The Revolutionary Pen - beta

By Frank Schiavone

Things used to be a lot simpler. We lived in smaller homes with just one TV. There was no shame in driving a used car. We were more earnest savers. A savings account got you about a 5% return on your “investment”. Banks would not dream of charging you a fee for the privilege of parking your money there. Banks and S&Ls would leverage the money you deposited to make home loans. Down payments were required so that the borrower had an equity stake in the home he or she was purchasing. More importantly, the borrower had to show that they could actually afford the loan.

A bargain was struck with the American people. We’d save, our money would be safeguarded, and government would act as the cop on the beat to insure our financial systems were stable. Seemed like a pretty good deal, albeit pretty boring.

During the 50’s and 60’s America was at her zenith. We were actually a creditor nation. Fully one third of all products consumed by the world were made right here. The middle class was thriving. Real wages went up annually.

But something changed. The rich were not getting rich enough. They needed more. Then along came Milton Friedman and his Chicago School of Economics. Friedman was a Keynesian and staunch supporter of the New Deal. But Milton had a conversion. In his groundbreaking book, Capitalism and Freedom published in 1962, he laid out an entirely divergent view of the marketplace and government’s role in it. In essence, Milton became the 20th Century incarnate of Adam Smith. His book and his numerous essays on laissez-faire capitalism gave American conservatives and libertarians the intellectual arguments they needed to advance their agendas.

Friedman likened the economy to an ecological system. Left to its own devices the market would ultimately reach perfect “ecological balance”. The market, like the natural world, was resilient. Shocks to the system would be quickly healed. Sometimes these shocks were necessary to restore balance.

In 1976, he won the Nobel Prize in Economics. The Right was giddy and now attributed an almost divine inspiration to his economic theories. A new religion was born.

Even so, Friedman’s world view was hardly mainstream. That changed on January 20, 1981. Regulations have been steadily dismantled since. When Reagan’s chief bank regulator warned of an impending bank crisis and asked for more regulators Reagan’s response was that it was his administration’s policy to give him fewer regulators not more.

Ultimately, both parties found “religion”.

Under Clinton, both the Financial Services Modernization Act of 1999 and the Commodities Futures Modernization Act of 2000 were enacted, each having bi-partisan support in Congress. The bright line between run-of-the-mill banks and investment houses and insurance companies was erased. Banks could now invest heavily in securities, stock options and futures. The cornerstones of today’s financial meltdown were laid. Finally after years of assault, a New Deal pillar, the Glass-Steagall Act, was removed once and for all.

A dizzying array of new and exotic financial products was devised. Investment and commercial banks, in the words of Warren Buffet, became “casinos”. Hedge funds, derivatives, spiders, tranches, collateralized securities, and credit default swaps all became part of the Nation’s lexicon even though we hadn’t a clue about what they were. The rich got really, really rich. The rest of us were content because our retirement savings were also growing.

But soon, the house of cards would begin crumbling. Wild speculation in the housing market (spurred on by cheap credit, predatory lending, lax oversight, ridiculously lenient underwriting requirements, and unrealistic and ill-informed realtors and consumers) led to a housing bubble. Housing booms spurred on by local politicians led to housing busts. Foreclosures and defaults followed.

Since these defaulting mortgages (now referred to as toxic assets) were intermingled with performing loans into something called mortgage-backed securities, the bad paper was negating the yield of the good stuff. Consequently, the value of these securities fell precipitously in value which, in turn, ate into balance sheets leaving little or no money to be lent or invested. And because our financial system has become as unfathomable and complicated as the electronics in a pricy German car the whole mess is coming to a grinding halt. More trouble lies ahead as a new round of home foreclosures and defaults can be clearly seen on the horizon. Many experts believe that defaulting Alt A and Option ARM loans will make the subprime fiasco look like a hiccup.

Banks and investment houses are in a survival mode, hoarding cash as their balance sheets are becoming upside down. And not unlike many homeowners, their equity is fast disappearing. They need to hold cash to avoid going negative (and to avoid bankruptcy).

It’s perplexing that the current meltdown took us by surprise. Each of America’s economic downturns has been preceded by wild bouts of speculation and “irrational exuberance”. Add irresponsible fiscal and regulatory policies (on the part of both Republicans and Democrats) to the brew and we have a recipe for disaster. It turns out Depression-era policy makers were pretty smart and current ones are pretty dumb.

Milton Friedman was correct to postulate that the market will reach a perfect “ecological” equilibrium. The only problem is that the interactions within the natural world are raw, untamed, and exceedingly cruel. True, altruism and selflessness does exist in the Animal Kingdom. But there is no fixed code of moral conduct. Some animals devour or kill others for survival, for territory, for dominance, for pack. They are called predators.

Copyright © 2008 Frank Schiavone