On July 11 President Obama said that thanks to his “swift and aggressive action . . . we’ve been able to pull our financial system and our economy back from the brink.”  Six days later, Larry Summers repeated the analogy: “We were at the brink of catastrophe at the beginning of the year but we have walked some substantial distance back from the abyss.”  After the failure of Lehman Brothers, Ben Bernanke was asked, “Well, what if we don’t do anything?”  To which he replied, “There will be no economy on Monday.”  Former President George W. Bush told ABC News in December that, in September, Bernanke and Treasury Secretary Paulson “said to me that if we don’t act boldly, Mr. President, we could be in a depression greater than the Great Depression.”  Chairman Bernanke, on July 26, told a Kansas City audience that he was “not going to be the Federal Reserve chairman who presided over the second Great Depression.”  When asked about bailing out the banks, Bernanke said, “nothing made me more frustrated, more angry, than having to intervene, particularly in a couple of cases where taking wild bets had forced these companies close to bankruptcy.”

The basic Obama administration rationale—“Things may seem bad now, but they would be much worse without us”—doesn’t sound like a strong line of defense.  Things are bad: This year we have been losing around 500,000 jobs per month, and in July we lost 276,000, bringing the total since January 2008 to 6.7 million.  Then, just as the White House began to talk incessantly about “green shoots,” personal income for June showed the biggest drop in nearly five years.  As the AP’s Stephen Ohlemacher reports, “Tax receipts are on pace to drop 18 percent this year, the biggest single-year decline since the Great Depression . . . Individual income tax receipts are down 22 percent from a year ago.  Corporate income taxes are down 57 percent.”

Could things be worse?  Always.  But the administration never outlined in detail what they thought was going to happen.  Doom, after all, could take many shapes, and if we were headed for something worse than the Great Depression, you would think they could have spelled out what was coming.  The most you can say for the administration’s argument is that it is unproved.

The financial crisis came along when there was very little real money available to deal with it in the conventional Keynesian manner, which is to throw money at it.  The government has had to resort to funny money—$23 trillion according to the Office of the Special Inspector General for TARP.  The main source of funny money is the Federal Reserve, which is supposed to be our independent central bank.  After we’ve spent our $15 or $23 trillion, have we done anything more than bail out our five big banks?

The big banks buy and sell derivatives—bets—to each other in vast amounts.  The comptroller of the currency reports that for the first quarter of 2009 JPMorgan Chase holds $81 trillion of derivatives while Goldman Sachs owns $40 trillion.  Bloomberg News reports that 40 percent of bank profits come from derivatives.  The banks are basically dealing with one another—they have created an exclusive Gamblers’ Club.

Bernanke believed the market needed more liquidity and acted to provide lots of it.  But, according to economist Anna Schwartz, liquidity is not the problem: “The real problem was that because of the mysterious new instruments that investors had acquired, no one knew which firms were solvent or what their assets were worth.”  Indeed, we still don’t know.  But the solution, if Schwartz is right, didn’t require any money; it only required transparency and a little candor.  The solution was to invite the five big banks to the Fed or Treasury and ask them to come clean about their derivative liabilities.  (Something similar was done by the Fed in 1998 to pressure the creditor banks to save Long-Term Capital Management.)  Then the banks could cancel some deals.  Investors—and other banks—could see what bets had been made and who was solvent.  The bankrupt banks would be shut.  Our current period, the time of the walking dead, would be avoided.  The only problem with Schwartz’s approach is that it required full disclosure: Some or all of the banks would have had to admit they were bust.

Larry Summers, in early July, told the Financial Times:

The president made two things clear to us early on.  He would do what he had to to fix the banking system, to get the economy out of the rut in which he was inheriting it.  But he had run for president to do long-run, fundamental things, like fixing healthcare, like having real energy policy, like reforming education.  And we weren’t going to be distracted from those things.

 

The President’s decision to press ahead on all fronts at once set the course of future events.

If the crisis was one of many things, it meant the President had to rely on advisors like Summers.  But that choice assured a conventional response and kept in power those responsible for creating the problem.  Summers had worked to repeal the Glass-Steagall Act in 1999 and immunize derivatives from state bucket-shop laws in 2000.  When Glass-Steagall was repealed, Summers said,

Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century . . . This historic legislation will better enable American companies to compete in the new economy.

