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.

Hell hath no fury.

Just when I had convinced myself that behind the curtain, hidden from public view, Barack Obama had a plan—for Afghanistan, for the Middle East, for Iran, for Russia, for education, for energy, for financial regulation, for health care… or at least for some of them—I saw Obama Campaign Manager David Plouffe pitching his book on The Daily Show.

Plouffe was in full campaign mode, selling the successes of the first year of the Obama presidency, as well as his new book—The Audacity of Winning. Grinning and determined, he spoke with an evangelical fervor.

The Audacity of Winning. Coming from the Obama campaign manager, the title itself is at best an ironic commentary on hope as a political strategy, but at worst the title bluntly mocks the electorate that invested their hopes and dreams in the Obama campaign.

Electoral losses this month in New Jersey and Virginia provided a grim reminder to Plouffe and the Democrats of the fragility of their electoral victories of just one year ago. If 2008 was an election year when young and independent voters set their cynicism aside and embraced the hope that a different tenor might come to national politics, 2009 saw young voters abandon politics and independent voters abandon the hope briefly flickered a year earlier.

The voters in New Jersey and Virginia did not get it wrong. They were not impatient. They were not premature in their assessment. By all accounts, the hope Obama offered—the belief that Washington can shift to a new trajectory and engage the real and deep challenges that threaten our nation’s future—is, if not dead, on life support. The past year has been one of deep and unremitting partisan rancor. A year has been lost with nothing to show for it but growing evidence that national politics is indeed a rigged game.

The easy response—and we have heard it for months—is that the Republicans are responsible for the intransigence in Washington. After all, it takes two to tango. But at a defining moment in the healthcare debate, John Boehner threw down the gauntlet. Healthcare reform, he stated, would be Obama’s Waterloo. Defeat healthcare legislation and you defeat Obama. Game on.

But at that moment, President Obama failed to engage the overarching issue of politics and partisanship, and instead the healthcare debate devolved into little more than another Washington food fight. Obama abdicated his commitment to reframe political debate and ceded the field to Congressional leaders with no interest or inclination to keep hope alive.

Harry Reid and Nancy Pelosi had no interest in Obama’s pledge to young and independent voters to change the tenor of politics in Washington, because it is their politics. For Reid and Pelosi, the political price of setting aside the interests of the SEIU and the Trial Lawyers and others in favor of a bi-partisan deal was too high to pay. Instead of reaching across the aisle, Democratic leaders preferred instead to mute industry opposition to healthcare legislation by bringing the industry heavyweights—big pharma, the hospitals association and ultimately the insurance companies—inside the tent. After all, that would only cost money.

The result is legislation that makes a mockery of sensible healthcare reform. It is expensive. It continues deeply entrenched incentives to overspending. Its financing is dishonest. And it protects those industry interests—promising expanding markets and limited cost controls—along with the interests of unions and lawyers heavily invested in the status quo, proving once again the power of lobbyists and contributors to take any major piece of legislation and manipulate it to their benefit.

So was it all just words? One year in, where is the evidence that the campaign that was designed to win by building on the hopes and dreams of the electorate was something more than just tactics? Where is the courage to take the long view? Where is the courage to take on your friends and occasionally accommodate your adversaries? And where is the courage to take on the contributors and lobbyists that neuter and manipulate one legislative initiative after another.

Have we seen any of that?

This year, we have watched events unmatched perhaps since the Gilded Age a century ago, as bankers have dipped their hands deeply into our pockets and those of our children to protect and enrich themselves, and nothing but whimpers from our elected representatives who tell us that this is the way it has to be—even as they take some of that very same money for their own campaigns.

But it is not just the bankers. The pharmaceuticals and insurance industries will dig deeper into the federal trough as subsidized drugs and insurance mandates are enacted. Energy companies and traders are eagerly ogling the new carbon trading bonanza that looms under the cover of cap and trade legislation. And out in the heartland, Monsanto is rewriting the rules of the farm economy under the protection of intellectual property laws that give it greater and greater control over the agricultural economy and farm incomes.

