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Of course lenders stopped lending. They’re not stupid.

COMMENTARY | July 22, 2008

The problem with the economy is that the market worked. That’s a concept reporters and editors need to grasp.

By Martin Lobel

Too many reporters and editors covering economic and governmental problems don’t seem to get the larger context of what is going on—that the problems and ineptitude are a direct result of the Reagan/Bush “deregulation, trust the free market” ideology. The Republican party is not the old Republican party of fiscal and ethical responsibility.

Whether Reagan/Bush Republicans actually believe the economic lunacy of the Laffer Curve or the “starve the beast, cut taxes” pronouncements of Grover Norquist is really not all that important. What is important is the impact of those policies. As one very drunk prominent Republican lobbyist told me the day after the 2004 election, “I’m going to get rich. My clients are going to get richer and then we’ll have a one-term Democratic President because she’ll have to clean up the [mess] we leave behind.” He may have been wrong about the sex of the next President but he wasn’t wrong about the mess.

Bush’s policies led to unprecedented increases in the wealth of the top 1/10th of one percent of the American population, whom Bush called his constituents, while the middle class lost ground and maintained its life style only by borrowing against the value of their homes and working harder and longer. The deregulation emphasis meant no one was policing the markets. This led to inevitable abuses:

  • The selling of mortgages to people who could not afford them. Sellers earned big fees for generating the mortgages but then quickly sold them and had no liability
  • The development of derivatives that were so opaque that no one could really value them. These also generated large fees
  • The use of Special Purpose Entities (SPEs) to keep liabilities off the books of banks even after Enron showed how risky they were. The Controller of the Currency approved Citibank’s use of SPEs to hide $81 billion of derivatives. Both acts—the approval and the hiding—border on criminal malfeasance.

Then the inevitable happened. The market worked. Lenders stopped lending to the banks and investment houses because no one knew what their derivatives were worth. The music stopped and there weren’t enough chairs for all these seers of Wall Street.

The result was predictable. Bush (the taxpayers) was forced to save them (his constituents?) from their over- leveraged risky investments by stepping in with $29 billion of taxpayers money to save Bear Stearns. Without that, the financial market might have come totally unraveled. And that may be only the first of many such likely scenarios, e.g. Fannie Mae and Freddie Mac, in which profits are privatized and risks socialized.

Most of the worst abuses could have been avoided if Alan Greenspan had not slavishly followed the Bush ideology and remembered the warning from William McChesney Martin, chairman of the Federal Reserve Board from 1951 to 1970, that the function of the Fed was to take the punch bowl away when the party got too exuberant. What did Bush do? He took enforcement power away from the SEC, a law enforcement agency, weak though it may be, and handed it to the Fed, which has been a cheerleader for the big banks and wouldn’t think of being an enforcement agency. While it is true that we should rethink the jurisdiction and power of the financial regulatory agencies, that’s a longer term issue. But anyone who has been involved in Washington problems can tell you, that the best solution is to go in quickly, clean out the mess and don’t let it linger.

Unfortunately, government agencies are led by people who don’t believe in policing the market and don’t understand that a free market only works when there are clear rules. Until there are such rules, and until they are enforced and people are held personally responsible for their actions, we will stagger from crisis to crisis.

Business will suffer too because the longer the financial mess lingers and hurts more and more people, the more likely some draconian action will be taken. A classic example is commodities market regulation. Many believe the so-called “Enron loophole” that allows traders to make unreported commodities trades offshore has added to the speculative increase in oil prices. Bills introduced to halt oil speculation could adversely affect all commodities trading. It would have made sense for the Administration to move to close this loophole earlier; now it’s too late.  Of course, as long as traders were making a lot of money by exploiting the loophole, the Administration decided to rely on the “free market” to correct any problems.

The same problems appear in taxes. Everyone agrees that the current tax code is too complicated. According to a recent investigation by the Senate Permanent Investigations Subcommittee, there are about $100 billion in uncollected personal taxes because of offshore tax abuses. Yet, the IRS is so understaffed that it can pursue only a few offenders even when it knows about the tax evasion.

UBS, a leading global wealth manager, reports having about 19,000 U.S. taxpayer accounts in Switzerland. American law requires that ownership of such accounts be made public but most have not been and the IRS doesn’t have the resources to go after more than a few of them. The extent of lost corporate revenue is much greater. Every IRS Commissioner who has testified about the transfer pricing system used by multinational corporations to shift profits to tax havens has admitted that the IRS cannot police the system, but the IRS refuses to support using a unitary accounting system that would be simpler and more effective in collecting taxes and leveling the playing field between multinational corporations that don’t have to pay taxes and domestic companies that do.     

One final area is worth mentioning: national security and transitioning to the new administration. The U.S. is most vulnerable during the transition from one administration to another, yet too many of the career bureaucrats who make transitions work because they know where the real problems are have been replaced by people who believe the less government the better and haven’t a clue about the problems that need to be solved.

More of the media need to focus on the larger context of each of the problem areas government faces. Very dangerous situations confront us.

[More detailed information about the issues addressed here can be found at www.tax.org. And click here for previous, related Nieman Watchdog articles by Lobel.]

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