The Role of Government
There is a Chinese curse: "May you live in interesting times." These certainly are interesting times. As this is being written, the American financial system teetering and a bailout package being debated in Congress. Here at The Party of Common Sense we are watching as free market Republicans attack a bailout plan as being socialist (who would have ever thought a Republican administration would "nationalize" firms - that's what happens in lawless places like Russia and Venezuela), those on the left attack a bailout plan for socializing losses and privatizing gains, and Congressmen and Congresswomen of both parties remember the last time this administration came to them with dire predictions of a mushroom cloud (this time being the collapse of the US financial system) and demanded Congress (a) act immediately and (b) turn all control over to members of the Administration - and we all saw how that worked out last time. The central question in the debate is: Should the American taxpayer bailout Wall Street?
At The Party of Common Sense, we believe in free market economies, for the most part. The free market guys would argue that the late 1970's bailout of the automotive industry was a bad thing. The big three were clearly a victim of poor management (lack of vision) and unions which wanted to share in their success but refused to limit themselves and pushed the companies to the brink. Failure of Chrysler alone, the company closest to the brink, would have put 140,000 people out of work. Clearly, there would have been severe pain in the economy. However, had the big three gone under, perhaps a viable automotive industry would have sprung up that would have been able to compete internationally by producing vehicles that people actually wanted and were produced economically. Instead we have a automotive industry that has hobbled along, to the point that it is now requesting another $25 billion to $50 billion bailout from the US government. Should we allow the US financial industry to collapse? After all, money is the lifeblood of the economy. Would an inevitable depression really make America stronger in the future? The other question is: What is the proper role of government? Did the collapse occur because of poor judgment by the financial firms themselves, poor judgment by those buying houses they couldn't afford, or a failure of the government to properly regulate? And if it is the latter, then perhaps the government should have some role in fixing it. It appears a little of each, but certainly the government was way too permissive in allowing the first two to happen.
As we've argued before, THe Party of Common Sense believes the government's job is to set the rules of the game and to enforce those rules fairly. Enforcement bodies need to represent both industry and the American people, with bias towards neither, much as a referee should in sports. Pure free markets don't work (as we saw in the early days of the industrial revolution) and neither does centrally, government run economies (as we've seen with the fall of communism). China is currently undergoing a baby milk scare - where manufactures watered down the milk to improve profits and then reinforced the milk with melamine to artificially increase the protein levels in the milk. Sure it was economically expedient for the manufactures, however, unknown to the manufacture, it can cause kidney stones in babies and four babies have died with another 13,000 hospitalized. From a pure free market perspective, people would stop buying the milk, the firm producing the doctored milk would go out of business, and other firms selling non-tainted milk would step up and all would be right again. However, this would occur at cost to society that is clearly unacceptable - I think all but the most hardened free market economists would agree that to prevent such societal calamities, government should have a regulatory role in business. Unfortunately, this administration has, in the name of free market economics, systematically hollowed out regulatory bodies across the board - and not just the financial oversight agencies. In addition, in the name of deregulation, they have weakened the rules in the believe that free markets work better than regulated ones.
Just this month the EPA issued a ruling that allows three times the level of Perchlorate than other state and scientific recommendations allow (see the Washington Post article here). Perchlorate, a chemical used in rocket fuel and has leached into our drinking water, causes thyroid problems in children and can cause an irreversible drop in IQ, behavioral, and perception problems. Not only did the EPA issue a finding that says 5 times the level that scientific research says is safe, it is also non-binding - meaning it is a mere recommendation and no remedial action need be taken. According the Washington Post, the finding was produced with a large amount of White House interference, and even with the high levels that ruling deems safe, still puts up to 2 million people at risk. Why? The Pentagon and large government contractors who would have to pay for clean-up pressured the White House, who, in a knee jerk pro-business ideology, wanted to protect businesses at the expense of the American people. Most Americans don't know about Perchlorate, nor should they. It is a reasonable assumption that it is the job of the EPA to act on American's behalf and protect the American people. This is just one example of many in which the EPA failed to do its job (the EPA is currently being sued by 17 states over a lack of enforcement of the Clean Air Act, being sued by 13 states in regards to ground pollutants, lost a case in Florida for failing to enforce the Clean Water Act in the Everglades, and, well, you get the point). This is also typical of regulatory bodies throughout the government. The Bush administration has named as heads of these oversight bodies industry insiders and lobbyists, all Republican card carrying ideologues with a singularly focused pro'business, free market mindset. I would argue that the job of these regulatory agencies is to setup the rules of the game and to referee the game fairly ' not to side with the industries they regulate at the expense of the American people. Instead we've got a fixed game where these crooked referees have caved repeatedly to business pressure, ultimately putting the American people at risk. We have tainted food, lead paint in our toys, mines that collapse, bridges that collapse, an oil industry that is in bed (literally and figuratively: the Department of Interior's Mineral Management Services was accused misconduct including sex with oil industry employees), unsafe water supplies, and so on...
