Treasury Dodgeball

News: Treasury Secretary Henry Paulson addresses the "changed nature of our financial system."

By Nomi Prins

March 28, 2008

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This week, Treasury Secretary Henry Paulson spoke about the housing and financial markets in front of the U.S. Chamber of Commerce, citing a shared commitment to competitive markets and promising an upcoming blueprint for regulatory reform. He also commended the Federal Reserve's actions regarding Bear Stearns last week. Their "heroism" included purchasing $30 billion of Bear's riskiest securities, turning the Fed not into a provider of last-resort liquidity but a speculative hedge fund. (If you buy risky securities, either you hope their condition improves, or you are throwing taxpayers' money down the drain.)

Paulson likened "this step in a period of stress" as part of the "changed nature of our financial system and the role played by investment banks in the post Glass-Steagall world…such direct lending from the central bank to nondepository institutions has not occurred since the 1930s."

But there was a reason that the 1933 Banking Act that established the Federal Deposit Insurance Corporation (FDIC) shunned rather than commended taxpayer-funded business with speculative financial institutions; it fostered a less risky financial environment.

Paulson didn't, given his free-market bend, suggest curtailing this activity of providing liquidity to investment banks, but instead wants to place it under the Fed's permanent purview while tinkering with the information requirements the Fed would need to affect this broader role. (Today, in a New York City speech, Senator Barack Obama echoed this component of Paulson's sentiment: "If you can borrow from the government, you should be subject to government supervision. The Fed should have supervisory authority over any institutions to which it's lender of last resort.")

When Congress founded the Federal Reserve System in 1913, its mandate was to provide a more stable monetary and financial system. It would protect the credit rights of consumers and contain systemic risk. With respect to how badly leveraged the banking system recently became, it has failed on those counts. It has not been engaged in preventative protection actions, but postdisaster management under fire.

With its seemingly unlimited supply of money, the Fed can throw $30 billion here or $50 billion there to "save the system" rather than prudently examine how to fix the system. It's like a crack dealer dispensing various size vials to addicts. Suggesting that more control over the process should be given to the Fed is like calling upon community crack dealers to man local rehab centers.

There remains an enormous deregulatory elephant in the room that no one is addressing, but rather everyone accepts as an irrevocable presence—Glass-Steagall repeal. In the face of current debate about whether more oversight will fix our nation's housing problems or the banking credit crunch of its own making, there is a steadfast refusal to consider that change can mean relying on past measures that have proven effective.

The banking system simply must be regulated at source. Thanks to Glass-Steagall repeal in late 1999, so-called commercial banks today are merely composites of investment and commercial banks that can manufacture loans on one side of their balance sheet and trade them on the other.

Investment banks lend to each other and to their customer hedge funds as if they were banks, but with less oversight. The New Deal, via the Glass-Steagall Act of 1933, sought to create transparency and regulatory ease over the banking system by separating the powers of investment banks (the speculative side) and commercial banks (the consumer-oriented side). It rewarded the less risky nature of commercial banks through the Banking Act of 1933, which established the FDIC with government funding to provide insurance for consumer deposits held in commercial banks.

We have abandoned that simple model so concretely that only the same kind of restructuring of the banking system will really cure the problems that have amassed since. Anything less is full of empty promises and misguided solutions.

Whatever the level of his involvement in the actual mechanics, Paulson, together with the Federal Reserve, by pushing Bear Stearns onto JPM Chase (a supermarket bank consisting of several commercial banks of the past—including Manufacturer's Hanover and Chemical Bank, plus the blue-blood investment bank child of JP Morgan), compounds the problem of a combined investment and commercial bank that Glass-Steagall sought to solve, and did solve for decades.

The more merged the players in the financial system, the more difficult it will be to understand what they are doing and the risk it presents to the greater public economy. You cannot have it both ways. Paulson is by no means an economic socialist, but as free market as he is, he should surely be able to comprehend that talking "oversight" and convoluting that which you are exposing to "oversee" are two mutually exclusive considerations. There is blame for this subprime-led banking crisis all around, including from the overseers who weren't doing their jobs in the Capitol, but giving the Fed more power, when they used the power they had so poorly, isn't the way to go. Nor is creating yet another combined Washington entity, a la the Homeland Security Department, to monitor the activities of ever-complex financial-institution conglomerates and the securities they create and trading they do. The SEC was supposed to do that and has consistently failed miserably.

Decreasing the complexity of the makeup of those institutions, however, will alleviate current and future catastrophes of our banking system—and their spillover onto the general population. In that vein, it would benefit Henry Paulson and Ben Bernanke to truly study what happened to the market leading into 1929 through 1933. They need to examine how the banking industry was successfully restructured (and incidentally enjoyed decades of the kind of growth that Paulson fears regulation would curtail), and then talk about some real solutions.

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