We tend to look at our economy as a diversion from the norm after a record financial set back.  But the economy we are in may well be closer to the norm.

The former economy was distorted by government policies that incentivized more money to go into housing than would have likely happened in a freer market. Banks were incentivized into putting large amounts of capital into securities that were not as secure as they were promised.

That is not to say that booms and busts are all the fault of government policies. Free markets do not totally counter the extremes of greed and fear; they just flush them out quicker.

Government policies want to protect us from the pain of adjustment to normal, but these policies only serve to make the recovery take longer, or worse, they avoid the recognition and correction of the extremes that caused the crash, ensuring a bigger crisis later.

This last crash was largely due to the failure to fully address the failure of Continental Illinois, Long Term Capital, and Enron. By blaming the greed of a few individuals we neglected to address systemic failures and regulatory shortcomings.

The prior market was one where the lessons of transparency and disclosure learned after the Great Depression were ignored.  The ability of a home owner to afford a house was ignored in deference to the ’social justice’ of promoting home ownership.

We now insist on down payments that put some of the owner’s skin in the game.  By being forced to seek growth that can be sustained by realistic cash flow, growth will be more sustainable.

Companies are now forced to control expenses, improve margins, and make a wiser and more realistic assessment of risk.  This is what used to be considered normal.  It only seems difficult and painful after a period of easy money, distorted incentives and unsustainable policies.

We are in a period of deleveraging.  It will be painful and some sectors will be hurt more than others.  The more the government tries to protect us from the pain of adjustment, the longer the adjustment will take, the longer unemployment will remain high, and the higher the deficit will grow.

Smaller businesses will suffer more, leaving less competition to the larger companies.  Larger companies will do better, income discrepancies will grow and the tax burden will become less progressive. This is the opposite of what one would expect from a president that wants to share the wealth.

This is the result of legislating so much drastic change that economic and business decisions are frozen in the headlights of uncertainty. Adding such uncertainty to the pain of deleveraging will cause this economy to stagnate for years.

The longer the economy stagnates under the burdens of higher taxes and more regulations, the more that stagnation will become the new norm like it is already in Europe. The potential for long term damage to our economic system is significant.

George Melloan writes in The Wall Street Journal,  The Lessons of Basel’s Bean Counters

Summarized:

In 1988 the banking regulators from  20 leading industrial nations of the International Monetary Fund met in Switzerland and created Basel I to create a common set of banking standards by setting risk based capital standards, and assigning degrees of risk.

But the Japanese banks were bragging about their compliance when they tanked in the 1990’s.

So they created Basel II.  Standards were toughened to include trading in securities and derivatives. All of this seemed irrelevant in stopping the meltdown of 2008.

Excerpt:

The international banking tumult of 2008 was not a result of insufficient rules or even primarily of noncompliance with the rules. Banking is perhaps the world’s most regulated major industry. As in Japan in 1990, the imperatives of politics simply overrode what the rule makers and rule enforcers were trying to accomplish, turning their labors to dust.

The 2008 crisis resulted when the Fed-created credit bubble collapsed and soaring housing prices deflated as well. To promote “affordable” housing, Bill Clinton had excused the two giant government-sponsored housing finance agencies, Fannie Mae and Freddie Mac, from normal banking rules, allowing them leverage ratios far in excess of the limits on ordinary lenders. Banks were forced to write risky mortgage loans, a large number of which were then folded into mortgage-backed securities that Fannie, Freddie and others sold internationally with triple-A ratings.

This business seized up, crippling banks throughout the world, when holders began to realize that the assets that backed the securities, home mortgages, were going under water at an alarming rate. One of the great ironies of our times is that the two strongest defenders of the Fannie-Freddie shell game, Chris Dodd and Barney Frank, are now in charge of reforming banking regulation.

The better solution is clear rules, commonly understood financial prudence, and control of debt.  Yet our current government administration, which practices none of this, proposes to fix our financial system. I have yet to hear a peep out of Congress taking any responsibility for our financial mess.  This will only increase the likelihood or repeating or worsening the next crash.

Zachary Adam Chesser

I am certainly not advocating any violent action, but I  wonder if  fanatics who publicly threaten the lives of America’s most popular cartoon creators would be in greater danger than Matt Stone and Trey Parker.

Can you imagine someone threatening Walt Disney?

Read story on Foxnews:  Road to Radicalism: The Man Behind the ‘South Park’ Threats

This merits a death threat?  Where is the outrage?

The debate of financial reform is looking eerily like the debate on health care reform.

In both cases both parties clearly see the need for change, and in both cases they disagree sharply on the means.

When the financial meltdown occurred neither party wanted to bail out Wall Street bankers and insurance companies with taxpayer dollars. But solutions to such emergencies often require distasteful actions.

But the point of financial reform is to prevent getting to the point where any party even needs to consider such a bailout.

Like the health care reform the attempt at financial reform seems to find all the fault in the private sector.  Congress, largely through Fannie Mae and Freddie Mac, were a central cause of this disaster and there is little or nothing  in this bill to address the role that lawmakers had in precipitating this crisis.

Obama has said he will veto the bill if it includes a $50 billion fund for failing institutions. On this he is siding with the House Republicans over the Democrats.  Such a fund protects the largest financial firms at the expense of the smaller firms. I hope he stays with that decision.

There is much to be improved.  New regulations should forbid off balance sheet accounting, derivative trading should be on exchanges where they can be supervised, capital requirements should reflect the risks of the investments.  There is a case to be made for restoring a safety wall between investment banking and commercial bank lending. There is even a good case to be made for busting up the largest players if that is necessary to bury the retarded concept of “too big to fail.”

But there is also an important need to keep Congress and their influence out of the financial sector.  Congress refused to acknowledge the crisis at Fannie Mae in spite of repeated warnings.  Fannie Mae plied Congress with campaign contributions and lobbyist pressures.

The more Congress regulates an industry the greater the role will be played by lobbyists. An administration that has repeatedly demonized lobbyists seems intent in creating an environment where lobbyists will grow in influence.

Man will always seek to improve his lot in life and he will always take risks to do so.  We will have bubbles, and it is a worthwhile tradeoff if it facilitates the economic growth that has created such prosperity for so many.

It is the job of the Fed ‘to remove the punch bowl when the party gets started’.  But it is the nature of Congress to avoid short term pain even if it leads to much greater long term pain. They have shown themselves able to be bought off and distracted from long term consequences.

While we need a wall between banking and investment , we need a wall between financial regulation and political influence even more.

When Alexis de Tocqueville wrote of America in the early 19^th century in his classicDemocracy in America, he was comparing America’s democracy to the declining norm in Europe: aristocracy.