November’s results were not haphazard. Voters have not forgotten or forgiven the Republican sins and profligacy of the Bush years. But that was then and this is now, and Dick Cheney is not on the ballot. But 2010 looms large, and 2012 not long after that, and for all the mocking of the Teaparties, Democrats are skating on thin ice, and there is real anger out there, and disgust and disappointment.

In all likelihood there will be no healthcare bill this year, and that may well be for the better. The Democrat strategy of relying on a narrow, partisan margin was undone in the House when an anti-abortion Democrats upended the political calculus and may leave Democrats to deal with their own internal battles. Then, perhaps, David Plouffe and his associates will look in the mirror. And perhaps they will not like what they see. Barack Obama is not doing well, despite what Plouffe insisted to an incredulous Jon Stewart.

If Barack Obama wants to get reelected, and win votes one more time from the young and independent voters who put him over the top, perhaps it is time he stop playing politics and govern like a president who is willing to lose. Nancy Pelosi and Harry Reid are not doing Obama any favors, and will not win a single young or independent voter to his side next time. Unless he redeems his campaign slogans about changing our politics and demonstrates the courage to do what he promised to do the first time around, Obama will lose anyway, and have nothing to show for it but words.

What are they thinking?

With the announcements of record Wall Street bonus pools, and rising credit card fees, it is time to sit back and see where we go from here.

In the wake of the near collapse of the US financial sector one year ago, Hank Paulson and Ben Bernanke took extraordinary measures to avert collapse. Turning caution to the wind, they arranged shotgun mergers, decided who would live and who would die, and brought the word trillions into our every day vocabulary. By the time they were done, the landscape of American banking has been transformed. Today, the six banking organizations that received $160 billion between— JP Morgan, Bank of America, Citigroup and Wells Fargo, and the former investment banks Goldman Sachs and Morgan Stanley—are now looking to a future in which they can dominate the financial services landscape.

But perhaps the term financial services is misleading in this context. After all, as bank earnings reports were rolled out for the most recent quarter, and news headlines announced the record bonus pools that the banks were preparing to pay, it became clear that these earnings derived from trading activities, rather than traditional commercial bank lending activities. Before our eyes—and with the full support of the Federal Reserve and the US Treasury—the transformation that we have witnessed is not of the conversion of major investment banks such as Goldman Sachs and Morgan Stanley into commercial banks, but rather of each of these firms into government guaranteed hedge funds.

I readily concede that I am using the term hedge fund loosely. After all, hedge fund is a generic term for a relatively unregulated investment vehicle, that is permitted to invest in a wide range of unregulated derivatives and other investments, and whose returns are dedicated to a limited universe of investors. And certainly, the practices of JP Morgan or Goldman Sachs, who undertake massive proprietary trading activities, run huge derivatives books, and dedicate the preponderance of their earnings to senior employees, should not be lumped into the same category.

But on the other hand, if it walks like a duck…

Today, the commercial banking world is sharply divided. With over eight thousand commercial banks and savings institutions, these six firms hold less than 50% market share. Therefore, by traditional measures of market concentration, they are far from monopolistic. But as individual firms, their size dwarfs their cohorts, even considering that two of them, Goldman and Morgan Stanley are not traditional depository institutions. Together, the six boast total deposits of $2.7 trillion, or an average of $444.8 billion per firm. This compares with an average of $107.2 billion for the next six largest banks, and $76.0 billion for the following six. The fiftieth largest—well within the top 1% among all banks—Associated Bank of Wisconsin, has deposits of $16.4 billion.

At the same time, as JP Morgan and its brethren have increasingly concentrated on derivatives trading, loan securitization, securities underwriting and proprietary trading—and as these activities have contributed disproportionately to profitability—the share of bank assets dedicated to traditional commercial bank lending—the type that is most directly linked to the local economy in towns across the nation—has similarly decreased. Therefore, it is not a stretch to suggest that even as the Federal Reserve and Treasury have concentrated for the past year on addressing the risks to the financial system that largely emanated from the largest firms, these firms have at the same time migrated the farthest from the tradition public mission of the commercial banking industry.

