Our current economy and financial system may sound like it’s chugging along strong, but unfortunately for the layman, understanding these systems can seem completely opaque. To learn more about hat mistakes economists and regulators have made in the past, and what mistakes they might make in the future if we aren’t careful, we spoke to Kathleen Day, experienced business journalist, professor, and author of a new book on the history of financial crises: Broken Bargain.
ABERMAN: Well I think that in our community, it’s really important that we have context. It really lacks in many circumstances. You know, things can come out of left field, and one of the things I like most about Broken Bargain is that the financial crisis of 2008, the stock market crash of ‘29, the quite possible financial crisis that will occur at some point the future, there’s a recurring pattern. And I think that’s a place to begin: you call the book Broken Bargain. What’s the bargain that you’re talking about?
DAY: One of the things that I discovered in writing this book is, I learned really how the corporate form developed. And incorporation is something that the government has to give to aid an organization, and a lot of people, going back to Jefferson and Hamilton, their argument, a lot of people think of it as an argument over a bank, but more fundamentally it was over: does the federal government have the right to grant incorporations?
And Jefferson didn’t want that, because he thought, they just fought a revolution. He thought Bank of England, kings and queens, we don’t want that. And Hamilton said, yeah, I get the dangers, but we are not just going to be an agrarian society, and we really need a stable national currency, and we’ll need a national bank, and a national bank is, by definition, incorporated by the federal government. So, what I discovered in writing this book is that, the history of the development of the shape of the core corporate form, is tied inextricably with banking. American bankers created the corporate formed that America then exported everywhere.
The beginning of the country, corporations, people understood their potential dangers and benefits, but they limited them to 20-year lifespans, and they would have to renew their incorporation. They had to be for a specific purpose, like creating a canal or a water system, but they wanted to limit their power. But most importantly, the bargain is that if you have an incorporation, which is a privilege, a status that a government bequeaths to you on behalf of the citizenry and taxpayers, it has a right to come in and make sure that you’re not doing something that is bad for the citizenry.
So, that’s number one. Then number two, once you incorporate a bank, it’s a double whammy, where it’s a double reason that the government is giving this status to these institutions, and we’ve gotten to the point where we have forgotten that this link, this bargain, and it was very much strengthened in the 1930s with the creation of deposit insurance. Because once you explicitly put the taxpayer’s liability on the line—FDR did not want to have the creation of deposit insurance, because he thought it would cause moral hazard, making bankers act irresponsibly.
And he only agreed to it in exchange for much tighter oversight. Bankers seem to forget this, and so does corporate America. They’re like, okay, incorporate us then go away, government. Don’t bother us with all your regulations. And over and over again, regulators buy into that. They go, yeah, we’re going to hamstring them, until they forget their job. So, the fact that someone in the Trump administration is calling the banks that he’s supposed to oversee on my behalf, on your behalf, and all taxpayers, he’s supposed to be policing them. For him to call them his customers just says it all about how regulators get it all wrong.
ABERMAN: You’re talking about incorporation, you talk about banking. The reason why, in my experience, incorporation matters, and why I always personally have all my businesses incorporated is, it allows me to avoid personal liability if the business fails, and allows me to go through a bankruptcy and start a new business the next day. Those are very important parts of what makes our market work, but also a really strong way to avoid personal risk when I take business risk. And as I hear it, and as I thought about in your book, it’s a very toxic mix when you take that limitational liability, and you add on top of that the ability to create credit out of midair.
DAY: Exactly. And then you take any policing out of the equation.
ABERMAN: You looked at the financial crisis of 2008, and you’re looking at other financial crises. What are some of the hallmarks of a financial system that’s out of control, or out of kilter?
DAY: One of the hallmarks is the Kool-Aid, which is a reference to Jim Jones. But on Wall Street, it’s a name for ridiculous premises that some know is ridiculous, but use it anyway. What a lot of people buy into, in hindsight, is ridiculous. So, for example, in the most recent crisis, the Kool-Aid was that home prices never go down. And even people like Alan Greenspan, head of the Federal Reserve, and Bernanke, who is at the Federal Reserve but not chairman, they were all saying that. And there is an economist at Yale, Shiller, who won a Nobel Prize for his work in behavioral economics.
He has said, go back and you can see that’s just demonstrably untrue. It was ridiculous for people to think home prices would never go down, or would always go up. That’s just ridiculous. In the savings and loan crisis, the Kool-Aid was, oh, we can grow out of our problems, when really they should have been put out of their misery. Those banks, we had too many banks, savings and loans are specialty banks that specialize in mortgages. We didn’t need all that. They should have been put out of their misery, not allowed to stay in existence, and grow into an even bigger problem.
ABERMAN: So for example, we talked about the conventional wisdom of Kool-Aid, I could say that the Internet bubble was built upon the Kool-Aid that the world was gonna change dramatically, and sock puppets are gonna be worth a billion dollars.
