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Let the Banks Fail: Why a Few of the Financial Giants Should Crash

The finance industry still owns mountains of bad paper and must absorb these losses -- or else we'll face a very long recession.

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During the intervening period, the "real" American economy was in doldrums: between 2000-2007, median household income dropped; the number of families living in poverty grew by almost 11 percent and the economy added jobs at the lowest rate in the post-World War II era. (I should add that those employment numbers look a lot worse when you take out the job growth in government and our uniquely inefficient health sector -- between 2001 and 2006, health care added 1.7 million (net) new jobs while the rest of the economy added zero.)

As Bloomberg reported, "The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century."

So much of the economic output of recent years has been ephemeral, fueled by the ever-growing financial industry and enabled by the deregulation for which it lobbied hard for years. When this "speculation economy" -- or at least the big chunk of it built on consumer debt and home mortgages (which I discussed in greater detail here) -- began to crash, it drove much of the real economy into the ground with it, and that’s where we stand today.

But the importance of this analysis goes beyond assigning blame. Today, we have a finance sector that is straining under the weight of a ton of fishy paper -- those much-discussed toxic securities -- and nobody knows exactly who’s holding what. What we do know is that since 2001, $27 trillion worth of bundled, debt-backed securities were issued, and a significant, if equally unknown, portion of those are nearly worthless.

This was always the fundamental flaw with the original " Paulson plan" -- buying a couple hundred billion worth of crappy paper when there’s trillions worth of the stuff on American banks’ book is tantamount to trying to bail out the Titanic with a thimble.

But more important is what these numbers suggest moving ahead. The hard reality is that these financial institutions must take huge losses on that paper or else this recession will likely deepen and drag out for years. Basic economic theory says that when a business is not sustainable and goes belly-up -- or a sector has unnecessary capacity and shrinks -- its capital, physical plant and other assets, expertise and employees will become integrated into firms that are productive.

When the Financial Tail Wags the Corporate Dog

The financial sector’s size isn’t the only thing to consider as we watch our government take a page from Venezuela's President Hugo Chavez and blow wads of state money purchasing bank stocks and those "troubled assets." The influence of the financial sector on the behavior of the rest of the corporate economy is something that we take for granted -- it’s business as usual in America -- but in a time of crisis, a rethink of the entire financial order is imperative.

The modern system of finance developed during the progressive era -- from the late 1890s through the 1920s -- and its creation was heavily influenced by the prevailing anger at the power of the huge trusts. Dispersed ownership and new forms of finance -- through stocks, corporate bonds and other securities -- were seen as an antidote to the influence of the robber barons, that handful of dynastic families who controlled key sectors of the American economy.

Since then, the original function of the financial markets -- to link investors’ capital with innovative firms -- has been turned on its head. Today, corporate behavior is very much dictated by the markets -- quarterly earnings, stock prices and the like -- and not the other way around. That’s not a good thing.

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