Monthly Archives: December 2009

Krugman Gets it Wrong

By L. Randall Wray

In his column in yesterday’s NYT, Professor Paul Krugman rose to the defense of Paul Samuelson. He argued that Michael Hudson’s piece, originally published in 1970, not only misunderstood Samuelson’s theories but also wrongly asserted that he was not deserving of a Nobel. Krugman’s main argument was that Samuelson’s version of “Keynesian” economics offered a solution to depressions that pre-existing “institutionalist” theory did not have:
Faced with the Depression, institutional economics turned out to have very little to offer, except to say that it was a complex phenomenon with deep historical roots, and surely there was no easy answer. Meanwhile, model-oriented economists turned quickly to Keynes — who was very much a builder of little models. And what they said was, “This is a failure of effective demand. You can cure it by pushing this button.” The fiscal expansion of World War II, although not intended as a Keynesian policy, proved them right. So Samuelson-type economics didn’t win because of its power to cloud men’s     minds. It won because in the greatest economic crisis in history, it had something useful to say.

This claim is bizarre, to say the least. First, Roosevelt’s New Deal was in place before Keynes published his General Theory, and it was mostly formulated by the American institutional economists that Krugman claims to have been clueless. (There certainly were clueless economists—those following the neoclassical approach, traced to English “political economy”.)

Second, it was Alvin Hansen, not Paul Samuelson, who brought Keynesian ideas to America. And Hansen retained the more radical ideas (such as the tendency to stagnation) that Samuelson dropped. Further, Hansen was—surprise, surprise—working within the institutionalist tradition (as documented by in a book by Perry Mehrling).

Third, many other institutionalists also adopted Keynesian ideas in their work—before Samuelson’s simplistic mathematization swamped the discipline. For example, Dudley Dillard—a well-known institutionalist—wrote the first accessible interpretation of Keynes in 1948; Kenneth Boulding’s 1950 Reconstruction of Economics served as the basis for four editions of his Principles book—on which a generation of American economists was trained (again, before Samuelson’s text took over). It is in almost every respect superior to Samuelson’s text. I encourage Professor Krugman to take a look.

Fourth, Hyman Minsky (who first trained with institutionalists at the University of Chicago—before it became a bastion of monetarist thought) took Samuelson’s overly simplistic multiplier-accelerator approach and extended it with institutional ceilings and floors. He quickly grew tired of the constraints placed on theory by Samuelsonian mathematics and moved on to develop his Financial Instability Hypothesis (which Krugman has admitted he finds interesting, even if he does not fully comprehend it). I ask you, how many analysts have turned to Samuelson’s work to try to understand the current crisis—versus the number of times Minsky’s work has been invoked?

And fifth, Samuelson’s “button” approach to dealing with the business cycle has been thoroughly discredited since the late 1960s—when he announced that we would never have another recession. In truth, as Minsky argued, it is not possible to “fine-tune” the economy because “stability is destabilizing”. The simplistic “Keynesian” approach propagated by the likes of Samuelson leaves out the behavioral and institutional analysis that is necessary to deal with instability and crisis.

Sixth, as has been long recognized, Samuelson purposely threw Keynes out of his analysis as he developed the “Neoclassical Synthesis”. The name dropping was intentional—Keynes was too radical for the cold warrior Samuelson. At best, what Samuelson presented was a highly bastardized version of Keynes—as Joan Robinson termed it, a Bastard Keynesian approach (we know the mother was neoclassical economics but we do not know who the father was).

Finally, and most telling of all, whose work is universally acknowledged as the most insightful analysis of the Great Depression? Might it be John Kenneth Galbraith’s The Great Crash? I have never heard anyone refer to any work of Samuelson in that context.

So Professor Krugman has got it wrong.

Bernanke Believes Monodisciplinary Means Multidisciplinary

By William K. Black

This column arose from research about President Obama’s proposed reappointment of Dr. Bernanke as Fed Chair. Bernanke was faced recently with the choice of who to make the head of Fed supervision. The context of that choice is extremely important and will be the subject of a longer essay. He made the choice, on October 20, 2009. He is lobbying for the passage of bills that would make the Fed the uberregulator in charge of safety & soundness and systemic risk regulation, so the importance of the top supervisor was extraordinary. As a future column will explain, the person he choose was exceptionally poor and demonstrates that Bernanke was not only one of the major architects of the current crisis – he is the primary architect of the next crisis. Bernanke made a theoclassical economist, Patrick M. Parkinson, the head of Fed supervision. The future essay will show that this long-time Fed economist has a track record of failure because of his fundamentalist beliefs in the gospel of anti-regulation and resultant naïve beliefs that “sophisticated” market participants are impervious to fraud.

This essay focuses on Bernanke’s explanation of why he chose Parkinson to be the Fed’s lead uberregulator. Bernanke is faced with an impossible task. Parkinson has never been a regulator, knows nothing about how to be an effective regulator, thinks that fraud (which causes the greatest banking losses) virtually does not exist, and has consistently proposed anti-regulatory policies that have proved disastrous. Bernanke has to explain why he has chosen, for the most important professional supervisory position in the world, an individual who he should have quietly asked to resign. Here is how he pitched (October 20, 2009) the appointment of one of the vast array of failed Fed economists as uberregulator:

“As an economist with deep expertise in financial markets, Pat Parkinson will be an important asset at a time when we are focusing on a multidisciplinary approach to banking supervision and regulation,” Federal Reserve Chairman Ben S. Bernanke said. “We’re working to supervise the banking sector in a way that focuses not just on individual institutions, but on how those institutions are interconnected and are integrated into the financial system and the economy. Pat is the right person to lead the division as we develop these new methods.”

If you know the Fed then you already get the hilarity of this comment and the arrogance and inanity it reveals. Parkinson is monodisciplinary, not multidisciplinary. He opines that fraud cannot exist among “sophisticated” parties even though the criminology literature has documented such fraud for over half a century as has all human experience including, recently, Drexel/Milken and Enron, et al. Because he is monodisciplinary and because he has no experience as a regulator (and because he is a theoclassical zealot) he has no idea that other fields have falsified his creed. He is not even aware that his own agency’s examiners, ever since the Fed was created, have repeatedly falsified his navie beliefs about fraud.
The joke, of course, is that the Fed has long failed as a regulator not because of its examiners but because of its senior leadership’s four crippling weaknesses.
  • The regional Federal Reserve Banks, which provide most examination and supervision, have conflicts of interest that we already decided, in the context of the Federal Home Loan Banks, was unacceptable. The fact that this conflict continues demonstrates the vastly greater political power of the banks compared to S&Ls.
  • The Board of the Governors of the Federal Reserve has, traditionally, made supervision at best a tertiary concern. Monetary policy and international dealings with sister central banks is what mattered. (Now) Treasury Secretary Geithner’s response to a question by Representative Ron Paul about his regulatory experience as President of the Federal Reserve Bank of New York epitomizes the senior Fed mindset: “I’ve never been a regulator….” True, but you’re not supposed to admit it.
  • The Federal Reserve, at all levels, is far too close to the industry it is supposed to regulate. It has been taught for years to view the industry as “the customer.”
  • Theoclassical economists dominate both the Board of Governors and the senior staff. The fact that this is considered normal and appropriate demonstrates how damaging that domination is. Theoclassical economists are very bad economists that cause recurrent, intensifying crises – but they are even worse anti-regulators.
Bernanke’s claim that putting a theoclassical economist in charge of supervision would fix the Fed’s pathetic anti-regulatory non-actions that were critical to causing the bubble and the Great Recession is an insult to the Fed’s examiners and professional supervisors. The claim that Parkinson needs to run supervision is implicitly a claim that none of the examiners or supervisors understands “how these institutions are interconnected and are integrated into the financial system and the economy.” Only someone with a doctorate in economics can understand those complex matters. Bernanke’s answer to the Fed’s anti-regulatory failures that arise because theoclassical economists dominate the agency is greater domination by those same anti-regulatory economists.

The arrogance and the bias of a monodisciplinary and theoclassical economist’s assurance that his field exclusively holds the answers is staggering. Let us be clear: Greenspan, Bernanke, Geithner, and Parkinson share many characteristics. They are all theoclassical zealots that ignored other fields, and other perspectives within their own discipline. They share an intense anti-regulatory bias. They are all naïve about fraud. None of them understood “how these institutions are interconnected and integrated into the financial system and the economy.” They were all abject failures at regulatory policy. The Fed’s anti-regulatory creed was so destructive precisely because it never understood banks, banking, criminology, and finance.

But Bernanke’s claim that an economist brings unique strengths to supervision is false on another substantive dimension. Greenspan, Bernanke, Geithner, and Parkinson did not simply miss systemic risk. They all missed garden-variety fraud and other forms of credit risk at individual banks. If they had identified and prevented those frauds and undue credit risks there would have been no systemic risk. Without the fraudulent underlying mortgage loans there would not have been a severe housing bubble, mass delinquencies, and the “underlying” that supposedly “backed” the toxic collateralized debt obligations (CDOs). This was an easy crisis to prevent. If the old rules on underwriting had been kept in force and enforced there would have been no crisis. It was the theoclassical economists that claimed that the toxic product was really manna and that the toxic derivatives spread the manna optimally.

What the Fed desperately needs is true multidisciplinary strength. Fraud causes the bulk of bank losses. White-collar criminologists are the experts in this field and have important insights into where “epidemics” of fraud will occur, why such epidemics hyper-inflate financial bubbles, and how to fight such frauds. It turns out that theoclassical economists’ anti-regulatory policy prescriptions optimize a “criminogenic environment” that produces these epidemics and hyper-inflated bubbles. Why don’t the Fed and its sister agencies have a “chief criminologist?”

Elegant Theories That Didn’t Work

The Problem with Paul Samuelson
“First Published on
“The following article was written in 1970 after Samuelson received the award”

Paul Samuelson, America’s best known economist, died on Sunday. He was awarded the Nobel prize for economics, (founded one year earlier by a Swedish bank in 1970 “in honor of Alfred Nobel”). That award elicited this trenchant critique, published by Michael Hudson in Commonweal, December 18, 1970. The essay was titled “Does economics deserve a Nobel prize? (And by the way, does Samuelson deserve one?)”

It is bad enough that the field of psychology has for so long been a non-social science, viewing the motive forces of personality as deriving from internal psychic experiences rather than from man’s interaction with his social setting. Similarly in the field of economics: since its “utilitarian” revolution about a century ago, this discipline has also abandoned its analysis of the objective world and its political, economic productive relations in favor of more introverted, utilitarian and welfare-oriented norms. Moral speculations concerning mathematical psychics have come to displace the once-social science of political economy.

