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 products—as 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 primaries—and 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.

Shameless.

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.

Horror!

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.

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.

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.

Dementia.

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 7^th 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.

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.

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.

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?

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.

Sauce for the goose.

The Feds, the mortgage bankers, commercial banks and investors in mortgage-backed securities conspired to let people buy homes with little or no money down. One’s choice of villains in the saga that ensued based on where one sits in the political wars. Investment bankers. Mortgage bankers. Standard & Poor’s. Barney Frank. Chris Dodd. Frank Raines. Alan Greenspan. Whatever.

But now, faced with a cascading foreclosure problem, homeowners—a questionable notion for owners of a property with zero equity—are being told that the moral and ethical thing to do is to let people stay in their homes, and make good on “their” obligations. After decades of watching Donald Trump walk away from any bad deal, declare bankruptcy, and go back to the same banks for another bite at the apple, American owners of bankrupt—debt exceeds asset value—properties are being asked to stay the course, to “do the right thing.”

This, of course, is the Paulson Doctrine. On March 3, 2008, two weeks before the collapse of Bear Stearns, the Treasury Secretary set forth the principle that—unlike Mr. Trump—homeowners should stay the course.

Homeowners who can afford their payments and don't have to move, can choose to stay in their house. And let me emphasize, any homeowner who can afford his mortgage payment but chooses to walk away from an underwater property is simply a speculator – and one who is not honoring his obligations.

Today, the Paulson Doctrine has been embraced from the President on down, as the responsible course of action. For an increasingly diverse America, this is the new Protestant Ethic. Forget Donald Trump, the serial bankrupt celebrity celebrated for a decade as the face of the American economy. Forget that the banks that made all those loans—time and time again—to Donald Trump, have had those and so many other bad beds paid off by the American taxpayers.

There is no greater irony than the continuing spectacle of American taxpayers—the yet-to-be-born grandchildren of American taxpayers actually—who once thought that they had secured their piece of the American Dream, are now being told by the very bankers who they have bailed out that their moral and ethical obligation is to stay the course.

Thirty years ago, in the first day of the class “Financial Markets and Disintermediation” at the Wharton School, Professor Smith began by musing that each of the world’s great religions decry the impact of debt on the individuals and society, and are derisive of bankers and banking activities. His words were lost on the gaggle of aspiring investment bankers, who aspired to follow in the footsteps of Michael Milken and Donald Trump rather than consider WWJD.

The Koran is enlightening on the subject of debt. The principles of sharia lending suggest that debt creates an undue power relationship between the lender and the borrower, and accordingly it suggests that there should be elements of risk-sharing in lending activities. While referencing the Koran in any regard may make one suspect in American discourse today, the notion of risk-sharing in financial arrangements, and in particular in financial arrangements where the power relationship is totally skewed toward the lender as in the world of consumer and mortgage banking, is worth considering.

While Professor Smith was reflecting on moral considerations, across the hall Professor Percival was articulating the Miller Modigliani Capital Asset Pricing Model, a central tenet of the Wharton finance program. In simple terms, this model—based on the theoretical work of Nobel laureate economists Franco Modigliani and Merton Miller—demonstrated that you cannot increase the value of a business by increasing the level of debt—the approach for which Wharton grads led by Michael Milken would become famous over the ensuing decade, unless debt receives favorable treatment under the tax code relative to equity.

If the last paragraph made no sense, don’t worry. The point is that we are in the process of unwinding a massive debt crisis that has laid bare a number of fundamental flaws with our financial system, inequities in our legal system, and corruption of our political system. And a central cause of the over-leveraging is that our tax code gives everyone incentives to “lever up.”

It is easy to point out the moral hypocrisy of demanding “homeowner responsibility” in a society that for years has celebrated business icons that eschew such practices. However, it will be harder to acknowledge how—much less garner the political will to change—the rules and practices that directly contributed to the financial crisis. Democrats will decry ending the tax deductibility of mortgage interest that appears to make homeownership more affordable. Even more difficult will be changes that provide balanced treatment of debt and equity. But if we are to build a more resilient economy and address the very real problems of over-leveraging, we have to consider the extent to which the crisis that emerged was a direct consequence of the incentives that the tax code created.

