Honing Capitalism - BAC vs. Fed

Political rhetoric has moved beyond socialism vs. capitalism. Instead, it centers on how to best hone capitalism for the common good. This insight comes directly from Barrack Obama’s autobiography. And in that context, it might just be semantics, replacing the term “socialism” with “honing capitalism for the common good”. The main difference, however, is that people will often have a definitive stance on socialism; but no one quite knows how to hone capitalism for the common good. This is why the Bank of America / Federal Bank scandal has emerged as bar none the most fascinating subplot of the financial collapse.

The basics of the scandal have been unfolding for some time: In September, BAC announced plans to acquire Merrill Lynch (ML). As the crisis worsened in the winter, BAC considered backing out based on ML’s projected 4th quarter losses. Paulson (previous US Treasury Secretary) and Bernanke (current Fed Chairman) pressured BAC to go through with the deal, threatening to withhold bailout should the economy worsen. BAC complied completing the deal around New Years. 2 weeks later, ML announced astronomical quarterly losses of about $20 billion. This outraged BAC shareholders who blamed CEO Ken Lewis, and Lewis in turn blamed Paulson and Bernanke. On top of all this, recently uncovered emails from the Fed show that they applied much more pressure to BAC than was previously thought, going so far as to threaten to remove Lewis. In the meanwhile, BAC, unsurprisingly, has received upwards of $50 billion in bailout funds, along with guarantees of twice that should they face future losses.

Bernanke and Pualson justified their actions as necessary to avoid widescale financial collapse. Afterall the failure of The Bank of the United States catalyzed the Great Depression in 1930. And it is thought that in order to avoid another Great Depression, we must prevent such large scale failures.

There is one view of history that says it’s determined by large-scale historical events. If you could’ve prevented the event, this line of thought goes, you’d have prevented its consequences. A more subtle view sees large historical events as the effect, rather than cause, of underlying social movement. Going by the latter, it doesn’t matter which large scale events you might prevent, because the underlying problem stays the same.

The BAC/ML merger didn't benefit the greater good at BAC's expense. In some ways, it has made the whole system worse. Going into the crisis, BAC was not only the healthiest bank in America, it belonged to a rare breed of successful commercial banks doing business with tens of millions of everyday people. Loading it up with ML's debt was the equivalent of further dragging down our banking system's best fruits with its worst apples. (Ironically, in 1933 the Glass Stegal act attempted to hone capitalism by doing the opposite, forcing the separation of commercial and investment banking.)

The underlying story of the financial crisis is that institutions which were too big to fail misread their risks and were too interconnected to each other. Fair enough. But to the degree that separate institutions are indeed separate, forcing BAC to merge with ML is simply perpetuating the original problem (of interrelated systemic risk) albeit to the nth degree. Instead of cutting our losses with ML and maintaining one great bank, we have a formerly great bank forced to remain on life-support from the government.

Public bewilderment towards the financial crisis stems partly from the fact that no one quite knows what to do. It makes one nostalgic for the 1980’s when things were as simple – at least in retrospect - as Reaganism and Thatcherism vs. Socialsim. Current economic debate - in contrast to the public’s partisan divide on Obama approval ratings - has become less polarized and ideological, more ambiguous and murky, and more important all at the same time. As Greenspan – a self-described Republican-libertarian - pointed out, his job was similar to those of communist central planners, only he was controlling a relatively smaller piece of the economy.

It’s a point worth repeating that the current depression is more complex than most of us can wrap our minds around. And it reveals one of democracy’s flaws, which is that running a country requires more detailed knowledge than is commonly held by the public. Our successful economic recovery - similar to the post-WWII recovery following the Great Depression - is likely to leave the public with few lasting insights about the economy or how the world works. It’s in this panicked context that we see such strange behavior as the Fed’s pressure to force the BAC/ML merger – a scandal occurring at the main nerve of the crisis, the lasting effects of which are unlikely to be well known by the public and experts alike.

