Economic Free Fall?

By William Greider

02/08/08 "The Nation" -- - Washington can act with breathtaking urgency when
the right people want something done. In this case, the people are Wall
Street's titans, who are scared witless at the prospect of their historic
implosion. Congress quickly agreed to enact a gargantuan bailout, with more
to come, to calm the anxieties and halt the deflation of Wall Street giants.
Put aside partisan bickering, no time for hearings, no need to think through
the deeper implications. We haven't seen "bipartisan cooperation" like this
since Washington decided to invade Iraq.

In their haste to do anything the financial guys seem to want, Congress and
the lame-duck President are, I fear, sowing far more profound troubles for
the country. First, while throwing our money at Wall Street, government is
neglecting the grave risk of a deeper catastrophe for the real economy of
producers and consumers. Second, Washington's selective generosity for
influential financial losers is deforming democracy and opening the path to
an awesomely powerful corporate state. Third, the rescue has not succeeded,
not yet. Banking faces huge losses ahead, and informed insiders assume a far
larger federal bailout will be needed--after the election. No one wants to
upset voters by talking about it now. The next President, once in office,
can break the bad news. It's not only about the money--with debate silenced,
a dangerous line has been crossed. Hundreds of billions in open-ended relief
has been delivered to the largest and most powerful mega-banks and
investment firms, while government offers only weak gestures of sympathy for
struggling producers, workers and consumers.

The bailouts are rewarding the very people and institutions whose reckless
behavior caused this financial mess. Yet government demands nothing from
them in return--like new rules for prudent behavior and explicit obligations
to serve the national interest. Washington ought to compel the financial
players to rein in their appetite for profit in order to help save the
country from a far worse fate: a depressed economy that cannot regain its
normal energies. Instead, the Federal Reserve, the Treasury, the Democratic
Congress and of course the Republicans meekly defer to the wise men of high
finance, who no longer seem so all-knowing.

Let's review the bidding to date. After panic swept through the global
financial community this spring, the Federal Reserve and Treasury rushed in
to arrange a sweetheart rescue for Bear Stearns, expending $29 billion to
take over the brokerage's ruined assets so JPMorgan Chase, the prestigious
banking conglomerate, would agree to buy what was left. At the same time,
the Fed and Treasury provided a series of emergency loans and liquidity for
endangered investment firms and major banks. Investors were not persuaded.
Their panic was not "mental," as former McCain adviser Phil Gramm recently
complained. The collapse of the housing bubble had revealed the deep rot and
duplicity within the financial system. When investors tried to sell off huge
portfolios of spoiled financial assets like mortgage bonds, nobody would buy
them. In fact, no one can yet say how much these once esteemed "safe"
investments are really worth.

The big banks and investment houses are also stuck with lots of bad paper,
and some have dumped it on their unwitting customers. The largest banks and
brokerages have already lost enormously, but lending portfolios must shrink
a lot more--at least $1 trillion, some estimate. So wary shareholders are
naturally dumping financial-sector stocks.

Most recently, the investors' fears were turned on Fannie Mae and Freddie
Mac, the huge quasi-private corporations that package and circulate
trillions in debt securities with implicit federal backing. Treasury
Secretary Henry Paulson (formerly of Goldman Sachs) boldly proposed a $300
billion commitment to buy up Fannie Mae stock and save the plunging share
price--that is, save the shareholders from their mistakes. So much for
market discipline. For everyone else, Washington recommends a cold shower.

Talk about warped priorities! The government puts up $29 billion as a
"sweetener" for JP Morgan but can only come up with $4 billion for
Cleveland, Detroit and other urban ruins. Even the mortgage-relief bill is a
tepid gesture. It basically asks, but does not compel, the bankers to act
kindlier toward millions of defaulting families.

A generation of conservative propaganda, arguing that markets make wiser
decisions than government, has been destroyed by these events. The
interventions amount to socialism, American style, in which the government
decides which private enterprises are "too big to fail." Trouble is, it was
the government itself that created most of these mastodons--including the
all-purpose banking conglomerates. The mega-banks arose in the 1990s, when a
Democratic President and Republican Congress repealed the New Deal-era
Glass-Steagall Act, which prevented commercial banks from blending their
business with investment banking. That combination was the source of
incestuous self-dealing and fraudulent stock valuations that led directly to
the Crash of 1929 and the Great Depression that followed.

Even before Congress and Bill Clinton repealed the law, the Federal Reserve
had aggressively cleared the way by unilaterally authorizing Citigroup to
cross the line. Wall Street proceeded, with accounting tricks described as
"modernization," to re-create the same scandals from the 1920s in more
sophisticated fashion. The financial crisis began when these gimmicky
innovations blew up.

Democrats who imagine they can reap partisan advantage from this crisis
don't know the history. The blame is bipartisan; so also is the disgrace. In
1980, before Ronald Reagan even came to town, Democrats deregulated the
financial system by repealing federal interest-rate ceilings and other
regulatory restraints--a step that doomed the savings and loan industry and
eliminated a major competitor for the bankers. Democrats have collaborated
with Republicans on behalf of their financial patrons every step of the way.

The same legislation also repealed the federal law prohibiting usury--the
predatory practices that ruin debtors of modest means by lending on terms
that ensure borrowers will fail. Usurious lending is now commonplace in
America, from credit cards and "payday loans" to the notorious subprime
mortgages. The prohibition on usury really involves an ancient moral
principle, one common to Judaism, Christianity and Islam: people of great
wealth must not be allowed to use it to ruin others who lack the same
advantages. A decent society cannot endure it.