To a large extent the discipline’s revolt against British classical political economy was a reaction against Marxism, which represented the logical culmination of classical Ricardian economics and its paramount emphasis on the conditions of production. Following the counter-revolution, the motive force of economic behavior came to be viewed as stemming from man’s wants rather than from his productive capacities, organization of production, and the social relations that followed therefrom. By the postwar period the anti-classical revolution (curiously termed neo-classical by its participants) had carried the day. Its major textbook of indoctrination was Paul Samuelson’s Economics.

Today, virtually all established economists are products of this anti-classical revolution, which I myself am tempted to call a revolution against economic analysis per se. The established practitioners of economics are uniformly negligent of the social preconditions and consequences of man’s economic activity. In this lies their shortcoming, as well as that of the newly-instituted Economics Prize granted by the Swedish Academy: at least for the next decade it must perforce remain a prize for non-economics, or at best superfluous economics. Should it therefore be given at all?

This is only the second year in which the Economics prize has been awarded, and the first time it has been granted to a single individual — Paul Samuelson — described in the words of a jubilant New York Times editorial as “the world’s greatest pure economic theorist.” And yet the body of doctrine that Samuelson espouses is one of the major reasons why economics students enrolled in the nation’s colleges have been declining in number. For they are, I am glad to say, appalled at the irrelevant nature of the discipline as it is now taught, impatient with its inability to describe the problems which plague the world in which they live, and increasingly resentful of its explaining away the most apparent problems which first attracted them to the subject.

The trouble with the Nobel Award is not so much its choice of man (although I shall have more to say later as to the implications of the choice of Samuelson), but its designation of economics as a scientific field worthy of receiving a Nobel prize at all. In the prize committee’s words, Mr. Samuelson received the award for the “scientific work through which he has developed static and dynamic economic theory and actively contributed to raising the level of analysis in economic science. . . .”

What is the nature of this science? Can it be “scientific” to promulgate theories that do not describe economic reality as it unfolds in its historical context, and which lead to economic imbalance when applied? Is economics really an applied science at all? Of course it is implemented in practice, but with a noteworthy lack of success in recent years on the part of all the major economic schools, from the post-Keynesians to the monetarists.

In Mr. Samuelson’s case, for example, the trade policy that follows from his theoretical doctrines is laissez faire. That this doctrine has been adopted by most of the western world is obvious. That it has benefited the developed nations is also apparent. However, its usefulness to less developed countries is doubtful, for underlying it is a permanent justification of the status quo: let things alone and everything will (tend to) come to “equilibrium.” Unfortunately, this concept of equilibrium is probably the most perverse idea plaguing economics today, and it is just this concept that Mr. Samuelson has done so much to popularize. For it is all too often overlooked that when someone falls fiat on his face he is “in equilibrium” just as much as when he is standing upright. Poverty as well as wealth represents an equilibrium position. Everything that exists represents, however fleetingly, some equilibrium — that is, some balance or product — of forces.

Nowhere is the sterility of this equilibrium preconception more apparent than in Mr. Samuelson’s famous factor-price equalization theorem, which states that the natural tendency of the international economy is for wages and profits among nations to converge over time. As an empirical historical generality this obviously is invalid. International wage levels and living standards are diverging, not converging, so that the rich creditor nations are becoming richer while poor debtor countries are becoming poorer — at an accelerating pace, to boot. Capital transfers (international investment and “aid”) have, if anything, aggravated the problem, largely because they have tended to buttress the structural defects that impede progress in the poorer countries: obsolete systems of land tenure, inadequate educational and labor-training institutions, pre-capitalist aristocratic social structures, and so forth. Unfortunately, it is just such political-economic factors that have been overlooked by Mr. Samuelson’s theorizing (as they have been overlooked by the mainstream of academic economists since political economy gave way to “economics” a century ago).

In this respect Mr. Samuelson’s theories can be described as beautiful watch parts which, when assembled, make a watch that doesn’t tell the time accurately. The individual parts are perfect, but their interaction is somehow not. The parts of this watch are the constituents of neoclassical theory that add up to an inapplicable whole. They are a kit of conceptual tools ideally designed to correct a world that doesn’t exist.

The problem is one of scope. Mr. Samuelson’s three volumes of economic papers represent a myriad of applications of internally consistent (or what economists call “elegant”) theories, but to what avail? The theories are static, the world dynamic.

Ultimately, the problem resolves to a basic difference between economics and the natural sciences. In the latter, the preconception of an ultimate symmetry in nature has led to many revolutionary breakthroughs, from the Copernican revolution in astronomy to the theory of the atom and its sub-particles, and including the laws of thermodynamics, the periodic table of the elements, and unified field theory. Economic activity is not characterized by a similar underlying symmetry. It is more unbalanced. Independent variables or exogenous shocks do not set in motion just-offsetting counter-movements, as they would have to in order to bring about a meaningful new equilibrium. If they did, there would be no economic growth at all in the world economy, no difference between U.S. per capita productive powers and living standards and those of Paraguay.

Mr. Samuelson, however, is representative of the academic mainstream today in imagining that economic forces tend to equalize productive powers and personal incomes throughout the world except when impeded by the disequilibrating “impurities” of government policy. Empirical observation has long indicated that the historical evolution of “free” market forces has increasingly favored the richer nations (those fortunate enough to have benefited from an economic head start) and correspondingly retarded the development of the laggard countries. It is precisely the existence of political and institutional “impurities” such as foreign aid programs, deliberate government employment policies, and related political actions that have tended to counteract the “natural” course of economic history, by trying to maintain some international equitability of economic development and to help compensate for the economic dispersion caused by the disequilibrating “natural” economy.

This decade will see a revolution that will overthrow these untenable theories. Such revolutions in economic thought are not infrequent. Indeed, virtually all of the leading economic postulates and “tools of the trade” have been developed in the context of political-economic debates accompanying turning points in economic history. Thus, for every theory put forth there has been a counter-theory.

To a major extent these debates have concerned international trade and payments. David Hume with the quantity theory of money, for instance, along with Adam Smith and his “invisible hand” of self-interest, opposed the mercantilist monetary and international financial theories that had been used to defend England’s commercial restrictions in the eighteenth century. During England’s Corn Law debates some years later, Malthus opposed Ricardo on value and rent theory and its implications for the theory of comparative advantage in international trade. Later, the American protectionists of the 19th century opposed the Ricardians, urging that engineering coefficients and productivity theory become the nexus of economic thought rather than the theory of exchange, value and distribution. Still later, the Austrian School and Alfred Marshall emerged to oppose classical political economy (particularly. Marx) from yet another vantage point, making consumption and utility the nexus of their theorizing.

In the 1920s, Keynes opposed Bertil Ohlin and Jacques Rueff (among others) as to the existence of structural limits to the ability of the traditional price and income adjustment mechanisms to maintain “equilibrium,” or even economic and social stability. The setting of this debate was the German reparations problem. Today, a parallel debate is raging between the Structuralist School ­ which flourishes mainly in Latin America and opposes austerity programs as a viable plan for economic improvement of their countries, and the monetarist and post-Keynesian schools defending the IMF’s austerity programs of balance-of-payments adjustment. Finally, in yet another debate, Milton Friedman and his monetarist school are opposing what is left of the Keynesians (including Paul Samuelson) over whether monetary aggregates or interest rates and fiscal policy are the decisive factors in economic activity.

In none of these debates do (or did) members of one school accept the theories or even the underlying assumptions and postulates of the other. In this respect the history of economic thought has not resembled that of physics, medicine, or other natural sciences, in which a discovery is fairly rapidly and universally acknowledged to be a contribution of new objective knowledge, and in which political repercussions and its associated national self-interest are almost entirely absent. In economics alone the irony is posed that two contradictory theories may both qualify for prizeworthy preeminence, and that the prize may please one group of nations and displease another on theoretical grounds.

Thus, if the Nobel prize could be awarded posthumously, both Ricardo and Malthus, Marx and Marshall would no doubt qualify, just as both Paul Samuelson and Milton Friedman were leading contenders for the 1970 prize. [Friedman got his Nobel in 1976.] Who, on the other hand, can imagine the recipient of the physics or chemistry prize holding a view not almost universally shared by his colleagues? (Within the profession, of course, there may exist different schools of thought. But they do not usually dispute the recognized positive contribution of their profession’s Nobel prizewinner.) Who could review the history of these prizes and pick out a great number of recipients whose contributions proved to be false trails or stumbling blocks to theoretical progress rather than (in their day) breakthroughs?

The Swedish Royal Academy has therefore involved itself in a number of inconsistencies in choosing Mr. Samuelson to receive the 1970 Economics Prize. For one thing, last year’s prize was awarded to two mathematical economists (Jan Tinbergen of Holland and Ragnar Frisch of Norway) for their translation of other men’s economic theories into mathematical language, and in their statistical testing of existing economic theory. This year’s prize, by contrast, was awarded to a man whose theoretical contribution is essentially untestable by the very nature of its “pure” assumptions, which are far too static ever to have the world stop its dynamic evolution so that they may be “tested.” (This prompted one of my colleagues to suggest that the next Economics Prize be awarded to anyone capable of empirically testing any of Mr. Samuelson’s theorems.)

And precisely because economic “science” seems to be more akin to “political science” than to natural science, the Economics Prize seems closer to the Peace Prize than to the prize in chemistry. Deliberately or not, it represents the Royal Swedish Academy’s endorsement or recognition of the political influence of some economist in helping to defend some (presumptively) laudable government policy. Could the prize therefore be given just as readily to a U.S. president, central banker or some other non-academician as to a “pure” theorist (if such exists)? Could it just as well be granted to David Rockefeller for taking the lead in lowering the prime rate, or President Nixon for his acknowledged role in guiding the world’s largest economy, or to Arthur Burns as chairman of the Federal Reserve Board? If the issue is ultimately one of government policy, the answer would seem to be affirmative.

Or is popularity perhaps to become the major criterion for winning the prize? This year’s award must have been granted at least partially in recognition of Mr. Samuelson’s Economics textbook, which has sold over two million copies since 1947 and thereby influenced the minds of a whole generation of — let us say it, for it is certainly not all Mr. Samuelson’s fault — old fogeys. The book’s orientation itself has impelled students away from further study of the subject rather than attracting them to it. And yet if popularity and success in the marketplace of economic fads (among those who have chosen to remain in the discipline rather than seeking richer intellectual pastures elsewhere) is to become a consideration, then the prize committee has done an injustice to Jacqueline Susann in not awarding her this year’s literary prize.

