Another World Economic Forum in Davos, Switzerland has come and gone. It didn’t get as much attention this year as in the past, and that is a good thing. Top government officials did not attend in their former numbers to mix with the rich and famous – and thus be subverted from their duties by the decadent glitz. With economic instability and rising tensions around the world, the libertarian notions the WEF was created to extol were being pushed aside by reality.
The WEF was dominated by business leaders, but major disagreements along national and professional lines were evident. Countries are climbing out of the Great Recession at different rates. A term used at Davos to describe the situation was LUV. An L-shaped stagnation in Europe; a U-shaped slow growth recovery in the United States; and a sharp V-shaped upturn in emerging economies like India, Brazil and China. The V is an exaggeration, as the emerging and developing countries continued to grow last year, just as a slower rate.
According to the International Monetary Fund’s World Economic Outlook released January 26, the output of the advanced economies declined by -3.2 percent in 2009, worse than had been projected. The United States was down -2.5 percent; the European Union, -4.0 percent; the United Kingdom, -4.8; and Japan, 5.3. In contrast, the emerging and developing countries increased their output by 2.1 percent, with China leading at 8.7 percent and India at 5.6 percent. Even Sub-Sahara Africa managed to grow by 1.6 percent. One of the key determinants was to what extent countries were tied into the Western banking system, which was the source of the financial collapse that dragged down national economies.
It should be remembered that during the Bush administration, Treasury Secretary Henry Paulson tried to persuade China to open up its financial system to American “innovation.” Paulson, the former CEO of Goldman Sachs, never abandoned his role as cheerleader for Wall Street. Beijing, however, was not buying any of Paulson’s snake oil and is now having a good laugh. There is nothing funny from the U.S. perspective as China waves around its huge currency reserves and touts is economic boom as a better model for the world than Western capitalism. Zhu Min, deputy governor of the People's Bank of China, told the Davos audience that loans
would continue to be guided by government policy into productive investments and away from speculation.
Western bankers were on the defensive at Davos, as well they should be. Industry leaders joined with government officials to call for tighter regulation of the financial sector to prevent another wild round of speculation and “innovation” that crashed the real economy, closing firms and throwing workers into unemployment lines.
Bankers may lack credibility, but they still have plenty of money for lobbyists. They will wage a rear guard action to defend their freedom of action. There were political fault lines in the battle over the reconfirmation of Federal Reserve Chairman Ben Bernanke they can exploit. The Senate eventually backed him by a vote of 70-30 with majorities in both parties. And though Bernanke had originally been appointed as Fed chairman by President George W. Bush, the main opposition came from Republicans friendly to Wall Street. They wanted to shift the focus of reform away from the bankers to the Federal Reserve, a government institution purposely set up to be outside the normal political turmoil.
The Fed is an organization of experts whose principle duties are to manage the monetary and credit conditions in the economy so as to maximize employment while avoiding inflation, and to provide stability to the private banking and financial system upon which modern capitalism depends.
It has always been easy for critics to portray the Fed as “elitist” and “undemocratic” even though its Chairman, Vice Chairman and the seven members of its Board of Directors are appointed by the President and confirmed by the Senate. The Fed operates with a great deal of independence and autonomy, as it was designed to do. It supports itself from the interest collected on U.S. government securities acquired through open market operations and loans to depository institutions; and from fees received for services provided such as check clearing, funds transfers, and automated clearinghouse operations. It is thus free of Congressional purse strings. Indeed, after paying its expenses, it gives 95 percent of its revenue to the Treasury. The principle is that monetary policy is too important to be left in the hands of politicians who are subject to mood swings, partisan ideologies, and special interest lobbying.
Bernanke has placed the blame for the crash squarely on Wall Street. At the annual meeting of the American Economic Association on January 3rd, Bernanke gave a major speech on the crisis, looking in particular at the “bubble” in the housing market whose bursting triggered the financial meltdown. Fed analysis found that the market had been running on its own internal dynamic and behaving outside the bounds of historical experience during the decade prior to the crash.
The Fed was not driving Wall Street with a loose monetary policy, nor making the decisions for the banks on how to allocate their resources. There was no general inflation nor was the money supply expanding at an abnormal rate. And while oversight should have been tighter in many government agencies, including the Fed, the banks designed their new instruments to fall outside the normal regulatory process to avoid constraints.
As Bernanke told the AEA,
“the most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards…. Stronger regulation and supervision aimed at problems with underwriting practices and lenders' risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates.”
A prime reason there was not stronger regulation and supervision is that Congress had given in to Wall Street lobbyists who had argued that the financiers were the “smartest guys in the room” who should be allowed to integrate and innovate in a “free market” to supposedly make capitalism more dynamic and efficient. Years of deregulation culminated in the Financial Services Modernization Act of 1999. The bill eliminated provisions of the Glass-Steagall Banking Act of 1933 which prohibited commercial banks from engaging in certain risky investment activity or owning other kinds of financial companies. Glass-Steagall had been enacted to protect the commercial banking sector, upon which the real economy depends for the financing of productive activity, against the temptations of speculation.
The bankers thought they had improved their ability to manage high risks, while still earning high profits. In the short-term, being let “free” did generate lavish returns and extravagant bonuses, but in the long run the wild ride ended in disaster on a global scale. The losses inflicted across national economies and which penetrated deep into society far exceeded the private gains to financiers. Institutions that had proudly boasted of their independence from government had to turn to government for their survival.
Sen. John Cornyn (R-TX) was one of the loudest voices against Bernanke’s reappointment. It should be noted, however, that Cornyn holds the seat previously held by fellow Republican Phil Gramm, the lead sponsor of the Financial Services Modernization Act. Gramm retired from the Senate and went to work for the Swiss bank UBS, which had to be bailed out by the Geneva government to avoid collapse. Moving full circle, Gramm was an economic adviser to Sen. John McCain during the 2008 presidential campaign, and McCain voted against Bernanke’s reappointment.
President Barack Obama hopes, “Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.” It will, however, take legislation to restore the protections once provided by Glass-Steagall. The Treasury in its statement on the 2011 budget declared, “Treasury is working closely with Congress to enact legislation that will promote more robust supervision and regulation of financial firms, establish comprehensive regulation of financial markets, protect consumers and investors, ensure the financial system works for our communities, provide the government with more powerful tools to manage financial crises, and improve international cooperation.” It is a job that must be done.
Lessons were learned in the 1930s which served to guide legislation and policy so that recessions were shorter and the financial system was stronger during the rest of the 20th century. Partisanship and special interest lobbying should not prevent the restoration of sound banking principles enforced by public oversight agencies dedicated to the advancement of the national economy.
FamilySecurityMatters.org Contributing Editor William R. Hawkins is a consultant specializing in international economic and national security issues. He is a former economics professor and Republican Congressional staff member.
