of the range of corporate interests brought “inside the tent” in the early days of the Obama administration—that the main challenge facing his efforts is dealing with the very people whose votes he needs. The changes wrought by Presidents Reagan and Clinton left us with a national capital where votes can easily be bought and the core principles of fiscal prudence are little more than buzzwords and political applause lines.

But I must remain optimistic about Alan Simpson’s new challenge. If—as Simpson suggests—everyone inside the beltway understands the truth of what we face, than they must succeed, because everyone outside the beltway understands it as well.

Monday, February 15, 2010

Risk of contagion.

After weeks of turmoil in the capital markets, the European Union has provided assurances that Greece will not be allowed to default on its debt. Like AIG before it, Greece has proven to be the domino that must not be allowed to fall, lest traders next take a run at Portugal, Italy and Spain, and ultimately bring the notion of a united Europe to its knees.

But those assurances, which at root suggest that Germany has agreed—behind closed doors—to serve as the de facto guarantor of the debt of Greece, would come with strings attached. Greece would have to cut its massive budget deficit, reduce public sector salaries, reduce farm price supports and restructure pension commitments. In sum, to do those things that Greece had agreed to do as conditions of joining the E.U. to begin with.

And now Prime Minister George Papandreou of the Panhellenic Socialist Party has to pick up the pieces. And he is not happy.

In an odd show of gratitude for the E.U. pledge of support, Papandreou has responded by accusing the E.U. of failing to do its homework when his conservative predecessors fudged earlier deficit numbers. But the integrity of economic data is a long-standing problem for Greece, dating to audits that showed that Greece routinely dissembled in its published data and essentially lied on its E.U. application. But whatever the history, it is Papandreou who now has to carry the bad news to the electorate.

Or he can let Greece default.

Maybe it is time for someone to stand up and stare the markets down. Maybe it is time for someone to demand that in a world of open capital markets, it is investors who must evaluate risk and take risk, and if markets are to efficiently allocate capital over time, investors must be accountable for their investment decisions.

The fact is that losing money is part of the process. Markets are supposed to weigh and price risk, and in so doing allow for the efficient transfer of information. In the case of Greece, this information is supposed to be about the long-term affordability of farm price supports and public pensions and other spending, balanced against the ability to support economic growth and wealth creation over time to pay for those politically attractive expenditures.

But we are no longer in the world of markets, we are now in the world of politics. After all, when Goldman and others took AIG counterparty risk but were let off the hook and paid out billions of dollars, that was not the markets working, that was politics. And over the past year and a half, we have watched bailout after bailout for fear of markets doing what markets are supposed to do. But risk is an essential part of the process. Risk is what free markets are supposed to be about.

And it is time that a socialist stood up and said so.

Now, of course, things will not go well for the Greeks, should Papandreou choose to take this path. The Greeks will have to pay a heavy price for the failures of their representative government. But they will make the Germans happy. Because the German people want no part of this.

But at the end of the day, Europe will work it out. After all, too much is at stake. The E.U. countries staked their futures on the idea that being part of one big country is better than being a small country. France wanted a bigger platform to steer a new foreign policy freed from the hegemony of America. Poland wanted to trade in the Zloty for the Euro, as protection against having to trade it in for the Ruble. And, coming off of a century of European wars, they both wanted institutional arrangements that would harness German might.

This appears to be the path the world has chosen. For fear of “contagion”—the notion that as Greece goes, so goes Spain, and Portugal, and perhaps Italy—the E.U. will construct an institutional “firewall” to show that Greece will not be allowed to collapse. The only firewall standing between the E.U. and its planned “firewall” may be the German people, who are scandalized that their tax dollars will be used to fix a problem of someone else’s making, and who may yet prove the last line of defense against the real contagion.

The real risk—the real contagion—as people from Main Street to the Bundestrasse understand intuitively, is the growing effort to take risk and accountability out of the financial system. It is the cascading issue of moral hazard. People—like derivatives traders—understand that risk does not go away, it just gets moved around. And they know that when the music stops, they end up paying the price.

In the U.S., the contagion is manifest in the refusal to take the steps necessary to break up the financial and political power of the largest financial institutions, to set limits on what is or is not allowable in the derivatives world, or to return risk to ownership of the financial industry. In Europe, it is the unwillingness to look at the institutional structure of the E.U. that severed currency control from national politics and fiscal policies, and made national fiscal crises all but inevitable.

For all the talk of financial reform in Washington, we are hamstrung by a system that allows affected industries with political clout to dictate policy, and in lieu of real reform we are marching down the path of more complex regulation, deluded in our fevered imagination that some team of smart regulators will ever be able to take on the political and financial power of our largest financial institutions, or match the cunning of well-incented and marginally shackled traders.

