Posts Tagged 'credit crisis'

On the Economy…

In 1933 in the midst of the Great Depression Congress was debating what would become the Glass-Steagall Act. Today, most economists agree that while there were numerous compounding causes of the Depression, the overarching cause was the lack of credit flow to the economy from the banks. 

The lack of credit flow, caused by banks taking unnecessary investing risks, and realizing a conflict of interest within a banking system that allowed a bank to both issue loans and trade investments based upon them, two Democratic senators had the following dialog as Congress debated new regulations:

(Mr. Glass:) Here [section 21] we prohibit the large private banks whose chief business is investment business, from receiving deposits. We separate them from the deposit banking business.
(Mr. Robinson of Arkansas:) That means if they wish to receive deposits they must have separate institutions for that purpose?
(Mr. Glass:) Yes.

(Sen. Glass was a former Secretary of the Treasury. His co-sponsor of the bill, Rep. Steagall, was the Chairman of the House Committee on Banking and Currency.)

Ultimately it was decided, that as shepherds to our economy and the heart that keeps our life blood pumping (credit), banks had to first and foremost be banks, and not engage in risky investing behavior. 

It was obvious then that society came first, and shareholders came second. Banks could make as much money as they could, but within reason, and not at the risk of the stability of the entire banking system.

This worked for decades, but then in the 1980’s banks started to get greedy, lobbying Congress to repeal the Glass-Steagall Act.

In 1987, the Congressional Research Service investigated the question, and came up with the following conclusions for both sides of the argument:

The argument for preserving Glass-Steagall (as written in 1987):

1. Conflicts of interest characterize the granting of credit – lending – and the use of credit – investing – by the same entity, which led to abuses that originally produced the Act
2. Depository institutions possess enormous financial power, by virtue of their control of other people’s money; its extent must be limited to ensure soundness and competition in the market for funds, whether loans or investments.
3. Securities activities can be risky, leading to enormous losses. Such losses could threaten the integrity of deposits. In turn, the Government insures deposits and could be required to pay large sums if depository institutions were to collapse as the result of securities losses.
4. Depository institutions are supposed to be managed to limit risk. Their managers thus may not be conditioned to operate prudently in more speculative securities businesses. An example is the crash of real estate investment trusts sponsored by bank holding companies (in the 1970s and 1980s).

The argument against preserving the Act (as written in 1987):

1. Depository institutions will now operate in “deregulated” financial markets in which distinctions between loans, securities, and deposits are not well drawn. They are losing market shares to securities firms that are not so strictly regulated, and to foreign financial institutions operating without much restriction from the Act.
2. Conflicts of interest can be prevented by enforcing legislation against them, and by separating the lending and credit functions through forming distinctly separate subsidiaries of financial firms.
3. The securities activities that depository institutions are seeking are both low-risk by their very nature, and would reduce the total risk of organizations offering them – by diversification.
4. In much of the rest of the world, depository institutions operate simultaneously and successfully in both banking and securities markets. Lessons learned from their experience can be applied to our national financial structure and regulation.
(Lists courtesy Wikipedia)

Ultimately, those in favor of repealing the Act won favor, and in 1999 Glass-Steagall was no more.

What followed was 8 years of astounding growth by banks, as they transformed themselves into full-service, one-stop, financial companies. As the (regular) bankers made money from taking deposits, fees, and loans, the normal methods available to a bank for creating revenue, the investors and traders at the new groups within these conglomerate banks started investing to try and make more. The loans the bank was granting were then being traded by the banks investors, re-instituting the conflict of interest Congress removed in 1933.

In the end, they lost most, if not all, the profits the regular bankers earned for the companies over those 8 years.

In the process, as these losses continuing to mount, the banks bled. Today, most of these conglomerate banks have so many debt obligations that they can no longer effectively distribute credit, and as we know the Federal Reserve has no facility for directly distributing credit to the populace – one of two primary functions of a modern-day bank. There are still some smaller, stable, banks lending as they always have. But in the age of conglomerates they are few and far between.

In response, the Federal Government has decided to shore up these banks financials to allow them to stabilize and lend more. This is necessary and good, as they are all likely to fail under the weight of their mistakes otherwise. However, the government is also currently of the opinion that lack of regulation and oversight is to blame in this crisis, and to a degree it is true. But the underwriting cause of it all is the banks greed, and the governments indulgence of it, that led to them taking risks that are quite frankly completely unacceptable when the potential loss is the destabilization of the entire global banking system.

Congress, the President, and the banks, all claim no one could see this coming. No one could predict what was deemed the “financial tsunami” or the financial “perfect storm”.

But they did, in 1933. “Those who cannot remember the past, are condemned to repeat it.” And repeat it we did.

Now Congress is facing a second challenge, that of rising unemployment, and they believe that forcing Federal spending will stem the loss of jobs, and even create up to four million anew. They believe the Federal government, no matter how much debt it currently holds, can simply spend the economy out of a recession/depression. This too was an opinion held in the 1930’s. It was tried then.

Later, Henry Morgenthau, FDR’s Treasury Secretary said, “We have tried spending money. We are spending more than we have ever spent before and it does not work. … I say after eight years of this administration we have just as much unemployment as when we started … And an enormous debt to boot!”

During the Depression they were never able to solve the credit problem. No matter how much the Federal Government spent on the economy, it was eventually lost as the economy failed to use that money to create growth. After all, sustainable growth isn’t possible without credit.

Now our Democratic leaders want to do it again. It won’t work any more now than it did then, and we have a debt load that is virtually overwhelming, something that didn’t exist in the 1930’s. All congressional Republicans, except three (weak) moderate senators, have resoundingly resisted Democratic efforts. Despite this, the House today passed a 1,071 page bill, that no Republican voted for, to repeat the mistakes of history by spending upwards of $800 Billion. Even the bipartisan Congressional Budget Office thinks this bill will lead to disaster.

In conclusion, I offer the following suggestions:
1. Congress needs to read its own history.
2. Banks need to revert to being banks first and foremost. As the shepherds of our economy they do not have the right to risk it all for a little extra profit. Leave the greed for the pure investment houses. Conflicts of interest should not be *possible* to exist.
3. The Federal Government should invest it’s time and money in stabilizing the banks and freeing the credit markets, not increase spending to create jobs.
4. If the credit markets are free, the private sector will create the jobs, as they have the motivation to make more money. Government employees do not.
5. Greed is human nature. Reliance on a person’s good will and free market principles is normally the right choice, but not when the alternative is as dire as a systematic banking collapse. Do not trust banks to not be greedy, or more precisely, only greedy within reason. Greed unfortunately does not work that way. Preventive measures must be taken, even if it means bank shareholders won’t be able to increase their value ad infinitum.

We have history to look upon for guidance. People did see this coming. Let’s remember them…

(This article may be reproduced without my explicit permission so long as proper credit is attributed to me where the article is reproduced and a link is provided to this blog. If you do reproduce it, I wouldn’t mind a message letting me know for my own ego’s sake :) )

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