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Who is Going to Watch the Financial Watchmen?

Edward Luce of the Financial Times, and Time Magazine Newsweek both have articles on the same story: liberal economists against the bail outs. Evan Thomas (in Newsweek) summarizes Krugman with this paragraph:

In his twice-a-week column and his blog, Conscience of a Liberal, he criticizes the Obama for trying to prop up a financial system that he regards as essentially a dead man walking. In conversation, he portrays Treasury Secretary Tim Geithner and other top officials as, in effect, tools of Wall Street (a ridiculous charge, say Geithner defenders). These men and women have "no venality," Krugman hastened to say in an interview with NEWSWEEK. But they are suffering from "osmosis," from simply spending too much time around investment bankers and the like. In his Times column the day Geithner announced the details of the administration’s bank-rescue plan, Krugman described his "despair" that Obama "has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they’re doing. It’s as if the president were determined to confirm the growing perception that he and his economic team are out of touch, that their economic vision is clouded by excessively close ties to Wall Street."

This touches on the populist anger which Time Magazine sees in the coming G-20 protests. But who is really in revolt? The press is portraying this the wrong way. What we are seeing globally is not a walk out of popular support against the system, but a lock out by the bankers from the system. Just like owners in the National Football League, the owners of the banking system see a stoppage of play as a problem that they can manage.

The reason for the unease about Krugman, Stiglitz, Sachs, Roubini, and others, goes deeper than "they might be right." It is farther than the fears about their rhetoric that Luce encapsulates:

Paul Krugman describes the toxic asset purchase plan as “cash for trash”. Jeffrey Sachs calls it “a thinly veiled attempt to transfer hundreds of billions of US taxpayer funds to the commercial banks”. Robert Reich depicts Tim Geithner, Treasury secretary, as a prisoner of Wall Street while Joe Stiglitz says the plan “amounts to robbery of the American people”.

Instead, the real fear is that it will change the terms of the debate, the famous "Overton Window." Right now, the political debate is between a cohesive and entrenched Republican bloc in the Senate, with Obama having to buy enough votes in no man’s land to get anything passed. And these votes have been expensive, with a few votes costing billions on the stimulus bill, and holding up Obama’s entire "down payment" approach to changing the US government’s spending priorities. As long as the debate is between subsidies à la Summers and massive tax cuts à la Barro the financial sector is not in any real position of concern. For them, mild regulation now, coupled with virtually unlimited free money, means merely having to wait out Obama.

The play we saw in the last two weeks from Geithner was to offer a truce and trade: the government would, in essence, bear all future risks in the fall of legacy assets, and loan the money for their purchase; in return the financial sector would accept greater regulation and an on going government stake in the financial system. The stock market rallied almost 21%, and Obama’s popularity, under pressure with the withering of the Dow, recovered. However, the financial world turned its nose up at the offer, and instead offers acceptance only of enough regulation to protect the bankers and the banks in future. Tax havens have growled that they will prevent any regime that would bring them under outside scrutiny of the estimated $7.3 trillion beyond the most cursory searches for tax cheats of the most obvious kind. They fear for their existence.

To understand what is really happening, it is useful to contrast this past generation with the generation before it. The era of modern liberalism was based on a straight forward reality: the need for mass mobilization to act as a bulwark against expanding communism from the Soviet Union. However bad a deal that big business might get from the AFL-CIO, or even the IRS, it would get a worse one from the USSR and KGB. If there had to be an alphabet soup, it was much better that it not be in Cyrillic. The Thatcher-Reagan moment represented a point where the demands of labor for higher wages, and the demands of capital for higher returns collided head on, and capital won, hands down. Since then almost all expansion in the developed economies has gone to capital and its profits.

This era has been the reverse: with banks and other forms of financial activity having the power to demand a greater and greater share of national wealth, and being the centerpiece of a bi-partisan agreement that the strength of the financial sector is the primary pillar of economic strength. America needed this as well for its military strength, since it was from the rest of the world that the US could borrow for military expansion through massive deficit spending that well outstripped both growth and inflation. The push against regulation is, then, this era’s version of wage-push inflation, the unacknowledged problem with basic policy. Banks had to get larger to stay in US hands rather than being bought up by foreign investors, and now we see that they also had to stay in the hands of a small globalized elite which would seek global returns, rather than reinvesting in US manufacturing and development. Americans were offered the ability to forget about the big picture, and not have to worry about learning Arabic.

