What are the lessons from the housing debacle that is now unwinding? That is, What are the lessons that should inform policy?
Too much congratulation and not enough corporal punishment is being dealt the Fed.
The need for financial markets to be regulated has been exposed by one crisis after another. The S&L bailout, the Long Term Capital Management fiasco, Enron and World Com and many more in between. Rather than set standards and hold to them, under Greenspan and Bernanke, there has been cheap money at the end. This in spite of a direct mandate from Congress.
- The Fed is not going to regulate, or indeed, set any standard at all, nor use any tool other than short-term interest rates, no matter what problem confronts it.
- The Fed is going to bail out the financial sector whenever things go bad for them. This insurance makes a mockery of the "risk" for which they compensate themselves so well. So mortgage holders should stop looking.
- No other sector will be bailed out, because the Fed is in thrall to the financial sector. When banks moved to broad services over the past four decades, they took their control of the Fed with them.
- Neither inflation nor recession is as important to the Fed as padding the financial sector. The need for "confidence" in the financial markets, which turns out to be a "confidence game," trumps both inflation and recession in the mind of the Fed. Prediction: As soon as financial firms and hedge funds signal their solvency, the Fed's practice will be to support the value of the dollar for as long as possible. This will be done for the benefit of its financial sector constituents. The announced reason will be to stem inflation pressure, but the inflation will be cost-push from higher commodities and imports, rather than demand-pull, and so higher interest will not touch it.
- The financial sector controls monetary policy and monetary policy is out of control (see inverted yield curve).
Seven Policy Remedies
- Financial transaction tax, a .0025 tax on the value of each financial transaction. This one-quarter of one percent. This will be incidental to most transactions. 25 cents on every one hundred dollars, or 25 dollars on every ten thousand dollars. For transactions with high leverage, this tax is relatively more for the hedge fund, since they will incur the tax on the total no matter that their total is small. That is, if using a million dollars, they leverage another nine million for the transaction, the effective tax on them is 2.5 percent. If money is being moved higgley piggley to take advantage of short-term arbitrage, over a year's time it will be subject to the tax several times. The yield of such a tax would be immense. The cost to the real economy would be negligible. (This is similar to the Tobin Tax, proposed to slow down the mad rush of currency speculation around the globe.)
- New top marginal rates on personal income tax, no income source excluded, of 50% on $1 million or more and 90% on $10 million or more. Take the reward out of high risk. Return sobriety to corporate governance. The companies of Europe are winning with executive salaries one-third of those in the U.S. Top hedge fund managers make $1 billion per year.
- Reestablish the SEC. William Donaldson, former head of the SEC, whose appointment actually brought confidence in Wall Street back from the grave after the Enron and World Com fiascos, abandoned the post after three years. Partisan hacks returned to the posts. Donaldson has called for "getting tough" on conflict of interests, increasing oversight and closing the loophole that lets hedge funds play in the market without disclosure of their practices.
- Windfall profits tax. There are obscene rewards to those who take a company private, do financial slicing and dicing, and sell it back to the public. These and other financial gymnastics are today's replacement for productive work. They do not have to be encouraged in the tax code.
- No free lunch on bailouts. Companies and funds who are bailed out with cheap money from the Fed need to be identified individually and dealt with individually. Rather than this upper class welfare, there needs to be a price for liquidity, a share of the firm or specific repayment conditions, that benefit the government and the people who are footing the bill. Stiglitz seconds this suggestion in his piece:
- Mortgage loan disclosure. Surveys, investigations and anecdotal evidence by the boxcar load have shown that many home loan purchasers do not understand the terms of their loans. This is not confined to unsophisticated subprime borrowers. A simple one-page disclosure summary is available that sets things down in black and white. It needs to be mandated for every mortgage.
- Strict limits on the type of mortgage instruments. The ARMs promoted by Alan Greenspan are not appropriate. They are speculative instruments. Prepayment penalties are loan shark stuff. Congress must set a strict limit on the types of loan that are eligible for income tax interest deduction.
Those in financial markets who believe in free markets have temporarily abandoned their faith. For the greater good of all (of course, it is never for their own selfish interests), they argued a bailout was necessary. While the US Treasury and the IMF warned East Asian countries facing financial crises ten years ago against the risks of bail-outs and told them not to raise their interest rates, the US ignored its own lectures about moral hazard effects, bought up billions in mortgages, and lowered interest rates.
It may make sense for central banks (or Fannie Mae, America's major government-sponsored mortgage company) to buy mortgage-backed securities in order to help provide market liquidity. But those from whom they buy them should provide a guarantee, so the public does not have to pay the price for their bad investment decisions. Equity owners in banks should not get a free ride.