“A dynamic economy will always have booms and busts. But the story of the past twenty-five years is that Washington has created a financial system that cannot withstand the destructive part of creative destruction – necessary for free markets- without destroying the economy.  We’ve grown so accustomed to government-subsidized failure in finance that we feel we have no choice. In accepting subsidized failure, we harm America’s trust in free markets, we harm the world’s trust in American markets, and we harm the financial innovation that advances the economy rather than smothers it.”

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

Does the rising stock market and improving unemployment numbers support Obama’s economic solutions?

It may appear so, but I remain skeptical for several reasons.

The stock market is rebounding off of the low of a year ago, which was largely oversold. The stock market may also be responding to a sharp increase in liquidity. There was almost 3 trillion dollars in money market funds earning a pittance in interest . The further away we get from the economic storm of 2008 the more likely investors will be to test the waters to get a better return.

Stocks seems a natural place to put that cash because it is so liquid. Once can liquidate with the push of a button on E-trade.  Real estate which is still depressed and business investment in expansion and equipment is very illiquid and unattractive in an environment of such political uncertainty.

Ironically in this sense, the political actions harming small business (higher taxes, cap & trade, card check, health care) may actually be serving to stimulate the sale of public securities, but this is not sustainable.

The shock to the system in 2008 and 2009 caused many companies to cut costs dramatically. I have never seen so many companies reduce salaries across the board.  With any rebound in business they will return to profitability very quickly. This would happen without any government stimulation, as it did in the stock crash of 1987.

I still believe it was necessary for the government and the Fed to bail out financial system, though I also largely blame them for getting the system into a position that required a bailout.

This rebound in securities may partially explain the improvement in employment. Even after accounting for substantial increase in government employment and the temporary bump from  census workers there is still a real gain. Yet the unemployment rate remains very high.  It is still conceivable that we will see an uptick in unemployment or more likely a very long slow drawdown from an economy burdened with political baggage, high taxes, and more regulation.

Warren Buffet noted that a weak economy can still support a rising stock market.  Productivity, employment, and growth are the signs of a strengthening economy.  It may be too soon to determine if the economic stimulus will counteract the political actions that are detrimental to job creation and a strong economy.

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.

A thorough review of what caused the financial crisis is needed and it should be  a fascinating subject. Unfortunately the hearings are weak and boring. In the Wall Street Journal’s “After the Crash, a Crashing Bore
The men behind the bailout take refuge in impenetrable jargon” Peggy Noonan writes of  her disappointment in the hearings.

In this excerpt she imagines what should be said but is not:

“Let’s be real. This is what happened the past 10 years. You, for political reasons, both Republicans and Democrats, finagled the mortgage system so that people who make, like, zero dollars a year were given mortgages for $600,000 houses. You got to run around and crow about how under your watch everyone became a homeowner. You shook down the taxpayer and hoped for the best.

“Democrats did it because they thought it would make everyone Democrats: ‘Look what I give you!’ Republicans did it because they thought it would make everyone Republicans: ‘I’m a homeowner, I’ve got a stake, don’t raise my property taxes, get off my lawn!’ And Wall Street? We went to town, baby. We bundled the mortgages and sold them to fools, or we held them, called them assets, and made believe everyone would pay their mortgage. As if we cared. We invented financial instruments so complicated no one, even the people who sold them, understood what they were.

“You’re finaglers and we’re finaglers. I play for dollars, you play for votes. In our own ways we’re all thieves. We would be called desperadoes if we weren’t so boring, so utterly banal in our soft-jawed, full-jowled selfishness. If there were any justice, we’d be forced to duel, with the peasants of America holding our cloaks. Only we’d both make sure we missed, wouldn’t we?”

I think she pretty much nailed it.

While the players and regulators were struggling to get investors to commit capital to the major banks to avoid a meltdown, Warren Buffet was called upon several times.  He consistently turned them down because the assets were too complicated to understand, and he did not trust most players on Wall Street. But he was finally offered a deal he could not refuse.

Warren was offered $5 billion worth of preferred stock in Goldman Sachs, the Cadillac of the Wall Street firms, with a 10% yield ($500 million annually), convertible into Goldman stock at $115 a share, 8% below the then current price.

That is why cash is king

Info from Too Big To Fail by Andrew Ross Sorkin