“Banks and Government – Crony Capitalism at its Worst”

Sydney M. Williams

Thought of the Day

“Banks and Government – Crony Capitalism at its Worst”

January 31, 2012

The relationship between banks and government has become increasingly symbiotic…and not in a good way.

As the twentieth century began, banks were essentially unregulated entities, governed solely by the risk of insolvency. The ‘Panic of 1907’ resulted in the Federal Reserve Act six years later, a Bill that created a central bank charged with setting monetary policy and being the lender of last resort. In 1933, four years after the stock market crash of 1929, the passage of Glass-Steagall separated investment banks from commercial banks and created a system of federal insurance for depositors.

The Depository Institutions Deregulatory and Monetary Control Act was enacted in 1980. The Bill, a response to the rapid growth in money market funds, phased out Regulatory Q, which had prohibited banks from paying interest on demand deposits and had limited the amount paid on savings accounts. Money market funds competed with banks for deposits, assuming more risk while paying higher returns. Greed replaced caution on the part of savers. Nineteen years later, Glass-Steagall was essentially repealed. It was that repeal, more than anything else that created today’s banking behemoths, which are now “too big to fail.”

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 did nothing to stunt the continued growth of the nation’s biggest banks, or the risk that their size means for our nation’s capital markets. What it did do was create a Consumer Protection Board. Additionally, it requires banks to hold more capital and to use less leverage. It has implemented (or so they claim) an “advanced warning system”, a role previously played by bond vigilantes. And it is supposed to improve transparency and accountability for exotic, derivative instruments. Its success remains to be seen.

However, the ultimate consequence of almost every action taken by government has been to increase the risk to the system, as the threat of bankruptcy has lessened. Typically, interest rates in Treasuries have been governed by expected rates of inflation, as the risk of default has been considered nil. In contrast, corporate bonds have historically been priced according to perceived risks of bankruptcy. The Credit Default Swap (CDS) market and markets for credit insurance were established, so that investors could track risk and issuers could more easily and less expensively access credit markets. (Unfortunately, the CDS market has developed without regard to the size of the underlying issues, a problem left unaddressed by Dodd-Frank.)

Now, the Federal Reserve has indicated that Fed Funds – the raw material for banks – will remain at zero through early 2014. Fed Fund rates have been at this level since January 28, 2009. When the price of your raw material is zero, it encourages, over time, speculative activity, as we saw in home prices in the early 2000s and more recently in commodity prices. Five years of keeping them at this level distorts capital markets. The very rapid increase in central bank assets is something we have never seen. Assets of the eight largest central banks approximate $14.5 trillion, or about a third of their combined GDPs, versus a number closer to 10% three years ago. When the spigot is turned off, as it will be someday, no one knows the reaction. Can central bankers articulate an exit strategy without spooking the markets? No one knows.

The problems in Europe clearly portray the problem of socialism – of promising more than can be delivered. Yet the massive involvement of central banks in markets implies a de facto return to planned economies. Is it too late for capitalism? Certainly, the administration in Washington sees no other way than the continued process of increasing dependencies. Wall Street has been demonized by the Obama administration, Occupiers of Wall Street have been glorified by the media, and those like Professor Joseph Stiglitz have characterized the situation as the “privatizing of gains and the socializing of losses”, with no mention of the role played by government in creating the environment that led to the problem.

Government sees its role as protecting consumers. Naked capitalism can seem brutal; for it punishes as well as rewards. On the other hand, the effect of socialism, or statism if you will, is to reduce personal responsibility, making people less able to fend for themselves. While purporting to do good, it harms initiative and progress. It increases dependency and limits personal responsibility. It leads to crony capitalism and economic stagnation. Definitionally, socialism is based on a cynical view of mankind, as it assumes dishonor and disdain. Capitalism, in contrast, relies on market forces and assumes openness, honesty and respect. It functions under a system of laws to protect both borrower and lender. Most importantly, it makes possible entrepreneurship and maximizes human potential. As Rabbi Aryeh Spero wrote in yesterday’s Wall Street Journal, “Nations that throw over capitalism for socialism have made an immoral choice.”

It is not that I am against regulation. Glass-Steagall served a good purpose. It prevented the emergence of super banks, and its repeal has done damage. Crony capitalism, within the financial sector, is based on banks and financial institutions that are too big to fail. In terms of aiding and abetting the housing bubble, the worst examples by far were the two Government Sponsored Entities (GSEs), Fannie Mae and Freddie Mac. The country cannot afford bank failures that jeopardize our financial and credit system. Treasury Secretary Henry Paulson tested the system in September 2008 when he let Lehman fail. It worked, but barely. A Goldman failure would have brought the system down. Unfortunately that lesson has not been learned, as bankruptcy was removed as an option. Banks, appreciative of their position, do everything they can to keep their “crony friends” in office. And by far, the best “friends” of bankers in the years leading up to the credit meltdown were Representative Barney Frank and Senator Chris Dodd. Yet, the bill purportedly aimed at preventing such a future occurrence ironically bears their name!

The problems we face will not be answered until there is an honest accounting as to who and what were at fault for the credit collapse of 2008. Thus far, Washington has been in denial as to the role they played. Certainly, unscrupulous bankers took advantage of the circumstances that lay before them, but the opportunities were provided by Washington. Rules and regulations were (and have been) reactionary, not anticipatory. Some individual consumers were surely duped, but most voluntarily walked to the guillotine on their own, accepting an unknowable level of risk in return for unrealistic gains – ignoring the fact that home prices that were expected to rise indefinitely had already risen too far; and they borrowed more than they could afford.

Banks may symbolize the greed that brought the system down and have become a convenient scapegoat, but the real fault lies with Washington that encouraged the environment and remains unrepentant. Today it is the Fed. Money may be cheap at the moment, but the consequences are likely to be expensive.