The irony is that while a socialist prime minister struggles to save his nation’s pension system and safety net, his efforts may ultimately be undermined by the E.U. efforts on his behalf. The problem that the moral hazard contagion presents to Greece—and to the rest of us— is that only a return to robust economic growth can provide the real growth in incomes and the investment returns that will be necessary for nations or states to fund their massive future pension obligations. And each new action that we take down the path that we are now on that undermines the effective pricing of risk in the capital markets, undermines our ability to return to a functioning and growing economy.

Thursday, February 11, 2010

Daisy chain.

It doesn’t get any better than this.

You sit down to write about the mundane corruption of our democracy, and the ease with which banks can announce on the front page of the New York Times that they are going to pull their political contributions from Democrats—who apparently are not treating them nicely—and the equal ease with which Republicans announce that they will go after those contributions, and treat the contributors with greater deference. Then you realize that that is not the pressing issue of the moment.

So you decide instead to write about the looming default of Greece on its debt, and the profound anger in Germany at waking up one morning to find that it has emerged as the defacto guarantor of not just Greece, but all of the overleveraged, profligate and unruly southern European nations that Germany tried so hard to hold under its thumb in centuries past. Indeed, the unraveling of the European Union—that great political institution created to contain the German colossus after the failure of the Maginot Line—is leaving German’s wondering how their aging nation has found itself on the hook for Greek bureaucrats who just this week marched in the streets to protest layoffs in the wake of Greek efforts to impose fiscal austerity.

But of course, the images of the righteous protests of Greeks marching in the streets, as though someone else is to blame for the overspending on the Olympics and pensions and every other matter, just foreshadows the pain that is looming across major state governments, who are just now coming to grips with the fact that the full force of the fiscal crisis is only now just about to land in the U.S., as Federal Impact Aid has been fully expended, and Republican and Democrat Governors alike are resorting to fiscal gimmickry and pension funding holidays as they struggle to avoid admitting the obvious: That if the states—and the Federal Government for that matter—are ever to return to real fiscal balance, they have to come to grips with the simple fact that they must spend less and/or take in more. And politicians, retirees and workers in many states will need to face the harsh reality that long-term pension obligations will never be fully met, and the sooner that they all come to grips with that fact, the more equitable the resolution will be.

Then, this depressing thought was sidelined by the first mention of the word quadrillion. And that seemed to trump thoughts of bank corruption, Greek bonds, German upset, state pension, and the rest of it.

Last night, I saw the $4 trillion Bailout ads on TV. And this morning, I received an email regarding the $25 trillion guarantee of financial derivatives by the Federal Reserve, sent to me not from some crackpot, but from a derivatives trader at Merrill Lynch. This email referenced a story—referring to names that will mean little to most people—about how the Depository Trust Company, the brokerage industry vehicle that handles all stock trades—$2 quadrillion annually—announced that “the Federal Reserve Board had approved its application to establish a DTCC subsidiary that is a member of the Federal Reserve System to operate the Warehouse for over the-counter credit derivatives.”

So what does this mean in English? Well, the piece argues that all credit default swaps, are now backstopped by the Fed. Because, as quoted from an Office of the Comptroller of the Currency letter, “Clearing is a form of extending credit, one of the main functions of banking institutions. A clearing agent substitutes its credit for that of its customers… and is liable to a clearinghouse for performance on all submitted contracts, and assumes, with respect to the exchange, clearinghouse, and counterparties, the risk of default.”

If there is a theme to all of this, it is that in the name of the security of the financial system, we are continuing to march down the path toward homogenization of all risk onto the books of the Federal Reserve and the U.S. Treasury. In our efforts to avoid cascading collapse in the early months of the fiscal crisis, the Fed and the Treasury merged failing investment, took over and posted collateral to avoid the failure of AIG, backed up all manner of bank obligations, swapped bad debt for cash on the books of the Fed, and took all manner of other arcane actions, all in the name of preserving the system from collapse.

But since things settled down, we have done nothing to ameliorate the massive problem of moral hazard, beyond very lame and totally unbelievable statements that banks “better not count on a bailout next time.” These statements are unbelievable exactly because every step taken so far has been to shore up and make stronger the abilities of the Fed to respond to future crises, and to have resources at its disposal to act with fewer constraints by Congress or the Executive.

Does the creation of a CDS clearinghouse within the Fed system constitute a federal guarantee of performance under those contracts? I don’t know, but every action taken so far constitutes a greater concentration of risk onto the books of the government, rather than actions that would lessen systemic risk and force risk-taking back onto the private market participants, where it belongs.

And there are no small number of viable suggestions that have been made over the past year for consideration.

· Reinstitute the separation of commercial banking and risk trading activities.

· Recognize that institution size and political influence exacerbate systemic risks.

· Reconsider the rationale, role and structure of deposit insurance.

· Reinstitute at-risk rules for trading and the partnership structure for investment banking and trading organizations.

