NINE

THE DEBT BURDEN AND FINANCIAL REGULATION

How do financial crises occur? In 2007, the American economy was booming. People were making money. They were buying homes and expensive cars. The stock market was active. Everyone planned to be wealthy.

But if you look more deeply, there were warning signs. Too much borrowing, homes sold to people who couldn’t afford them, greedy banks eager to cash in, credit rating agencies overstating value, regulators not putting on the brakes, and then, suddenly, Lehman Brothers collapsed, the financial system threatened to freeze, and the world economy began to lose trillions of dollars.

No one could determine any particular bank’s risks. Because of derivative trading, a bank’s value couldn’t be assessed. Banks hesitated to lend to other banks. No one could tell whether any particular financial institution might suddenly implode.

BEFORE THE GREAT RECESSION IN 2008

The United States enjoyed a period of great economic growth and prosperity from 1945 to 1970. We thrived as the world’s leading economic and military power. Part of our success came from the fact we were never invaded or bombed during World War II. WWII devastated much of the infrastructure of Europe and Asia. These countries turned to the U.S. for needed equipment, supplies, and food. Our manufacturing industry grew and prospered. Unions were strong. American workers got used to the idea of rising wages and rising consumption.

By the 1970s, many nations in Europe and Asia had managed to rebuild their infrastructure and manufacturing. Germany once again was building better cars and other goods, and commanding better prices. And Japan entered the U.S. market with cheaper and often better-made goods. Japan won market share increases in a number of industries, including automobiles, motorcycles, cameras, radios, watches, and small appliances. To compete, some U.S. companies moved overseas to make use of lower labor and material costs. This meant a loss of jobs in the U.S. In addition, women were increasingly entering the labor force. Immigration was also increasing, with many of the new arrivals accepting lower wages. All this led to an oversupply of labor that kept wages from rising. Unions, without the ability to extract higher wages from management, grew weaker and lost members.

Wages became stagnant starting in the mid-1970s. Workers responded to the flat wages by working longer hours and taking on more jobs. They ended up working 20 percent more hours, whereas the French were cutting down their workweek hours by the same level. American husbands and wives were both working and their older children were getting jobs at McDonald’s. Americans still wanted to enjoy rising consumption, so they borrowed money to supplement their earnings. Initially they borrowed against their mortgages, which at least represented secured credit—namely, their homes. They later turned to credit cards, representing unsecured credit, to finance their consumer appetite, which continued to be fanned by heavy advertising. The result was growing consumer debt. For many workers, their debt was equal to their annual income.

The banks were loaded with money to lend to consumers. They actually pushed the money out even to those who couldn’t easily pay it back with interest. General Motors, in seeking to sell more cars, created General Motors Acceptance Corporation (GMAC) to lend money to car buyers at a good profit. GM was happy to sell its cars for less and make it up in interest payments. GM became a bank as well as a car manufacturer and made more money on its interest payments than on its automobiles.

In the 1980s, the computer came into increasing use and killed numerous jobs held by secretaries and other office workers. Computers, along with advances in factory automation, delivered a big increase in company productivity and in company profits. Relatively flat wages plus growing productivity created high profits.

What happened to those growing profits? First, executive salaries steadily increased to the extent that now CEOs of many corporations are paid 200 or 300 times as much as the average worker, whose wages didn’t increase. Second, some of the money goes into supporting politicians, political parties, and lobbyists to preserve or extend the benefits and privileges enjoyed by the rich capitalists. Third, some money goes into philanthropy to help those who suffer from poverty, low wages, or unemployment and to support hospitals, churches, museums, and performing arts organizations. Fourth, much of the rising profits goes into banks, where it can be lent to workers who need to borrow more money to keep up their consumption. Consumption becomes the payment to workers to compensate for poor treatment by their company. Ironically, instead of the workers sharing the good times with management and getting higher wages, they were instead getting the privilege of borrowing money that might have been theirs and paying it back with interest. Today, the interest rate on credit-card borrowing is as high as 18 percent in many cases.¹

THE U.S. GREAT RECESSION (2008–2011)

The U.S. experienced eleven economic downturns between 1945 and 2007, averaging about six years. They were called recessions and believed to be intrinsic to a capitalist economy of the American type. But the recession that started in 2008 was the most severe since the Great Depression of the 1930s.

