In a recent op-ed titled “Financial Crisis Amnesia,” Treasury Secretary Timothy Geithner blamed the financial crisis and “Great Recession” of 2008-2009 on insufficient government power to intervene and control reckless credit practices in the private sector. He assigned special blame to bankers and the financial sector for having “no memory of extreme crisis” and “no memory of what can happen when a nation allows huge amounts of risk to build up outside of the safeguards all economies require.”
In truth it’s Mr. Geithner who seems to suffer from amnesia, although you can’t really forget what you never learned in the first place. The record shows that Mr. Geithner has learned very little in the quarter century that he has worked in public finance, whether at Treasury (1988-2003, 2009-2012) or as president of the New York Federal Reserve (2003-2009). Indeed, men like Geithner and Congressional allies caused America’s financial mess.
First, some evidence on the mess: at every level of government in America we see reckless deficit spending and borrowing, we see banks reluctant to lend and firms unwilling to hire, stubbornly high jobless rates, real incomes shrinking three years in a row, and turmoil in stagnant European welfare states that are but a few decades older than ours. Democracy – mob rule – is slowly going bankrupt, as our Founders said it would.
Now, can such troubles be resolved by having still more government controls and mandates, as Mr. Geithner recommends? The U.S. financial sector is already one of the most regulated of all the economy’s major sectors, and that was the case before 2008, too. Today there is only partial private ownership of our money and credit system; the heavy hand of government monopolizes money, and when it comes to credit and financial exchanges, it tells banks and underwriters what to do, how to do it, and when. No wonder we’re in a mess; central planning is a disaster, wherever tried, and no sector is more prone to it today than the financial sector, if only because it is most affected by the Fed and Treasury (as well as the FDIC, SEC, CFTC, etc).
In any mixed political-economic system – i.e., one that’s only partly free and partly controlled and co-opted by government – officials and voters alike must be sufficiently astute, learned, and free of amnesia to be able to discern the genuine root of a systemic financial problem, and to assign blame where it truly belongs. Here’s the oft-forgotten principle: liberty succeeds, compulsion fails. That is, capitalism succeeds, socialism fails. That’s the plain history. Who today can still deny it? The facts can’t be evaded with impunity, unless you’re a high-ranking government finance official who, despite repeated failure, keeps getting promoted. In any mixed system the source of failure, crisis, and breakdown is always the socialist elements, in whatever degree they exist, not the capitalist elements which remain despite the efforts of statists to extinguish them.
This is where Geithner goes so terribly wrong. Did he never learn, in all his years at Dartmouth College, at Johns Hopkins University, at Kissinger & Associates, at the Fed, and at the Treasury, the well-established historic truth that capitalism and freedom succeed while socialism and controls fail? Or did he learn it but then forget it? I can’t say, but his op-ed is clear: he wants more controls, because, he claims, the crises of 2008-2009 occurred because “financial safeguards in the law” were “tragically antiquated and weak,” because “neither the Fed, nor any other federal agency, had the necessary comprehensive authority” to regulate Wall Street firms, because “regulators did not have the authority they needed to oversee and impose prudent limits on overall risk and leverage,” and because there was “no authority to put these firms, or bank holding companies, through a managed bankruptcy.” He then whines that some securitizations occurred “without meaningful regulation,” and loans were made “with little to no supervision and poor consumer protections.”
Mr. Geithner says he’s confident that the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (enacted into law in July 2010, but still in the rule-making phase) will impose “safer and more modern rules of the road for the financial industry,” but he also worries it’ll be diluted by “lobbyists trying to weaken or repeal” it. Geithner denies that Dodd-Frank is too complex, costly, or paralytic to financial institutions; seeking more controls, he believes too much liberty persists in the already heavily-controlled financial sector, and as much liberty as possible must be snuffed out. He even claims that if Dodd-Frank controls “had been in place a decade ago, the rise in debt and leverage would have been less dangerous, consumers would not have been nearly as vulnerable to predation and abuse, and the government would have been able to limit the damage that a financial crisis could have on the broader economy.” Is this amnesia, or fantasy play?
