Sunday, January 29, 2012

A Laissez Faire-y Tale

Libertarianism and deregulation successfully trashed the US economy. Americans lost their savings, their homes, and their jobs in record numbers unprecedented since the Great Depression. Former Federal Reserve Chairman Alan Greenspan’s libertarian philosophy that markets know best is responsible for the U.S. financial crisis that erupted at the end of George W. Bush’s presidency. Greenspan’s acolytes – Treasury Secretaries Robert Rubin, Larry Summers, and Timothy Geithner – also bear responsibility for the existing international economic debacle. And it all began with Ayn Rand.

Rand immigrated to the United States from Russia in 1926, the year Alan Greenspan was born. The celebrated fiction author of the novels The Fountainhead (1943) and Atlas Shrugged (1957), Rand championed libertarianism. She famously told Mike Wallace in a 1959 CBS television interview that she believed in “the separation of state and economics.” She opposed all regulations of markets. Greenspan became her pupil and she was present when he was sworn in as President Gerald Ford’s chief economic advisor. That she came from an oppressive government regime likely explains her extremist laissez-faire attitude – something that Republicans love.

By the time Rand became a Hollywood screenwriter, President Franklin Roosevelt signed the Banking Act of 1933 (Glass–Steagall Act). This New Deal legislation established the Federal Deposit Insurance Corporation (FDIC) and introduced banking reforms to control speculation. Following an era of corruption, financial manipulation and "insider trading" resulted in more than 5,000 bank failures following the 1929 Wall Street crash.  The Glass–Steagall Act also allowed the Federal Reserve to regulate interest rates in savings accounts.

Deregulation fever took hold in 1980 with the enactment of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) that gave the Federal Reserve greater control over non-member banks. Among other things DIDMCA allowed banks to merge, forced all banks to abide by the Fed's rules, and removed the powers of the Fed under the Glass–Steagall Act to set the interest rates of savings accounts. Ronald Reagan became president that year, famously saying that government was not the solution to the country’s problems, “government is the problem.”

The Alternative Mortgage Transactions Parity Act of 1982 (AMTPA) removed regulations that barred banks from making anything but the conventional fixed-rate loans. That gave birth to the kind of mortgages that put borrowers in default situations; Adjustable-Rate mortgages (ARM), Balloon-payment mortgages, and Interest-only mortgages crushed borrowers. The option-ARM allowed borrowers to underpay by as much as they want during the first few years of the loan so that the unpaid monthly interest got tacked onto the size of the loan.

A $300,000 mortgage could become a $350,000 loan. Homeowners could find themselves out of equity, upside down, and into default.

As for Alan Greenspan, he continued to build upon his libertarian Wall Street-friendly influence in Washington. On August 11, 1987, the Senate confirmed Greenspan as President Reagan’s nominee for chairman of the Federal Reserve. Paradoxically, the Ayn Rand influenced, anti-regulation, free-market economist Greenspan became the ultimate regulator as the head of the central bank. Two months later, on October 19, the Dow Industrials' plunged 508-points and the New York Stock Exchange crashed.

But as a disciple of Ayn Rand, Greenspan presumed that “the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms,” as he testified before Congress. He sought and attracted fellow believers in free-marketeering who grew in their influence and power during the Clinton administration. Greenspan’s inner circle included Wall Street financier Robert Rubin, Harvard economist Larry Summers, and the Treasury Department’s Timothy Geithner. Each of them became Secretary of the Treasury.

The so-called go-go ‘90s seemed to confirm Greenspan’s hands-off approach to regulation. But as a result the financial world suffered a fiscal heart attack in 1998.  

Long Term Capital Management (LTCM) started to meltdown. The secretive computer model driven firm made huge leveraged bets on various forms of arbitrage, in particular securities called over the counter derivatives. Derivatives made up an unregulated $27 trillion dollar international market. Unfortunately, LTCM’s proprietary computer models failed when a financial crisis in Russia fractured their virtual financial world and crashed those models. It took a private bailout, overseen by the Federal Reserve, to prevent systemic financial catastrophe.

Congress summoned Fed chairman Greenspan. He again assured them that markets know best. He told them that he knew of no regulations that could prevent people “from making dumb mistakes.” So despite the systemic meltdown, Congress took no regulatory action. The following year Congress sent President Clinton the Financial Services Modernization Act of 1999 (Gramm–Leach–Bliley Act) which he signed. The Gramm–Leach–Bliley Act allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate.