It may be hard in the face of the drumbeat of stories about the banks and their problems and their bonuses to remember that commercial banking is an industry with a specific public mission: To take deposits and make loans. It was in the wake of the Great Depression, that the Glass-Steagall Act was passed to restore confidence in the commercial banking industry. Glass-Steagall forced the separation of commercial banking (lending) and investment banking (trading, underwriting), and created the FDIC to insure the deposits of commercial banks.

Beginning around 1980, the banking industry began a steady assault on Glass-Steagall, as investment banking firms sought access to the large pools of commercial bank deposits and commercial banks sought to expand into trading activities that would allow each type of firm larger profit and bonus opportunities. These efforts finally culminated in the Financial Services Modernization Act of 1999, which finally ended the Glass-Steagall restrictions and allowed the complete merger of investment and commercial banking organizations. However, the 1999 Act left FDIC insurance in place, resulting in the hybrid creature that emerged, able to attract government-insured deposits, and utilize those deposits across a range of lending, securities trading, and newly emerging derivatives trading activities.

Today, the financial policy brain trust of Ben Bernanke, Larry Summers and Tim Geithner have rejected calls for structural reforms to the banking system and to reinstate the Glass-Steagall restrictions. Despite the experience of the past several years, culminating in the financial crisis one year ago, they are suggesting that the concentration of power represented by these six firms is acceptable and desirable, and reform efforts should focus instead on the creation of a single systemic risk regulator to oversee those institutions deemed too big to fail.

Standing alone against Bernanke, Summers and Geithner within the Obama administration is former Fed chairman Paul Volcker. Volcker continues to call for the reinstatement of the Glass-Steagall restrictions, and recognizes the imperative of maintaining the link between deposit insurance and commercial bank lending.

It is hard to imagine what Bernanke, Summers and Geithner are thinking, and how they can look at the devastating experience of the past two years, and not conclude that something is fundamentally wrong. Financial modernization did little to help those thousands of commercial banks who have stuck to their knitting, and who now have been sorely disadvantaged by the federal bailouts of their large competitors. Proponents of financial deregulation argue that Volcker and other advocates for turning back the clock are recalcitrant Luddites, yet they have been hard pressed to demonstrate how the creation of the new class of hybrid commercial-investment banks and unregulated derivatives trading have added value to the economy.

Can Bernanke, Summers and Geithner seriously believe that a systemic risk regulator can control the risks that are embodied in these massive firms? Recent history suggests that the risks entailed in the trading strategies, quantitative models, complex derivatives and contract risks were never fully understood by the risk managers, bank CEOs and directors of their own organizations. Bank regulators were captive of the banks themselves as they sought to understand the information that was provided to them. Capital requirements other traditional tools for containing risk proved to be of only marginal value in the face of derivatives with nearly unlimited leverage, and collateralization requirements buried deep in unregistered and unregulated contracts.

Furthermore, political influence over regulators is a fact of life in Washington, and over time will undermine whatever independent structure these three wise men might have in mind. One need only point to Summers’ own success in 1998 in silencing Brooklsey Born—the head of the independent Commodity Futures Trading Commission—when she argued the inconvenient truth of the growing systemic risks presented by the unregulated derivatives market, at a time when Summers and the Clinton administration were arguing the merits of financial deregulation.

It is mind boggling that we can continue down this road. Paul Volcker must be applauded and supported for his unflagging efforts to bring attention to this issue. He is a wise man standing against smart men. And he is right.

Heads I win. Tails you lose.

Thirty years ago, Salomon Brothers and Goldman Sachs were two of the “bulge bracket” underwriting firms that dominated Wall Street. Both firms with partnerships with trading cultures that characterized their organizations. It was a time when Wall Street firms were looking far and wide for ways to increase their access to capital. Trading firms make money by making bets. More capital meant bigger bets. Bigger bets meant more money.