The U.S. and the world economy experienced a disastrous financial crisis. A number of companies went under—Lehman Brothers and Bear Stearns being the most notable. Other companies were saved by the government throwing them a lifeline—AIG, Fannie Mae, Freddie Mac, and General Motors—as well as the government’s $204 billion share purchase of several hundred banks. This doesn’t include the $860 billion in stimulus money from the American Recovery and Reinvestment Act of 2009.

The government was criticized for saving companies and banks that were “too big to fail.” There was an outcry in some quarters about “deficit financing” and predictions that it would lead to hyperinflation. Yet the fact is that the quick action by the Obama administration prevented the collapse of the economy. With further government spending through 2012 estimated at $4 trillion,² the unemployment rate dropped from 10 percent in 2009 to 7.3 percent in September 2013, and a gradual postrecession GDP growth of 2.2 percent was seen by the end of 2012. The stock market returned to the pre-financial-crisis level, largely due to profitable cost cutting and dividend increases from corporate cash reserves.

The U.S. economy is still stuck with tough problems to manage in the aftermath of the calamity. Taking into account the vast number of pre-financial-crisis employees who have dropped out of the labor market and the increase in part-time employment, instead of full-time employment, Gallup estimates underemployment (counting dropouts and part-time workers) of 17.2 percent for October 2013 as against an “official” unemployment rate of 7.5 percent.³

The current U.S. debt burden is extremely high and taxpayers aren’t happy about the enormous interest payments on federal debt they must make to lenders to keep buying U.S. securities. U.S. interest payment on the federal debt is estimated, for 2013, at $416 billion,⁴ or roughly 7 percent of federal revenues. “Uncle Sam will shell out more than $5 trillion in interest payments over the next decade,” according to projections from the Congressional Budget Office. “Over the decade, more than 14 percent of all federal government revenue will be sucked up by interest payments.”⁵ I won’t examine here the growth of state and local government debt.

There is no way this debt can be repaid. It would take the entire annual U.S. GDP to pay it off, which itself is impossible because there would be no economy left to generate the required GDP amount. The public fear of ever-greater debt warrants more public discussion. Many established economists say that there is no near-term reason to be alarmed. Paul Krugman leads in this view, saying if we work on job and income growth, we’ll be in a better position to substantially reduce the debt. Other suggested solutions such as austerity are likely to impoverish the economy (consider the crisis in Greece) and make it even harder to ever pay down the debt. But most economists do recognize a mid-term and long-term crisis of spending growth in the face of a declining rate of GDP growth. Politically, we face widespread public and popular concern, since the magnitude of this problem exceeds any household comparisons used to comprehend this scale of repayment.

It’s true that over 60 percent of this debt is owed domestically to the Fed, the banks, and pension funds. While these institutions will grow richer on the interest on their holdings, the American people realize that an ever-smaller percentage of U.S. revenue will be available for government operations, transfer payments (Social Security, Medicare, Medicaid), and social programs like education. Elected officials should not be allowed to get away with refusing to publicly address this problem. The Tea Party gained considerable power by insisting on large spending reductions, but the debate still rages over where cuts should be made.

There was a valiant attempt to officially address this issue in the 2010 Bowles-Simpson Deficit Commission, which recommended a $4 trillion deficit reduction for outlying years. This plan had no traction and remains today only a shadow of its original self. The sequestration of 2013 reduced spending authority on approximately $85.4 billion (vs. $42 billion in actual cash outlays) during fiscal year 2013. But in spite of these cuts, the Congressional Budget Office estimated that the total federal outlays will continue to increase, even with the sequester, by an average of $238.6 billion per year during the next decade.⁶

What about the danger of inflation? Although core inflation has remained under control, food, energy, health care premiums, and education costs are not included in the official U.S. inflation index. All of these and other nonindexed items far exceed core inflation. Many people believe that higher inflation is just around the corner and it will be impossible to pay down the high debt burden resulting from continued high spending/low tax policy of the past two presidential administrations.

