Memo to Investigators: Dig Deep
Who Let the Dogs Out?
The question of political blame is explosive but not partisan. Both parties collaborated in stripping away the safeguards against greed and recklessness, authorizing the culture of permissiveness that led to ruin. The invitation to irresponsibility originated on the right with the naïve ideology of Milton Friedman. Republicans were the most zealous advocates for gutting New Deal regulations that had produced financial stability for three generations, but Democrats started the game when they repealed the federal law against usury and the legal ceilings on interest rates in 1980 (before Ronald Reagan came to Washington).
Both parties championed the creation of all-purpose mega-banks with the 1999 repeal of the Glass-Steagall Act. The Federal Reserve permitted Citibank to ignore the law even before it was repealed. Indeed, nearly every offense attributed to reckless bankers was authorized by Congress and presidents--over-borrowing against bank capital, hiding debt with accounting tricks, evading regulatory laws by interacting with hedge funds and other nonbanks. The political culprits have not shown much remorse or offered apologies. That's what makes the prospective investigations so important.
The Failure of the Fed.
The Federal Reserve's dereliction as the regulator of the banking system is by now widely understood. But far more grave was the central bank's failure to conduct responsible monetary policy. Driven by Friedmanite ideology, Fed governors tipped the normal balance in favor of capital over labor, the financial sector over the productive economy. The result was numerous disorders, including the triumph of the financiers and swelling income inequality. Monetary policy became unreliable as "bubbles" inflated, followed by recession. Instead of moderating, Fed policy swung between extremes and ultimately destabilized the entire economy.
One reason for the Fed's failure is that deregulation undermined the central bank's ability to manage the supply of credit. As rules and prudential limits were abandoned or unenforced, the Fed's policy mechanisms were steadily weakened, and it lost control of its core function--countering the real economy's excesses both on the upside and the downside. Debt exploded, accumulating far faster than economic growth. Instead of candidly addressing the central bank's weakness, though, Alan Greenspan led cheers for the new order--right up to the day it collapsed. If nothing significant is changed about monetary policy, more bubbles and crashes will surely follow.
. Surely the political system itself is a root cause of the financial crisis. The swollen influence of financial interests pushed Congress and presidents to repeal regulation and look the other way as reckless excesses developed. Efforts to restore a more reliable representative democracy can start with Congress. The power of money could be curbed by new rules prohibiting members of key committees from accepting contributions from the sectors they oversee. Regulatory agencies, likewise, need internal designs to protect them from capture by the industries they regulate.
The Federal Reserve, having failed in its obligations so profoundly, should be reconstituted as an accountable federal agency, shorn of the excessive secrecy and insider privileges accorded to bankers. The Constitution gives Congress, not the executive branch, the responsibility for managing money and credit. Congress must reassert this responsibility and learn how to provide adequate oversight and policy critique. [See "Dismantling the Temple," Aug. 3/10.]
Reforming the financial system, in other words, can be the prelude to reviving representative democracy.
Origins of the Debtor Nation
. Congress instructed the Angelides commission to examine lopsided financial flows in the global economy and the global imbalance of savings. How did China wind up with a mountain of surplus capital while the US economy has had to borrow more heavily from abroad each year just to stay afloat? One obvious explanation is the unbalanced trading system in which the United States has been steadily weakened by serving as "buyer of last resort" for other nations' exports. During the past two decades, the United States piled up something like $15 trillion in debt from trade deficits, as value-added production and jobs were relocated overseas. Simply put, we import a lot more than we export, goods we buy from abroad that used to be manufactured in the United States.
Political debate usually avoids the links between negative US trade and our weakened condition as a debtor nation, but the consequences are visible through several channels. The out-migration of production and jobs drives the long-running stagnation of industrial wages, roughly stuck at the same level as in 1973. The annual trade deficits, recently as high as 6 percent of GDP, subtract directly from domestic economic growth. These ill effects and others have created a permanent shortfall in aggregate demand--not enough consumers with the money to buy the stuff they need or want. So households rely on borrowing to pay the bills and hang on to their faltering living standards.
The financial crisis crisply marks an end to that era of false prosperity. The illusion of living well on borrowed money cannot be revived by repairing the banking system. The restoration of prosperity will require wrenching economic changes, including a very different US approach to the global trading system. No one expects the commission to solve the trade problem, of course. But the investigation can restart the debate on more honest terms. Asking deeper questions about the true sources of the calamity is a first step toward developing authentic answers to the nation's predicament.