From 1999 to 2008 the grateful financial industry spent $2.7 billion on lobbying, while individuals and committees affiliated with it made more than $1 billion in campaign contributions. During this time, the banking industry hid its use of off-balance-sheet derivatives and its excessive use of leverage. That created a shadow banking system  in which the banks relied heavily on short-term debt. The lobby got what it wanted and Greenspan got the praise. However, Greenspan's apparent successes in managing the economy from 1987 to 2006 are a façade. That management created the largest credit bubble in world history.

President George W. Bush awarded the Presidential Medal of Freedom to Alan Greenspan after his 18 years at the Federal Reserve In 2005. Hailed as a financial wizard, Greenspan retired in 2006. Dr. Ben Bernanke, a Princeton University Economics Professor, succeeded him. Goldman Sachs Chairman and CEO Henry M. Paulson became Treasury Secretary. Greenspan’s protégé Timothy Geithner served as the CEO of the Federal Reserve Bank of New York. The U.S. housing bubble continued to swell.  

In 2008 a systemic failure like the LTCM meltdown a decade earlier hit the Wall Street. The investment house Bear Stearns began to meltdown. It imperiled the interconnected global financial market, largely because of derivatives that had been created with toxic mortgage backed securities. Federal intervention in the form of a loan to J.P. Morgan Chase as an intermediary allowed Bear to be bailed out, but it did not solve the underlying problems such as secrecy, avarice, and fraud.

Next, the epidemic mortgage crisis forced the Treasury to nationalize Fannie Mae and Freddie Mac, putting each of the mortgage giants into conservatorship. Secretary Paulson said that "that conservatorship was the only form in which I would commit taxpayer money to the GSEs [Government Sponsored Entities]."  The Treasury committed to invest up to $200 billion to keep the GSEs solvent.

Wall Street’s Lehman Brothers faced bankruptcy next. Secretary Paulson decided to teach Wall Street a lesson. He told Lehman management that the government would not step in. Lehman needed a buyer but found none. Forced into bankruptcy, the government allowed Lehman to fail. With that, the systemic risk plunged Ireland into trouble. The Bank of England had to start bailing out banks. Iceland went bankrupt. China faced 0% growth. At home U.S. banks stopped lending. The world financial system began to meltdown.

Then one of the world's biggest insurers, American International Group (AIG), fell victim to the mortgage backed security crisis. This time, however, the government decided AIG truly was too big to fail and seized control. The $85 billion deal demonstrated the government’s extreme concerns about the danger of what such a collapse could pose to the financial system.

Secretary Paulson and Fed Chairman Bernanke called congressional leaders to Nancy Pelosi’s office and bluntly requested $700 billion dollars to save the US economy. At first rejected by the House, the Emergency Economic Stabilization Act of 2008 was signed into law by U.S. President George W. Bush on October 3. It created the Troubled Asset Relief Program (TARP) which allowed the United States government to purchase assets and equity from financial institutions.  

To solve the lending crisis, Secretary Paulson summoned 9 of the largest banks’ CEOs to the Treasury. He forced them to accept capital injections that made the United States a stockholder. To prevent the failure of Wall Street’s Merrill Lynch, Paulson arranged its buyout by Charlotte based Bank of America. Under TARP some banks got bailed out. Other banks were seized by the FDIC and placed into conservatorship until they could be purchased.

In retrospect, many analysts and economists now blame weak Fed policies for the 2006–2008 housing crash, the Wall Street financial crisis, and resulting recession. Failing to take action to stem the bubble in housing prices, inadequate oversight of financial firms, and keeping interest rates low for an extended period are major contributors.

Alan Greenspan now says, "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms." He testified to congress that he “found a flaw.” Greenspan said the crisis had shaken his very understanding of how markets work. He also agreed that despite his former opposition to it, financial derivatives should be regulated.

The Ayn Rand-inspired laissez faire libertarianism that Greenspan and his fellow US financial regulators practiced not only failed on a colossal level but led to phenomenal government interventionism. Deregulation and the absence of regulating allowed for massive investment fraud hidden in an opaque and secretive international monetary system. It also concentrated Wall Street firms and U.S. banking, which will continue to pour money into opposing past and future regulations. Rand’s philosophy emanated from a world coming into the 20th century. It failed the world coming into the 21st.  

 Originally published as A Laissez Faire-y Tale on Blogcritics.

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