The fast-acting politicians may hope to cover over their past mistakes
before the public figures out what's happening (that is, who is screwing
whom). But the Federal Reserve has a similar reason to move aggressively:
the Fed was a central architect and agitator in creating the circumstances
that led to the collapse in Wall Street's financial worth. The central bank
tipped its monetary policy hard in one direction--favoring capital over
labor, creditors over debtors, finance over the real economy--and held it
there for roughly twenty-five years. On one side, it targeted wages and
restrained economic growth to make sure workers could not bargain for higher
compensation in slack labor markets. On the other side, it stripped away or
refused to enforce prudential regulations that restrained the excesses of
banking and finance. In The Nation a few years back, I referred to Alan
Greenspan as the "one-eyed chairman" [September 19, 2005] who could see
inflation in the real economy--even when it didn't exist--but was blind to
the roaring inflation in the financial system.

The Fed's lopsided focus on behalf of the monied interests, combined with
its refusal to apply regulatory laws with due diligence, eventually
destabilized the overall economy. Trying to correct for previous errors, the
Fed, with its overzealous free-market ideology, swung monetary policy back
and forth to extremes, first tightening credit without good reason, then
rapidly cutting interest rates to nearly zero. This erratic behavior
encouraged a series of financial bubbles in interest-sensitive assets--first
the stock market, during the late 1990s tech-stock boom, then housing--but
the Fed declined to do anything or even admit the bubbles existed. The
nation is now stuck with the consequences of its blindness.

The Federal Reserve's dereliction of duty is central to the financial
failures. It betrayed the purpose for which the central bank was first
created, in 1913, abandoning the sense of balance the Fed had long pursued
and that Congress requires. Most politicians, not to mention the press, are
too intimidated to question the Fed's daunting power, but their ignorance is
about to compound the problem. Instead of demanding answers, the political
system is about to expand the Fed's governing powers--despite its failure to
protect us. Treasury Secretary Paulson proposed and Democratic leaders have
agreed to make the insulated Fed the "supercop" that oversees not only
commercial banks and banking conglomerates but also the largest investment
houses or anyone else big enough to destabilize the system. This "reform"
would definitely reassure club members who are already too cozy with the
central bankers. Everyone else would be left deeper in the dark.

The political system, once again, is rewarding failure. The Fed is an
unreliable watchdog, ideologically biased and compromised by its conflicting
obligations. Is it supposed to discipline the big money players or keep them
afloat? Putting the secretive central bank in charge, with its unlimited
powers to prop up troubled firms, would further eviscerate democracy, not to
mention economic justice.

If Congress enacts this concept early next year, the privileged group of
protected financial interests is sure to grow larger, because other
nonfinancial firms could devise ways to reconfigure themselves so they too
would qualify for club membership. A very large manufacturing
conglomerate--General Electric, for instance--might absorb elements of
banking in order to be covered by the Fed's umbrella (GE Capital is already
among the largest pools of investment capital). Private-equity firms, with
their buccaneer style of corporate management, are already trying to buy
into banking, with encouragement from the Fed (the Service Employees
International Union has mounted a campaign to stop them). A new President
could stop the whole deal, of course, but John McCain has surrounded himself
with influential advisers who were co-architects of this financial disaster.
For that matter, so has Barack Obama.

The nation, meanwhile, is flirting with historic catastrophe. Nobody yet
knows how bad it is, but the peril is vastly larger than previous episodes,
like the savings and loan bailout of the late 1980s. The dangers are
compounded by the fact that the United States is now utterly dependent on
foreign creditors--Japan and China lead the list--who have been propping us
up with their lending. Thanks to growing trade deficits and debt, foreign
portfolio holdings of US long-term debt securities have more than doubled
since 1994, from 7.9 percent to 18.8 percent as of June 2007. If these
countries get fed up with their losses and pull the plug, the US economy
will be a long, long time coming back.

The gravest danger is that the national economy will weaken further and
spiral downward into a negative cycle that feeds on itself: as conditions
darken, people hunker down and wait for the storm to pass--consumers stop
buying, banks stop lending, producing companies cut their workforces. That
feeds more defaulted loan losses back into the banking system's balance
sheets. This vicious cycle is essentially what led to the Great Depression
after the stock market crash of 1929. I offer not a prediction but a
warning. The comparison may sound farfetched now, but US policy-makers and
politicians are putting us at risk of historic deflationary forces that,
once they take hold, are very difficult to reverse.

A more aggressive response from Washington would address the real economy's
troubles as seriously as it does Wall Street's. Financial firms have lost
capital on a huge scale--more of them will fail or be bought by foreign
investors. But Wall Street cannot get well this time if the economy remains
stuck in the ditch. Washington needs to revive the "animal spirits" of the
nation at large. The $152 billion stimulus package enacted so far is
piddling and ought to be three or four times larger. Instead of sending the
money to Iraq, we should be spending it here on getting people back to work,
building and repairing our tattered infrastructure, investing in worthwhile
projects that can help stimulate the economy in rough weather.

An agenda of deeper reforms can boost public confidence even as it undoes a
lot of the damage caused by the financiers and bankers. Some suggestions: