1929 Redux: Heading for a Crash?

The following is Robert Kuttner's testimony before the House Financial Services Committee on October 2.

Mr. Chairman and members of the Committee:

Thank you for this opportunity. My name is Robert Kuttner. I am an economics and financial journalist, author of several books about the economy, co-editor of The American Prospect, and former investigator for the Senate Banking Committee. I have a book appearing in a few weeks that addresses the systemic risks of financial innovation coupled with deregulation and the moral hazard of periodic bailouts.

In researching the book, I devoted a lot of effort to reviewing the abuses of the 1920s, the effort in the 1930s to create a financial system that would prevent repetition of those abuses, and the steady dismantling of the safeguards over the last three decades in the name of free markets and financial innovation.

Your predecessors on the Senate Banking Committee, in the celebrated Pecora Hearings of 1933 and 1934, laid the groundwork for the modern edifice of financial regulation. I suspect that they would be appalled at the parallels between the systemic risks of the 1920s and many of the modern practices that have been permitted to seep back in to our financial markets.

Although the particulars are different, my reading of financial history suggests that the abuses and risks are all too similar and enduring. When you strip them down to their essence, they are variations on a few hardy perennials - excessive leveraging, misrepresentation, insider conflicts of interest, non-transparency, and the triumph of engineered euphoria over evidence.

The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy. This was the essence of the abuse of public utilities stock pyramids in the 1920s, where multi-layered holding companies allowed securities to be watered down, to the point where the real collateral was worth just a few cents on the dollar, and returns were diverted from operating companies and ratepayers. This only became exposed when the bubble burst. As Warren Buffett famously put it, you never know who is swimming naked until the tide goes out.

There is good evidence - and I will add to the record a paper on this subject by the Federal Reserve staff economists Dean Maki and Michael Palumbo - that even much of the boom of the late 1990s was built substantially on asset bubbles. ["Disentangling the Wealth Effect: a Cohort Analysis of Household Savings in the 1990s"]

A second parallel is what today we would call securitization of credit. Some people think this is a recent innovation, but in fact it was the core technique that made possible the dangerous practices of the 1920. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank - e.g. Morgan or Chase - as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act, requiring bankers to decide either to be commercial banks - part of the monetary system, closely supervised and subject to reserve requirements, given deposit insurance, and access to the Fed's discount window; or investment banks that were not government guaranteed, but that were soon subjected to an extensive disclosure regime under the SEC.

Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s - lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way. And, much of this paper is even more opaque to bank examiners than its counterparts were in the 1920s. Much of it isn't paper at all, and the whole process is supercharged by computers and automated formulas. An independent source of instability is that while these credit derivatives are said to increase liquidity and serve as shock absorbers, in fact their bets are often in the same direction - assuming perpetually rising asset prices - so in a credit crisis they can act as net de-stabilizers.