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

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

Authors Bill Greider and Dean Baker argue that the latest Wall Street
woes expose the finance industry's deep need for reform.

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.

William Greider is The Nation magazineÂ’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.