Tuesday, April 6, 2010

Own the Fed, Part XVII: The Age of Deregulation

A basic principle of internal control is that incompatible functions must always be separated. Internal control is the accounting term for the system that ensures that a business entity — or any other entity concerned with securing the safety of its assets, up to and including an entire economy — has the capacity to 1) safeguard its resources against waste, fraud, and inefficiency, 2) promote accuracy and reliability in accounting and operating data, 3) encourage and measure compliance with policy, and 4) judge the efficiency of operations in all sectors. Clearly, assigning incompatible functions to any individual, group, or institution is a way virtually to ensure not only that fraud can more easily be carried out, but that genuinely honest mistakes will not be detected and corrected.

The problem is that there are two types of control that can be used to regulate a system at any level — internal and external. The idea of internal control is to ensure that the system works in the way intended so as to match inputs and outputs, and to attribute to each input an accurate pro rata share of output based on the proportionate objective value of each input to the whole of the output. In other words, the system should be arranged in such a manner as to treat the contribution of each input with proportionate equality, e.g., an input responsible for producing 10% of the output is credited with 10% of the output. When extended to the whole of the social order, or even the economy, properly designed and implemented internal controls ensure as far as humanly possible equality of opportunity — a "level playing field."

When the system operates badly and distortions creep in — as is the case with assigning incompatible functions to different parts of a system (for example, a business in which the individual authorizing expenditures also has the power to sign checks) — some parts of the system will take unfair advantage of the other parts. This is often without conscious intent, or even contrary to what was intended, simply because of the way the system is set up. Unfairness gets built into the system.

Paradoxically, violating the system in order to gain a desired, even a just result, even when the system is unfair, is wrong. The proper response is to change the system so that it operates fairly, not to violate the system. This is called "social justice." Still, the temptation is always to try and correct an unjust system by overriding or eliminating the system, imposing external controls in an effort to achieve desired results. People in authority see that the system isn't working properly. They assume that the power of the State or some other institution can achieve the desired end by fiat.

This is not to say that there is no place for external controls. When individuals, groups, or institutions violate systemic (internal) controls deliberately, they must be held accountable. When a violation of the system is sufficiently serious or material, the State itself may be required to step in and punish the offender. This also applies in cases in which an individual, group, or institution violates the systemic controls without meaning to, for whatever reason. The State may find it necessary to correct the situation, or assist the individual, group, or institution to restructure the system so that the violation does not happen again, sometimes reinforcing the correction with the imposition of penalties.

Sometimes, however, the State or some other authority attempts to impose desired results as something other than a temporary measure or expedient while the system is being restructured. When that happens, not only does power become unnecessarily (and unacceptably) concentrated at the "higher" levels of society, but those levels — especially the State itself — reach functional overload, and the system implodes.

The State's job as an extremely specialized and powerful tool is to oversee and maintain the system of internal controls of the common good — the social order — so that the system works properly. The State should never, except as a temporary measure in an emergency and as an expedient, attempt to supply a lack in the system by mandating desired results or attempting to provide those desired results itself. Politics — the art of the possible — involves people coming together in communities (the "polis") and organizing matters so that each person may exercise his or her natural rights to the maximum without harming him- or herself, other individuals, groups, or the common good as a whole.

There is, however, a serious problem. Both of the two predominant schools of political thought today, broadly if inaccurately known as "liberal" and "conservative," deny humanity's character as a political animal. Briefly, Aristotle's observation that "Man is by nature a political animal" means that the human person is both an individual and a social being. As an individual, he or she has inherent or natural rights to assist him or her in the lifelong task of acquiring and developing virtue, and thereby becoming more fully human.

As a member of society, however, each individual has the responsibility of exercising his or her individual rights with an eye toward the common good. That is, even rights that are possessed absolutely are to be exercised only in a manner that does not harm the individual, other individuals, groups, or the common good as a whole. The common good is not the aggregate of individual goods or those goods held in common by the State for the sake of expedience. Instead, the common good is the complex network of institutions by means of which individual human beings are assisted in their task of acquiring and developing virtue.