What makes this scandal unique is that it's not quite a financial one, and it is a political scandal but not in the regular sense. What, in the end, did Paulson and Bernanke have to gain by forcing the merger? It wasn't money, votes, or even popularity. It didn't spark public outrage like the Madoff or AIG bonus scandals. And the perpetrators weren't guided by partisan or ideological grounds as in the case of Acorn's voter fraud. Unlike any of the previous examples, the perpetrators' motives are not immediately obvious; you have to sit back and think about it before understanding why Paulson and Bernanke felt the need pressure BAC into the merger. And you also have to sit back and think about it before understanding why Paulson and Bernanke's actions were wrong.

-KJ

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Media (in order of appearance)

Photo: (1)Obama at the Texas book festival, 10/28/2006, by Mr. Wright; (2)Bank of America Logo, 08/19/2007, by Neubie; (3)fail, 09/29/2008, by rin3y; (4)Joan of Arc, 08/23/2006, by dbking;(5)Aghast, 08/28/2008, by Daveness98. Sphere: Related Content

Turbulence

The Age of Turbulence abruptly begins with Alan Greenspan on a flight across the Atlantic. The captain brings him up front and tells him that the World Trade Towers were hit, and the plane had been redirected back to Zurich. It was 9/11, and he recalls his racing thoughts about what this would mean for the new world. Second to his wife, his obvious concern was for the economy. It was clear that the terrorists weren’t directly after the financial system, or else they would’ve hit the banks, but everyone knows that a sound economy abhors such instability.

“The mood in the cockpit was somber,” writes Greenspan. “’You’ll never believe this,’ the captain said, ‘Listen.’ I put my ear to the headset but couldn’t hear anything other than static. ‘Normally the North Atlantic is full of radio chatter,’ he explained. ‘This silence is eerie.’ Apparently nobody was out there.”

Greenspan recalls the likewise eerie aura on Capital Hill over the next year. Everybody kept insisting that America was safe and her citizens should stay calm, but there was no concrete evidence for this; and in contrast to their words, it looked like White House officials were bracing for a second large-scale attack, as if it was more of a question of when, instead of whether, it would happen.

Amidst the chaos and the aftermath, however, Greenspan was rather surprised about how the economy managed to get itself right back onto its feet. While it did involve some minor tinkering with air-travel and communications, for the most part, business as normal resumed rather soundly.

The lesson that Greenspan took away was that it reflected the rigidity of the economy. 9/11 left a political and social gash on the country, but from the eyes of the economy, it was just a blip on the radar. For Greenspan 9/11 was a testament to the strength and independence of the US economy.

It borders on irony that less than a year after publishing his monumental autobiography – 544 pages long, and with an $8.5 million advance from Penguin Press – his book is already outdated, with the banking system on the brink of failure and the US potentially facing the worst depression since the 1930's. Indeed, the economy is sound and it is rigid. But it seems to be a beast onto itself - strong enough to bear external blows as heavy as 9/11, while anything but immune to its own internal writhing and convulsions.

The Blame Game

Jim Cramer recently had a comedic, and quite frankly shameful, run-in with Jon Stewart, in which Cramer blamed his interviewees for lying to him. No doubt the blame game has just begun.

Bernanke, Greenspan’s successor, recently came out with his most emotional statement yet, in part blaming AIG’s irresponsible risk-taking for the collapse.

“If there’s a single episode in this entire 18 months that has made me more angry, I can’t think of one, than AIG,” he said. “AIG exploited a huge gap in the regulatory system. There was no oversight of the financial products division. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets, took huge losses. There was no regulatory oversight because there was a gap in the system.”

Of course what Bernanke partly overlooks is expanding credit in the economy – largely through the rise of credit default swaps – which AIG was in part responsible for backing up. Credit-expansion during a boom is one thing, but similar to investment banking it crumbles when the economy falters in the least. Merrill Lynch and Bear Stearns can blame their falls on the stock market; creditors can blame their problems on the lack of funds to repay debts; and Bernanke can blame it all on those who were responsible for backing the expansion of credit. But what’s shortsighted is a thorough examination of the system in and of itself.