In 1980, in pursuit of a bigger balance sheet, Salomon CEO John Gutfreund negotiated the sale of his firm to Philipp Brothers, then the largest commodity trading firm in the world. The sale was not without controversy. Within Salomon, bond traders—led by Salomon family member William Salomon—opposed the sale. How, they asked, would traders be paid what was their due in the event the new firm lost money in other far-flung commodity businesses? As partners, they had a reason to be concerned by over-expansion into business lines that they neither understood nor controlled. They did not yet appreciate the benefits of trading with Other People’s Money.

But the sale of Salomon went through—John Gutfreund pocketed his $30 million bonus—and over the next few years, the new firm, Phibro-Salomon was acquired by Travelers Insurance. Travelers, in turn, was acquired by Citibank, to create the financial supermarket that was supposed to give American banking a global dominance to match the well-capitalized Asian and European counterparts.

The Salomon story was part of the evolution of Wall Street over the past thirty years, as the storied Wall Street firms succumbed to the lure of capital to give up their partnership status and merge into commercial banks and to become publicly traded corporations. And while the Wall Street investment banks did achieve their goals of increasing their access to capital—and ultimately won back their access to the massive pools of depositor money that they lost with the passage of the Glass-Steagall Act in 1933—the cost to the rest of us has been significant.

Where, after all, was William Salomon when Lehman Brothers decided to bet the ranch on collateralized mortgage securities that would ultimately bankrupt the firm. Where was William Salomon when Bear Stearns increased its leverage to thirty times, based on financial models that few in the firm really understood. And where was William Salomon when Joseph Cassano, the head of AIG Financial Products took the insurance giant headlong into the credit default swap business.

There was a moment when Cassano made his case to the AIG Board of Directors. The credit default swap contracts that AIGFP was providing to financial giants such as Goldman Sachs had no risk to AIGFP, argued Cassano, and therefore all of the annual receipts paid to AIGFP under those credit default swap contracts could be taken as current income—and used to pay very large bonuses—rather than held as reserves against future risk. CDS contracts are essentially insurance contracts provided to guarantee against defaults on corporate bonds, but Cassano argued that the bonds were so strong that there was no credit risk, and therefore the money paid to AIGFP was essentially free money.

But there was no William Salomon on the AIG Board of Directors. Unlike the old Wall Street partnerships, directors of corporations are largely insulated from the financial consequences of their decisions. Had AIG been a partnership like the old Salomon Brothers, a William Salomon would likely have asked the logical question of Joseph Cassano:

Goldman Sachs is paying us tens of millions of dollars a year, but you are telling us there is zero risk. One of us is wrong. This is a game of poker, and there is an idiot at the table. And you are telling me that Goldman Sachs is the idiot? I don’t think so. I think we are the idiots at this table. If Goldman Sachs is paying us tens of millions of dollars a year, we are taking risk, and we sure better know what that risk is, because we are betting our future on it.

But, of course, AIG was not a partnership, and the rest is history.

But the Phibro-Salomon story had one chapter left. This summer, Citibank—the failed financial supermarket that is now a ward of the State—sought approval from the US Treasury to pay bonuses in order to keep a group of highly profitable traders from leaving the bank. The bonuses—the most famous being the $100 million for Andrew Hall—were to be for traders in its Phibro commodity trading subsidiary.

William Salomon saw the writing on the wall. The partnership trading culture that was critical to Salomon Brothers success—a culture that combined incentives and accountability—would not survive an evolution into a corporate model. What we have learned is that the incentives to make big bets and take big risks has survived, but without the accountability. Andrew Hall made $2 billion for Citigroup placing energy bets, and was due to be paid $100 million. But what of those whose bets lost Citigroup $2 billion? They have not even lost their jobs.

The trading firms gained the access to the capital that they sought in the 1980s, and they found the joy of playing with Other People’s Money. And for twenty years, the game has gone on.

Heads I win, tails you lose. Or in David Einhorn's more elegant formulation, Private Profits, Socialized Risk.

