America has become a pretty discouraging place. If Ronald Reagan were still
with us, I wonder if he would again refer to the United States as a city on a
hill, a light unto the world.
I think not. Reagan brought America back from
discouragement, but it didn�t stick. Subsequent administrations erased
Reagan�s accomplishments. Reagan defeated stagflation and ended the cold war,
producing a peace dividend to be divided among taxpayers, social programs, and
national debt reduction. However, without the Soviet Union as a
check on neoconservative
ambition, the neoconservatives launched America on an unrealistic path of world
hegemony. The economic restoration that Reagan achieved was not shored up by
his successors. Instead, they used the Reagan restoration to run the American
economy into the ground in ways that benefitted the super rich and the
military-security complex. Some of America�s best jobs were offshored in order
to boost share prices and executive compensation, and the financial sector was
Americans, for the most part, will never know what happened
to them, because they no longer have a free and responsible press. They have
Big Brother�s press. For example, on September 28, 2008, a New
York Times editorial blamed the current financial crisis on �antiregulation disciples of the Reagan Revolution.�
What utter nonsense. Every example of deregulation that the New
York Times editorial provides is located in the Clinton administration and
the George W. Bush administration. I was a member of the Reagan
administration. We most certainly did not deregulate the financial system.
The repeal of the Glass-Steagall Act, which separated
commercial from investment banking, was the achievement of the Democratic
Clinton administration. It happened in 1999, over a decade after Reagan left
It was in 2000 that derivatives and credit default swaps
were excluded from regulation.
The greatest mistake was made in 2004, the year that Reagan
died. That year the current Secretary of the Treasury, Henry M. Paulson, Jr.,
was head of the investment bank Goldman
Sachs. In the spring of 2004, the investment banks, led by Paulson, met
with the Securities and Exchange Commission. At this meeting with the New Deal
regulatory agency tasked with regulating the US financial system, Paulson
convinced the SEC commissioners to exempt the investment banks from maintaining
reserves to cover losses on investments. The exemption granted by the SEC
allowed the investment banks to leverage financial instruments beyond any
bounds of prudence.
In place of time-proven standards of prudence, computer
models engineered by hot shots determined acceptable risk. As one result, Bear
Stearns, for example, pushed its leverage ratio to 33 to 1. For every one
dollar in equity, the investment bank had $33 of debt!
It was computer models that led to the failure of Long-Term Capital
Management in 1998, the first systemic threat to the financial system. Why
the SEC went along with Paulson and set aside capital requirements after the
scare of Long-Term Capital Management is inexplicable.
The blame is headed toward SEC chairman Christopher Cox. This
is more of Big Brother�s disinformation. Cox, like so many others, was a victim
of a free market ideology, itself a reaction to overregulation, that was
boosted by academic economic opinion, rewarded with Nobel prizes, that the
market �always knows best.�
The 20th century proves that the market is likely to know
better than a central planning bureau. It was Soviet Communism that collapsed,
not American capitalism. However, the market has to be protected from greed. It
was greed, not the market, that was unleashed by deregulation during the
Clinton and George W. Bush regimes.
I remember when the deregulation of the financial sector
began. One of the first inroads was the legislation, written by bankers, to
permit national branch banking. George Champion, former chairman of Chase
Manhattan Bank, testified against it. In columns, I argued that national branch
banking would focus banks away from local business needs.
The deregulation of the financial sector was achieved by the
Democratic Clinton administration and by the current secretary of the Treasury,
Henry Paulson, with the acquiescence of the Securities and Exchange Commission.
The Paulson bailout saves his firm, Goldman Sachs. The
Paulson bailout transfers the troubled financial instruments that the financial
sector created from the books of the financial sector to the books of the
taxpayers at the US Treasury.
This is all the bailout does. It rescues the guilty.
The Paulson bailout does not address the problem,
which is the defaulting home mortgages.
The defaults will continue, because the economy is sinking
into recession. Homeowners are losing their jobs, and homeowners are being hit
with rising mortgage payments resulting from adjustable rate mortgages and
escalator interest rate clauses in their mortgages that make homeowners unable
to service their debt.