· Eliminate collateralization provisions in derivatives contracts so that counterparties must consider and accept counterparty risk, and to prevent counterparty collateral claims from undermining senior debt holder rights.

· Regulate credit default swaps and other derivatives that undermine appropriate functioning of corporate finance and bankruptcy process.

Just to bring all of this full circle, the reason so many are rejected has to do with at least in part with the corruption of the political process referenced at the outset. Failure to chart a path that reinvigorates the private assumption of risk will surely lead us one of these days to be facing the question that many Germans are asking this morning, when the next, far bigger, crisis hits, and the U.S. Government no longer has the resources available to absorb everyone’s risks: How did we let this happen?

Saturday, February 06, 2010

Losing the Kennedy seat.

The Scott Brown election in Massachusetts is far less momentous than has been depicted.

To understand it simply requires holding onto two attributes of the Massachusetts electorate that might seem contradictory, but are not. First, that Massachusetts Democrats have a large registration edge over Republicans. Second that Massachusetts has close to if not the largest proportion of independent voters among states. Gallup achieves its ranking of Massachusetts as the third leading Democrat state—with a 34% edge over Republicans—only by allocating independent voters to the side to which they “lean.”

For some, the election results were touted as a bombshell because of the notion that this was Teddy Kennedy’s Senate seat. But if that Senate seat were to be an hereditary peerage, a Kennedy would have to step up and seize it. The Massachusetts election results might have been startling if Joe Kennedy had run and lost. But he chose not to run.

Despite its reputation, Massachusetts is not the Democrat bastion of national imagination. Over the past half-century, we have seen Republicans ruling the Statehouse more than Democrats—though long-time Senate President Billy Bulger would certainly protest the notion that any Governor ruled the Statehouse during Bulger’s reign. The 28 years of John Volpe, Frank Sargent, Bill Weld and Mitt Romney outstripped the 20 combined years of Mike Dukakis, Endicott Peabody and Deval Patrick. By way of comparison, in both New Jersey and Virginia, the sites of the other recent Republican gains, these numbers are reversed, with 28 years of Democrat rule compared to 20 Republican years.

A defining characteristic of top of the ticket statewide races in Massachusetts—a state with a hard earned reputation for local politics, patronage and corruption—is that they have not been dominated by old time pols, and each of these Governors—Democrats and Republicans alike—ran and won as reform candidates campaigning as much against the entrenched party establishments as embraced by them. Statehouse operative John Sasso may have greased the wheels to assure Michael Dukakis won the nomination, but the liberal Democrat from Brookline never won the hearts of party regulars. (I will leave aside for the moment the question how a half century of reform governors could have resulted in so little reform.)

If one is to draw a lesson for national politics from Massachusetts, it is less about policy—the notion that the Massachusetts electorate was voicing its opposition to federal healthcare legislation—than about politics. And in this regard, the message from Massachusetts is not particularly different than from New Jersey or Virginia. It is that the Democrat candidates lost the good will among independent voters—the voting block that was essential to the Obama victory two years earlier—as those voters leaned the other way.

Ironically, losing in Massachusetts—and losing the 60th vote in the Senate—may have been the best thing that could happen for Barack Obama. The Massachusetts loss should mark the end of Obama’s ceding the floor to Harry Reid and Nancy Pelosi—whose leadership has been anathema to the change the independent voters thought they were getting in 2008—and force a realignment of the President’s strategy. While in the first few days following the Brown election, the White House appeared to be flailing about for a message—leading to real fears that the wheels were coming off the bus—its ultimate embrace of the nationally broadcast question time with Republicans may have marked a turning point.

For the first time in many years, the public was able to witness—and our elected officials were able to participate in—real discussion over real issues. This was an astonishingly simple antidote to dangerous levels of public cynicism, at a time when Washington has been reduced to rhetoric and spin, and talk show hosts wield dangerous influence over our politics.

Every hour of every day, we are pummeled by a media that makes its living stirring us up, and exacerbating the fears and resentments that are easy enough to feel without the encouragements of Sean and Rush and Michele and Ed and the rest. And time is on their side, because most of the challenges we face take time. The economy will take time. Deleveraging takes time. The real world takes time. The only think that does not take time is the Internet and cable TV. They get faster every day.

As a nation, and as a polity, having our leaders discuss matters directly is a refreshing change. After years of debating the best format for presidential debates, we have never really gotten past various versions of gotcha questions. Yet, last week, when they put the President and Congress into a room, gave them a microphone and told them to have at it, apparently they were able to do just that. And do so intelligently and with civility.

So perhaps the message from Massachusetts is just what it should be: That the electorate—led by a growing, independent center—will continue to vote for the other guy until they see something that looks like progress. And progress does not mean a filibuster-proof majority for one party, it means injecting some degree of integrity into political debate and moving away from a system simply defined by the pursuit of partisan advantage.

And that would be a good thing.