First, A bit of personal background. I majored in Mathematical Economics with a minor in Social Relations as an undergrad and went on to get an MBA in Finance/Accounting. That info is more to help you understand my geeky side and fascination with all things economy, rather than to try to impress. My academic history simply serves to make me dangerous when I try to take on serious economic issues.
That background may also be why I love reading Paul Krugman, since he has about 1,000 times the brainpower and knowledge than yours truly.
On that note, I want to highlight a column Krugman wrote this past Sunday titled “Private Credit and the New World Financial Risk”. The entire column is worth a read.
The key takeaway up front is that financial institutions – regulated banks as well as non-regulated pseudo banks – are always looking for ways to goose return (regardless of increased risk) away from the watchful eyes and mandated oversight of regulators and regulations.
The battle has always been thus.
The problem is twofold: lack of historical memory and loss/lack of accountability.
Krugman opens with:
On July 15, 2007, the New York Times published an article titled “The richest of the rich, proud of a new Gilded Age.” The article was centered on a profile of Sanford Weill, CEO of Citigroup, who, like others in the financial industry, believed that they were leading America into a new era of prosperity — justifying their immense wealth — and that the government should scrap regulations that were getting in the way of financial innovation.
Exactly one year and two months later, Lehman Brothers failed, plunging the world into the worst financial crisis it had seen in more than 70 years. Many of the innovations of which Weill and others were so proud had, it turned out, created a system of poorly regulated financial institutions — so called “shadow banks” — that were exposed to a 21st-century version of the vast wave of bank runs in 1930 and 1931 that turned an ordinary recession into the Great Depression.
But the 2008 crisis was 17 years ago, and political support for the precautions introduced after 2008 has waned. The Treasury Department is moving to gut the Office of Financial Research, which monitors risks of financial crisis. There is once again a push to deregulate, to embrace financial innovations like crypto that arguably recreate the risks that brought the world economy to its knees in 2008. Shadow banking has had a major revival; by some measures, as I’ll explain, shadow banks are bigger relative to the financial system as they were when Lehman collapsed. And it’s only reasonable to worry about the possibility of a new financial crisis.
Prior to the SEC Acts of 1933 and 1934, in the 19th – early 20th centuries, the U.S. had recessions approx. every 4 years and major “Panics” (what economic crises were formerly called) roughly every 15-20 years, including:
Panic of 1819. First major U.S. financial crisis caused by credit contraction and land speculation collapse
Panic of 1837. Triggered by speculative lending and bank failures
Panic of 1857. Sparked by railroad speculation collapse and bank failures
Panic of 1873. Triggered by railroad overexpansion and financial speculation
Panic of 1893. One of the worst depressions of the 19th century
Panic of 1907. Banking panic leading to runs on financial institutions which helped spur creation of the Federal Reserve (1913)
Depression of 1920–1921. A sharp but short deflationary recession
Great Depression (1929–1933). Triggered by the Wall Street Crash of 1929 resulting in bank failures, stock collapse, mass unemployment and led to the SEC Acts of 1933 and 1934.
With the creation of the Federal Reserve in 1913 and the passing of the SEC Acts of 1933 and 1934, after the Great Depression, while recessions did occur as part of the regular economic cycle (though generally less severe and less often), there essentially were no “Panics” until the Great Recession of 2008. Over 70 years of relative prosperity and stability.
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Post Interlude:
The immediate pre-WWII and post-WWII periods were also defined by decreasing inequality and the rise of the Great American Middle Class. Two major factors were high marginal income tax rates on the richest earners and the rise of labor unions:
· From 1932 – 1980, the top marginal tax rate in the U.S. averaged 74.1%. In fact, the only times since 1917 (the income tax as we know it was established in 1913 and was single digits for the first few years) when the top marginal rate was below 50% was preceding the Great Depression (1925-1931) and preceding the Great Recession (starting with the “Reagan Revolution” post in 1987 to current day)
· Union participation jumped in 1933, peaked in the 1940s and 50s, and started to decline thereafter, accelerating with the “Reagan Revolution” in 1980 thru today (see chart below)
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Back to Krugman. He further writes (bold emphasis mine):
The price of financial stability is eternal vigilance. When crisis strikes, bailouts of failing financial institutions are, alas, the only wise course of action. Much as you may dislike shoveling money at banks or bank-like institutions that don’t deserve to be rescued, even if you believe that their actions brought on the crisis, denying them aid when panic strikes means deepening the crisis, inflicting huge punishment on workers and innocent businesses. So the money must flow.
But to limit both the need for and the size of bailouts, between crises one needs to regulate the institutions that might cause the next crisis. Thus banks and, since the post-2008 reforms, “systemically important” institutions are subject to extra capital requirements — basically forcing their owners to put substantial amounts of their own money at risk — limits on the kinds of investments they can make, and more.
However, financial regulation always leads to an arms race, as private-sector players try to find ways to avoid the regulations. Establish rules that limit risk-taking by banks, and people will create institutions that function like banks but don’t meet the traditional definition — e.g., issuing repo rather than accepting deposits.
For about 50 years after the 1930s — what Gary Gorton calls the “quiet period” — regulators mostly won that arms race. But then they began falling behind, for several reasons.
For one thing, there was a general rightward ideological tilt, the Reaganesque view that government is always the problem, never the solution. This view proved remarkably robust even in the face of the 2008 crisis, when the private sector obviously created the problem and emergency government action was the solution, the only reason we didn’t experience a full replay of the Great Depression.
Underlying the persistence of an anti-regulation mindset in the face of catastrophes was the Upton Sinclair principle: “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” Even in the runup to 2008, and even more now, there are large financial rewards — campaign contributions, but also, these days, outright personal financial gain — for politicians who weaken regulation on financial institutions that may threaten financial stability.
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[In another post, I’ll discuss my paraphrased corollary to Upton Sinclair’s accurate principle (which Krugman alludes to): “It is difficult to get a politician to understand something, when his personal political survival and future financial well-being depends on his/her not understanding it.”]
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As far as accountability goes, it basically no longer exists for the wealthy elites in our society. As I’ve previously written, in the Savings & Loan debacle of the late 1980s-early 1990s when over 1,000 S&L banks failed, over 1,100 people were convicted of felonies. In the 2008 mortgage-backed securities financial crisis that literally nearly destroyed our economy, No senior executives at major Wall Street banks were criminally convicted for crisis-related conduct. Only a rare few even lost their jobs.
Political accountability has gone by the wayside as well (if we ever truly had it). Nixon was preemptively pardoned by President Ford for Watergate (and other potential crimes). Convicted participants in the Iran Contra scandal were pardoned by President HW Bush (with the help of the ever sleazy and crooked Bill Barr). And, of course, all January 6 participants were pardoned by Trump.
Other democratic countries don’t seem to have this problem. Here is a partial list of countries that have convicted high ranking electeds in the recent past, Israel, France, Italy, South Korea, Taiwan, and Greece. Other countries who have convicted electeds of corruption include: Brazil, Peru, Argentina, Panama, Guatemala, South Africa, Pakistan, Malaysia and Romania, to name a few.
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With the flood of issues we are dealing now in our country – the current Iran War, the attempt to restrict voting rights, the discovery of the existence of a cabal of a wealthy and influential elite engaged in a ring of pedophilia (and the ensuing coverup), and a President who is an ignorant, pathologically lying malignant narcissist, we ignore at our own peril the need to ensure strong regulation, oversight and accountability in our financial system. Because it is financial system “panics” that truly open the door for demagogues, strongmen and authoritarians to walk through and grab the reins of power.