To summarize, reality and relevance rather than “purity” and elegance are the burning issues in economics today, political implications rather than antiquarian geometrics. The fault therefore lies not with Mr. Samuelson but with his discipline. Until it is agreed what economics is, or should be, it is as fruitless to award a prize for “good economics” as to award an engineer who designed a marvelous machine that either could not be built or whose purpose was unexplained. The prize must thus fall to those still lost in the ivory corridors of the past, reinforcing general equilibrium economics just as it is being pressed out of favor by those striving to restore the discipline to its long-lost pedestal of political economy.

*At the time I wrote this critique I was teaching international trade theory at the Graduate Faculty of the New School for Social Research at the time. Subsequently, I criticized Mr. Samuelson’s methodology in “The Use and Abuse of Mathematical Economics,” Journal of Economic Studies 27 (2000):292-315. Most important of all is Mr. Samuelson’s factor-price equalization theorem. I finally have republished my Trade, Development and Foreign Debt: A History of Theories of Polarization v. Convergence in the World Economy.

Michael Hudson is a former Wall Street economist. A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002) He can be reached via his website, [email protected]

Update: See here and here.

Is It Time to Reduce the Ease to Prevent Inflation and Possible National Insolvency?

By L. Randall Wray

The growing consensus view is that the worst is behind us. The Fed’s massive intervention finally quelled the liquidity crisis. The fiscal stimulus package has done its work, saving jobs and boosting retail sales. The latest data show that net exports are booming. While residential real estate remains moribund, there are occasional reports that sales are picking up and that prices are firming. Recovery is just around the corner.

Hence, many have started to call on the Fed to think about reversing its “quantitative ease”—that is, to remove some of the reserves it has injected into the banking system. Further, most commentators reject any discussion of additional fiscal stimulus on the argument that it is no longer needed and would likely increase inflation pressures. Thus, the ARRA’s stimulus package should be allowed to expire and Congress ought to begin thinking about raising taxes to close the budget deficit.

Still, there remain three worries: unemployment is high and while job losses have slowed all plausible projections are for continued slack labor markets for months and even years to come; state and local government finances are a mess; and continued monetary and fiscal ease threaten to bring on inflation and perhaps even national insolvency.

Me thinks that reported sightings of economic recovery are premature. Still, let us suppose that policy has indeed produced a resurrection. What should we do about unemployment, state and local government shortfalls, and federal budget deficits? I will be brief on the first two topics but will provide a detailed rebuttal to the belief that continued monetary ease as well as federal government deficits might spark inflation and national insolvency.

1. Unemployment

Despite the slight improvement in the jobs picture (meaning only that things did not get worse), we need 12 million new jobs just to deal with workers who have lost their jobs since the crisis began, plus those who would have entered the labor force (such as graduating students) if conditions had been better. At least another 12 million more jobs would be needed on top of that to get to full employment—or, 24 million total. Even at a rapid pace of job creation equal to an average of 300,000 net jobs created monthly it would take more than six years to provide work to all who now want to work (and, of course, the labor force would continue to grow over that period). There is no chance that the private sector will sustain such a pace of job creation. As discussed many times on this blog, the only hope is a direct job creation program funded by the federal government. This goes by the name of the job guarantee, employer of last resort, or public service employment proposal. (see here, here, and here)

2. State and Local Government Finance

Revenues of state and local governments are collapsing, forcing them to cut services, lay-off employees, and raise fees and taxes. Problems will get worse in coming months. Most property taxes are infrequently adjusted, and many governments will be recognizing depressed property values for the first time since the crisis began. Lower assessed values will mean much lower property tax revenues next year, compounding fiscal distress. Ratings agencies have begun to downgrade state and local government bonds—triggering a vicious downward spiral because interest rates rise (and in some cases, downgrades trigger penalties that must be paid by governments—to those same financial institutions that caused the crisis). Note that contractual obligations, such as debt service, must be met first. Hence, state and local governments have to cut noncontractual spending like that for schools, fire departments, and law enforcement so that they can use scarce tax revenue to pay interest and fees to fat cat bankers. As government employees lose their jobs, local communities not only suffer from diminished services but also from reduced retail sales and higher mortgage delinquencies—again pushing a vicious cycle that collapses tax revenue.
The solution, again, must come from the federal government, which is the only entity that can spend countercyclically without regard to its tax revenue. As discussed on this blog in several posts (here and here), one of the best ways to provide funding would be in the form of federal block grants to states on a per capita basis—perhaps $400 billion next year. A payroll tax holiday would also help—increasing take-home pay of employees and reducing employer costs on all employees covered by Social Security.

3. Federal Budget Deficit, Insolvency, and Inflation

Resolving the unemployment and state and local budget problems will require help from the federal government. Yet that conflicts with the claimed necessity of tightening fiscal and monetary policy in order to preempt inflation and solvency problems. Two former Fed Chairmen have weighed in on US fiscal and monetary policy ease and the dangers posed. On NBC’s Meet the Press, Alan Greenspan argued:
“I think the Fed has done an extraordinary job and it’s done a huge amount (to bolster employment). There’s just so much monetary policy and the central bank can do. And I think they’ve gone to their limits, at this particular stage. You cannot ask a central bank to do more than it is capable of without very dire consequences,”

He went on, claiming that the US faces inflation unless the Fed begins to pull back “all the stimulus it put into the economy.”

In an interview (with SPIEGEL ONLINE – News – International) former Chairman Paul Volcker said the deficit will need to be cut:

Volcker: You’ve got to deal with the deficit and you’ve got to deal with it in a timely way. Right now, with the unemployment rate still very high, excess capacity is still evident, and the economy is dependent on government money as we said. We are not going to successfully attack the deficit right now but we have got to prepare for attacking it.
SPIEGEL: Should Americans prepare themselves for a tax increase?
Volcker: Not at the moment, but I think we would have to think about it. The present tax system historically has transferred about 18 to 19 percent of the GNP to the government. And we are going to come out of all this with an expenditure relationship to GNP very substantially above that. We either have to cut expenditures and that means reducing entitlements and certainly defense expenditures by an amount that may not be possible. If you can do it, fine. If we can’t do it, then we have to think about taxes.
Both the Fed and the Treasury are said to be “pumping” too much money into the economy, sowing the seeds of future inflation. There are two kinds of cases made for the argument that monetary and fiscal policy are too lax. The first is based loosely on the old Monetarist view that too much money causes inflation., while the second is more Keynesian, pointing toward the money provided through the Treasury’s spending. The evidence can be found in the huge expansion of the Fed’s balance sheet to two trillion dollars of liabilities and in the Treasury’s budget deficit that has grown toward a trillion and a half dollars. Chairman Greenspan, a committed Monetarist, points to the first of these, recognizing that most of these Fed liabilities take the form of reserves held by banks—which will eventually start lending their excess reserves. Chairman Volcker points to the second—federal government spending that will create income that will be spent. Hence, those trillions of extra dollars provided by the Treasury and Fed surely will fuel more lending and spending, leading to inflation or even to a hyperinflation of Zimbabwean proportions.
Some have made a related argument: all those excess reserves in the banking system will be lent to speculators, fueling yet another asset price bubble. The consequence could be rising commodities prices (such as oil prices) feeding through to inflation of consumer and producer prices. Or, the speculative bubble would give way to yet another financial crisis. Worse, either inflation or a bursting bubble could generate a run out of the dollar, collapsing the currency—and off we go again toward Zimbabwean ruin.
Finally, over the past two decades the Fed—accompanied by New Consensus macroeconomists—has managed to create a widespread belief that inflation is caused by expected inflation. In other words, if everyone believes there will be inflation, then inflation will result because wages and prices will be hiked on the expectation that costs will rise. For this reason, monetary policy has long been directed toward managing inflation expectations, with the Fed convincing markets that it is diligently fighting inflation pressures even before they arise. Now, however, the Fed is in danger of losing the battle because all of those extra reserves in the banking system will create the expectation of inflation—which will itself cause inflation. For this reason, the Fed needs to begin raising interest rates and (or, by?) removing reserves from the banking system. That would prevent expected inflation from generating Zimbabwean hyperinflation.

Unfortunately, all these arguments misunderstand the situation. Here is why:

You cannot tell much of anything by looking at current bank reserve positions. As and when banks decide they do not need to hold so many reserves, they will begin to unwind them, repaying loans to the Fed (destroying reserves) and buying Treasuries (the Fed will accommodate by selling assets in order to keep the overnight fed funds rate on target—if it did not, excess reserves would drive the fed funds rate to zero).There are no direct inflationary pressures that result from such operations. Indeed, all else equal, the reserves will be reduced with no new bank lending or deposit creation.

Banks normally buy financial assets (including loan IOUs) by issuing liabilities (including deposits). As the economy recovers, banks will want to resume such activities. If there is a general demand to buy output or financial assets, coming from borrowers perceived to be creditworthy, banks normally accommodate by making loans. This does not require ex ante reserves (or even capital if regulators do not enforce capital requirements or if banks can move assets off balance sheet). Yes, such a process can generate rising asset prices and banks broadly defined might accommodate this as they seek profits through lending to speculators. In this respect you could argue that expected inflation of asset prices fuels actual inflation of asset prices since that can fuel a speculative run up. Yet, this can occur with or without any excess reserves–indeed even if banks were already short required reserves they could expand lending then go to Fed to get the reserves. In other words, banks do not lend reserves nor is their lending constrained by reserves. Thus, while it is true that banks can finance a speculative bubble in asset prices, they can do this no matter what their reserve position is.

Nor will bank lending for asset purchases necessarily generate inflation of output prices. Any implications of renewed bank lending for CPI or PPI inflation are contingent on pass through from commodities to output prices. If the speculative binge in, say, futures prices of commodities feeds through to commodities spot prices, and if this then pressures output price inflation (as measured by the CPI and PPI), there can be an effect on measured inflation. There are lots of caveats–due to the way these indexes are calculated, to the possibility of consumer and producer substitutions, and to offsetting price deflation pressures (Chinese production and all of that). In any case, if there is a real danger that the current commodities price boom could accelerate to the point that it might create a crash or output price inflation, the best course of action would be to constrain the speculation directly. This can be done through direct credit controls placed on lenders as well as regulation of speculators.