Painting the picture in extremely broad strokes and necessarily oversimplifying, "conservatives" tend to view the human person solely as an individual, while "liberals" tend to hold that humanity is only important as a member of the collective. In the former case, the State is necessary in order to coerce (other) people into behaving, while in the latter, the State is essential as the embodiment of the collective will of the people.

The correct view, of course, is that the State exists to facilitate humanity's social interaction, maintaining the institutions of the common good, and adjudicating disputes, thereby providing a level playing field wherein every individual meets on equal terms, at least with respect to basic civil rights. It is not a weapon to use against others, or a universal panacea providing or guaranteeing all that the individual cannot do for him- or herself. Both the "liberal" and "conservative" viewpoints misunderstand the role of regulations, the former rejecting appropriate internal control in favor of inappropriate external control (collectivism), while the latter rejects all control, especially by the State, as inappropriate — anarchy.

Of concern to us in the context of the role of the central bank and the structuring of the financial system is that, whether in reaction to the "liberal" victories of the 1960s and 1970s, or for some other reason, the 1980s and 1990s seemed to embody a "conservative" backlash. "Deregulation" became the order of the day in order to achieve and maintain an environment suitable for business. In theory, this would result in economic growth and prosperity for all — a rising tide that lifts all boats.

Unfortunately, branding all regulation as undue interference on the part of the State tends to deny the State its proper — if extremely limited — role. The backlash failed to distinguish between regulations as necessary internal control measures, and intrusive misuses of State power. Consequently "regulation" became viewed as bad, in and of itself. All regulation was tarred with the same brush. The baby was thrown out with the bath.

It is true that some of the regulations that burdened the financial industry were efforts by the State to impose desired results. For example, "equal opportunity" in consumer lending, especially for housing, was often interpreted as meaning that lending institutions must lower their standards in order to allow people who otherwise were not good credit risks to qualify for loans.

Ironically, however, regulations attempting to impose desired results were not those targeted for repeal. Instead, regulations such as the 1933 Glass-Steagall Act, that inhibited or prevented financial institutions, especially commercial banks, from assuming incompatible functions and engaging directly in speculation, were seen as interfering with the growth and profitability of the financial sector — which was true, if we ignore the fact that such growth and profitability only comes at the expense of genuinely productive investment. As we've seen in this series, since the early 20th century people have confused speculation (gambling) and genuine investment.

It is not entirely clear what led to the overconfidence of the decades of the 1980s and 1990s. What is clear is that there was a concerted — and successful — effort to dismantle the internal controls that had been carefully put into place since the Panic of 1907. Deregulation was in many respects a good thing. The State is an extremely specialized and extraordinarily powerful tool. The State must, therefore, be carefully watched by the citizens to make certain that it does not begin to take over areas in which it has no competence and which are best left to the citizens themselves or, especially in social justice, to the design of the system.

Deregulation mania actually began before the 1980s, when the Securities and Exchange Commission mandated the deregulation of the brokerage industry on May 1, 1975. This opened up the door for the discount brokerage houses to undercut the traditional institutions, greatly decreasing costs for investors and speculators. This was a good thing in that it opened up the brokerage industry to competition and made the purchase of secondary debt and equity instruments for investment much easier for ordinary people. The "invention" of the mutual fund, made possible by the Investment Company Act of 1940, had done something similar a generation earlier.

Unfortunately, coming as it did into an environment in which far too many people were, frankly, ignorant of the difference between investment and speculation, the end result of brokerage deregulation was to make it much easier for ordinary people to lose a great deal of money in the belief that their gambling was actually allowing them to provide for their future. "How To" books on ways to make a fortune speculating on Wall Street proliferated. Some of these were (and remain) excellent guides on how to gamble — Peter Lynch's One Up on Wall Street (New York: Simon and Schuster, 1989) is superb — but only for people who know what they are doing and are fully aware that they are rolling the dice in a very risky and expensive game. Others are trash, luring people into purchasing a gambling system of which the only guarantee resembles the old joke of how to make a small fortune on Wall Street: start with a large one.