However, if it were just the matter of a few economists declaring that it is wrong for the US to buy assets at dollars on the penny, it would not cause so much concern. The other reality is that the rest of the world as well wants greater regulation, and not merely to protect bankers, but their own dollar holdings. As Bloomberg’s Simon Kennedy, Matthew Benjamin, and John Rega report, there is a global convergence on the need for regulation, including hedge funds, private equity, and other elements of the "shadow banking system:"

“There is reason for optimism that progress toward stronger global regulation has begun,” says Daniel Price, who was President George W. Bush’s G-20 negotiator and is now senior partner for global issues at Sidley Austin LLP in Washington. “We’re beginning to see the outlines of a convergence.”

Agreement on a shared regulatory agenda would provide the G-20 summit with a measure of success even as leaders remain at odds over trade policy, fiscal stimulus and the status of the dollar. A joint regulatory approach is crucial to prevent investors from seeking out markets with the most permissive rules, setting off a race to the bottom as countries vie to attract capital.

The call for greater regulation unites China, possessor of the most vibrant economy in the developing world, and the U.S., possessor of the world’s largest economy. China’s central bank governor, Zhou Xiaochuan, challenged the West to fix flaws in financial supervision on March 26, the same day U.S. Treasury Secretary Timothy Geithner outlined a broad initiative designed to do just that.

It is this global pressure for regulation that makes Krugman, Stiglitz, Sachs and others the focus of attention, because this global pressure goes far beyond merely Basel II and Sarbox tinkering with reporting requirements. Stiglitz was on a UN commission which outlined the need for an economic security council. Similar calls have come from financier George Soros, who has argued for using the IMF Special Drawing Rights, and not the dollar, as the measure of global risk. This creates a three, not two, part pressure. On one side are those, such as James K. Galbraith, arguing for a much weaker dollar, on the other a global consensus for a revaluation of the Asian currencies, ennunciated by Martin Wolf of the Financial Times, and among financiers for a strong US dollar in order to protect their trading advantage the world’s most powerful currency. This even as all three admit that in the long term, the end game of the present wave of bailouts and stimulus, is inflation.

Summers, Geithner, Romer and the rest of Obama’s economic team, by themselves, are a force that bankers can deal with, because they understand that Obama needs them, as much as they need him. A continued collapse in the Dow would wound Obama’s economic credibility and popular support: his short swoon in the polls coincided with the Dow’s fall, and his bounce back tracks its resurgence. However, the triple convergence of a reform minded administration, international pressure, and a growing populist revolt that has now grown elite credentials is a much larger hill to climb, and one that leads to the possibility of a scenario where they are not even the primary players in the shape of the new financial architecture. Obama’s team would swing from being on the left post of an Overton Window opposite Republican Hooverism and Wall Street conservatism, to the center post of a negotiation between internationalism and populism, and not just on regulation, but on diverse matter such as trade and stimulus as well. Hence, the present Mexican standoff is a better position than bankers would have if the debate were radically broadened. As we have seen the press repeatedly attempt to "left post" Obama’s first steps towards an agenda, both slowing down his progress and paving the way for a hard right Presidential successor, the financial world is attempting to push the purpose of regulation to "preventing another financial collapse" rather than creating a more equitable system.

The ultimate principle under debate is whether the present collapse is an irrational moment which is preventable with restrictions, or a recurring feature of the present financial system. Prof. Brad DeLong theorizes that the loss of institutional memory of the Great Depression has returned America to the normalcy of speculation and panic which began in 1825. More forcefully the coming of global warming and peak oil into the economic scene argues that what is going on is an entirely rational discounting of the value of the capital of the combustion era. In this view what is going on is not a momentary instability which can be blocked with technocratic fixes, but a fundamental feature of the financial landscape which must be met with larger and broader measures than simply leveraging TARP money, or which must be accepted as a periodic phenomenon.

This is why an obscure debate in Washington over how "systematic risk" to the financial system should be regulated is taking on larger proportions. One camp wants to assign the matter to Treasury and the Federal Reserve, with the FDIC doing clean up, another wants a different mechanism, arguing that Treasury and the Fed both have short term pressures to ignore instabilities, since these instabilities produce more growth on the way up, and more damage on the way down. Shades of Greenspan’s argument that bubbles should be left alone, and then dealt with only in the aftermath. For bankers, having one of their own at the Fed determining risk is very much like having private companies such determine credit ratings, it isn’t exactly the fox watching the chicken coop, but let’s say a very hungry dog.

This question, quis custodiet ispso custodies, is an old one. The shape of how it is to be debated is taking place, and the public, angry at the outcomes so far, is still stuck at the door, without even the ability to jump in to the deliberations and shout "Veto!" The major players are the holders of dollar instruments, both bankers and their major clients, the governments of the world which want a return to global financial driven capitalism without the political exposure, and an angry public which has not yet decided what it wants, but is unhappy with what it is getting.

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