It is true that the Fed has operated on the belief that by controlling inflation expectations it prevents inflation. Low inflation, in turn, is supposed to generate robust economic growth and high employment. This has been exposed by the current crisis as an unwarranted belief. The Wizard of Oz behind the curtain was exposed as an impotent fraud—while Bernanke remained focused on controlling inflation expectations for far too long, the whole economy collapsed around him. It was only when he finally abandoned expectations management in favor of bold action—lending without limit to institutions that needed reserves—that he helped to quell the liquidity crisis. All of his subsequent actions have had no impact on the economy—“quantitative easing” is nothing but a slogan, meaning that the Fed accommodates the demand for reserves (which it has always done, and necessarily must do so long as it has an interest rate target and wants par clearing).

It is sheer folly to believe that inflation expectations lead to inflation and that by controlling the expectations one controls inflation. In the modern capitalist economy, prices of output are mostly administered, with the caveat that competitive pressures from low cost producers in China and India put downward pressure on prices that may force domestic sellers to cut prices. Hence, US inflation has remained low in recent years because there has been little cost pressure; and note that most countries around the world have also experienced low inflation over the same period even though they did not enjoy the supposed benefits of a Wizard in charge of monetary policy. In the current environment of a global financial and economic calamity, the real danger is price deflation. The bit of inflation we do experience is due almost entirely to energy price blips—which could be prevented if we would just prohibit pension funds from speculating in commodities.

Still, there remains one path to Zimbabwean hyperinflation: a collapse of the currency due to insolvency and default by our federal government on its debts. Yet, as many have discussed on this blog (see here, here, here, here, and here), the US government is the sovereign issuer of our dollar currency. It cannot be forced into bankruptcy because it services its dollar debt by crediting bank accounts. It can never run out of these credits, since they are merely electronic entries on balance sheets, created at the stroke of a computer key. It can, and will, make all payments as they come due. In short, federal government insolvency is not possible.

To be sure, as we have emphasized many times, too much government spending can be inflationary. But the measure of “too much” cannot be found by looking at the size of the deficit (or, equivalently, at the shortfall of tax revenue), or at the ratio of government spending to GDP, or at the outstanding debt stock. Rather, government spending will approach an inflation barrier as the economy approaches full employment of resources, including labor resources. Yet, we are no where near to full employment. Any fear that current levels of spending, or even much larger amounts of federal spending, might be inflationary are premature. With 12 to 25 million jobless workers remaining, inflation is not a legitimate worry.

You can be sure that no matter how misguided President Obama’s policies might be, he is not taking us down the path to a Zimbabwean hyperinflation. This is not the place for a detailed analysis of the probable course of the dollar. In coming months it might decline a bit, or rise a bit (I’d bet on the latter if I were a gambler)—but there will be no global run out of the dollar. For one thing, runners must run to something—and as recent reports suggest, Euroland’s prospects look dire. That leaves smallish nations (Japan, the UK—both with their own problems) or big nations (China, India) that are too risky for foreigners. The best place to park savings will remain the US dollar.

Obama Finds His Spine and Attacks Fat Cat Bankers

By L. Randall Wray

President Obama has finally castigated the fat cat bankers that caused the crisis that forced millions of Americans from their jobs and their homes. Let us hope this represents a much awaited reversal of his here-to-for prostration before Rubin’s Wall Street buddies. (See Matt Taibbi’s Obama’s Big Sellout)

Trends always begin with a first step. Now he must prove that he really means it by firing Timmy (why haven’t you resigned yet?) Geithner and Larry Summers for crimes against the economy. We might even hope for a more deserved outcome:

The next step will be to send the FDIC into the largest, “systemically dangerous”, financial institutions to shut them down. Fire all the top management plus any traders who have earned six figure bonuses in any of the past three years. Replace them with lowly paid middle management. We will need a new Jessie Jones (President Roosevelt’s selection to head the Reconstruction Finance Corporation that took over half of the nation’s banks in the Great Depression, successfully resolving most of them); my colleague, Bill Black (who helped to resolve the thrift crisis, standing up to Charles Keating, John McCain and the rest of the Keating 5), is the leading candidate. His task will be to downsize the financial sector, starting with the top two dozen or so banks—which will be broken into small pieces. Their former management and traders will be investigated for fraud, which will be found with a probability approaching certainty in all cases.

We will also need to round-up all the Goldman Sachs alum now working in government– shoveling favors to their former employer—for special treatment. Part of the President’s remaining stimulus funds can be devoted to building new prisons for them and the thousands of other financial market predators. The new penitentiaries ought to be sited in places like Modesto, California that are suffering the most from the real estate collapse, making use of foreclosed properties and providing jobs as prison guards to those who have been displaced. At their hands, poetic as well as Biblical justice could be visited on Wall Street’s finest.

The notion that these “highly skilled” whiz kids need huge bonuses to retain them is, as Keynes would remark “crazily improbable–the sort of thing which no man could believe who had not had his head fuddled with nonsense for years and years.” Your average Brooklyn plumber has more financial markets sense than all of these clowns combined. Their efforts were directed to another goal—running a kleptocracy that would make a Russian mobster blush. There is no evidence that they have learned anything from this debacle and unless they are removed, they will dig the financial black hole even deeper.

This is the real change we have been waiting for since Obama took office. The Obama elected by the American people has been AWOL since last November, with an evil twin occupying the White House and repaying Wall Street for its campaign contributions. However, America is still a democracy—one citizen, one vote—and Obama has got to realize that while the fat cats might have contributed most of the money, they did not provide many votes. It is time to boot the imposter and downsize Wall Street’s influence on Washington.

The electorate voted for change. I have the audacity of hope to believe that the real Obama is the one we saw this week. Send the fake back to Goldman’s.

Obama’s New-Found Populism: All Hat, No Cattle

By Marshall Auerback

President Obama is taking a sharp, populist tone with Wall Street and scolding the ways of Washington as he once again looks to the Senate to follow the House and pass one of his top legislative priorities: sweeping financial regulatory reform. It might feel satisfying to hear the President criticize “reckless”, “fat cat” bankers, but the financial reform legislation passed by the House last Friday (and lauded by the President) provides little incentive to change their behavior. In reality populism, with nothing of substance behind it, is just cynical posturing designed to mask genuine failure. Like everything else with this President, he is again showing himself to be (to use an expression of his predecessor), all hat, no cattle.

Appealing to the peanut gallery at this stage is an insult to the voters’ intelligence. The current bill is yet another in a series of major disappointments. The most telling comment on the latest reforms came from the stock market: Bank stocks ended the day higher last Friday (when the House bill was passed to great fanfare), with the KBW Banks index slightly outperforming the benchmark Dow Jones industrial average.

At its most basic level, a bank is an entity that has a reserve account at the Fed, which makes loans and takes deposits. That is its primary public purpose, and we should not be allowing activities which undermine this central function, especially seeing as it is the government which guarantees the public’s deposits via the FDIC. (As an aside, even though the government creates all reserves and guarantees deposits, we do not want it to be directing lending activity because, as “Winterspeak” notes, “we do not want the Government to make credit decisions, they are too likely to dole out money to politically connected constituencies, while starving worthwhile, but unconnected borrowers”.

However good the political optics of resorting to name-calling and demonization of Wall Street, the legislation itself does nothing to recognize that the behavior criticized is a direct consequence of incentives built into the current institutional structure. It completely misses the point because it does nothing to ban activities which were at the heart of the crisis and which will likely be perpetuated as a consequence of the new legislation. All the new legislation does is institutionalize tax payer bailouts and, in so doing, continues the process of privatizing profits and socializing losses. There is no attempt to ban activities that were central to this crisis. The problem is that insolvent institutions have a habit of “betting the bank” through control fraud and the new legislation will not prevent this.

Even positive aspects of the bill, such as the establishment of the Consumer Financial Protection Agency, were significantly watered down. New Democrats – the people we used to call “Republicans” – won concessions that give federal regulators more scope to preempt state consumer-protection laws deemed to “significantly interfere with or materially impair a national bank’s ability to do business.” The change was sponsored by Congresswoman Melissa Bean, who is the most bought for and paid member (by bankers) in the House , not an inconsiderable political achievement amongst our current political profiles in courage in Congress. Bean justified the change on the basis of having, “robust national standards and enforcing them uniformly”, which sounds good until one considers the history of federal regulators, none of whom have historically moved when they plainly should have done so. How many federal regulators do you recall actually blocking the most egregious excesses in the mortgage market over the past 15 years? Preventing the states from moving proactively means that we will likely repeat the experience of the 1990s. Historically, the reform impetus has emanated from the states, not the Federal Government, Governor Eliot Spitzer’s administration being a prominent illustration.

More and more voters are beginning to believe this façade of reform is deliberate – a cynical act of kabuki theatre by the President to mask his own reticence to deal with the problem in an honest manner. It was clear to many of us that the President may not have been serious about reform when he picked Tim Geithner and Larry Summers as the leaders of his economic team a year ago, and essentially relegated any genuine progressive to the Cabinet equivalent of Siberia, as Matt Taibbi recently highlighted Yes, Summers and Geithner both have ample experience: but does that mean that they were qualified to take on the positions they were granted in the Administration? I suppose that depends on whether you think a doctor who botched your surgery ought to be given the role for the next one, simply because he has greater familiarity with your body than another surgeon.

Some on the left have attacked Taibbi very hard for the attacks on Obama, and Matt is no conservative. More importantly, he is correct: Taibbi calls the President for what he is, a sweet talking man who cannot fulfill one single promise he made to the public to get elected. So we have this incompetent financial reform bill, which will not place any limits on another systematic collapse. We have a health bill with no means of sensibly restraining cost pressures within the private health insurance industry. We are still fighting two wars, one of which is being escalated. The economy is still struggling and jobs are being lost.

Far easier to resort to cheap populism that actually do something about it. If the President were serious, he would be pointing out that the bankers have been undercutting every effort at reform, and have been paying off Congress to put loopholes into all legislation. If he were genuinely upset, he would be channeling the country’s anger constructively, by calling on the population to take to the streets in mass protests against Wall St with a view to shutting down the biggest banks and breaking their power once and for all. Of course the President would never do anything so “irresponsible”. Far better to throw a few bones to the peasants and hope that the appearance of reform pacifies them.

The economist Hyman Minsky argued that the Great Depression represented a failure of the small-government, laissez-faire economic model, while the New Deal promoted a Big Government/Big Bank highly successful model for capitalism. The current crisis just as convincingly represents a failure of the Big Government/Crony Capitalist model that promotes deregulation, reduced oversight, privatization, and consolidation of market power. Yet the very people, who have shredded the New Deal reforms and replaced them with self-supervision of markets, are the champions of today’s financial “reform”. As appealing as the story of Paul on the road to Damascus might be, there is no certainly no evidence of any Damascene conversion here amongst the policy makers of the Obama Administration. It’s business as usual, along with the championing of monetary and fiscal policy that is biased against maintenance of full employment and adequate growth to generate rising living standards for most Americans.

