The default belief  of our economic history of the last 100 years has been an acceptance of the dynamic growth of capitalism punctuated by excesses of market greed that have to be corrected by the singular wisdom of government regulation.

On closer examination many of those moments of market greed and excess look more like incompetent government meddling caused the problem.

During the Depression of 1929 we saw 10,000 banks collapse in the United States. Yet during that same period the number of bank failures in Canada were zero.  Was Canada spared the depression that engulfed the United States? No, but Canada was spared a regulation that prevented banks from crossing state lines.

Bending to pressure to protect local banks from encountering big business center banks, they got relief and protection from the Federal government in the restriction of interstate competition.  But that also severely limited their flexibility in dealing with a crisis, a limit that did not exist in Canada where risks were spread over larger areas and underutilized assets could be easily relocated.

Yet to respond to the bank failures that the government largely caused they created the FDIC (Federal Deposit Insurance Corporation).  FDR opposed the FDIC because he saw it would create a sanction for reckless behavior and penalize prudently run banks.  FDR capitulated in a compromise and the FDIC began by insuring deposits for $2500 in 1934. It was raised to $5,000 in 1935, $10,000 in 1950 (Truman), $15,000 in 1966 (Johnson), $20,000 in 1968 (LBJ again), $40,000 in 1974 (Nixon), and then $100,000 under Jimmy Carter in 1980.  Bush raised it to $250,000 before he left office, but it is due to revert back to $100,000 in 2013.

Ten years after Carter raised the limit we experienced the Savings and Loans meltdown, caused by the excessive risk taking in that industry. The government again intervened and created the Resolution Trust Corporation (RTC) to dispose of failed thrift institutions taken over by regulators after January 1, 1989 in an orderly manner.

The FDIC created the moral hazard FDR feared. It privatized the profits and socialized the risks.  This behavior was repeated, but on steroids, with the implicit assumption of risk by Fannie Mae and Freddie Mac.

Housing was deemed a federal priority, and helping the poorer people get into housing has been a priority since Fannie Mae was created again by FDR in 1938.  But housing prices were highest and least affordable in select areas where local ordinances had restricted supply and raised prices far more than in areas were market forces prevailed.

Tax policies such as mortgage interest deductions and preferred capital gains treatment increased the demand for housing. The Community Reinvestment Act, passed under Carter but exploited under Clinton and Bush, pressured banks to make mortgage loans to less and less qualified buyers. Fannie Mae guaranteed loans, clearing the ratings agencies which had a government protected franchise; to give higher ratings than these mortgage backed securities could have conceivably obtained on the merits of their assets. This widened the market for these securities and caused even more money to be driven into the housing market from all over the world creating the bubble that had to burst.

To compound the damage the government required a mark to market rule for valuing these mortgage loans at the worst possible time; when no market existed.  The market to market rule causes valuations to go to extremes, high and low.  This caused capital to dry up and regulations required banks to rebuild capital reserves instead of making loans. Then at a time when information was critical to valuing these securities, the government suspended short selling, a critical source of such information.

During the recent financial disaster, Canada did not exhibit near the real estate collapse we did in the United States.  In Canada they had far less exposure to sub prime loans, large down payments were still required while we all but eliminated down payments for the poorest home buyers in the name of ‘compassionate conservatism’, and mortgage borrowers in Canada were still held personally liable for their loans. Canada had tougher and more prudent lending standards, but they avoided the fiasco foisted on us by well intentioned but misguided moral supremacists on the government payroll.

The government in the U.S. inflated this bubble as eagerly as any on Wall Street, but our government “had a much bigger pump”.

Seventy five years ago we could have looked to our northern neighbor and learned better behavior instead of demonizing capitalism. Today we can learn the same lesson, but again we seek to demonize the private sector for conditions created by incompetent government regulation. Wall Street clearly has its demons to account for, but its greed was enabled and often encouraged by incompetent regulations and policy that has a long history.

As we crave more government oversight we should ask who will oversee the government that has demonstrated such spectacular failure.

“In truth, markets had been trying to work since 1984, with Continental Illinois, desperately sending signals that the modern financial system was shot through with untenable risks that required a renewal of long-held regulatory principles. But government bailouts thwarted real market information at every turn. Washington allowed failure only when it didn’t threaten systemic risk, as in the case of Enron, and did not learn the subtler lessons that such failure provided.”

From After the Fall:  Saving Capitalism from Wall Street- and Washington by Nicloe Gelinas

(this was published previously in the Macon Telegraph)

Being in the middle of a record economic crisis presents a rare learning opportunity.  Several books are worthwhile for those seeking to understand what just happened.

Too Big to Fail by Andrew Ross Sorkin details the action of the Fed under Benanke and Treasury under Paulson during the crisis period between August and December.  While Geitner as head of the New York Fed was also featured the central player of this crisis was Hank Paulson.