Geithner’s claims are nonsense, because the U.S. financial system was neither unregulated nor underregulated pre 2008, and the controls being imposted post 2008, and those still to come, will at least double the strings (and nooses) attached to our financial institutions. that is, before and after the 2008-2009 crisis. Yet politicians claim to be puzzled about why banks aren’t lending and firms aren’t hiring.
According to a recent account in The Economist, even though sections 404 and 406 of the Dodd-Frank law are two pages long, regulatory agencies have derived from them a 192-page form that hedge funds and other firms must fill out, at a cost of $100,000-150,000 for each firm the first time (and $40,000/year thereafter). At 848 pages, this law is multiple times longer than the 29-page National Banking Act which established America’s nationwide banking system (1864), the 32-page Federal Reserve Act (1913) which nationalized the currency, and the 37-page Glass-Steagall Act (19342), which bifurcated commercial and investment banking.
By some estimates, a single page of financial legislation is typically leveraged into 30 pages or so of financial regulation by federal agencies (as recorded in the Federal Register); thus the Dodd-Frank law could eventually entail more than 25,000 pages of regulation, on top of the pages the financial sector already faces. The so-called “Volcker Rule” in Dodd-Frank, which regulates proprietary trading, is 11 pages long, but agencies have issued a 298-page “proposal” with 1,420 questions for affected firms; the 298 pages were described as “unintelligible any way you read it” by a banker who supports Dodd-Frank.
A top law firm has uncovered 355 distinct steps bank clients should take if they are to comply with the law. The Commodity Futures Trading Commission (CFTC) recently issued its own plan to control the very same proprietary trading; that plan is 489 pages long. So far only a quarter of Dodd-Frank’s 400 rule-making mandates have been finalized, and the law requires 87 studies of such things as the impact of drywall on mortgage defaults; fewer than half the studies are done. J. P. Morgan Inc. says Dodd-Frank will cost the firm $400-600 million annually. Even manufacturing firms are facing costs imposed by the law. The Economist concludes that “the overall cost of all this, both directly to public and private institutions and indirectly to the markets, is staggering.”
What many bankers ignore when they complain about the burden and spread of regulation is the broader context: regulations in fact are the “strings attached” to taxpayer subsidies, and although these strings often become nooses around banks’ necks, victims can’t logically demand deregulation without also foreswearing the subsidies.
Excessive leverage and risk-taking are indeed endemic to the financial system, not because it’s too lightly regulated but because it isn’t capitalistic (free and unsubsidized) enough. Over the years the system has been increasingly subsidized and co-opted by government, through easy liquidity loans from the Fed’s discount window, cheap FDIC coverage, a “too-big-to-fail” (bailout) doctrine, and GSE securitizations and guarantees. Dodd-Frank alters none of these evils, and instead layers onto an already ossified and shaky system still more regulation, which, in time, the subsidized risk-takers will learn to skirt. Politicians will publically decry the financial lobbyists, but in private welcome them heartily as a source of campaign cash.
The context today isn’t much different from that which preceded the crisis of 2008-2009. The Fed still has its harmful monopoly on the currency – it still exerts an unhealthy influence on bank reserves – it still acts as the system-wide lender of last resort to deadbeats – and it still controls short-term interest rates, thus the all-important shape of the Treasury yield curve. The Fed’s deliberate inversion of the yield curve in 2006-2007 – done on Geithner’s watch – triggered the latest crisis and recession, as the policy did in prior instances too (see my column on this key topic from last summer: “How Bernanke’s Fed Triggered the Great Recession”).