We must return to a more sensible model, with enhanced supervision of financial institutions and with a financial structure that promotes stability by aligning the banks’ activities with public purpose, rather than abetting speculation and then bailing the financial sector out after the fact. President Roosevelt proved that we could reform the financial system, rescue homeowners, and deal with the unemployed even as we mobilized and then fought World War II. By contrast, this is an Administration that defines reform as muddled compromise within a profoundly broken polity.

Failed Economics Creates Failed Families

By June Carbone
Edward A. Smith/Missouri Chair of Law, the Constitution and Society, University of Missouri-Kansas City

Where is the economics of the family when we need it? Family instability magnifies societal inequality and undermines the foundation for the next generation. Yet, the ideas that helped secure a Nobel Prize in economics for Chicago economist Gary Becker, which still provide the starting point for every discussion of the economics of the family, have been proved wrong in almost every respect – and lay the foundation for an economy that looks like Yemen’s.

Becker won the Nobel Prize, at least in part, because of his identification of marriage with specialization and trade: men “specialize” in the market and women in the home. His critical prediction: with the wholesale movement of women into the labor market, the gains from marriage would decline and family instability would rise.

Yet, Becker’s theory cannot explain why the only group in society whose marriage rates have increased are college-educated women or why, contrary to Becker’s predictions, the divorce rates of two career college-educated couples have returned to the levels of the early sixties. Nor does it make any attempt to account for how class now dictates family form, with family stability increasingly a product of education and income. (For more on this, see Naomi Cahn and June Carbone, Red Families v. Blue Families.)

It has no hope of explaining these factors because it misses the most significant developments of the day. The idea that men “specialize” in the market is absurd. The very idea of the market as separate from the home is a product of nineteenth century industrialization, and the specialization that occurred in that era was a much greater investment in middle class males that increased the returns to education, enhanced differentiation among male workers, and magnified income inequality. The idea that women “specialize” in the home is even loonier – the female homemaker is the very epitome of the generalist, cleaning, cooking, mending and providing child care. While my husband “specializes” in corned beef and cabbage in contrast to my salads and tomato sauce, no one would confuse the result with professional accomplishments that are the result of decades of education and experience. (For more on this, see June Carbone, From Partners to Parents: The Second Revolution in Family Law.)

Ideas, however, have consequences, and a major one that follows from getting this wrong is understating the importance of investment in women. The big story of the last half century is greater returns to investment in women, investment that is derailed by early marriage and childbearing. The second, more pernicious consequence is that Becker misses the fact that what he characterizes as specialization rationalizes domination. Women’s domestic roles – including younger average ages of marriage, multiple children born in close succession, and the lack of external sources of income – correspond closely to a lack of power in relationships. As Nicholas Kristof writes in his inspiring accounts of women from the developing world, give women just a little bit more education and independence and they leave or reform abusive mates, producing healthier children and a more productive society.

In contrast, the policies that have tried to bring back Becker’s specialized family – which include abstinence education, the shot gun marriage, and declining access to family planning – simply ensure the U.S.’s declining economic competitiveness. Teenage girls in the red states that place single-minded emphasis on marriage are MORE likely than their blue state sisters to have sex and get pregnant, marry early and get divorced, stop going to school and go to work, and end up raising their children in poverty.

Geithner as Our “Last Action Hero”

By William K. Black
Associate Professor of Law and Economics, University of Missouri-Kansas City

This is my third essay commenting on Bo Cutter’s essay defending Treasury Secretary Geithner.

The prior installments can be found here and here.

Bo was a managing partner of Warburg Pincus, a major global private equity firm and led President Obama’s Office of Management and Budget (OMB) transition team. He was Bob Rubin’s deputy at the National Economic Council and Deputy Director of OMB for Carter. Bo’s defense of Geithner ends with his view that Geithner emerged as The Last Action Hero:

Tim Geithner acted. He acted at the moment action was required … with the full knowledge that he would face exactly what he is now facing.

Get off his back.

This essay provides an alternative view. I have written elsewhere of why Geithner’s actions once he became Treasury Secretary were so harmful. This essay discusses his failures to act when he was President of the Federal Reserve Bank of New York (FRBNY). First, Bo concedes that Geithner did not act “at the moment action was required” – he was years late and trillions of dollars short.

[T]his crisis was long in coming and it was a totally integrated failure of intellectual traditions, global macro-economic imbalances, government policy making, regulatory supervision, financial sector greed, incomprehensible boards of directors’ absences without leave, and breath-taking management short-sightedness. No one and no institution put together an understanding of the set of factors that triggered this particular debacle. Tim [Geithner] is included in this “no one,” but so is everyone else.

I think the last two years have revealed the single largest failure of senior management in the financial sector, and of the board system in American history. I think I am correct in saying that there was not a single independent director in America who stood up on this issue. I do not understand why every board of every institution that failed was not asked to resign immediately. But I guess the answer is “when you are up to your ass in alligators, it is hard to think about draining the swamp.” Geithner had other things to do at that moment than settle scores.

In fact, by 2006 and early 2007 everyone thought we were headed to a cliff, but no one knew when or what the triggering mechanism would be. The capital market experts I was listening to all thought the banks were going crazy, and that the terms of major loans being offered by the banks were nuttiness of epic proportions.

Bo admits that even the most ideologically-blinded theoclassical economists (his phrase is “failure of intellectual traditions”) knew “we were headed to a cliff” by 2006. “Everyone,” including “the capital market experts” knew that “the banks were going crazy.” Moreover, the experts all knew that the banks were not merely “crazy” but farblondget (a Yiddish term literally meaning “lost” but with the connotation of insanely lost: as in I tried to drive from Kansas City, Missouri to Lawrence, Kansas and 28 hours later it began to dawn on me that I might be lost because all the signs were in Spanish). The banks were so farblondget that Bo aptly describes the “terms of major loans” as “nuttiness of epic proportions.” In my first essay I explained that this pattern demonstrates that there was an epidemic of what white-collar criminologists term “accounting control fraud.” Honest banks would not make loans on such terms because they were suicidal. The housing bubble had already stopped inflating by 2006 and the nonprime specialty lenders were blowing up.

The FBI warned publicly in September 2004 that an “epidemic” of mortgage fraud was developing and that it would cause a crisis if it were not stopped. It later emphasized that 80% of mortgage fraud losses occurred when lender personnel were involved in the frauds. Geithner, Bernanke, Paulson, and Greenspan took no effective action against the growing epidemic – even when Fed Member Ned Gramlich warned them of the housing bubble and urged Greenspan to send in the examiners to contain the raging problems in nonprime lending. Geithner, Bernanke, and Greenspan bear special culpability for their refusal to act against the epidemic of accounting control fraud because (1) Congress mandated that the Fed hold hearings on nonprime loans (which revealed (a) extremely high delinquencies, (b) frequent predation, and (c) widespread mortgage fraud involving lender personnel), and (2) the Fed had unique statutory authority to regulate otherwise unregulated mortgage lenders. The Fed refused to use its authority despite Gramlich’s warnings, the hearing record demonstrating widespread lender abuses and fraud, the rapidly inflating housing bubble, the warnings of non-theoclassical economists, and the FBI’s 2004 warnings.

Bo is correct, “the crisis was long in coming.” Bo is incorrect in claiming that “no one” saw it coming. Many others did and they warned Geithner and Bernanke years before the crisis while they had ample time to act and prevent the crisis from occurring. (Here, I will not set out the number of non-theoclassical economists that got it right. We all know that Geithner and Bernanke still ignore these voices. For the purposes of this essay I discuss only a few warnings we know they received – and ignored.) Bernanke and Geithner held key positions during the long period in which the crisis grew. Geithner was President of the Federal Reserve Bank of New York from October 23, 2003 until President Obama chose him as his Treasury Secretary. In that role he was supposed to serve as the lead regulator of many of the nation’s largest bank holding companies. He was an abject failure as a regulator, and a major cause of the “economy falling off the cliff.” Bernanke held prominent positions in the Bush administration from 2002 through the administration’s end (as a Fed member, Chair of Bush’s Council of Economic Advisors, and then his return to the Fed as its Chair). He was an abject failure as a regulator and as Bush’s economic advisor.

Bo does not recognize that his account of the industry’s long, downward spiral into an epidemic of control fraud while Geithner and Bernanke stood silent and impotent while closing their ears to the timely warnings of the coming crisis constitutes a scathing critique of Geithner’s and Bernanke’s failures as regulators. He literally has zero expectation that Geithner and Bernanke would do anything useful as regulators before the global crisis raged and he imposes no accountability on them for failing to act. Bo was Carter’s Deputy head of OMB and Obama’s transition team leader for OMB. OMB is, in every administration, the institutional enemy of vigorous regulation and vigorous regulators. (It was OMB that threatened to make a criminal referral against Bank Board Chairman Gray on the “grounds” that he was closing too many insolvent S&Ls.)

If we continue to have low expectations for our regulators, we will continue to have failed regulation. Let us reprise Bo’s facts, using a radically different standard under which we expect senior regulators making roughly $400,000 annually (Geithner as FRBNY President) and roughly $200,000 annually (Bernanke as Fed Chairman) to take regulatory action against unsafe and unlawful practices so obviously disastrous that “everyone thought we were headed to a cliff.” When capital market analysts “all thought the banks were going crazy, and that the terms of major loans being offered by the banks were nuttiness of epic proportions” even minimally competent regulators would order them to cease such lending immediately and make criminal referrals.

As two of the most important regulatory leaders, Geithner and Bernanke had the duty (and the power) to fix the broken regulatory system. Bo makes the point that “this crisis was long in coming” and arose from the “failure” of “government policy making [and] regulatory supervision.” Bernanke and Geithner were leaders in shaping those failed government policies and regulatory supervision. Those failures continued for over five years under their leadership and still have not been fixed.

In addition to Bo’s demonstration (1) that Geithner and Bernanke failed to order an end to lending practices they knew were suicidal (and should have known were fraudulent) and (2) their failure to fix their failed regulatory agency and their failed governmental policies, he shows (3) that they also failed to deal with endemic failure of bank managers and directors.

