Big Banks Go Bust: America's Financial System in Crisis

The Nation and Campaign for America's Future. Posted September 16, 2008.

Below are two key articles for understanding the current financial crisis:

William Greider: "Creative Destruction"
The Nation

Dean Baker: "Time to Reform Wall Street"
Campaign for America's Future.

Creative Destruction

The epic deflation of Wall Street rolls forward like a blood-spattered steamroller, claiming more important victims. It takes down noble old names like Merrill and Lehman Brothers, destroys the savings of large pension funds and mom-and-pop investors, throws tens of thousands of financial workers out of jobs.

But let's not dwell on the downside. This is the process Joseph A. Schumpeter famously described as "creative destruction" -- capitalism's way of clearing away debris from the past so that new flowers may bloom. In this drama, what is being swept away is the monumental arrogance of celebrated financiers, also the fraudulent gimmicks that created lots of new billionaires by selling bad paper to the world's investors. A great bubble of wealth grew in the canyons of Wall Street -- a run-up of falsified financial assets that lasted for roughly twenty-five years. Now the air is rushing out of that balloon with no way to stop it.

In the long run, the destruction of concentrated wealth and power is always good for democracy, liberating people from the heavy hand of the status quo. Unfortunately, many innocents are slaughtered in the process. As the US manufacturing economy was dismantled by downsizing and globalization, the learned ones (Alan Greenspan comes to mind) told everyone to breathe easy -- ultimately this would be good for the workers and communities who lost the foundations of their prosperity. Now that "creative destruction" is visiting the bankers, we now observe they are not so accepting of their own fate.

The destruction of Wall Street's girth and power is unavoidable, in any case. To switch metaphors, Humpty Dumpty fell off the wall and not even the king's horses in Washington can put him back together again. It would have been far better if the federal government and national politics had recognized the great deceptions of Wall Street and put a stop to them before catastrophe unfolded. Since that didn't happen, we are all now doomed to take a perilous ride -- the economy, the country, the world -- and hope for the best.

However, we can look forward to the new order that emerges from the wreckage. The financial wizards who have dominated politics and economic orthodoxy for a generation are unmasked, their delusions failed. We have an opportunity to think anew, at least to hope that governing elites in both political parties will finally come to their senses or, better yet, get out of the way.

Last weekend's events come down to this: The authorities in Washington and Wall Street finally admitted what they persistently brushed aside during this year of turmoil and government bailouts. The Federal Reserve and Treasury treated the financial system's problem as "psychological" and assumed they could manipulate investor confidence by pumping lots of public money into the embattled financial firms and banks. Financial markets are gripped by desperate psychology -- fearful people fleeing from the consequences of their own reckless behavior -- but the core of this crisis is real and will not yield to happy talk from the authorities.

The long-running inflation of financial values and phony accounting allowed by deregulation created an unworldly sense of new wealth. It was essentially false and is now gradually receding, coming back down to something resembling honest valuations.

As a result, the financial system has lost as much as $1 trillion in capital, maybe twice that much. Wall Street will not truly recover until it has replenished that capital -- most unlikely, given the worldwide skepticism of investors. Or it may grow smaller -- shrinking balance sheets and employment, resulting in fewer firms and less economic influence over the rest of us. When the blood dries, people will be able to see this is good news for the republic -- a chance to rebalance our society and politics -- but the road ahead is going to be rough and uncertain.

Last weekend, the Fed and Treasury Secretary took a modest step toward acknowledging the truth. They implicitly admitted that their rescues have failed. If the government continued its psychological approach, bailing out the big boys one by one, the public's assets and public patience would soon be exhausted. Now we shall see whether financial markets worldwide can endure the stern doctrine of "creative destruction" that was so confidently imposed on others.

Big Banks Go Bust: Time to Reform Wall Street

With the demise of Fannie Mae, Freddie Mac, IndyMac, Bear Stearns and now Lehman Brothers, we've been treated to the failure of more major financial firms than during any year since the Great Depression. The sight of rich bankers getting the boot might be lots of fun if it were just a spectator sport. Unfortunately, we are in the game with these clowns.