Only if reformers identify the five main causes of excessive leverage, undue risking-taking, financial crises, and recessions can they start doing the right thing. Here are the five main causes – and how to fix them:
1. The Federal Reserve and the yield curve. As was true in all other U.S. financial crises, recessions and credit crunches since 1966, the latest one was triggered by a deliberate inversion of the Treasury yield curve by the Federal Reserve. Not a single reform or law today precludes the Fed from adopting that punitive policy again. As a more fundamental solution, the Fed should be phased out entirely and replaced with a gold standard free of political manipulation. The U.S. had a well-functioning gold standard with no central bank and minimal financial regulation for most of its first 125 years (1790-1913) – and it performed superbly.
2. “Too-Big-to-Fail.” This policy induces banks that don’t want to fail to boost asset size, with little regard for asset quality, liquidity or capital adequacy. It includes easy and cheap access to the Fed’s discount window, which subsidizes banks that mismanage their liquidity. Any scheme that designates certain (usually reckless) banks “too big to fail” also renders responsible banks – and the banking system – too burdened to succeed. The policy should be abolished, and failed banks should go to bankruptcy court, as they now cannot, by law.
3. Government deposit insurance (FDIC). This allegedly “stabilizes” banks but in truth they pay the same (low) premium, so sound banks are taxed while unsound ones are subsidized; it also induces a displacement of equity with publicly-guaranteed funding, thus excessive leverage. FDIC account coverage has been expanded from $10,000 in 1950 to $100,000 in 1980 and $250,000 in 2008 – almost three time the rate of inflation – and it now covers more than half of the system’s deposits (and even some bank debt). This is a back-door nationalization of banks. Truly safe and sound banking requires phasing out the FDIC. It can be done over a 3-5 year period by gradually ratcheting back account coverage and then eliminating it entirely.
4. Fannie Mae and Freddie Mac. These “government sponsored enterprises” (GSEs) went bust in September 2008 (the FHA probably is also now bust), with nearly $6 trillion in assets (and even more in liabilities), having securitized or purchased a slew of bad residential mortgages in a deliberate (and politicized) scheme to promote home ownership for the undeserving. Since then, the GSEs have received $170 billion in more funding and guarantees from the Treasury and Fed. The right thing must be done: Washington must liquidate and terminate these corrupt, blood-sucking monstrosities – poste-haste.
5. CRA and other inducements to unsound lending. The Community Reinvestment Act (CRA) and related laws compel banks to lend to the un-creditworthy; it contributed to the latest housing-credit-financial crisis. Not a single reform scales back these laws or their related agencies (like HUD); in fact Dodd-Frank expands them, (via the “Consumer Financial Protection Agency,” or CFPC), which robs the banks of freedom and profits, while ensuring a future repeat of crises. The case for the CFPC rests on the false presumption that the latest crisis was caused by “predatory lending;” the real disease was predatory borrowing, with banks and investors (in MBS) victimized by irresponsible deadbeats (“liar loans”) favored by government policy. All such laws should be repealed immediately, so as to stop the rank injustices and economic losses they inflict.
It’s easy these days to criticize clueless treasury officials like Tim Geithner (or his much worse predecessor, Hank Paulson), or clueless central bankers like Fed head Ben Bernanke (or his far worse predecessor, Alan Greenspan). At the highest levels today there’s simply no equivalent of Alexander Hamilton to be found – that is, no pro-capitalist financial genius with the courage to defend sound money, private property rights, and sanctity of contract. Instead we suffer power-lusting, amnesic central planners and devotees of paper money. Yet the evil lies in central planning itself, not so much in the central planners. The planners must fail, do fail, and will fail – and then they’ll blame others (private sector victims) while insisting that all would be well if only they could wield wider powers. That’s how it is with the statists. But no one need believe their lies. Unconstitutional, over-sized government tends to attract the wrong sort of people – those eager to play the practicing statist and expand state power to near-totalitarian proportions – but the real solution is fundamental and institutional change that once again gives America a rights-respecting, law-abiding government.
Mr. Salsman is the president of InterMarket Forecasting, Inc., an investment research and advisory firm.