Just as unwise was the deregulation of the savings and loan industry beginning in 1979. This culminated with the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980, and the Garn-St. Germain Depository Institutions Act of 1982, which partially repealed Glass-Steagall. This was not, of course, the 1932 Glass-Steagall that provided the legal justification for the complete switch from a money supply backed by private sector hard assets to government debt (external control). This was the 1933 Glass-Steagall that instituted separation of function of different types of financial institutions (internal control).

Deregulation permitted savings and loans not only to provide a broader range of savings vehicles for their depositors, but to make loans in areas formerly considered outside their competence, such as commercial real estate. This allowed many savings and loans, forgetting their specialized character, to diversify away from residential real estate (their traditional area of expertise) and try to cash in on the real estate boom of the 1980s.

Manipulation of the interest rate by the Federal Reserve only added to the problem. Chairman Paul Volcker began raising short-term interest rates late in 1979. Suddenly, returns on short-term loans were higher than those on long-term loans, such as the home mortgages (many with low fixed interest rates) that were the specialty of savings and loans. This encouraged savings and loans to engage in short-term speculation in commercial real estate in order to maintain or increase their profit margins rather than long-term consumer finance that was their mainstay. The problem, known as "Asset-Liability Mismatch," got worse as interest rates soared in the early 1980s. When the real estate bubble burst, the market took many savings and loans down with it.

Despite the obvious failure of deregulation that accompanied partial repeal of Glass-Steagall, the banking industry continued pushing for full repeal. In 1987 the Congressional Research Service prepared a report that presented the case both for and against full repeal. The reasons as stated are revealing. They exhibit a distinct lack of appreciation on both sides of the real issue involved: whether a society is to be organized on the basis of internal control imposed by the proper and rational structuring of the system itself (social justice), or whether desired results will be imposed by State mandate (socialism).

Unfortunately, the arguments in favor of keeping Glass-Stegall on the books were seriously weakened by taking the tenets of the Currency School for granted. This, however, should have made no difference, had the powers-that-be truly understood the difference between internal and external controls, or (more fundamentally) where sovereignty truly lies: with the people, as opposed to the State. Still, the arguments against full repeal were, within the limits noted, compelling. They should have carried the day had not the banking industry continued to exert pressure to repeal Glass-Steagall in search of speculative profits:

First, there is a serious conflict of interest when the same institution both grants credit and controls the use of the credit. This led to the abuses that originally justified Glass-Steagall. (This is the same issue that every business must address by separating the department and the individuals responsible for authorizing disbursements and for making the disbursements.)

Second, banks exercise great power over other people's money. This control over what belongs to other people must be limited to ensure that both loans and investments are sound, and that there is an adequate level of competition for both in the market. (This is a little off-base. Commercial banks do not, in general lend deposits, but use deposits as reserves and create money backed by fractional reserves by issuing promissory notes. This does not, however, change the point: combining different types of financial institutions, especially commercial banks and investment banks, eliminates competition and removes an essential level of scrutiny.)

Third, dealing in securities can be risky, leading to great losses. Such losses can threaten the safety of deposits. Because the federal government insures deposits, a collapse of the system could result in the government (i.e., the taxpayer) having to bailout the financial system. (This confuses investment and speculation, but the point is well taken. Permitting financial institutions to create money at will for speculation, as happened in the Crisis of 1920 and the Crash of 1929, destabilizes the financial system and undermines the economy — which runs on production, not speculation.)

Fourth, and finally, depository institutions (again the confusion between banks of deposit and banks of issue — commercial banks) are supposed to be run in the interests of their shareholders and depositors. This means limiting unnecessary risk. Bank managers are not trained to operate prudently in the more speculative types of securities. (The slight confusion in the roles of different types of banks makes no difference; the point remains the same: commercial banks are supposed to make loans for qualified industrial, commercial, and agricultural purposes, not gambling.)