This is true across the board including the oversight bodies of the financial industry. Secretary Paulson comes from Goldman Sachs - an industry insider. France's economy isn't collapsing; Germany's economy isn't collapsing - maybe in part because they have rules that prevented the run-away freight train that was the American financial system - and they enforced these rules. Examples are abundant.
Firms peddled auction rate securities as being as safe as cash, until it wasn't (the government was quick to close this barn door, but after the horses escaped and they made the firms peddling these securities make their customers whole).
A new unregulated financial instrument called credit default swaps were created to insure bonds against default - which meant that home loans could be made, packaged, sold and insured - in theory making them safe, but with a high rate of return than other options such as Treasury Bonds. Sure, the regulators knew about these derivative instruments, knew they were unregulated, knew firms were leverage to the tune of 30:1 (unlike regular insurance firms which have to have assets on hand to payout in the event of catastrophic claims) - but they did nothing about it. How did this happen? On Dec. 15, 2000, hours before Congress was to leave for Christmas recess Republican Texas Senator Phil Gramm had a 262-page amendment slipped into the appropriations bill which forbade federal agencies to regulate the financial derivatives.
A Republican congress overturned the shorting uptick rule (which used to prevent shorts from piling on and driving a company out of business). Naked shorting1, always illegal, became the norm as regulators turned their heads to these abuses. These put in place the necessary mechanisms to drive otherwise good firms into the ground. Since mutual funds cannot short, only hedge funds and individuals are allowed to short stocks, the primary shorter was hedge funds. Short selling a stock isn't possible if the company is fundamentally sounds, so hedge funds would argue don't blame them, they are just the executioner. They were wrecking firms, as Gordon Gekko, a character in Oliver Stone's 1987 movie Wall Street said, "because they are wreckable". The mechanisms were there, greed kicked in, and to make a quick buck the hedge funds began destroying Wall Street. When the credit market seized up, banking firms held securities that were illiquid - that is there was no market to buy or sell them and without a market, no one knew how much they really were worth. With this unknown, it was impossible to price assets and therefore determine an overall price for the firm as a whole. The process was straight forward to drive a firm under: A rumor would start (for example, that Bear Sterns didn’t have enough money) - the hedge funds would short the stock, causing the stock to fall. In light of the falling stock price, those long on the stock can't measure the actual value of the firm took the safe route dumping their shares, which caused the stock to fall further. The credit rating agencies (who had their own part to play in the problem by providing ridiculously high credit ratings to collateralized debt obligations - the Street term for the packaged home loans) would downgrade the bank's credit rating, which would trigger greater liquidity requirements (more assets on the books), and since the stock was worth so little, they were unable to raise money, which would cause the firm to fail. Hedge firms repeated these steps for Bear Sterns, Lehman Brothers, AIG, and they were teeing up Goldman Sachs, JP Morgan, Wachovia, and Washington Mutual when the Fed stepped into temporarily stop the shorting process. It was too easy, and billions were made by hedge firms (and lost by owners of the stock including main mutual funds Main Street counts on for the 401(k), investment funds, and the like) in the process.
Granted there was greed at the hedge funds, on Wall Street, and on Main Street with people buying houses without any means to pay the mortgages. But this was no Enron, a singular firm that strayed out of bounds, rather it was a government assisted crash. At least during the tech bubble of 2000 we had Alan Greenspan warning of "irrational exuberance" - this time the regulatory bodies who were supposed to be refereeing the game, were on the sidelines cheering as the Wall Street ran up the score with record profits. So, yes, the government helped create this mess and the government is going to have help fix this mess. My hope is that we have a philosophical fix in the next administration - where balance, science, and common sense replace ideology throughout our government regulatory agencies.
1Short selling occurs when someone borrows a share of stock, pays a small commission for the right to borrow that stock, and then returns the stock later. So a short might borrow a share of stock selling at $50, counting on it to go down, and they buys it in 30 days at the lower price of $40 returns the borrowed stock and pockets the $10 difference. If stock rises, the shorter will usually cover, meaning they might put a buy order in at $52, so if the stock rises they will only be out $2. In theory, in order to short a stock you need to identify the person loaning that share. Since it's not in the best interest for someone owning a stock to have that stock shorted, sometimes there aren’t enough shares available to be shorted (ironically, anyone with a margin account implicitly allows their stock to be shorted meaning you could be contributing to downward stock price pressure on stocks you own). In naked short selling there is no identified borrowed stock, and therefore no limit to the amount of selling that can occur. Millions or tens of millions of shares can be sold driving the price down, and therefore causing the stock to fall and ensuring the hedge fund makes money.