GROWING INCOME INEQUALITY

There remains a giant concern about the growing income disparity (see Chapter 2). In 2012, the incomes of the top one percent rose nearly 20 percent compared with a one percent increase for the remaining 99 percent. The top 5 percent of households earned 22.3 percent of all the nation’s income in 2012. The income of these highest-earning Americans has recovered completely from a fall after the financial crisis, compared with the 8 percent decline for the median American household.⁷

The middle class, which used to have some discretionary income and good credit, now finds the cost of college and the cost of health care to be significantly high for their incomes. This has made them more cautious in their spending. Many people worry about being able to remain in the middle class. The middle class has been the mainstay of the case for capitalism. Or is the middle class only an 1945–1970 aberration in the history of capitalism? Capitalists have to worry about a shrinking middle class and its possible threat to reducing or ending the privileges of the wealthy class.

Personal savings in the United States increased to 4.6 percent of income in August 2013. Higher savings combined with reduced spending keep businesses and jobs from expanding.

Consumer spending drives 70 percent of economic activity. Because of reduced spending, the Federal Reserve forecasts an estimated overall GDP growth of around 2.0 percent for 2013.⁸ Despite three rounds of quantitative easing since 2008, there is not enough domestic spending to lift GDP to what the Feds consider a robust growth rate of 2.5 percent.

Two facts stand out. The first is that the United States, which stood as the largest creditor nation in 1970, is now the world’s largest debtor nation. Second, the U.S. economy has undergone a radical transformation from being manufacturing-led in the past with a healthy number of employees earning a middle-class income to a financially driven economy where Wall Street and the financial sector holds the greatest share of assets and income. These financial sectors grow while the middle class dwindles. Banks, brokerage houses, investment banks, insurance companies, hedge funds, and others determine the future direction of the U.S. economy.

Manufacturing has dropped from 26 percent of all jobs in 1970 to just 9 percent in 2010. Trade, transport, and utilities jobs declined from roughly 21 percent to 16 percent of jobs. Calling these two sectors the “labor sector,” we see a total decline from 47 percent of jobs to 25 percent. Even the percentage of government jobs declined by almost 2 percent, but we’ll leave this finding out of our equation.

By contrast, financial services jobs increased from 15 percent to 22 percent in the same period; business and professional service jobs increased from 5 percent to 12.5 percent; and health services increased from roughly 4 percent to 8 percent of jobs during this same period. Let’s call these last three sectors the “professional sector.” From 1970 to 2010 the “professional sector increased from 24 percent of jobs to 42.5 percent of jobs (largely nonunionized).⁹

The difference between 47 percent of “labor” jobs, largely unionized, and 42.5 “professional” jobs, mostly not unionized, is a telling landscape of change in income and spending power, as well as income inequality. The range of income difference in the labor sector is far smaller than the range of income in the financial services and the business and professional sectors. “Professional” may sound like a higher paid job sector, but as a sector class it is on average lower paid than the “labor” sector of manufacturing and trade, utilities, and transport; and hence, in aggregate it has less consumer spending power.

The top 5 percent households that earned 22.3 percent of all the nation’s income in 2012 are in the “professional” class, not the “labor” class. The top one percent income earners (minimum income of $350,000) are an investor class, not a consumer spending class.¹⁰ The greatest portion of their income is invested in wealth management, not consumer goods and services. Members of this class may have several mansions and a yacht, but this is small potatoes compared to what they invest in financial products. Very little of this 22.3 percent of the nation’s income flows into the real consumption economy.

While the numerous poor and middle class spend their income on 70 percent of the U.S. economy, the rich spend relatively little on consumption. This transformation manifests itself in three outstanding features of the economy: (1) the reduction in median income; (2) the historic declining annual rate of GDP growth; and (3) the declining percentage of the labor force to population.

These numbers are also a structural snapshot of the paradox of having income inequality and trying to increase national GDP. How can so many households with less real income than in the past spend enough to increase GDP more than in the past? The answer to the GDP riddle is consumer credit and personal debt for most households, notwithstanding the investment transactions of big money by the top one percent of households. Both of these sources of monetary circulation are the core activities of the growing financial service sector.

HOUSEHOLD DEBT

The national average wage index for 2011 was $42,979. Assuming that you have to have a job to get a credit card, we find that as of 2014, the average U.S. household credit-card debt, among credit-card-indebted households, stands at $15,607.¹¹ Compare this figure to 1970, when consumer credit was virtually zero. The blunt fact is that from 1970 to the present, the growth in consumer spending and GDP is a significant function of consumer credit debt, or other varieties of personal debt, rather than a rise in disposable income of labor. In short, most people who are denominated as middle class supplement their disposable income with credit cards. Over 50 percent of Americans have credit cards.