 

Summers, shortly after a five-year term as president of Harvard University, told the New York Times, “There is a temptation to go for what is comfortable, but this would be a mistake. . . . The universities have matchless resources that demand that they seize the moment.”  Summers sought, in the words of Vanity Fair’s Nina Munk, “to lead (or force) the university into a glorious renaissance.”  There were, of course, many who did not think Harvard needed a glorious renaissance.  Under Summers’ watch, Harvard used interest-rate swaps to hedge against some of their riskier investments.  These swaps have come back to haunt the university.  Interest rates plunged and the losses piled up—eventually reaching one billion dollars.

In the 1960’s our commercial banks decided that commercial banking—within the confines of Glass-Steagall—was not a good business model.  First, they tried to do an end-run around the statute.  In Investment Co. Institute v. Camp (1971), the Supreme Court struck down a common trust fund proposed by the banks, which looked a lot like a mutual fund.  The Court found the language of Glass-Steagall “appear[s] clearly to prohibit this activity.”  Section 16 of Glass-Steagall provided “nothing herein contained shall authorize the purchase by a national bank for its own account of any shares of stock of any corporation.”  Section 21 stated that

it shall be unlawful for any person or firm issuing, underwriting, selling, or distributing stocks, bonds, debentures, notes, or other securities to engage at the same time to any extent whatever in the business of deposit banking.

 

Once the banks were freed from the constraints of Glass-Steagall, they quickly changed their business model, chasing more complex, higher-profit, and ever-riskier financial instruments.  They retained the privileges and protections that the regulatory period had provided, including implied taxpayer liability.  Banks purchased securities for their own proprietary accounts and for making and taking bets in their new gamblers’ club—thus becoming hedge funds, though the public thought they were still banks.  Their bets were not all winners: In September 2008 TARP put $85 billion into AIG, we were told, to save that insurance company.  Five months later, the Obama administration, under intense congressional pressure, disclosed that $13 billion of that figure had allowed AIG to pay 100 cents on the dollar on Goldman Sachs’ bets.  Some said the $13 billion saved Goldman from the fate of Lehman and Bear Stearns.

In January, former Fed Chairman Paul Volcker said the conglomerates enabled by the lifting of Glass-Steagall restrictions are “unmanageable.”  Then in March, Bloomberg News reported, he suggested that “Maybe we ought to have a kind of two-tier financial system.”  Volcker believes the bankers’ proprietary trading—even if it was not pure gambling—is incompatible with a taxpayer guarantee against failure.

Volcker was appointed by President-elect Obama in November 2008 as the chair of his Economic Recovery Advisory Board.  But Volcker’s Glass-Steagall-like recommendations were at odds with the President’s point man on the economy.  In July, Larry Summers told London’s Financial Times, “My role is to make sure that the President gets access to the best economic thinking he can on everything that touches the economy . . . That means making sure that no arguments go unscrutinized.”

New York State Attorney General Andrew Cuomo reported that the five largest banks that received TARP funds from the federal government had paid 5,000 employees more than one million dollars each in 2008:

When the banks did very poorly, they were bailed out by taxpayers and their employees were still paid well.  Bonuses and overall compensation did not vary significantly as profits diminished.

 

JPMorgan Chase led the Millionaires Club with 1,626 employees who received at least that amount; Goldman Sachs had 953, while Citigroup, which is 30-percent owned by the U.S. government, had 738.

American households have lost $14 trillion in wealth—more than their collective earnings last year.  The Bush and Obama administrations have borrowed and spent vast sums to cover the bankers’ losses.  New taxes on the middle class—despite President Obama’s pledge—are on the table.  Treasury Secretary Geithner said on August 2 that to fight deficits, “We are going to do what it takes.”

In 1816, Thomas Jefferson wrote,

I am not among those who fear the people.  They, and not the rich, are our dependence for continued freedom.  And to preserve their independence, we must not let our rulers load us with perpetual debt. . . . If we run into such debts, as that we must be taxed in our meat and in our drink, in our necessaries and our comforts, in our labors and our amusements, for our callings and our creeds, as the people of England are, our people, like them, must come to labor sixteen hours in the twenty-four, give the earnings of fifteen of these to the government for their debts and daily expenses; and the sixteenth being insufficient to afford us bread, we must live, as they now do, on oatmeal and potatoes; have no time to think, no means of calling the mismanagers to account; but be glad to obtain subsistence by hiring ourselves to rivet their chains on the necks of our fellow-sufferers.