Against these more or less solid — if not quite accurately stated — arguments, the banking industry countered with the following points:

First, the financial industry is losing money to un- or less regulated securities firms and foreign competitors that are not subject to Glass-Steagall. The industry needs deregulation in order to compete effectively and maintain and increase profits. (That is, poachers are stealing profits. Instead of demanding that internal controls apply equally to anyone engaged in securities dealings on the secondary market, internal controls should be removed. Two wrongs are necessary to make a right.)

Second, conflicts of interest can be eliminated by enforcing the laws prohibiting them, and by separating functions within a single financial institution. (That is, institute less effective external control by the State in place of more effective internal control by the system, and permit financial institutions to replace effective systemic controls with ineffective nominal separation of function.)

Third, the proposed securities activities are low risk, and diversification would reduce total risk in any event. (Neither of these assertions was true. Speculation is always high risk; the proposed activities were only "low risk" in comparison with other speculative ventures — and were not confined to "low risk" speculation in any event. Further, "diversification" was grossly inadequate if not misleading, being based not on spreading risk, but on betting on which securities would be "losers" through the use of hedging.)

Fourth, and finally, the financial industry argued that commercial banking and investment banking was common throughout the rest of the world, and operated successfully in both the banking and the securities markets. The U.S. financial industry could learn from the system in other countries and apply the lessons in structuring domestic regulations. (The obvious response to this is what your mother always asked when you wanted to do something unwise just because your friends were doing it: "If so-and-so jumped off a cliff, would you?" Further, not only were and are foreign financial markets not all that well run — usually relying on direct State support if not outright connivance between the public and the private sector elites to maintain a semblance of stability — the U.S. financial industry failed to learn anything.)

The pressure the banking industry exerted on Congress was evidently too much. On November 12, 1999 Congress enacted the "Gramm-Leach-Bliley Act" ("GLBA"), officially the "Financial Services Modernization Act of 1999." GLBA allowed the formerly carefully separated commercial banking, investment banking, and insurance industries to combine in a single monolithic entity of incredible power — the "financial services industry." GLBA also allowed financial holding companies to own non-financial institutions as long as they are not corporations.

All of this had already been permitted on a temporary basis under a waiver issued in 1995, under an amendment to the provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (IBBEA) that was made effective February 7, 1995. The IBBEA repealed the interstate restrictions of the Bank Holding Company Act of 1956. The IBBEA permitted interstate mergers of "adequately capitalized and managed banks, subject to concentration limits, state laws and Community Reinvestment Act (CRA) evaluations."

Perhaps the most spectacular combination — a virtual "financial trust" that rivaled J. P. Morgan's influence and power before the Panic of 1907 — was the formation of the Citigroup conglomerate in 1998. This combined Citicorp, a commercial bank holding company, and Travelers Group, an insurance company, which offered a complete range of financial services from commercial banking, investment banking, brokerage services, and insurance. Had it not been for the temporary waiver, the combination would have violated not only Glass-Steagall, but also the Bank Holding Company Act of 1956. Technically, then, GLBA did not permit combinations, but legalized those that had already occurred under the waiver and made them permanent.

Thus, in the name of free market reforms, the last vestiges of freedom were removed from the market. Those pushing for deregulation seem to have had little appreciation for the power of the system to regulate itself if structured properly. As "free" market adherents continue to believe to this day, they assumed that something they vaguely call "the free market" will somehow take care of itself. This is presumably accomplished without careful popular oversight of the system, and without bothering to put adequate internal controls in place or maintain those that already exist.

Ironically, removing internal controls that allow the system to regulate itself necessarily results in the State imposing external controls when the inevitable abuses and mistakes occur. The end result is to put the market completely under the control of the State through the imposition of often arbitrary external controls, putting the financial system — and thus the economy — at the mercy of those who control the State.

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