The sad fact is that U.S. citizens have a very low savings rate. Their savings rate was 4.6 percent in 2013. Contrast this with China where in 2012, the average Chinese family saved 50 percent of its income, despite rising incomes. In Western Europe, households also save. In 2012, Germany had an 11 percent savings rate; France had a 16.1 percent rate; and Norway, which has a higher per capita GDP ($54,947) than the U.S. ($54,101), has a savings rate of 8.1 percent. In spite of the fact that these other countries have cheap money, along with credit cards, mortgages, auto and personal loans, and low interest rates, they save more.

The temptation to buy is too great with credit cards and other financing schemes so readily available. Too many Americans buy lottery tickets with their almost zero chance of winning rather than put the same money into a savings account. I’ve heard the suggestion of offering a lottery chance tied to savings accounts, so the more money people keep in their savings account, the higher their chance of winning.

But easy consumer credit is not the greatest source of middle-class debt that drives 70 percent of the U.S. economy. As of 2010 average mortgage debt is $147,133 and average student loan debt is $31,509. From a U.S. household debt of nearly zero in the 1950s, American consumers reached a towering debt of $11.13 trillion by 2012, including $849.8 billion in credit-card debt; $7.81 trillion in mortgages; and $996.7 billion in student loans. Household debt as a percent of disposable income rose from 68 percent in 1980 to a peak of 128 percent in 2007, prior to dropping to 112 percent by 2011. Household debt as a percent of nominal GDP rose from 47 percent in 1980 to 77 percent in 2012. U.S. household debt rose from nearly zero in the 1950s to $12.9 trillion by the second quarter of 2012.¹²

Student loan indebtedness is moving higher, toward $1.2 trillion, and is now a burden for 40 million Americans who have at least one open student loan. This situation poses a considerable drag on the economy. Young people are not buying cars, homes, or furniture as they have in the past. Some can’t get married because the other party doesn’t want to assume a partner’s student loan debt. This is seen as a major problem by economists. One proposed solution calls for student loan forgiveness, but this would put a major hole in the U.S. Treasury. Another proposal is to lower the interest rate on these loans. Some students still pay 7 percent on these loans, even though interest rates have dropped considerably in recent years. The argument is to cap all past and new student loans at 3.8 percent. This, too, will put a hole in the U.S. Treasury that would have to be filled by finding other tax sources. Another suggestion is that no person with a student loan has to pay back monthly more than 10 percent of their current income.

From a socioeconomic perspective, capitalism as practiced in the United States is really debtor-capitalism, rather than capital accumulation or saver-capitalism. Household debt of every type represents a rough average annual amount of consumption of at least 25 percent above disposable income. Rising debt explains how a declining median income can still generate a growing GDP!

Today, the median American household debt is $75,600. Twenty-five percent of Americans have no savings at all. A majority of Americans are not able to save anything from paycheck to paycheck. Approximately 35 percent of Americans are in debt collection after 180 days of failed payment. Today one out of six Americans receive food stamps, with 46 million Americans qualifying for food stamp debit cards and the average recipient receiving $150 worth of food stamps per month. Americans really don’t have much more borrowing capacity to carry out further consumer spending.

A major function of capitalism is not only to generate jobs and household disposable income, but to market household debt to keep a 70 percent consumption economy going. Capitalism, which historically started as a credit system for enterprise supply, is now a debt system for household consumption. Capitalism’s success depends on its ability to get people to “buy now, pay later.” Capitalism has been able to market debt to households in spite of households having to pay high interest, sometimes 20 percent to 28 percent, on their credit-card debt. Note that this payment is made to banks and financial services, not to producers of goods.

We keep thinking that the key to economic growth is job and income creation, when in fact it is the ability to market debt to U.S. households. A monthly household debt index would be a better sign of economic growth than monthly unemployment figures. The economy can grow without employment growth. How else can we explain recent U.S. GDP growth of around 2.2 percent even though unemployment stays at around 7.4 percent?

