The most disturbing thing about Barack Obama's call for financial reform
was the way in which the president falsified our predicament. He tried
to make it sound as though everyone was implicated in the financial
breakdown and therefore no one was really to blame. "A culture of
irresponsibility took root from Wall Street to Washington to Main
Street," Obama explained. "And a regulatory system basically crafted in
the wake of a 20th century economic crisis--the Great Depression--was
overwhelmed by the speed, scope and sophistication of a 21st century
That is not what happened, to put it charitably. Unlike some other presidents, Obama is much too intelligent not to know this. The regulatory system was not overwhelmed by historic forces. It was systematically gutted and dismantled by the government in Washington at the behest of the banking interests. If Obama wants details, he can consult his economic advisors--Summers-Geithner--who participated directly as accomplices in unwinding the prudential rules and regulations. Cheers were led by the Federal Reserve with heavy lifting by both political parties.
The president's benign version of events reminds me of what compliant politicians and opinion leaders said after the war in Iraq they had endorsed turned disastrous. "Hey, we were all fooled." If Obama were to tell the truth now about what went wrong in the financial system, he would face a far larger political problem trying to clean up the mess. Instead, he has opted for smooth talk and some fuzzy reforms that effectively evade the nasty complexities of our situation. He might get away with this in the short run. Congress doesn't much want to face the music either. But Obama's so-called reform is literally "kicking the can down the road," as he likes to say about other problems. In the long run, it will haunt the country because it fails to confront the true nature of the disorders.
Giving more power to the Federal Reserve to be the uber-regulator of banking and finance is a terrible idea (I examine the dangers in a forthcoming Nation article). Asking the cloistered central bank to resolve all the explosive questions about the over-reaching power of financial institutions is like throwing the problem into a black box and closing the lid, so people will be unable to see what happens next. That is the idea, after all, the reason Wall Street's leading firms first proposed the Fed as super-cop, then sold it to George W. Bush and now Barack Obama. Give the mess to the Wizard of Oz, the guy behind the curtain. He can do miracles with money, but don't watch too closely. This constitutes the high politics of evasion.
Still, I am thrilled to observe a nascent rebellion gathering strength in Congress. Some 230 House members have endorsed a measure to force GAO auditing of the Fed--a small but vital step toward dismantling the central bank's privileged secrecy and intimidating mystique. Even House Speaker Nancy Pelosi expressed concern (and gave a nice plug for my 1987 book about the Fed). "The fact is that the American people want to know more of the Secrets of the Temple," she said. If they do learn more, I guarantee shock and awe will grow into outrage.
Outrage is good. As someone who has been around this subject for three decades, I came to understand that the power of financial titans and their friends at the Fed depends crucially on public ignorance. Most elected representatives and senators are just as clueless as their constituents. This is not entirely their fault. The system is designed to encourage deference to murky power. In our present crisis, people and politicians are naturally bewildered by the complexities. If they knew more about how the system works, they might be able to see that most of Obama's reforms are insubstantial gestures, not actual remedies.
The president, for instance, proposes to raise the requirements for capital and liquidity held by commercial banks with strict limits on leverage--their ability to borrow. That is a virtuous proposal, but it begs the question. Why did the legal limits already in place fail to restrain the appetites of bankers? Indeed, several times in the last two decades the Fed and other central banks enacted new and supposedly more effective capital requirements to curb the excesses. The big dogs of banking broke free of the leash again and again while vigilant watchdogs at the Fed and elsewhere looked the other way. Why should we expect different results next time?
One reason why old restraints failed is the so-called "modernization" that shifted the credit functions outside regulated banks and into a variety of unregulated money pots--the so-called shadow banking system of hedge funds and private-equity firms. These all interact intimately with traditional banks and give the banks profitable ways to evade the old rules or conceal the actual condition of their balance sheets from both regulators and innocent investors. This interactions are dazzlingly complex--too complex for even the bankers themselves to fully understand--but this was not an accident of nature. It was the goal of financial deregulation enacted by Bill Clinton, arm-in-arm with the Republican Congress.