DAY: Yes, and also if you remember at that time, going into the Internet bubble, people were talking about the new economy. It sounded exactly like the the words people used in the 1920s where the Kool-Aid was that the stock market will never go down.
ABERMAN: Right. And the third world debt crisis, the Kool-Aid was that lenders will never default. It’s really fascinating to me that we’re in a free market economy, we see ourselves as free marketeers, but if we don’t actually regulate the financial markets… Well, in your book, you mention the former president of Citibank looking at the regulators and basically saying, you have to stop us from writing all these bad mortgages. But yet they don’t want to. By the same token, the financial service industry clearly doesn’t want to be regulated.
DAY: Except when they have done things so stupidly that they’re about to go under, then they say excuse me, please come in.
ABERMAN: Like 2007 with Bear Stearns and then 2008 with Lehman and AIG..
DAY: Exactly. Exactly.
ABERMAN: Do you feel, having written this book and gone through this experience, you’re a little bit like somebody in a movie theater saying fire, and there’s actually a fire?
DAY: Yes. And I will say, some people I know, one review said, this is accurate but dispiriting, like sort of depressing. I don’t mean it to be a depressing book, but I do mean that for voters, hopefully they will understand better how these things come to be, because the only thing that can really counter lobbying money and the financial services industry, they’re the most well-heeled lobbyists bar none. The only thing that can counter that money that elected officials are getting from them, are voters who say we’ve had enough. Now, people at the end of the most recent financial crisis created both the Occupy Wall Street and the Tea Party movement.
So, people were very angry about it, but they didn’t really understand it. The journalist who is given dubious credit for creating the Tea Party. He was a CNBC reporter who said, do you want to pay for your neighbors? And so, the fact is he had no idea what he’s talking about. And that was a really silly thing to say, because yes it was repugnant we had to bail them out. But the problem is, we’d let them get into such a crazy situation that we had to, or it would hurt everyone. It’s more akin to the person who smokes in bed, and they burn their house down.
Do you say, well, we’re going to let the fire engulf the neighborhood, because they were so irresponsible? Yes, they were so irresponsible. But you should have stopped them from smoking in bed. Once you have the neighborhood burning down, yes, you have to have the bailout.
ABERMAN: Yeah, I mean, you have to have them. I mean, that’s why in 2008, as I see it with my own hat on, the market literally had seized up. There was an international bank run. It was a disaster.
DAY: It was a national security crisis. This is a national security crisis! At one point, there is a scene that I paint in the book that, to me, is one of the most poignant, where Treasury Secretary Paulson is in China for the Olympics, and a Chinese official says to him, you know, the Russians called us and said, why don’t we sell all our mortgages? Fannie and Freddie mortgages, why don’t we sell all that, let’s do a coordinated effort. And he said, the fact is, being so indebted as we are as a country, it really opens us up to being manipulated by foreign interests who’re not aligned with ours. Just like our dependence on oil allows us to be manipulated by players in the Middle East. Whereas, if we were more energy independent, we would be better off from a national security point of view. This is just common sense.
ABERMAN: So, last thing before I let you go. Having been through this experience, looked at all these crises. What are your policy prescriptions? What would you like our listeners to be thinking about, talking with their representatives about, what is the right way to regulate the financial service industry and an economy like ours?
DAY: Enforce the rules! Do common sense underwriting. People say Dodd-Frank, that’s legislation that was put in place after the crisis, is so cumbersome. You know that’s just malarkey. You know what it says about mortgage lending? It says, guess what mortgage lenders, from now on, when you lend someone money, you have to assess whether they can afford to repay it. Now, that may sound ridiculous, and I’m sure listeners will say, well, that’s ridiculous, of course they wouldn’t lend money to people who couldn’t afford to repay it.
It’s exactly what they did, because they had a short term view of things! And there’s a saying on Wall Street, and I hope I get this right: IBG YBG. It’s initials for “I’ll be gone, you’ll be gone.” Som it’s a short term outlook where, if we can just meet our quarterly goals of making this many mortgages, we don’t care that people are going to default later, because we’ll be gone. Let’s make all these mortgages, meet our targets, we’ll get our big bonuses. And then if these people default, we don’t care.
So, they really had this short term mentality, and it caused what’s known in finance as moral hazard. Which, my definition of it is: you privatize the gain, and socialize the risk. Meaning, if they do great, they get to keep the profits. If they don’t do well, hey, Kathleen Day, the taxpayer, has to come in. I’m really sick having my wallet picked, aren’t you?
ABERMAN: Absolutely, yes. But I’m not sick of talking on this topic, but unfortunately I’m gonna have to stop. Kathleen Day, the author of Broken Bargain. I highly recommend you all check this book out if you want to know more about how our financial services industry actually works. Kathleen, thanks for joining.
DAY: Thank you so much for having me.
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