There are signs today that banks are again pushing more debt on Americans who cannot afford it. An automobile company today advertises that its car can be purchased with a zero percent down payment and zero interest rate! A great number of Americans with shoddy credit are able to obtain subprime auto loans from used-car dealers even though they clearly won’t be able to repay their loan and will end up having their car repossessed.¹³ And the “payday industry” that makes short-term loans is getting people to borrow continuously at onerous fees. One payday company’s manual instructs its employees to “create a sense of urgency” and offer the delinquent borrower the option of refinancing or extending the loan even after borrowers have said they can’t afford to repay.¹⁴ The newly established federal Consumer Financial Protection Bureau is busy formulating rules to protect borrowers from unscrupulous lenders so that we don’t have another bubble burst on the scene.

THE FINANCIALIZATION OF THE AMERICAN ECONOMIC SYSTEM

Gary Hart, who once ran for U.S. president, shared an important insight on capitalism’s unfortunate transformation:

The confusion within the ranks of capitalism is stimulated by the shift in our economy from making and selling things to manipulation of money . . . and involves mergers and acquisitions, venture capitalism, leveraged buyouts, workouts and turnarounds, currency speculation, and arbitrage. While the money culture was booming . . . manufacturing was declining.¹⁵

Since the time of Gary Hart’s statement, the U.S. financial industry has grown much larger relative to the U.S. GDP over the years. The U.S. finance industry grew to 50 percent of the non-farm GDP by 2010. Income from the finance industry rose to 7.5 percent as a proportion of GDP and 20 percent of all corporate income.¹⁶

We have witnessed the growing role that Wall Street and financialization has played in creating booms and busts, most recently in the marketing of unsound mortgages, the excess lending with insufficient capital reserves, the issuance of the hard-to-understand derivatives, and the activities of hedge funds. Ralph Nader, a leading critic of corporate America, vented the strongest charge against banks for financing highly speculative investments, facilitating the takeover of companies and bilking their assets, helping companies move their assets abroad and leaving American workers without jobs, and paying themselves obscene salaries from profits in the process.¹⁷

One of the first moves to financialize the American economy occurred in 1996, when Citicorp planned to merge with the insurance company Travelers. Such a merger was illegal under the Glass-Steagall Act, which blocked banks from owning businesses in other financial sectors such as investment banking and insurance. Robert Rubin, then secretary of the treasury under President Bill Clinton, lobbied for removing the restrictions on banks, and a bill passed in 1999 with a heavy bipartisan majority voting to eliminate the Glass-Steagall Act. When Rubin left the Treasury Department exactly one day after the bill passed, he was hired by Citigroup for a salary of $15 million a year without any operating responsibilities.¹⁸

The financialization of the American economy is reinforced by the fact that the tax on long-term (over one year) capital gains is only 15 percent rather than the normal tax rate of 30 percent to 39 percent on earned income. Much of the earnings of the rich come from capital gains (also known as “unearned income”) and account for people like Mitt Romney and Warren Buffett paying only 15 percent tax on their income when middle-class income earners pay 30 percent to 39 percent. The irony is that these financiers are not creating real goods and services, but earning money primarily from managing money.

Financialization is evidenced further by the large number of new types of products developed by innovative financial engineers. A major idea was “securitization,” namely, the bundling-up of income streams such as credit-card and car-loan payments and mortgages, and then repackaging them as “asset-based” securities and selling them in “tranches” with varying levels of risk. Some of them included subprime mortgages of almost worthless quality. Add to this other derivatives and arcane and unregulated hedge funds that add another source of concern.

This is not to condemn all new financial products, especially those designed to create new insurance programs to cover currently uncovered risks. The term “missing markets” is used to describe some risks that should be covered, but so far there is no market to cover them. Robert Shiller, the Nobel Prize economist, described some of these “missing markets” in his book The New Financial Order.¹⁹ He proposed that there should be a market in which a person could buy “livelihood insurance” to cover the possibility that his profession becomes obsolete or that his chosen profession was a mistake. Shiller proposed creating a “home equity insurance” market where people can buy insurance to guard against a decline in their home’s value. He proposed “income-linked loans” where interest rates on loans would rise or fall with one’s income, region, or profession. Not all of these ideas are practical, but they are designed to meet needs that currently present risks.²⁰