Monumental decisions involving billions of dollars of assets were made in days, sometimes hours.  Both Paulson and Geitner had a sense that the market was due for a correction long before the crisis hit, but they probably did not see it coming as fast and as broad as it did. Bernanke noted that just as there are no atheists in foxholes there are no ideologues in economic crisis either. Neither Republicans or Democrats wanted to bail out Wall Street , but the crisis dictated actions that were against the grain of capitalists of both parties.

Paulson worked tirelessly to find appropriate merger partners for weak players like Merrill Lynch, Wachovia, and Lehman.  He almost had Barclays ready to buy Lehman when the British Financial Services Authority ( FSA) refused to approve the acquisition/merger because of the risk it brought to the British financial system.

Lehman was singular in the fact that it was not acquired or bailed out and thus had to go bankrupt.  Part of this was timing; Congress was just in no mood to bail out a Wall Street player.  Part of the reason was George Bush’s cousin who worked for Lehman and his brother Jeb’s association with the firm. Such close political relations probably worked against the interests of the firm.

In retrospect bailing our Lehman’s may have forestalled the panic that engulfed the rest of the system. With Bear Sterns gone and now Lehman’s gone, depositors wondered who was next and there began a run of the other banks like J.P Morgan and Morgan Stanley.

While Paulson’s association with Goldman was suspect the fact was he had to severe his tie and sell his stock ($485 million worth) in order to take his job at Treasury. Since his actions were so scrutinized he was careful to avoid even conversations that would indicate favoritism toward his old firm.

The most difficult decision was to bail out AIG whose credit default swaps acted as insurance against many of the cdo’s (collateralized debt obligations) that infected the financial markets. As the underlying assets plummeted in value AIG was downgraded and had to put up more capital that it could not provide.

Having to make such massive changes and decision in such short time meant that perfection was not obtainable. Barney Frank justifiably wanted some assurance that compensation to the executives would suffer from their misdeeds, but there simply was not enough time to rule of thousands of contracts during the time period that decisions had to be made.

Wall Street clearly engaged in risks it did not understand, but neither did the regulators such as Greenspan and his successor Bernanke. Complicated risk models gave the CEO’s delusional certainty, but eventually the party came crashing down for the same reason all bubbles burst;  lack of trust and confidence.

But Sorkin spends little space getting into the detail of the causes of the crash and suitably stays focused on the urgency and the actions required in response. 

For more information on the background that caused the crisis I recommend The Housing Boom and Bust by Thomas Sowell,  Financial Fiasco by Johan Norberg, most of all After the Fall: saving Capitalism from Wall Street – and Washington by Nicole Gelinas.

Sowell and Norberg focus more on the misguided Government fiscal and monetary policies that inflated the housing bubble, but Nicole Gelinas also analyzes which good regulations were unfortunately removed (and by who) and which bad ones were inappropriately applied.

A crisis of this nature required the perfect storm of many great errors to all focus their retribution at the same time. Unfortunately the media large engages in partisanship and demonization and few people will take the time to understand what happened and why.  It is complicated but engaging the problem reveals basic principles of sound policy that were violated as they were in previous bubbles.

History repeats itself but never the same way.

Sometimes optimism and contrarianism can complement each other.   Here is a thought.

The health care bill is so unpopular and causing such outrage that other damaging proposals like the Union Card Check bill and Cap and Trade may have no opportunity at all.

By staking all their value on the health care bill which is years away from being effective, and filled with provisions that may not pass Constitutional muster, they risk having it overturned by the new Congress if the Democrats lose substantial representation.

The Democrats may have pushed too far which will erode their power.  A year ago the Republicans were badly whipped, and the Democrats talked about a 50 year reign. Now polls have the Democrats down substantially. The promise of a new era of bipartisanship has ended with the most radical bill yet passed in the Senate with not a single Republican vote.  The promise of transparency has become just another hollow and unfulfilled promise.

The independents that elected Obama have no party loyalty and will turn much quicker than the committed party members.

All of this may be factored into market expectations. The net effect of overreaching arrogance may a far shorter reign than the administration expected.

If the Democrats had been more inclusive and centered they could have gotten more Republican support and we would have possibly ended up doing more damage to the economy than their extreme tactics have caused.

The stock market has risen over 40% from the March lows.  While the administration is sure to take credit for the market, they should do so cautiously.  Since only a very small part of the stimulus package has been spent, it seems hard to contribute much of the success to that.

It is more likely a regression to the mean; the market was just severely oversold from the credit disaster of last fall.  There is also tremendous liquidity in the market with over 3.5 trillion dollars in money market funds.  Rather than tie success to the stock market within a short term period we should look at employment and capital investment.  Perhaps this recession has just run its course as others have and the markets are repairing themselves by shedding costs and reducing debt and inventory.

If card check, cap and trade, extravagant debt  and the health care issues affect our economy (as I believe they will)  we are still early in the game and this may seem temporary. But if the recovery is real and we are getting it after spending only 10% of the stimulus package; it would be wise to cancel the rest of it.