“Another Crisis like this one and the West will be wiped out,” said German Chancellor Angela Merkel on June 1.  “Once we have overcome this Crisis, the question will be how can we return to a path of virtue as far as public debts are concerned.”  Of course, the first question is whether the West will, in fact, survive the present crisis.  All the Western governments have decided to bail out their financial systems with taxpayer “money.”  Then again, as President Obama said on May 23, “we are out of money now.”  What our government is actually doing is bailing out the financial system with debt, which amounts to promises the government makes on behalf of the next generation.  The trouble is that neither the next generation nor the current one has authorized the government to make such promises.  In September 2008, the Bush administration told Congress that we would all be doomed if we did not bail out the financial system.  Congress first resisted but then authorized $700 billion.  But the voters reacted badly, and Congress, since then, has been clear that it will not authorize another dime to bail out the banks.  The people hate the Bailout.

The Constitution provides that “No money shall be drawn from the Treasury but in consequence of appropriations made by law,” which sounds like you need Congress to raise the money and authorize bailout spending.  Nonetheless, the Bush and Obama administrations have committed $15 trillion, according to the Wall Street Journal (June 10), in cash, purchases, guarantees, and loans to finance the Bailout.  The Bailout used the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) as vehicles to perform an end run around democracy.  The Bailout has now been running since September 2008 and has developed its own culture—nondemocratic, lawless, and inclined to strong-arm tactics whenever it is deemed necessary.

The bank losses exist; there is no question of that.  The IMF reports global bank losses of $4.1 trillion.  The only question is where the losses will fall—on the banks who caused them or on the taxpayers.  The government and banks agree the taxpayers should pay.  The public does not agree—any congressman voting for more money for the banks will likely be defeated in the next election.

Congress has surrendered control of, and responsibility for, the Bailout to the President.  The Supreme Court has signaled it will not interfere.  This joint abdication leaves the field open for the President and the theoretically independent Federal Reserve.  The government, using the Federal Reserve, the FDIC, and the Treasury, has set up an alphabet soup of 27 programs to bail out the banks and particular businesses.

Treasury programs include the Temporary Money Market Funds Guarantee Program; the Obama stimulus package, $800 billion; the Troubled Asset Relief Program (TARP), $700 billion; the GSE Bailout; the Bush stimulus, $168 billion; student-loan purchases; the Treasury Exchange Stabilization Fund (ESF); and tax breaks for banks.  (The Temporary Money Market Funds Guarantee Program was announced by the Treasury in September 2008.  It was originally scheduled to expire on April 30, but it has been extended to September 18.  A Treasury press release dated March 31 states, “The Program currently covers over $3 trillion of combined fund assets.”  The Treasury has not cited any statutory authority that permits it to guarantee any amount, much less three trillion dollars.  This action is lawless.)

FDIC programs include the Public-Private Investment Program (PPIP); debt guarantees for the TLG Program; and an asset guarantee to Citigroup/Bank of America.

Federal Reserve programs include funding for the Commercial Paper Funding Facility (CPFF); the Term Auction Facility (TAF); the Term ABS Loan Facility (TALF, which has bought $27 billion in securities backed by credit-card debt, car loans, and student loans); currency swaps; the Money Market Investor Funding Facility (MMIFF); the MBS Purchase Program; the Term Securities Lending Facility; the U.S. Treasuries Purchase Program; the AIG credit extension; GSE Debt Purchase Program; the primary credit discount; the Primary Dealers Credit Facility (PDCF); Maiden Lane, LLC; ABCP Money Market Fund Liquidity (AMLF); Securities Lending Overnight; and secondary credit.  Only around ten percent of the Bailout has any democratic legitimacy—the $700 billion TARP and the $950 billion in Bush and Obama administration stimulus programs were enacted by Congress.

When the Federal Reserve was created by act of Congress in 1913, its stated purpose was to establish “Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper to establish a more effective supervision of banking in the United States . . . ”  The Fed is intended to guide the economy by setting interest rates and controlling the money supply; it is not intended to finance businesses.  The Fed is authorized to issue Federal Reserve notes—what we call money.  Its notes are its liabilities; it needs assets to balance its liabilities.  The Fed’s balance sheet, in response to the financial crisis, will balloon to more than three trillion dollars from not even one trillion dollars less than two years ago.  The Fed has bought, with new money, some dubious assets—toxic and legacy assets and agency debt (Fannie Mae and Freddie Mac).