The financialization of the American economy is further evidenced by the rapid growth of leading banks and investment houses, many of them called “too big to fail” at the time of the 2008 economic meltdown. In 1990, the five biggest U.S. banks held 9.67 percent of the financial assets of the banking system; by the end of 2013, the five biggest banks held 44 percent or $6.46 trillion, according to SNL Financial. In 1947, the financial sector represented only 2.5 percent of GDP. By 2006, it had risen to 8 percent. And during this decade, it averaged 41 percent of all the profits earned by U.S. businesses.²¹ Historically, finance’s share of the economy has become “a self-sustaining perpetual motion machine that extracts money from the rest of the economy.”²² A working paper titled “Too Much Finance?” published by the International Monetary Fund concluded that at high levels of financial debt, a larger financial sector is associated with less growth. A smaller financial sector might be desirable and reduce the chance of misallocation of capital and crisis.

Some suggest that the U.S. economy has moved from “pro-market” capitalism to “pro-business” cronyism. Thousands of lobbyists are engaged in influence peddling to get pro-business bills passed against the interests of the average citizen. Luigi Zingales, in his book A Capitalism for the People: Recapturing the Lost Genius of American Prosperity, asserts that the Occupy Wall Street and the Tea Party movements are actually aligned against the same opponent.²³ The Occupiers may focus their wrath on business and the Tea Party on government, but Zingales sees this as two sides of the same coin.

SOLUTIONS: MEASURES TO REGULATE THE FINANCIAL SYSTEM

If restructuring can’t stop the large banks from being “too big to fail,” the other answer is more regulation to limit their leverage and their movements into additional businesses. Neither Congress nor the White House has set up adequate restructuring and regulations to make sure the financial industry will not again go overboard in issuing junk securities and overextending credit, once more bringing down the whole economy. Unfortunately, there is currently a big lobbying movement to return to securitization without proper regulation.²⁴

Let’s consider what needs to be done to get the financial system to operate safely and profitably.²⁵ The first need is to make sure that no American banks become so big and important to the economy that we cannot allow them to fail. We can’t rely on printing money to save these banks at the cost of great taxpayer losses and unleashing a huge inflation.²⁶ These banks need to be broken up and forced to operate with clearer limits on what different types of banks can do, distinguishing between a savings bank, a retail/commercial bank, and an investment bank, and preventing them from getting into other businesses, such as insurance, travel, and the stock brokerage industry. Among the proposals are to restore the Glass-Steagall Act to separate commercial banking from investment banking and from brokerage and insurance. The banking industry opposes this move, especially given that investment banking promises to yield a greater return, even given the greater risk, than commercial banking. This may partly explain the reluctance of commercial banks to lend money to small and medium-size businesses, since the same money might yield greater returns when put into financing trading and investment activities.

Another proposal would be to require banks to back up more of their lending operations with their own capital. Stanford University’s Anat Admati, in her book The Bankers’ New Clothes with Martin Hellwig (Princeton University Press, 2013), asks: Why are banks allowed to operate with 95 percent borrowed money when no other business can do this? No wonder banks can grow too big to fail. She advocates that banks should hold reserves of 20 percent to 30 percent to lend out as their own money. This may result in banks lending out less and not growing so big. She grants that banks might make fewer loans to small businesses and that entrepreneurs would be less able to get bank funding. But slightly slower economic growth is better than the greater risk of highly interconnected banks failing and dragging down the whole economy. She is against bankers making enormous sums with little personal risk and taxpayers picking up the tab for their failures.

Paul Volcker, the former Federal Reserve Bank chairman, proposed that government-insured commercial lending be separated from risky trading operations by a bank. On December 10, 2013, federal regulatory authorities adopted the Volcker Rule to ban banks from trading for their own gain and limit their investment in hedge funds. The rule holds that markets, not individual bank depositors, should fund risky trading. The Federal Deposit Insurance Corporation (FDIC) insures bank deposits up to $250,000, and depositors should not be at risk. The basic idea is to require banks to have more capital available (and less leverage) to repay loans and withdrawals when needed.