Tilting at windmills.

Senators Maria Cantwell (D-Wash) and John McCain (R-Ariz) have joined together to in a show of bipartisanship to promote what should be obvious: Our banking system is structurally flawed, and the changes instigated by the passage of the Financial Services Modernization Act of 1999 should be fundamentally reconsidered. Cantwell and McCain have proposed legislation to reverse the provisions of the 1999 Act that ended the Depression-era Glass Steagall Act rules that separated investment and commercial banking.

While the conventional wisdom is that Cantwell and McCain are tilting at windmills, Congress must consider three simple notions as it considers financial services reforms. First, that institutions playing with insured deposits should be limited in what they do with public money. Second, that institutional size is a threat, and therefore large banks should be broken up into smaller banks. Finally, that financial innovation and trading in financial derivatives must be evaluated and regulated with respect to risks and benefits.

Interestingly, the arguments against these notions have remained largely unproven. Paul Volker—one of the few remaining Wise Men on financial matters in Washington, with the death of Bill Seidman—has wryly argued that for all the talk, there has been no financial innovation of widespread value since the invention of the ATM. Financial derivatives—heralded by Alan Greenspan as tools that would transfer risk to those most able to afford it—have turned out, in the words of Financial Times editor Martin Wolf, to have transferred risk to those least able to understand it.

Financial derivatives, and in particular credit default swaps, were at the center of the collapse of AIG. A credit default swap (CDS) contract is in its essence an unregulated form of insurance against the risk of default on a bond, wherein the purchaser of the contract pays the counterparty—the insurer—an annual payment in exchange for protection in the event of a bond default.

The CDS market is a huge market, with the bulk of the insurance provided by our largest banks. For those banks providing insurance, there is no requirement for setting aside capital against the risks that are undertaken, and as such the annual payment on the contracts constitute a type nearly unlimited leverage.

One question that has to be asked is what societal purpose is served by CDS contracts. Consider the two possible scenarios, using a company we will call YRC, Inc. In the first scenario, an investor holds a portfolio of YRC bonds. The bonds were purchased at a dollar price of 100, and if all goes well, the investor will receive 100 cents on the dollar at the maturity of the bonds. In this case, the investor would like to insure against the risk of YRC going bankrupt, and purchases a CDS contract that will protect it from any losses in the bonds if YRC goes belly-up. While this may sound like a fine idea, it is a socially destructive proposition, as in the event of financial problems at YRC it places that investor in a position of preferring bankruptcy to a negotiated restructuring of the company that would preserve the company but require some sacrifice on the part of the bondholders, as traditionally happens in a workout. Therefore, instead of aligning the interests of stakeholders, it undermines the alignment of interests that is necessary for navigating difficult situations.

In the second scenario, traders that do not hold YRC bonds decide to speculate on YRC’s financial condition, and purchase CDS contracts on YRC bonds in the hope of selling those contracts later at a higher price—when the likelihood of a YRC default is perceived to have increased. (Remember, the value of the CDS contract rises as perceived default risk on the bond rises, as the contract pays out upon bankruptcy).

In this scenario, the CDS contracts do not serve a fundamental societal purpose, but rather are trading instruments, or—in the words of Michael Lewis—side bets. With approximately $60 trillion of CDS contracts outstanding—an amount that far outstrips the outstanding principal amount of corporate bonds—these side bets constitute the bulk of outstanding CDS contracts.

The case against allowing such CDS contracts was made early on in the financial crisis by Lehman Brothers CEO Richard Fuld, who argued that traders at Goldman Sachs and Bear Stearns exacerbated the collapse of Lehman by shorting the stock and going long (purchasing) the Lehman CDS contract, with each trade—pushing down the stock price and pushing up the CDS price (or spread)—creating a reinforcing cycle that confirmed the market perception that the collapse of Lehman was inevitable. As the collapse neared, the traders won on both trades.