Today, the US Treasury and the Fed are trying to hold the pieces together. AIG. Citi. Bank of America. GMAC. Fannie Mae. CIT Financial. But why? Where is the evidence that large financial corporations are more efficient at allocating capital than smaller banks? Surely, they have not been sound custodians of depositor funds or of the public trust. Neither have they proven they can deliver more predictable returns on shareholder equity than smaller, more nimble financial institutions, who themselves are increasingly disadvantaged by each bailout. Whose interest has conglomeration served but that of insiders seeking greater compensation with less risk?

One central question to all of this is whether the fundamental corporate model is not central to the problem. Today, absent prosecution for fraud, the CEOs and directors of all of these failed firms will walk away with much of their wealth intact, insulated from the consequences of the decisions they made. For years now, they have been playing with our money.

New regulatory regimes will not be adequate to control this systemic risk. Controlling banker compensation might have a populist appeal, but no one should imagine it constitutes systemic reform. Regulatory bureaucracies cannot control systemic risk in massive financial corporations, because the systemic risk is the massive financial corporation.

Thirty years ago. William Salomon was suggesting a simple truth: Sound decision-making, incentives and accountability require that those who are making decisions and placing bets have their own capital at risk.

They're back.

It is not clear how foreign policy strategy is being set in the Obama administration. But the execution has the appearances of a well-considered and orchestrated dance. And when the music stopped this week, standing together on the stage, united in common purpose, were the Big Four of wars gone by—the U.S., Great Britain, France and Russia.

The surprise this week was not the disclosure of a second, secret Iranian uranium enrichment site. Nor the ensuing condemnation and threats of collective action. What was surprising was the distinct voices that were heard. It was French President Sarkozy and British Prime Minister Brown whose declarations were strongest, with Russian President Medvedev joining shortly thereafter. Finally, an American President was able to speak a bit more softly—and by the demonstration of common purpose suggest a bit more stick on behalf of the international community.

For the first time in a while, Iranian President Ahmadinejad seemed caught off guard. His normal swagger was muted, perhaps with the realization that his days of manipulating Russia against the West have ended. More perhaps with cold fear that it was he that was manipulated by Russia, and that his miscalculations may weaken him considerably in his battles to retain power at home.

Perhaps American foreign policy is coalescing around some basic realities of the world. There are real threats out there, and we do not have the capacity to fight them alone. The unilateralism of the past decade was defined less by our determination to go it alone into war than by the belief that we could fight all battles and recast all nations in our own image. Almost without exception—perhaps China, as our lead banker, was the exception—we demanded fealty to our image of democratic progress from all of our antagonists.

But when you are fighting on all fronts, your ability to build enduring coalitions on any one of them is diminished. Russian Foreign Minister Sergey Lavrov has long articulated this view. Yes, as he has suggested for the better part of a decade, Russia and the United States have more issues that unite them than divide them. And yes, when presented with the top five issues of concern facing the U.S. in the international arena—perhaps including among them Afghanistan, Iran, Iraq, Islamic fundamentalism, drug trafficking, nuclear proliferation—Russia was a potentially valuable ally in all of them.

But the problem was that Russia had their own top five list, and Lavrov has long complained that if there was to be a partnership, it could not be one-sided. Russia’s concerns had to matter as well. Yes, Russia was prepared to be an ally in the Global War on Terror, but the Russian list had to be on the table. And they had a different list. Chechnya. Georgia. NATO. Missile defense. Encirclement. Status.

Russia’s list was fundamental to the continued integrity of the Russian nation. Russians may be paranoid, but the simple fact is that people are out to get them. U.S. official policy has been and continues to be one of encirclement, while many prominent voices go well beyond that—most notably Carter-era National Security Advisor Zbigniew Brzezinski—and argue that U.S. policy should be the dismemberment of the Russian state.

The dismemberment of the Russian state is not so far fetched. Before the fall of the Soviet empire, the Soviet Union claimed a population of nearly 300 million people. Today, Russia is a nation of just over 140 million, and it is shrinking rapidly. With low birth rates, high infant mortality, short life expectancy, and minimal immigration, by mid-century Russia’s population is projected to decline by more than 20%, to approximately 110 million.