I think the last two years have revealed the single largest failure of senior management in the financial sector, and of the board system in American history. I think I am correct in saying that there was not a single independent director in America who stood up on this issue. I do not understand why every board of every institution that failed was not asked to resign immediately. But I guess the answer is “when you are up to your ass in alligators, it is hard to think about draining the swamp.” Geithner had other things to do at that moment than settle scores.

Bo asks why the directors of every failed institution were “not asked to resign immediately.” That’s a necessary but incomplete question. The first question is why senior regulatory leaders, including Geithner and Bernanke, did not act to end “the single largest failure of senior management” and the failure of every “single independent director.” Real regulators don’t wait for the bank to fail before acting against the largest failure of senior management in history. The second question is who failed to ask for the boards (and the officers) to “resign immediately” upon the failure of the banks. Bernanke and Geithner are two of the regulatory leaders that should have adopted policies mandating those resignations.

The third question is when these banks “failed.” Bo implies that they failed in late 2008 and 2009, but the facts he presents demonstrate that they had failed years before. When banks made “major loans” in 2006 on terms that “were nuttiness of epic proportions” they made themselves insolvent. Bo’s colorful phrase means that the yield on the loans was not remotely adequate to allow the lender to earn a profit because so many of the loans would default as soon as the housing bubble stalled. If the lenders, as required by generally accepted accounting principles (GAAP), established adequate loss reserves to cover those losses from the coming wave of defaults they would report massive losses and be forced to recognize that they were insolvent. Instead, even as they made loans on terms of ever increasing “nuttiness of epic proportions,” which required record high loss reserves they instead reduced their already grossly inadequate loss reserves to record low levels so that they could report (fraudulent) profits. A.M. Best warned in its 2005 report that “the industry’s reserves-to-loan ratio has been setting new record lows for the past four years.” These “profits” led to enormous “performance” bonuses to the senior executives running the control frauds.

The same A.M. Best report made a point that has great importance for considering Geithner’s failures as a regulator and Bernanke’s failures as both a regulator and as Bush’s chief economic advisor: a “10-year record low number of problem banks for the quarter results ended Sept. 30, 2005.” The regulators determine which banks are “problems.” It sounds like good news, but the finding is actually proof of a catastrophic regulatory failure. The number of failed – not simply “problem” – banks was surging but the regulators were blind to the epidemic of accounting control fraud that was masking their failures. The greatest value that banking regulators can add is to recognize the distinctive pattern of such accounting frauds and to close them at the earliest possible time.

Nonprime specialty lenders loan terms exhibited “nuttiness of epic proportions” well before 2006 and that made them insolvent well before 2006. “MBA [Mortgage Bankers’ Association] data show that interest-only and adjustable-rate mortgages made up 65% of new mortgages in 2004, up from 18% in 2003″ (February 27, 2006). The FBI’s September 2004 warning about the epidemic of mortgage fraud and coming crisis was spot on.

The nonprime specialty lenders, of course, did not report that they were insolvent when then made loans on terms certain to destroy the lenders. They followed the standard recipe for lenders optimizing accounting control fraud: extremely rapid growth, making exceptionally bad loans, extreme leverage, and providing only minimal loss reserves. This guaranteed that they would report record “income” in the short-term.

The fourth set of questions is where are the enforcement actions by the Fed to remove and prohibit the officers and directors that Bo confirms represent an endemic failure to comply with their fiduciary duties or safety and soundness, and where are the Fed enforcement actions to recover their bonuses and other fraudulent gains? The fifth question is where are the Fed’s criminal referrals against the accounting control frauds. Bo’s answer to this question is fully representative of big finance’s attitude towards the prosecution of elite white-collar criminals:

I do not understand why every board of every institution that failed was not asked to resign immediately. But I guess the answer is “when you are up to your ass in alligators, it is hard to think about draining the swamp.” Geithner had other things to do at that moment than settle scores.

I write now from the perspective of one wearing both regulatory and white-collar criminology “hats.” When the industry has become an alligator-filled swamp draining that swamp is precisely what you need to do. The swamp is the “criminogenic environment” that creates perverse incentives that produce the alligators (control frauds) and gives them cover so that they can attack with impunity. You need to drain the swamp and you need to simultaneously target the biggest, “baddest” alligator. You tan his hide on the side of your shed and show that no alligator is too big to flail. Bo will not hold any financial elite accountable. He treats accountability – which is essential if we are to reduce the risk of future crises – as a shameful practice: “settling scores.” Is it any wonder that while we obtained felony convictions in over 1000 “priority” cases during the S&L debacle there has yet to be a single indictment of a senior manager of a large nonprime lender?

The sixth set of questions has to do with loss reserves. The banks’ loss reserves were unlawfully low in order to inflate income and the senior officers’ bonuses. The banks’ loss reserves were obscenely inadequate – often a small percentage of the actual losses. Instead of demanding that the banks add adequate loss reserves, Geithner and Bernanke acquiesced to legalized accounting fraud. They stood by while the industry extorted Congress and Congress extorted the accounting profession to reprise the disastrous Reagan era policy of covering up a financial crisis through accounting scams. The Fed, however, can use its supervisory powers to mandate adequate loss reserves regardless of whether the newly neutered GAAP requires adequate reserves. Geithner and Bernanke are refusing to use their supervisory powers to require banks to recognize their losses. Without honest accounting for losses virtually all supervisory powers are crippled.

If Geithner and Bernanke (or Greenspan) had acted as minimally competent regulators in response to the FBI’s September 2004 warnings the epidemic of accounting control fraud could have been contained and an acute financial crisis prevented. As late as 2006, they could have prevented over a trillion dollars in losses had they been effective regulators.

Geithner’s Self-fulfilling Prophecy of Regulatory Failure

The questions above arise from Bo’s indictment of the finance industry and implicit admissions as to Geithner’s and Bernanke’s recurrent failures. This essay concludes by asking the broader question of why Geithner failed so badly as a regulator. Geithner does not understand, or value, regulation or white-collar crime prosecutions. Consider three aspects of this that draw on his statements. First, he admits (see here and here) that he has never regulated even though one of his primary duties was to lead the examination and supervision of many of our nation’s largest bank holding companies.

Tim Geithner: I would just want to correct one thing. I’ve never been a regulator….

Second, he testified, in response to a question from Representative Ron Paul in 2009, that excessive regulation was among the fundamental problems leading to the crisis was:

Tim Geithner: We have parts of our system, which are overwhelmed by regulations. Overwhelmed by regulations. It wasn’t the absence of regulations that was the problem, it was despite the presence of regulations, and you have huge risk built up.

Third, he believes that regulators are helpless in the face of an inflating asset bubble. On March 6, 2008, Geithner offered this explanation for his failure to take any regulatory action against the housing bubble and the nonprime lending crisis: “I don’t believe that asset price and credit booms are preventable.” There is nothing as debilitating as believing that one is helpless. Geithner and Greenspan believed that they were helpless as regulators, which created a self-fulfilling prophecy of failure.

Fourth, Geithner’s testimony in response to Ron Paul’s questions indicates that he believes that, absent deposit insurance, there is no risk of “moral hazard” and no strong basis for regulation.

Because they’re vulnerable to runs, governments around the world have put in place insurance protections to protect the inside risks.

Because of the existence of those protections, you have to impose standards on them on leverage to protect against the moral hazard created by the insurance. That is a good economic case for regulation –

This is good theoclassical economics, which is to say it is devastatingly bad economics that has been repeatedly falsified by reality and by white-collar criminological research. Geithner has been taught that “private market discipline” prevents fraud absent government “interference” in the markets (e.g., deposit insurance) that removes the incentive of creditors to exercise discipline against fraud. It follows that financial derivatives pose no meaningful fraud risk and financial markets will be “efficient.” The problem is that accounting control fraud does not simply defeat private market discipline – it renders it perverse and creates a “Gresham’s dynamic” in which dishonest corporate officers and firms that cheat gain a competitive advantage and may drive honest actors from the marketplace. Enron, WorldCom, and the 80% of the nonprime specialty lenders that were unregulated have repeatedly shown that accounting control fraud can become endemic in industries that do not have government guarantees. Greenspan shared Geithner’s failure to understand how accounting control frauds work and why anti-regulation effectively decriminalizes the fraud and turns it into virtually a perfect crime.

Bo seeks to make light of Geithner’s critics by joking that we’re upset at Geithner’s being short of height. Our concern is that he is short of integrity, independence from Wall Street, and ability. Geithner knew that he had unlawfully failed to pay taxes. He also knew he could get away with not paying many of those taxes because the statute of limitations had run. The context of his moral challenge was an IRS audit in 2006 while he was President of the FRBNY. That is one of the most prestigious and senior regulatory positions in the world. Geithner had been highly compensated while working for the International Monetary Fund (IMF), which is where he failed to pay a substantial (but small relative to his wealth) amount of taxes. His compensation as FRBNY President (roughly $400,000 by 2007) placed him in the upper tiers of income. He was probably the most highly compensated regulator in the world. He chose not to pay the taxes he owed that were past the statute of limitations because he could get away with it. That’s the perfect circumstance to judge a person’s core integrity. He was already wealthy and could have paid the taxes without any meaningful sacrifice. He did not need the money to educate his kids or pay for their health care. He was simply greedy and willing to cheat if he could do so with impunity.

Geithner did not act as FRBNY President to protect the public. He wasn’t heroic, competent, or even honest. If Bo is correct and Geithner and Bernanke represent the very best of the leaders of the finance industry, then the inevitable conclusion is that we need to remove not only Geithner and Bernanke, but also clean the entire Stygian Stables that is Wall Street. That task is so large as to be a modern labor of Hercules.

Geithner as Martyr to an Ungrateful Nation: Bo Cutter’s Tragicomic Portrayal of Tim as Our “Man for all Seasons”

By William K. Black

This is the second installment in my comments on Bo Cutter’s essay defending Treasury Secretary Geithner.
Bo was a managing partner of Warburg Pincus, a major global private equity firm and led President Obama’s Office of Management and Budget (OMB) transition team. He was Bob Rubin’s deputy at the National Economic Council. The first installment discussed Bo’s extraordinary indictment of the finance industry.

Bo views Geithner as a martyr subjected to unfounded, ungrateful attacks for his actions that prevented the Second Great Depression. Bo doesn’t have much use for Americans that are upset with the senior managers of the finance industry. (This is a bit weird because Bo denounces these senior managers as universally incompetent, cowardly, and unethical.)

[L]iberals hate [Geithner] because he did not take over or dismember the banks, and publicly execute their senior managements.