As a result of their incompetence, irresponsibility and greed, the housing bubble was allowed to grow to dangerous proportions. Its collapse threw the economy into recession, putting millions of people out of work and lowering the wages of those who still have their jobs. The plunge in house prices has destroyed much of the life savings for tens of millions of people nearing retirement.

Meanwhile, the bankers who messed up and destroyed the companies who hired them are still multimillionaires. Most of them are still in their old jobs getting multimillion-dollar pay packages. This is a sector that badly cries out for reform and there is no better time than now to put it into place.

The first target for reform should be the outrageous salaries drawn by the top executives at financial firms. The crew that lost tens of billions at Citigroup, Merrill Lynch and the rest have received tens of millions, possibly even hundreds of millions, in compensation for their "work" over the last few years.

There is a general problem in corporate America of stockholders being unable to effectively organize to rein in top management. This problem is most serious in the financial industry.

Thankfully, the credit crisis gives us the tools we need to rein in executive pay. Currently, the major surviving investment banks (e.g. Merrill Lynch, Morgan Stanley, Goldman Sachs) are operating on life support. They are drawing money at below market interest rates from the Federal Reserve Board's discount window. This privilege (for which they pay nothing) can easily be worth billions of dollars a year.

These banks are also operating with an explicit guarantee from Fed Chairman Ben Bernanke to their creditors that he will honor their loans in the event that an investment bank, like Bear Stearns, goes belly up. This guarantee is enormously valuable. Investors who make loans to Merrill Lynch or Morgan Stanley don't have to worry about the health of these companies because Bernanke has said that, if necessary, he will use public money to pay them back.

While we don't want a chain reaction of banking collapses on Wall Street, the public should get something in exchange for Bernanke's generosity. Specifically, he can demand a cap on executive compensation (all compensation) of $2 million a year, in exchange for getting bailed out. For any bank that is not on board, Bernanke could make an explicit promise to their creditors -- if the bank goes under, you will get zero from the Fed.

This can be an effective way to restore sanity to the salaries paid on Wall Street. And, this can be a good example for setting executive pay more generally. Any time a company comes to the public for a handout, like tax breaks for oil companies or low-interest loans for auto companies, the $2 million cap on all compensation goes into effect.

This is important directly because much of the country's wealth has been steered into these folks' pockets, but also because the outrageous compensation packages on Wall Street distorted pay structures throughout the economy. Presidents of universities often get over $1 million a year, and even top executives at private charities can often earn near $1 million a year. These salaries seem low when compared to their counterparts in the corporate world, but they are outrageous when compared to the pay checks of typical workers.

Of course we must go further in fixing the financial sector -- most importantly by downsizing it. The financial sector accounted for more than 30 percent of corporate profits in 2004. Back in the 1950s and 1960s, the country's period of most rapid growth, the financial sector accounted for less than 10 percent of corporate profit.

The financial sector performs an incredibly important function in allocating savings to those who want to invest in businesses, buy homes, or borrow money for other purposes. But shuffling money is not an end in itself. The explosion of the financial sector over the last three decades has led to a proliferation of complex financial instruments, many of which are not even understood by the companies who sell them, as we have painfully discovered.

The best way to bring the sector into line is with a modest financial transactions tax. Such taxes have long existed in other countries. For example, the United Kingdom charges a tax of 0.25 percent on the purchase or sale of share of stock. This is not a big deal to someone who holds their shares for ten years, but it could be a considerable cost for the folks who buy stocks in the morning that they sell in the afternoon.

Comparable taxes on the transfer of all financial instruments (e.g. options, futures, credit default swaps, etc.) could go a long way in reducing speculation and the volume of trading in financial markets. Such a tax could also raise an enormous amount of money -- easily more than $100 billion a year. This would go a long way toward funding national health care insurance or a major green infrastructure project.

And, this tax would be hugely progressive. Middle-income shareholders might take a small hit; but it would be comparable to raising the capital gains tax rate back to 20 percent, where it was before it was cut to 15 percent in 2003. The real hit would be on the big speculators and the Wall Street boys, the folks who gave us the housing crisis. Given what the Wall Street crew has done for us, this is change that we can believe in.

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William Greider is The Nation magazine’s National affairs correspondent. He is the author of, most recently, The Soul of Capitalism (Simon & Schuster).

Dean Baker is co-director of the Center for Economic and Policy Research.

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