The prospect of Chechen independence—and the demands for independence that would likely ensue from other minority groups should Chechnya succeed—further threatened the future of Russia. This fear explained in large measure Russia’s vociferous objection to NATO’s declaration of independence for Kosovo, and Russia’s steadfast claim that the international community can only grant nationhood through the legal powers granted to the United Nations.

Russia’s intransigence in dealings with the United States is rooted in its defense of national self-interest. For several years, Putin and Medvedev have been intent in their actions in international affairs—from supporting Iran to instigating the Ukrainian natural gas crisis—to force the United States to deal with them and their issues.

U.S. actions over the past nine months indicate that U.S. policy has evolved, and that we may finally be paying attention. The nuance is the distinction between what we say and what we do. The Bush administration talked about partnership and an alignment of interests, but took every opportunity to dismiss Russian concerns on the ground.

Now, the process seems to have been inverted. Vice President Biden—an early and vociferous backer of the Kosovo action that was so objectionable to Russia—has emerged as the voice of American support for the process of democratization and continued support for Ukraine and Georgia.

But Putin and Medvedev are realists, less moved by words than action. At the same time as Biden was talking the talk, the administration was walking a different path. During the early months of the administration, Russia threatened U.S. resupply routes into Afghanistan, and U.S. access to a key air base in Kyrgyzstan. One can imagine at that moment that the administration looked down the road at the real threats that loomed, and took a hard look at the facts on the ground. One can imagine that at that moment, they weighed the real impact on the ability of the U.S. to pursue its strategic goals and determined that Russia was—as Lavrov long suggested—better to have as an ally than face as an obstacle and an adversary.

It really was never a question. After all, for all the rhetoric—whether from Biden, Bush or Cheney—about U.S. support for Georgia or a common defense of Ukraine—neither we nor our European allies have had or likely would ever have the willingness to go to war with Russia in their Near Abroad. Our actions may have been designed to tweak them and continue the great game wherever possible—but never with the intention of real escalation.

One question this week has been how long ago did the U.S. learn of Iran’s second enrichment facility. Was it many months ago, and were the strategic moves to bring ourselves closer to an effective alliance with Russia—such as shifting our policy on strategic missile defense in Poland—in preparation for this next phase of the confrontation with the Iranian regime? Or was it simply fortuitous that the steps had been taken, and the groundwork had been laid that would allow Russia and the U.S. to stand together against a common threat?

Perhaps it doesn’t matter. But it does matter that our foreign policy may be built less on rhetoric, and more on our capacity to build effective alliances against real, and common, threats.

The grand illusion.

Most of us have lived through, or will live through, the painful years of watching our parents’ health decline. Behind the ugly partisan rancor of the town halls and the healthcare debates is the simple truth of that common experience.

Whether our parents have cancer or Alzheimer’s or dementia, or are simply dying of old age, we watch as their bodies become frail and their minds fade. These are our parents, once our providers and protectors, sapped of the energy and vitality that we for so long took for granted.

The medical bills. The residential communities. The in-home care. The drugs. They drain our parents’ savings and ultimately strain our family resources. We may have thought that Medicare would suffice, until one day a bill arrives from a rehab facility or a hospital, or a new drug is prescribed. From that day, the emotional pain of end of life care is compounded by the financial strains that bleed outward, undermining sibling comity, and threatening the resources set aside for kids' education, for family vacations, or for retirement.

There is no easy solution to this. We are all living longer, and the advances of technology and science now offer us the ability to fend off diseases that years ago barely existed—largely because we used to die younger and never contracted them. As a close friend put it—a Jesuit priest with a way with words—the longer any machine works, the more the maintenance costs go up.

People like to compare Medicare with Social Security, but the challenges facing Social Security are manageable by comparison. When Franklin Roosevelt created Social Security in 1935, it was a stroke of political—if not financial—genius. Social Security offered retirement security at age 65 to American workers whose average mortality at the time was 59. Therefore, it offered an entitlement to people who—on average—would be dead before they were eligible.