This passage tells us nothing about liberals, but much about Bo and his peers’ fears of the public. The finance leaders know they are guilty of destroying much of the global economy – while growing extraordinarily wealthy in the process. They know that their primary means of destruction was accounting “control fraud.” They cannot understand why the public has not turned on the finance industry and demanded that the fraudulent financial leaders be prosecuted and their immense gains from fraud recovered. They also cannot understand why we allow the continued existence of systemically dangerous institutions (SDIs). Geithner, Paulson, and Bernanke have warned that the failure of any SDI could cause a global crisis. Under their logic, SDIs are ticking time bombs that will cause recurrent global crises. Geithner, like Paulson, is making the SDIs much larger and much more dangerous by using them to acquire other large, failed financial institutions. This policy is insane. Virtually no one (that isn’t on their payroll) supports the continued existence of SDIs and no one publicly argues they should be made even larger – but that is our policy. Bo is the authentic voice of giant finance: the idea of shrinking the giant banks to this community is so painful, so personal that it is equivalent to “dismemberment.” (It also shows that the giant finance is predisposed to view itself and its allies as tragic martyrs.)

Bo is only getting started with Geithner’s martyrdom and the ingratitude of the murderous mob to this modern martyr.

And no one thinks he is tall enough. If you read the accounts of Secretary Geithner’s hearings last week, you know this is all classic Washington behavior. If there is one thing at which the glibocracy in DC excels, it is coming out of the hills after the battle is over and shooting the wounded. This is Washington today, a system in total gridlock, in which counting coup is the central activity.

So, Geithner is picked on by nearly everyone, not given any respect because he is short, and now that he is wounded the D.C. denizens are out to shoot him. Despite our scorn, Geithner continues to step into the breach on our behalf. Bo was a senior federal official in crises and found his peers to be cowards: “the crowd of people willing to join you in taking responsibility gets smaller by the second.”

This is why he is so impressed by Geithner:

Then, beginning with his assumption of the Treasury job in November — long before he was confirmed, so he was clearly going to be beaten up on every action he took, but he went ahead and took them – he was at the lead of every major decision made in the recovery effort. (During this presidential transition period, it would have been easy to keep away from the decisions by saying that power was still in the hands of President Bush. But the Bush Administration by that point was completely spent. Someone had to step up and Tim Geithner did.)

Unlike Bo’s cowardly heroes, Geithner is a hero – repeatedly taking the lead in responding to the crises even when he knew that if he did so “he was clearly going to be beaten up on every action he took.” Geithner was abused for using stress tests.

His use of stress tests, which was roundly laughed at by everyone, worked,helping enormously to make much more transparent and less scary the situations all of the major banks were in.

The purported stress tests [see here, here, and here] did make banking seem “less scary” because they were not real and were part of the Geithner/Summers/Bernanke coverup strategy. The SDIs demanded that the accounting rules on loss recognition be junked – and the trio acceded to that travesty. Bo tells us why the SDIs demanded that they be able to hide their massive losses when he explains why he supports the Bush/Obama administration bailouts of AIG’s counterparties: “most of the banks had either insufficient or no capital.” To put it more bluntly, most of them were insolvent and the remainder had so little capital that they posed intense, global systemic risk. The Bush and Obama administration have followed a three-part strategy towards these insolvent and crippled SDIs: (1) cover up the losses through (legalized) accounting fraud, (2) launch an “everything is great” propaganda campaign (the faux stress tests were key to this tactic), and (3) provide a host of secret taxpayer subsidies to the SDIs. This strategy is the opposite of making banks “much more transparent.” The strategy is not shaped by finance, but by politics. Both administrations have sought to keep the American people from knowing about these cover-ups and secret subsidies because they know that we would not tolerate either policy. The cover-ups and secret subsidies are not simply awful financial policies; they are also a betrayal of democracy. When Bernanke writes that the sky will fall if the Fed is subject to audit it is precisely because he knows that the Fed’s policies cannot withstand scrutiny by anyone serving the interests of the citizens (as opposed to the interests of the SDIs). (John 3:20 “For every one that doeth evil hateth the light.”)

Bernanke may believe that when he acts in the interests of the SDIs he is acting in our interests. Charlie Wilson (GM President and President Eisenhower’s nominee as Secretary of Defense): “I thought that what was good for our country was good for GM, and vice versa.” But that’s the point; the Fed and so many of its senior officials such as Bernanke and Geithner are dangerous because the institution identifies too completely with the SDIs. Like Bo, they also see us as murderous populists that cannot be trusted to make democratic decisions about SDIs. Calling Geithner’s and Bernanke’s cover-ups and secret subsidies “transparency” is Orwellian. The best one can say is that Paulson, Geithner, and Bernanke decided (undemocratically) that it had become necessary to destroy capitalism and democracy in order to save them.

Bo’s final claim in support of his martyrdom motif is:

Tim Geithner acted. He acted at the moment action was required … with the fullknowledge that he would face exactly what he is now facing.

Get off his back.

Luckily, I like Star Trek so I have experience puzzling through time paradoxes similar to the one Bo presents here. Geithner had “full knowledge … that he would face exactly what he is now facing.” What he’s facing is calls for him to resign his position as Treasury Secretary. He became Treasury Secretary in 2009. Bo, however, emphasizes:

Starting from late 2007, as the crisis began to unfold, Geithner was at the spear point of every issue and, along with Bernanke, was a creative policy maker who clearly saw the immense dangers we faced and stretched all of the powers of the Federal Reserve Board to find solutions no one else could.

So, Geithner acted “from late 2007” with “full knowledge” that his actions would be so unpopular that it would destroy his career and that he “would face exactly what he is now facing” (calls for him to resign as Treasury Secretary). Geithner’s career went ballistic after “late 2007.” In 2009, President Obama appointed him Treasury Secretary and has moved to reappoint Bernanke as Fed Chairman. Those are the two most prestigious financial positions in the world. Exactly which aspect of being promoted to his dream job made Geithner a martyr? Where can we sign up for similar martyrdom? Tevye’s response to Perchik’s claim that “money is the world’s curse” applies to Bo’s claim that Bernanke’s promotion makes him a martyr.

May the Lord smite me with it. And may I never recover. [Fiddler on the Roof.]

All time paradoxes are, of course, paradoxical and Bo’s doesn’t disappoint. How exactly did Geithner know in “late 2007” that (1) Obama would be elected President, (2) would appoint Geithner as his Treasury Secretary, and (3) that he would face calls in 2009 to resign as Treasury Secretary?

Why Praise Faux Martyrs When Ed Gray is Available?

If Bo wants to praise a real regulatory martyr – one who got the finance and regulatory issues correct early enough to prevent an economic crisis, reregulated successfully in the face of virulent, powerful opposition, and who did so despite knowing that it would destroy his career at a point where he was in financial distress the obvious candidate is Ed Gray. As Paul Volcker wrote about Ed Gray in a post-publication blurb for my book, The Best Way to Rob a Bank is to Own One (2005 University of Texas Press):

Bill Black has detailed an alarming story about financial and political corruption….the lessons are as fresh as the morning newspaper. One of those lessons really sticks out: one brave man with a conscience could stand up for us all.

Paul Volcker was Ed Gray’s only pillar of support for his reregulation of the S&L industry. When Gray became Federal Home Loan Bank Board Chairman in 1983 the S&L industry was coming out of the first (interest rate risk) phase of the debacle but descending into an even more severe second phase of accounting control fraud. The National Commission on Financial Institution Reform, Recovery and Enforcement’s 1993 report on the causes of the debacle explained the characteristic failure pattern:

The typical large failure was a stockholder-owned, state-chartered institution in Texas or California where regulation and supervision were most lax…. [It] had grown at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used to make the institution look profitable, safe, and solvent. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization through high dividends and salaries, bonuses, perks and other means (NCFIRRE 1993: 3-4).

In 1983, the S&L accounting control frauds grew at an average rate of 50%. The Texas state S&L Commissioner was sleeping with prostitutes provided by the second worst control fraud in the nation – Vernon Savings (known as “Vermin” to its federal regulators). The California state commissioner, according to the documents, was secretly in business with the worst control fraud in the nation – Charles Keating’s Lincoln Savings. Texas and California approved over 300 new S&L charters. Most of them were troubled real estate developers with severe conflicts of interest. Many of them were control frauds. The rate of applications for new charters was expanding.

Gray’s predecessor, Richard Pratt (a theoclassical finance professor) led the deregulation of the industry at a time of mass insolvency. He also largely desupervised the industry. He gimmicked the accounting rules to cover up losses and create fictional income. He cut the number of examiners. There were no criminal referrals or prosecutions of senior S&L officials. The industry was completely out of control. A regional bubble in commercial real estate was already growing in 1983.

Gray reregulated and re-supervised the industry. He ended most regulatory accounting abuses. He doubled the number of examiners and supervisors (over the vigorous objection of OPM and OMB). We began targeting the worst control frauds for closure while they were still reporting record profits and minimal losses. We adopted a rule restricting growth aimed at the Achilles’ heel of every Ponzi scheme – the need to grow massively. Gray brought in experienced regulators with a track record of vigor, courage, and professionalism and put them in place in the Dallas (Joe Selby) and San Francisco (Mike Patriarca) because they were the two worst regions. We deliberately burst the Southwest’s commercial real estate bubble.

Gray put in place a system of criminal referrals and made supporting criminal prosecutions a top priority. The agency (and here great credit must also be given to OTS Director Ryan and the Department of Justice and FBI) effort was so successful that over 1000 “priority” felony convictions of senior S&Ls insiders were obtained – the most successful effort in history against elite white-collar criminals.

We almost always resolved serious failures in a manner that wiped out entirely “risk capital” (shareholders and subordinated debt holders). Gray blocked Texas’ and California’s land rush style grants of hundreds of new charters by refusing to approve FSLIC insurance for any new S&Ls in those states. Gray did all this with the certain knowledge (which he often stated to us) that it would end his career. He was in his 50s and he was in financial distress, so he knew the sacrifice he would make would be severe.