Shifting the troubled assets from the financial sectors�
books to the taxpayers� books absolves the people who caused the problem from
responsibility. As the economy declines and mortgage default rates rise, the US
Treasury and the American taxpayers could end up with a $700 billion
Initially, the House, but not the Senate, resisted the
bailout of the financial institutions, whose executives had received millions
of dollars in bonuses for wrecking the US financial system. However, the
people�s representatives could not withstand the specter of martial law and
Great Depression with which Paulson and the Bush administration threatened
them. The people�s representatives succumbed as they did during the New Deal.
The impotence of Congress traces to the Great Depression. As
Theodore Lowi in
his classic book, The
End of Liberalism, makes clear, the New Deal stripped
Congress of its law-making power and gave it to the executive agencies. Prior
to the New Deal, Congress wrote the laws. After the New Deal a bill is merely an
authorization for executive agencies to create the law through regulations. The
Paulson bailout has further diminished the legislative branch�s power.
Since Paulson�s bailout of his firm and his financial
friends does nothing to lessen the default rate on mortgages, how will the
bailout play out?
If the $700 billion bailout is based on an estimate of the
current amount of bad mortgages, as the recession deepens and Americans lose
their jobs, the default rate will rise. The $700 billion might not suffice.
The Treasury will have to go hat in hand to its foreign creditors for more
As the US Treasury has not got $7 dollars, much less $700
billion, it must borrow the bailout money from foreign creditors, already
overloaded with US paper. At what point do America�s foreign bankers decide
that the additions to US debt exceed what can be repaid?
This question was ignored by the bailout. There were no hearings. No
one consulted -- China, America�s principal banker, or the Japanese, or
the OPEC sovereign wealth funds, or Europe.
Does the world have a blank check for America�s mistakes?
This is the same world that is faced with American demands
that countries support with money and lives America�s quest for world hegemony.
Europeans are dying in Afghanistan for American hegemony. Do Europeans want
their banks, which hold US dollars as their reserves, to fail so that Paulson
can bail out his company and his friends?
The US dollar is the world�s reserve currency. It comprises
the reserves of foreign central banks. Bush�s wars and economic policies are
destroying the basis of the US dollar as reserve currency. The day the dollar
loses its reserve currency role, the US government cannot pay its bills in its
own currency. The result will be a dramatic reduction in US living standards.
Currently, Treasuries are boosted by the habitual �flight to quality,� but as Treasury
debt deepens, will investors still see quality? At what point do America�s
foreign creditors cease to lend? That is the point at which American power
ends. It might be close at hand.
The Paulson bailout is predicated on cleaning up financial
institutions� balance sheets and restoring the flow of credit. The assumption
is that once lending resumes, the economy will pick up.
This assumption is problematic. The expansion of consumer
debt, which kept the economy going in the 21st century, has reached its limit. There
are no more credit cards to max out, and no more home equity to refinance and
spend. The Paulson bailout might restore trust among financial institutions and
enable them to lend to one another, but it doesn�t provide a jolt to consumer
Moreover, there may be more shoes to drop. Credit card debt
could be the next to threaten balance sheets of financial institutions. Apparently,
credit card debt has been securitized and sold as well, and not all of the debt
is good. In addition, the leasing programs of the car manufacturers have turned
sour. As a result of high gasoline prices and absence of growth in take-home
pay, the residual values of big trucks and SUVs are less than the leasing
programs estimated them to be, thus creating more financial problems. Car
manufacturers are canceling their leasing programs, and this will further cut
According to statistician John Williams, who measures inflation,
unemployment, and GDP according to the methodology used prior to the
Clinton regime�s corruption of these measures, the US unemployment rate is
currently at 14.7 percent and the inflation rate is 13.2 percent. Consequently,
real US GDP growth in the 21st century has been negative. (The Clinton regime --
and the Boskin Commission -- rigged the CPI in order to cheat retirees out of
their Social Security cost of living adjustments and ceased to count as
unemployed discouraged workers who cannot find a job. To be counted as
unemployed, a person has to be actively seeking a job.)
This is not a picture of an economy that a bailout of
financial institution balance sheets will revive. As the Paulson bailout does
not address the mortgage problem per se, defaults and foreclosures are likely
to rise, thus undermining the Treasury�s estimate that 90 percent of the mortgages
backing the troubled instruments are good.