Needless to say, the over 2,000 banking lobbyists have managed to stop some of these measures or blunt them by pushing for less money for regulation enforcement. Their aggressive and well-financed lobbying has prevented 60 percent of the Dodd-Frank Wall Street Reform rules from being enacted—rules that would make the banking system safer. The problem is that political candidates of both parties receive a lot of campaign funds from banking interests and are not likely to vote for curbing risky banking activities. In mid-December 2014, Congress rolled back a Dodd-Frank rule, making it possible for banks to engage again in derivatives.²⁷

The second need is to do a better job of overseeing and regulating the new types of financial instruments that have come into the world’s financial system. Derivatives, credit-default swaps, and various complex financial instruments—including money-market funds that are not FDIC insured—have been called potential weapons for mass financial destruction. Many investors and institutions don’t fully understand these instruments, and any sudden drops in their value can create panic in the financial market. There is a need to determine which existing and new financial products are acceptable, so these products should be transparent regarding risk and return.

The third step is to drive banking back to its original purpose—meeting the needs and interests of small-, medium-, and large-scale businesses, both here and abroad. In spite of the huge amount of money in the hands of banks, many banks unduly limit their lending. Banks are cautious about lending to individuals or lending to businesses that need cash to cover costs or buy goods or invest in production. They’re more comfortable using their money to buy U.S. Treasury bonds. They can pay the Federal Reserve a half percent a year to get the money they need printed by the Federal Reserve and then use this money to buy U.S. Treasury notes that yield 2 percent to 3 percent. There is no risk in earning this differential. Banks have also been lending money to stock traders, which partly explains the rise in share prices. In the meantime, these bank lending practices are not producing any output for improving the U.S. economy and the lives of ordinary people.

The largest banks don’t want to bother dispensing small loans when they can make more money in high-frequency trading and global investment banking. There are too few smaller independent banks left to take an interest in financing local businesses. We may need to establish a separate type of bank to serve the small business market, just as the savings and loan banks of the past served the mortgage market.

The financial industry operates under many favorable conditions. For example, while there is a state sales tax on most purchases of products and services, there is no sales tax on financial transactions. If states could put even a one percent sales tax on the buying and selling of stocks and bonds, this could put needed billions of dollars into the coffers of cities and even tame down speculative fever.

Other suggestions include devising a better system for rating the creditworthiness of banks. The classic credit rating bureaus—Standard and Poor’s, Moody’s, and Fitch—completely missed seeing the financial risk that led to the Great Recession, partly because their income comes from the banks that they rate. We also need better qualified, higher paid regulators. We can’t expect too much when we pay them in six figures while they are regulating banks and bank lawyers making seven and eight figures. We need to be harder on financiers who allow large bad loans to be made under their watch. Bankers should be put under the same Sarbanes-Oxley Act that requires CEOs to be responsible for big mistakes. Finally, when a bank sells questionable securities and buys insurance against these securities going sour, this should lead us to wonder why the bank should be selling these securities in the first place. Financiers should be liable for taking actions that might trigger financial crises.

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Martin Wolf, the most astute financial economist with the Financial Times, stresses the urgent need for deep reforms in the financial system in his book The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—from the Financial Crisis. From endorsing in earlier days a strongly conservative view of financial freedom, Wolf has come around to worrying deeply about financial instability and rising inequality and the damage that they can do to democratic institutions. He has observed that another financial crisis could be so severe that “our open world economy could end in the fire.”²⁸ Wolf favors higher capital requirements for financial institutions, less income inequality so that there is less credit growth, higher taxes on the rich, and higher Keynesian stimulus spending during recessions.

Echoing these concerns, Mark Carney, the governor of the Bank of England, told his audience at a May 27, 2014, conference on Inclusive Capitalism that banks operated “in a privileged heads-I-win-tails-you-lose bubble” and that “there was widespread rigging of benchmarks for personal gain.”²⁹ Bankers receive big bonuses in good times, and usually receive their normal income in bad times. This can lead them into excessive risk-taking.

New York Fed President William Dudley proposed that instead of banks paying bonuses all in cash upfront, bonuses should be paid in installments over five years. If a bank got into difficulties, the deferred bonuses would be used to help recapitalize a restructured bank operation and also to pay any fines imposed on the bank.³⁰

Clearly, when some of our most intelligent financial minds start calling for an urgent and deep reform of the present financial system, the time has come.