The Fed is central to the Bailout.  Since the summer of 2007, it has created the new programs listed above, citing the authority of Section 13(3) of the Federal Reserve Act.  This section, which has not been used since the Great Depression, authorizes the Federal Reserve Board, “in unusual and exigent circumstances . . . to discount for any individual, partnership, or corporation, notes, drafts and bills of exchange when such notes, drafts and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank.”  The statute further provides that the Fed “shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions.”  The previous and only use of Section 13(3) occurred between 1932 and 1936 and provided approximately $1.5 million in loans (around $23 million in today’s dollars).  On January 19, the New York Fed’s general counsel said that, while the Fed must act within the parameters of the law, “we will interpret our legal mandate in a manner that facilitates our policy objectives.”

The purpose of the Federal Reserve System was to create an entity independent of the Treasury.  The nation’s resources should be allocated by the government and business—not by the central bank.  And yet, under the auspices of the Bailout, the Fed buys U.S. bonds from the Treasury with newly printed Federal Reserve notes, which the Treasury will spend.  Economists call this “monetizing” the debt.  The Fed intends, by the end of August, to purchase $300 billion of debt from the Treasury under this program.  Obviously, there is no need for the Chinese if the government can finance itself by buying its own debt.

As the auto industry weakened, the CEOs of the Big Three asked Congress to fund a bailout.  That was necessary because TARP funds, under the Emergency Economic Stabilization Act of 2008, can only be used for “Financial Institutions”—TARP is not a general slush fund for the Treasury to spend at will, and a car company is not a financial institution.  Congress refused to authorize the auto bailout, but President Bush went ahead and gave Chrysler and GM an initial bridge loan of $17.4 billion from the TARP money.  President Obama increased the loans to a total of $85 billion—$63 billion for GM, $17 billion for Chrysler, and another $5 billion to suppliers in exchange for preferred stock and warranties.

Without any new legislation, the President and his automobile czar pushed through the Chrysler bankruptcy.  President Obama chastised the objecting creditors, calling them speculators and saying they would be responsible for Chrysler’s liquidation and all the lost jobs that would follow.  Three Indiana state pension funds brought suit, arguing the President’s bankruptcy was illegal because the bankruptcy court was rolling over the existing rights of secured creditors and the government had no standing to bring any action because it was not a shareholder, since Chrysler is not a financial institution and (therefore) the TARP transaction was null and void.  The funds compared the President’s takeover of Chrysler to President Truman’s 1952 seizure of the steel mills, which the Supreme Court found unconstitutional (Youngstown Sheet and Tube v. Sawyer).  The lower courts upheld the President, and on June 11, the Supreme Court refused to hear the Indiana funds’ appeal.  The Founding Fathers despised the king’s judges, and many feared that a separate judicial branch would be largely unaccountable and dangerous.  The Constitutional Convention, however, concluded it was critical to establish a real check on the legislature and executive.  The convention granted the justices lifetime tenure to assure the Court’s independence, which would allow it to decide controversial cases fairly.  The pension funds’ arguments are substantial, and the country would have been served by a public debate of the Bailout’s legality.  Instead, the judicial branch joined Congress on the sidelines as spectators.

Backers of the Bailout are quite willing to use strong-arm tactics when they believe it necessary.  In September 2008, Bank of America entered into an agreement to acquire Merrill Lynch, which was scheduled to close on January 1, 2009.  By December, however, the bank discovered Merrill’s losses were much larger than previously reported.  The Fed’s own analyst suggested that “Merrill was a black hole.”  Bank of America sought to rescind the merger, a move permitted by a provision of the contract called a MAC (Material Adverse Change) clause.  But on December 21, Treasury Secretary Henry Paulson—with Fed Chairman Bernanke present—told the bank’s CEO, Ken Lewis, “I’m going to be very blunt, we’re very supportive of Bank of America and want to be of help but the government does not feel it’s in your best interest for you to call a MAC and that we feel so strongly, we would remove the board and management if you called it.”

Paulson also told Mr. Lewis that he should not inform the bank’s shareholders of the Merrill losses or their little chat.  The next day, Bernanke e-mailed another Fed officer: “[Lewis] said he now fears lawsuits from shareholders.  I don’t think that’s very likely and said so.”  Lewis wanted a letter from the Fed saying they had ordered him to complete the merger, but Bernanke refused.  Bernanke asked whether he could assure Lewis that the Fed would help if he was sued.  Fed counsel advised him not to.  Lewis’s notes from a New Year’s Eve phone call indicate that Bernanke said, “We will not leave you in the lurch.”  Bank of America went ahead with the merger, and Paulson and Bernanke effectively imposed Merrill’s losses on BofA’s shareholders.  Lewis’s fears have been realized, and a class-action lawsuit is pending.  Lewis testified to the House Committee on Oversight on June 11 that the Paulson and Bernanke threats were made “with the best of intentions.”