And, of course, YRC is a Fortune 500 trucking company—YRC Worldwide—that almost went the way of Lehman Brothers. As reported yesterday in the Wall Street Journal, the company almost failed to win bondholder consent for a restructuring plan, as bondholders holding CDS contracts preferred to hold out for bankruptcy to trigger a payout on those contracts. The bondholders consented only after threats of public protests by the Teamsters against institutional fund managers led in an agreement. The fundamental point regarding the destructive role of the CDS contracts was made in the WSJ article, in a comment by Mike Green of Tenex Capital, an advisor to YRC:

“It’s fundamentally improper that people can force an insurer to pay a policy when the person insured has the right to destroy his property.”

Congress appears to be ready to accept fundamental principles that must be questioned. First, institution size creates an inherent risk to the system. Arguments that institutional interconnectedness means that smaller institutions also create systemic risk does nothing to respond to the suggestion that the risk is greater with larger institution size. The problems created by institutional size include financial risk, institutional complexity that will inhibit both regulatory oversight as well as effective resolution actions, and the political power that increases with size and will mitigate against enforcement action and legislative reform over time. The latter issue should be self-evident as we watch the growing stranglehold that Wall Street has over federal policy.

Second, there should be a connection reestablished between deposit insurance and institutional role and function. Bank lending is a core function in the real economy, and this function is not augmented by institutional size or trading prowess.

Third, there should be a connection reestablished between participation in the Federal Reserve System and institutional role and function. It is hard to imagine the continuing rational for Goldman Sachs and Morgan Stanley to continue as bank holding companies.

Fourth, while the rhetoric of efficient transfer of risk sounds like an admirable principle, attention should be given to the notion that risk is an important element of lending and credit decisions. Accordingly, products that appear to mitigate transactional risk—such as credit default swaps—may exacerbate systemic risk. If CDS contracts undermine the alignment of interests between bondholders and the company, those contracts should not be allowed.

Strictly business.

Just imagine how angry the American public would be if they knew the whole story.

For months, we have listened to the whining from Wall Street. U.S. banks are having a record year, and they want to be paid a lot of money. Billions and billions of dollars.

Public indignation is deep. After all, over the past year, we have watched as hundreds of billions of dollars of public money has been poured into bank balance sheets. We have—we are assured—taken steps that were necessary to bring our financial system back from the brink. We may not have liked it, but we had no choice.

But now that we have stemmed the tide, now that the Great Panic of 2008 has abated, we have been forced to watch these same institutions moan about how bad they have it. Citigroup—the one that received $45 billion in taxpayer funds, plus a couple hundred billion extra in public underwriting of bad assets—wants to wipe the slate clean by paying the money back and calling it even. So they can pay themselves billions of dollars in bonuses.

Wells Fargo, the arriviste among the financial elite, is complaining about the competitive disadvantages that they face as a consequence of federal compensation constraints. Constraints that prevent them from paying themselves billions of dollars in bonuses.

Goldman Sachs—caught in a lie by a federal Inspector General who refuted Goldman’s sanctimonious claim that even if the world had collapsed, they would have been fine—is trying to fend off accusations of unwarranted hubris and greed—which reached a pinnacle when they announced plans to pay themselves $21 billion in bonuses—by announcing that their senior partners will take their share of the billions in stock.

But what if the public understood the whole story? How is it that the banks are now having one of their most profitable years ever? Given that there is not much lending going on, and that the newly increased credit card fees have only just begun to flow into bank coffers, where is all that money coming from?

It is coming from proprietary trading. “Prop trading” is the kind of betting with the bank balance sheet that was made illegal for commercial banks back during the Great Depression, when the FDIC and deposit insurance was created. The price of having the federal government guarantee bank deposits was separating the lending and depositary functions of commercial banking from trading and risk activities of investment banking. Thus, in 1935, the commercial bank J.P. Morgan & Company was separated from the investment firm Morgan Stanley.