Gray took on, simultaneously, the Reagan administration (particularly Don Regan and the OMB), a majority of the members of the House (who co-sponsored a resolution calling on us not to reregulate), House Speaker Jim Wright, five U.S. Senators (the “Keating Five”), the S&L trade association (which some political scientists rated the third most powerful in the U.S., his two fellow Bank Board members, much of the agency (including two of our economists that met secretly with Keating’s lawyers), and most of the media (which sometimes referred to him as “Mr. Ed” – from the TV program about the talking horse). Charles Keating sued him in his personal capacity for $400 million. The administration threatened to prosecute him for closing too many insolvent S&Ls (under the Anti-Deficiency Act). The administration tried to appoint two members chosen by Charles Keating (the most notorious S&L control fraud) to the agency (which would have given them majority control of the three-person Bank Board). (Pause for two minutes and consider how catastrophic it would have been if the administration had succeeded in giving control of the agency to that decade’s most notorious control fraud.) He served as a “mole” for Keating and proposed to amend the direct investment rule (which Lincoln Savings had violated by more than $600 million) that would have had the effect of exempting it from enforcement. Lincoln’s lawyers drafted the amendment (which, of course, never mentioned Lincoln). I blew the whistle on Keating’s mole, which eventually led him to resign. After I blew the whistle (but before he resigned), the administration nominated him for a full term. The day after he resigned four U.S. Senators (the “Keating Five” minus Senator Riegle) met with Gray to pressure him not to take enforcement action against Lincoln’s massive violation of the direct investment rule.

Don Regan tried very hard to force Gray to resign. He refused, so Treasury Secretary Baker met secretly with Speaker Wright (who, at the behest of Texas control frauds, was holding our proposed bill to recapitalize the FSLIC insurance fund hostage in order to prevent us from securing the funds to close more of the control frauds). Baker and Wright reached a cynical deal: the administration would not reappoint Gray to a new term and would not oppose Wright’s demands for “regulatory forbearance” (which included debasing – again – the accounting rules and adopting other measures drafted by attorneys for the control frauds designed to make it far harder to close insolvent S&Ls. Wright agreed that he would support a $15 billion FSLIC recapitalization bill (instead of the $5 billion bill that the industry and control frauds supported. Wright got the better of the deal because his allies spread the word that the Speaker didn’t really support the $15 billion bill and the House voted for the $5 billion bill.

Gray remains unemployed and unemployable today. But he doesn’t have to avoid mirrors.

Unlike Geithner, Paulson, and Bernanke, Gray acted before the epidemic of accounting control fraud produced a bubble so large that it produced a general economic crisis. Consider what would have happened had Gray not reregulated and resupervised the industry beginning in November 1983. The roughly 300 control frauds in 1984 would have grown at 50% annually and scores of new Texas and California frauds would have entered each year. The result would have been a commercial real estate bubble of epic proportions. Such a bubble would have taken down not only the S&L industry, but also the banking industry (which had massive commercial real estate exposure) and would have severely damaged the insurance industry (which provides much of the permanent/takeout financing for commercial real estate). We cannot yet demonstrate when a bubble will collapse, but we know that accounting control fraud epidemics are capable of extending the life of financial bubbles and hyper-inflating them for several years. The direct losses among S&Ls, absent Gray’s reregulation, would have been over a trillion dollars within five years. The losses to banks and insurance companies would have exceeded the S&L losses. Losses of that magnitude would have caused a severe recession.

It also needs to be stressed that subprime and alt-a loans, qualifying loans based on teaser rates, bonuses to loan officers based on volume (not loan quality), inflated appraisals, and accounting control fraud are not new. They always end badly. Mike Patriarca lead the supervisory effort in 1990-92 that prevented a nonprime lending crisis by forbidding lending practices that we have long known end in disaster. He then left federal service and went into business.

You might think that the first two calls Geithner, Paulson, Summers, Rubin, and Bernanke would have made once they finally realized there was a crisis would have been to Ed Gray and Mike Patriarca to see how successful reregulation is accomplished and how one successfully prosecutes the accounting control frauds that drove the current crisis. But, if you think that you probably also think that the one regulator that stood openly in support of Gray’s reregulation of the industry – Paul Volcker – would be President Obama’s primary economic advisor. Instead, Summers, Geithner, and Bernanke have marginalized Volcker. The Bush and Clinton anti-regulatory Wrecking Crews remain in power in the Obama administration despite a dismal record. They are never held accountable. Bo wants them left in power. He wants us to stop criticizing their failures, to apologize to them for our ingratitude, and to honor them for the terrible career sacrifices they have (mythically) made to protect us from harm.

I disagree. I urge us to learn the lessons not simply of regulatory failures but regulatory and prosecutorial successes (the Gray and Ryan years). Mike Patriarca is in his prime. Put him in charge of a major regulatory agency immediately. Paul Volcker is a national treasure that petty, power-hungry failures (yes, I mean Summers) are wasting.

Oh, and Jim Baker, Jim Wright, and John McCain should show some class and apologize for the shoddy treatment they handed out. Let me be clear on this last point – they shouldn’t apologize for the shoddy treatment of Ed Gray the man – they should apologize for the damage they caused our nation when they took their policy advice from major political contributors (that were leading control frauds) and impeded Gray’s substantive reforms that were essential to protecting our citizens.

Bo Cutter’s Indictment of the Finance Industry

By William K. Black

Bo Cutter has presented the best possible defense of Treasury Secretary Geithner.

It is a remarkable defense because it is premised on a scathing indictment of Wall Street, theoclassical economics, modern finance, and the sycophants that the financial community installed as anti-regulators. Indeed, Bo’s account is sometimes particularly credible because it is a confession. Bo was a managing partner of Warburg Pincus, a major global private equity firm and led President Obama’s Office of Management and Budget (OMB) transition team. His defense of Geithner provides so rich a vein of ore that I will mine it in three installments: (1) Bo’s indictment of the finance industry, Greenspan, Geithner, Paulson and Bernanke, (2) the martyrdom of Geithner, and (3) Geithner as Bo’s Last Action Hero.

Bo’s explanation of Geithner’s unique virtues begins the indictment.

It comes down to this: the combination of brains, guts, calmness, and a willingness to act are virtually non-existent in Washington in any era, but particularly in this one. When you find the combination in a significant cabinet level job, you should value it.

“Virtually non-existent … particularly in this [era].” This phrase comes from the head of President Obama’s OMB transition team. Bo, an Obama Democrat, believes that Geithner represents the epitome of Obama appointees. President Obama’s other appointees are far worse than Geithner. That is an extraordinary indictment of the administration.

Bo’s indictment then expands to the financial community:

[T]his crisis was long in coming and it was a totally integrated failure of intellectual traditions, global macro-economic imbalances, government policy making, regulatory supervision, financial sector greed, incomprehensible boards of directors absences without leave, and breath-taking management short-sightedness. No one and no institution put together an understanding of the set of factors that triggered this particular debacle. Tim [Geithner] is included in this “no one”, but so is everyone else.

I think the last two years have revealed the single largest failure of senior management in the financial sector, and of the board system in American history. I think I am correct in saying that there was not a single independent director in America who stood up on this issue. I do not understand why every board of every institution that failed was not asked to resign immediately.

Bo’s indictment is compelling, but his logic proves a deeper failure. There is no reason to restrict his indictment to “the last two years.” The senior managers’ and directors’ failure did not begin with the recession. They failed throughout the expansion of the bubble, the backdating of stock options, after-hours trading, the collapse of the auction rate securities market, the “epidemic” of mortgage fraud by lenders, the massive scandals of the Enron and Worldcom era, and the savings and loan debacle. The financial sector has been in recurrent, intensifying scandals for decades.

Bo’s arguments require us to focus on at least the last four years (even if he continues to ignore the FBI’s 1984 warning that the mortgage fraud “epidemic” would cause a crisis).

In fact, by 2006 and early 2007 everyone thought we were headed to a cliff, but no one knew when or what the triggering mechanism would be. The capital market experts I was listening to all thought the banks were going crazy, and that the terms of major loans being offered by the banks were nuttiness of epic proportions.

By early 2006 – roughly four years ago – “everyone” agreed “we were headed to a cliff” and that the banks’ “major loans” were “nuttiness of epic proportions.” An industry, whose claimed expertise is the sophisticated evaluation of risk and value, universally failed to come remotely close to valuing either. As Bo emphasizes, these were massive errors. These managers got immensely wealthy because – not despite – their willingness to make hundreds of thousands of loans that were certain to crash and burn as soon as the bubble ceased to inflate (which it did in 2006). Bo knows them, and Bo says that every independent (sic) director betrayed their fiduciary duties to shareholders. Every senior officer at the major banks failed. Bo portrays them as incompetents, cowards, and moral failures.

Bo’s indictment of his finance peers is even more severe than his portrayal. White-collar criminologists have shown that the lending pattern he describes (“nuttiness of epic proportions” when “everyone” agrees “we were headed to a cliff”) demonstrates that the lenders are frauds that have produced an epidemic of accounting “control fraud” (where the persons controlling a seemingly legitimate organization use it as a “weapon”). The FBI began publicly warning of an “epidemic” of mortgage fraud in September 2004, with 80% of the losses occurring when lender personnel were involved in the fraud. The number of criminal referrals for mortgage fraud indicates an annual rate of mortgage fraud in the many hundreds of thousands. The recipe for a lender optimizing accounting control fraud is: (A) grow extremely rapidly, (B) make extremely bad loans, (C) have extreme leverage, and (D) provide minimal loss reserves. (The first two ingredients are related. In a mature product like home mortgages the optimal way to grow extremely rapidly while increasing yield is to make loans to individuals that cannot repay the loans. The rapidly expanding bubble allows fraudulent lenders to postpone loss recognition by refinancing the bad loans.) Nonprime specialty lenders followed this recipe. The pattern produces guaranteed, record accounting profits in the short-term. Because a significant number of lenders follow the same strategy the result was a hyper-inflated financial bubble followed by an economic crisis.

The accounting fraud optimization pattern that a lender follows, however, creates two weaknesses that we exploited as S&L regulators during the debacle. The lender must gut its loan underwriting standards and suborn its internal controls. Secured lenders must encourage inflated appraisals. Officers must be disciplined for rejecting bad loans and given bonuses for making bad loans. No honest lender would follow such suicidal practices. Bank examiners can easily, quickly, and precisely identify these perversions of honest, normal underwriting practices. We made closing such lenders our top priority – while they were still reporting record profits and minimal losses. The Best Way to Rob a Bank is to Own One (University of Texas Press 2005). The economists and lawyers thought that this proved we were insane because they were clueless about accounting fraud. The second weakness is that optimizing accounting fraud requires extremely rapid growth. This provided a quick screening device for identifying likely frauds and a means to force their rapid collapse – by restricting their growth. Regulators could have targeted these same weaknesses and contained the ongoing crisis. Instead, despite the FBI’s early warnings about the fraud epidemic, they functioned as anti-regulators. The FBI has put the matter starkly: it is “irresponsible” to purport to explain the crisis without discussing fraud.

Update: See Prof. Black’s selected posts here, here, and here.