The Bailout’s central deceit is that the “toxic” or “legacy” assets held by the banks are worth more than anyone will pay for them.  If the banks sold them, they would have to recognize at least one trillion dollars of losses, which would bust most of them.  According to accounting rules, however, even if the assets are not sold they are required to be “marked to market.”  This is necessary to keep the banks’ balance sheets honest.  Facing bankruptcy, the banks argued that they should be excused from the requirement; the market had become too dysfunctional to set values properly.  Could the accounting rule please be changed?

In early 2009, the nine largest financial firms formed the CDS Dealers Consortium, and the new entity gave $18,500 to Rep. Paul Kanjorski (D-PA), chairman of the House Financial Services Subcommittee.  Kanjorski summoned the Financial Accounting Standards Board (FASB) to a hearing on March 12, where he issued them a threat: “If the regulators and standard setters do not act now to improve the standards, then, the Congress will have no other option than to act itself.  We want you to act. . . . You do understand the message that we’re sending?”

A representative of the FASB replied, “Yes, I absolutely do, sir.”

The FASB revised the rules to permit the banks to continue cooking the books.  Citigroup said the accounting change added $413 million to its first-quarter earnings.  The banks then dumped the Public-Private Investment Program—an FDIC plan to use taxpayer guarantees to buy the “legacy” assets from the banks at above-market prices.

If the books were kept honestly, most of our banks would have gone bust.  The risk of busted banks should be transferred back to the private sector where it belongs—from the taxpayer to the shareholders and creditors who were supposed to prevent the banks from taking the grotesque risks they did.  More than half a million jobs have vanished each month since October 2008.  Official unemployment is at 9.4 percent; if all marginally attached workers are included, the figure is 16.4 percent—approaching Great Depression levels.  The net worth of American households has plummeted by 20 percent.  Total worldwide losses of capital valuation of financial assets, according to the Asian Development Bank, may reach $50 trillion—the equivalent of one year of world GDP.  U.S. GDP has fallen at an annual rate of six percent.

The problem with governmental intervention is that you cannot be sure where you are—whether you have reached the bottom or have a good deal further to fall. Neither the Bush nor Obama administration has made an effort to explain what brought the system down.  In the 1930’s, the Senate Banking Committee, led by a special counsel, Ferdinand Pecora, held two years of hearings to determine exactly what had happened.  Pecora questioned the nation’s bankers and stockbrokers.  The hearings revealed to the public the bankers’ abusive practices—many of which have now been repeated.  This led to reform legislation (including the Glass-Steagall Act), which kept the system honest until the Depression-era regulations were repealed by the Clinton administration, at the suggestion of Larry Summers and Timothy Geithner, in 1999 and 2000.  This ushered in a period of rapid growth in new and complex inventions, including derivatives, credit-default swaps, and collateralized debt obligations.  When the crash came, hardly anyone had ever heard of these things.

With the Bailout in place, the banks are unrepentant of their abusive practices.  In fact, they seem to be in charge of the Bailout and the Obama administration’s proposals for regulatory “reform,” which will leave derivatives largely untouched by federal regulation.  Derivatives (what Warren Buffett calls “weapons of financial mass destruction”) should be banned.  They are traded today as if nothing happened.  Indeed, the credit-default-swap market is booming again, because the players now believe the bets are backed by the U.S. taxpayers.  Before the crash, the market was constrained by what is called “counterparty risk,” which meant that your insurer—AIG, for example—might go bust and not pay out your winning bet.  But in September 2008, Paulson, Bernanke, and Timothy Geithner used taxpayer money to bail out AIG so it could pay out Goldman-Sachs and the European banks on their bets.  The market now assumes that the U.S. taxpayer will continue to make all such wagers winning bets.

Louis XV could tell you that the longer real reforms are put off, the more severe will be the ultimate correction.  On June 3, Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, warned that, “if we hesitate to make needed changes, we will perpetuate an oligarchy of interests that will fail to serve the best interests of business, the consumer and the U.S. economy.”

The first step in any serious reform should be to restore the Glass-Steagall Act, which kept the banks from functioning like casinos.  On June 17, President Obama unveiled his proposed reforms to the financial system.  They will grant yet more power to the unaccountable Fed.  Glass-Steagall is not mentioned.

The derivatives market is vast ($680 trillion) and opaque.  Some sunshine would help.  The Obama administration, however, only proposes that most—but not all—of the derivatives be run through exchanges.  Even that pitiful reform is too much for Representative Kanjorski.  At a June 9 hearing he said, “Subjecting all contracts to mandatory exchange trading may cast too wide a net.”  His Republican counterpart, Scott Garrett (R-NJ), is equally soft on the banks: “The government should not regulate the heck out of them.”

Chancellor Merkel wanted to know how, after this Crisis, the United States is going to return to a “path of virtue.”  She should probably forget about asking the people’s representatives in the U.S. Congress.