Likewise, banks were allowed to play these games by legislative creation of "off-balance sheet entities" where they can park their holdings--debts or assets--beyond the view of casual observers. This is essentially the same accounting trick that empowered Enron and other corporations to hide their true condition (then collapse). The biggest bankers played roughly the same game. In fact, it was the bankers who taught Enron and others these tricks. What public purpose is served by these devices except to conceal reality from public investors? For that matter, what is the public purpose of letting corporations, banks and wealthy individuals park their wealth in the Grand Cayman Islands? Everyone in Wall Street knows the answer. It allows them to evade "legally" US regulations and tax law.
Summers-Geithner suggest the shadowy banks like GE Capital or major insurance companies can be regulated by the Fed as "Tier 1 Financial Holding Companies." No real details available. As Joe Nocera recently noted in the New York Times, "Tier 1" sounds like the new name for "Too Big to Fail." The Fed will watch them (we are assured) to prevent "systemic risk" that could lead to national breakdown. But that is what the Federal Reserve was supposed be doing already as the "lender of last resort" charged with defending the "safety and soundness" the banking system. The Securities and Exchange Commission, likewise, is supposed to monitor hedge funds and private-equity firms that thrive on secrecy. Since the SEC failed miserably to police regular corporations, it does not sound reassuring.
Another example of extremely wishful thinking is the proposed rule on securitization of mortgages. The method of bundling home mortgages and turning them into saleable bonds was supposed to reduce risk but did the opposite. The mortgage lenders were able to execute dubious, even fraudulent loans, collect their profits up front and then sell the package to unwitting investors around the world. Obama's answer is to require the originating lender to retain a 5 percent interest in the mortgage and pass on the rest. That seems ludicrous and innocent of how that cutthroat world actually works. The financial geniuses who created the subprime mortgage scandal could hide 5 percent of the mortgage value with a couple of keystrokes--adding fees, closing costs or other dodges. To hold lenders genuinely responsible, they should be made to hold onto something like 50 percent of liability for the original loan with perhaps the other 50 percent assigned to whatever bank or investment house packages the mortgage security and sells it to financial markets. That would be "responsibility" with old-fashioned force.
The one great bright spot in Obama's plan is the new regulatory agency he recommends to protect consumers on financial products. This was inspired by Elizabeth Warren, the Harvard professor who has been a brave and brilliant critic of the credit-card industry and other forms of predatory rip-offs. While it depends entirely on the details, this innovative agency could become the new tiger among tired, toothless regulators--especially if Obama has the courage to name Warren as the inaugural chair. The bankers hate this idea and will fight to kill it. They know this regulator will not be captive to them, at least not yet.
The essence of what's missing in the Obama plan is the presence of hard rules--the classic quality of laws that command private behavior by prescribing "thou shalt" or 'thou shalt not." Drawing up concrete prohibitions and commandments is obviously a tougher challenge because it requires deeper understanding of the dysfunctional qualities in the financial system. You cannot design organic reforms until you understand what really led to the breakdown. Since the government has avoided that kind of serious examination, the limp response is to turn these explosive issues over to expert regulators--the same experts who failed to see the trouble coming.
Right now, I think the political imperative is to slow down the rush to weak solutions. The political leaders understandably want to do something swiftly and get the subject off the table, but Congress would do well to drag its feet and insist instead on deeper investigations. (Rep. John Dingell and others have proposed establishing a Pecora-like commission to investigate the crisis.)
Give subpoena power to Elizabeth Warren the Congressional Oversight Board she chairs. Hire some of those investigative reporters who have no political investment in digging deeper into the mulch. What exactly went wrong? Who has bloody hands? Where are the fundamental reforms? If the economy returns to "normal' rather soon, the ardor for serious reform might dissipate with much left undone. That is a small risk to take, especially if the alternative is enacting the bankers' pallid version of reform.