But this separation was undone in 1999 to facilitate the creation of the megabanks that we have today. However, while the Financial Services Modernization Act of 1999 ended the separation of activities, FDIC deposit insurance remained in place. And this year, the elite of the financial world—JP, Citi, Wells, BofA, Goldman and Morgan Stanley—have finally emerged for what they are: Gigantic hedge funds backed up by the full faith and credit of the United States of America. Wall Street bankers making big bets with our money, content in the knowledge that if they win their bets, they will pocket the cash. And if they lose, we will all pick up the mess.

But it really does get better. So exactly how did they make all that money this year?

Well, the trade of the moment has been the U.S. dollar carry trade. A foreign currency carry trade is simple in concept. Borrow money where interest rates are low, and invest where interest rates are high. Or simply stated: Short the U.S. dollar. Buy the currency of a country where interest rates are higher. The beauty part is that by continually assuring the world that U.S. interest rates will remain near zero for the foreseeable future, the Federal Reserve has assured traders that they can keep the trade in place for some time.

So the Wall Street elite, just months removed from their near-death experience, are now making a fortune shorting the U.S. dollar. One year ago, faced with the greatest financial panic in generations, the American people swallowed hard and bailed out the banks. Today, the banks have moved on, and are tearing down the currency of the nation that saved them.

But it is nothing personal. It is strictly business.

And the carry trade will work out fine. Until it doesn’t. Then the trade will unwind quickly, and those who do not get out in time will get hurt badly.

But the banks are not worried. If the unwinding of what NYU economist Nouriel Roubini has labeled “the mother of all carry trades” takes a bank or two down with it, everything will be all right. Because the bank deposits are still insured, and we now know to an absolute certainty that if one of the elite institutions fails, we will bail it out. Again.

It is time that we come to grips with the depravity of the current situation, and potential damage that continuing down this path may yet do to the financial system and to our economy.

Our commercial banks are not, and should not be, hedge funds. U.S. dollar carry trades and writing credit default swaps are not core commercial banking functions. They are not necessary to the efficient functioning of our financial system.

The U.S. dollar carry trade is destructive to our currency, and is creating asset bubbles across the world, as leverage is transferred from our markets into others. For their part, credit default swaps serve no useful purpose in proportion to the systemic risks they create.

It is time to go back to basics. Commercial banks provide essential services in our economy. They enable the Fed to control the distribution and pricing of capital to the productive sectors of the economy. They provide secure depositary and asset management services.

Unfortunately, pending Congressional legislation has done nothing to address the central risks that the new financial landscape presents to our economy. Rather than reinstitute restrictions on bank activities or restrain institution size, Congress is looking to regulatory solutions that hold little promise of success when the next crisis emerges. And rather than recognizing the problem of moral hazard, this week Congress took the first step of embracing it in statute.

This year, Wall Street has shown its true colors, but the public has yet to understand the depth of the betrayal. It is not the continuing absence of lending, or jacking up credit card fees, or hiking consumer interest rates, or even the constant refrain of complaints about limitations on executive compensation. No, the greatest betrayal is that with the American economy as weak as it has been in years, with the dollar weakness threatening to unravel the international commitment to the role of the dollar as the reserve currency, Wall Street has shown no shame about attacking the currency of the nation that came to its aid.

If this is the path that the elite commercial banks have chosen, if they have been fully seduced by the lucre of trading, Congress needs to revisit the fundamental rules of the game, and revisit the central rationale for deposit insurance and the structure of the commercial banking system.

Bankers leaving town?

So what was this image from the New York Times this week?

Healthcare lobbyists coming crossing the Potomac for a meeting on the Hill?

Goldman Sachs bankers heading to the Hamptons to spend their bonus checks?

No, it turns out it was a group of uninvited guests crossing the reflecting pool on their way to a reception on the White House lawn. You can see Tareq Salahi, standing fourth from the left, in his formal hoodie.