Communism, after all, would work perfectly if only the laborers worked hard. Yet blaming the fall of communism on laborers' laziness is futile, because they’re not working for a reason: No incentives.

Every society has its screw-ups. Shit happens as Forest Gump might say. But society banks on the fact that these screw-ups remain small in number and are randomly dispersed. When their numbers grow and their mistakes become more apparent, then you have to start looking for other answers. In other words, you have to dig deeper when shit starts happening in a frequent and consistent manner.

Which is why the notion of an "insurance" company that backs credit defaults is absurd, because the frequency of credit shit happening is non-random and inter-dependent. Other types of insurance depend on the fact that the covered averse events occur randomly and independently. If all of GEICO's customers, for instance, crashed their car on the same day, then it would surely go out of business, but that's not how car crashes work. However, such is how the credit business works, with one default often linked to another in a chain of events, having a similar effect as a massive car collision pile-up spanning the entire country would have on GEICO. Third parties can't feasibly "insure" credit contracts; you can't hedge the risk of credit defaults with successful creditors, because both events are tied to eachother. That's also why Bernanke's anger towards AIG is misdirected.

Indeed, AIG acted irresponsibly, but why were they in a linchpin position to aid in the collapse of the entire economy? Where were the corrective forces that should’ve come into play?

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Depression Economics

Murray Rothbard’s America’s Great Depression (which I’ve just started) opens with a similar point regarding business cycles and failures: Just like screw-ups and bad-apples, they’re seen throughout society. What’s rare is when a nation experiences a string of failures – each tied to the other – and the economy as a whole (rather than any particular company) lacks the corrective forces to get back on track. The Great Depression, similar to current times, has been blamed on various individual enterprises, such as Galbraith’s 200-page rant against speculators of the 1920’s, or the accelerative properties of the capital goods sector. But these explanations ring hallow insofar as they’re always present, and, if true, are relatively non-specific to a particular time period.

Rothbard continues that the largest tragedy of the Great Depression wasn’t the pain forced upon the nation, but the dearth of literature explaining it. Most commentators on the subject agree. Indeed previously the country had seen various mini-crises, but they proved to be self-correcting within a year or two. The Great Depression was shocking, not because of the panic of 1929, but because of the huge length of time it took to be resolved.

Part of the dearth of study, Rothbard contends, is because few theories account for the business cycle. Recessions are conceptualized as the exception rather than the rule, and when they last for more than a few years, this is generally true. But that’s no reason to shy away from studying them. Insight can be gleaned from them, similar to an extreme medical case. Phinneas Gage – the railroad worker who had his frontal lobes shot through with an iron spike – was also the exception, but it was the extreme and curious nature of his state that kick started modern brain science as we know it today. Advances in neuroscience have only increased our understanding of Gage’s case, even a century and a half after the event. Such aberrations have proved invaluable to neuroscience and to medical science as a whole; and likewise economic aberrations should be a natural starting point for inquiry into economic theory. Unfortunately, the later is rarely the case, and we may have to wait much longer to understand current economic events.

-KJ

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Media (in order of appearance)

Photo: (1)Greenspan, 09/15/2007, by chickenhawkdown; (2)President George W. Bush address to the nation and joint session of Congress Sept. 20; (3) Plane, 02/20/2007, by ores2k; (4) Cover of Greenspan's 2007 book, The Age of Turbulence; (5) Ben Bernanke, 03/06/2006, by Simon; (6) Mad Money, 08/16/2007, by Carlos Gomez; (7) Murray Newton Rothbard, 02/01/2009, by Taylor; (8)Phineas Gage (Lesioni), 09/28/2008, by epanto.

Video: (1) Daily Show interview with Jim Cramer, of CNBC's Mad Money, 03/13/2009. Sphere: Related Content