But even with longer lifespans, Social Security is a controllable and predictable program. The mortality curve shifts slowly and we can—at the end of the day—choose to change the parameters of the program that affect cost: the retirement age, the cost of living adjustments, the basis of pay, and the basis of taxation.

Healthcare has no such certainties. Unlike information technology, which offers greater and greater power at less and less cost, investments in healthcare technology and pharmacology that increase longevity and cure rare diseases may be moral victories for humanity but only exacerbate the financial strain on society and families. This is the dilemma of healthcare: The better we get at it, the faster the costs will escalate.

Dr. Andrew Weil, and many others, have pointed out that the solution to our healthcare crisis lies in how we choose to live our lives, and ultimately how we choose to die. In a similar vein, Atul Gawande suggests that the solutions to the cost and quality of healthcare lie in large part in the choices and conduct of the providers themselves. If physicians turn the practice of healthcare into an exercise in profit maximization, they will do better as individuals, but their patients and the system itself will suffer.

But as in most areas of life, good choices and ethical practices cannot be compelled or overseen by government. Regulatory regimes can enforce measurable practices—such as the concentration of melamine in dog food, or rat hairs in cola. But the federal government has no capacity to regulate the quality of collaboration among and conduct of individual medical practitioners.

The person who cried out at one town hall meeting to not let the government get its hands on Medicare has been duly castigated for the irony and ignorance of the remark. But at a deeper level, the remark encapsulates the problem we face.

Medicare is a government program. While many proponents of single payer healthcare point to Medicare as a model, it is a program that pays providers far less than the cost of services, and therefore results in substantial cost-shifting that exacerbates the medical insurance costs paid across the rest of society.

But Medicare is the lifeline of the elderly, and of the families of the elderly. That person may want to believe that Medicare exists above and apart from government, but of course it does not. Each Medicare patient—and their families—are relying on Other People's Money for their care, but they feel entitled to have it with few strings attached nonetheless. But the truth is that it is one more tax-funded program. Just like the stimulus money. Just like the wars. Just like everything else.

Medicare is our cushion. It insulates us from painful decisions that otherwise would be ours. But it is an illusion.

The fear and rage evinced by the person at the town hall presages the pain to come as that illusion is laid bare. If Medicare is Other People’s Money, then those other people are surely entitled to set the rules. But even worse is the realization of what would happen if it were not there. Without Medicare, we would have to be paying those costs for our parents’ end of life care ourselves.

Based on Dartmouth research data, per patient Medicare costs for the last two years of life range from approximately $50,000 to $100,000 across the country. And this is just the part paid by Medicare, which as we all learn is only part of the puzzle. These costs stand in stark contrast to the Federal Reserve data on household finances, that indicate that the median family net worth has fallen from $120,000 in 2007 to $99,000 as of October of last year. It is not a stretch, therefore, to suggest that we are spending with other people's money far more than we could spend if it was our own.

The person who cried out at the town meeting may have been voicing a fear we all hold deep inside. What if it is all an illusion? What if Medicare is not an impenetrable wall that protects us from those decisions that are most painful?

For many years we have accepted the illusion and comfort that Medicare offers. Spending Other People's Money has changed the decisions that we make, and our assumptions and expectations about the care our loved ones receive. We now clamor to rest assured that they will receive all of the care a physician might recommend—with little consideration of the cost to the system of which we are a part.

But federal government resources are no more than the pooling of our collective family resources. In the end, we will return to the questions that for many years we have been able to avoid. How would we choose what steps to take—and what procedures to forego—if it was our limited family resources that would be drained away by each of our decisions? And what choices would our parents make if they understood the magnitude of the impact of each decision on their children and grandchildren?

The question of how we are going to spend scarce resources is with us. We confront it around the kitchen table, and it is time that we accept that it is the central question of healthcare challenge. It is the question that will consume our politics in the years ahead, because the years of free money and free choices have come to an end.