Moreover, one consequence of the ongoing financial crisis is
financial concentration. It is not inconceivable that the US will end up with
four giant banks: J.P. Morgan Chase, Citicorp, Bank of America, and Wachovia
Wells Fargo. If defaulting credit card debt then assaults these banks� balance
sheets, who is there to take them over? Would the Treasury be able to borrow
the money for another Paulson bailout?
During the Great Depression of the 1930s, the Home Owners�
Loan Corporation refinanced one million home mortgages in order to prevent
foreclosures. The refinancing apparently succeeded, and HOLC returned a profit.
The problem then, as now, was not �deadbeats�
who wouldn�t pay their mortgages, and the HOLC refinancing did not discourage
others from paying their mortgages. Market purists who claim the only solution
is for housing prices to fall to prior levels overlook that rising inventories
can push prices below prior levels, thus causing more distress. They also
overlook the role of interest rates. If a worsening credit crisis dries up
mortgage lending and pushes mortgage interest rates higher, the rise in
interest rates could offset the fall in home prices, and mortgages would remain
unaffordable even in a falling housing market.
Some commentators are blaming the current mortgage problem
on the pressure that the US government put on banks to lend to unqualified
borrowers. The proliferation of privilege that bureaucrats pulled out of the Civil
Rights Act led, in 1993, to Shawmut National Corporation�s acquisition
plans being blocked by federal regulators until its subsidiary entered into a
consent agreement with the US Department of Justice to racially norm its
mortgage lending. This agreement was quickly
incorporated into the growing body of regulations. Next, Chevy Chase
Federal Savings Bank was forced by the DOJ to open new branches in �majority
African-American census tracts.� Chevy Chase had to provide below-market
loans to preferred minorities at interest rates �at
either one percent less than the prevailing rate or one-half percent below the
market rate combined with a grant to be applied to the down payment requirement.�
In 1995, the DOJ forced American Family Mutual Insurance Company to sell
property insurance to preferred minorities on uneconomic terms. [See Roberts
and Stratton, The
New Color Line]
Thus, it is true that it was the federal government that
forced financial institutions to abandon prudent behavior. However, these
breaches of prudence only affected the earnings of individual institutions. They
did not threaten the financial system. The current crisis required more than
bad loans. It required securitization and its leverage. It required Fed Chairman
Alan Greenspan�s inappropriate low interest rates, which created a real estate
boom. Rapidly rising real estate prices quickly created home equity to justify
100 percent mortgages. Wall Street analysts pushed financial companies to
improve their bottom lines, which they did by extreme leveraging. The full
story goes far beyond the propaganda videos put out by Republicans blaming
An alternative to refinancing troubled mortgages would be to
attempt to separate the bad mortgages from the good ones and revalue the
mortgage-backed securities accordingly. If there are no further defaults, this
approach would not require massive write-offs that threaten the solvency of
financial institutions. However, if defaults continue, write-downs would be an
Clearly, all Secretary Paulson thought about was getting
troubled assets off the books of financial institutions.
The same reckless leadership that gave us expensive wars
based on false premises has now concocted an expensive bailout that does not
address the problem, which will fester and become worse.
Craig Roberts [email
him] was Assistant Secretary of the Treasury during President
Reagan�s first term. He was Associate Editor of the Wall Street Journal. He has
held numerous academic appointments, including the William E. Simon Chair,
Center for Strategic and International Studies, Georgetown University,
and Senior Research Fellow, Hoover Institution, Stanford University. He was
awarded the Legion of Honor by French President Francois Mitterrand. He is the
author of Supply-Side
Revolution : An Insider�s Account of Policymaking in Washington; Alienation
and the Soviet Economy and Meltdown:
Inside the Soviet Economy, and is the co-author with Lawrence M.
Stratton of The
Tyranny of Good Intentions : How Prosecutors and Bureaucrats Are Trampling the
Constitution in the Name of Justice. Click here for
Peter Brimelow�s Forbes Magazine interview with Roberts about the recent
epidemic of prosecutorial misconduct.