How much financial reform do we need?

I begin this post with some trepidation. If you're really smart, I always say, you're never afraid to say "I don't know," and I certainly cannot claim to understand contemporary finance, derivatives, credit default swaps, and the rest of the new financial paraphernalia that have made multimillionaires out of Wall Street traders while bringing the world economy to it knees. Gradually certain critical facts seem to be emerging, and I am tentatively trying to put two and two together and hoping for a result that is reasonably close to four. I hope that any more knowledgeable readers will comment--we all need to know as much as can about what is happening in order to behave like informed citizens.

One doesn't hear much about Enron nowadays, but I am beginning to think that it was far more than just a brilliantly fraudulent new enterprise that came a cropper. Enron was, as I understand it, the pioneer in creating and selling energy derivatives, a form of futures contract that allowed large energy consumers to insure against swings in prices. They had many consequences. According to the excellent documentary, The Smartest Guys in the Room, Enron's instruments allowed it to drive the price of power in California through the roof in 2001, leading directly to the recall of Democrat Gray Davis and the election of Arnold Schwarznegger. Enron itself collapsed shortly thereafter and several of its executives were convicted of fraud. The Sarbanes-Oxley Act was also passed, requiring greater financial transparency, but nothing, apparently, was done to restrict or regulate trading in derivatives, which became a mainstay of the new big banks. In 2007-8, as we know know, those banks managed to bid the price of oil up to new heights--in part, presumably, by using derivatives. The price fell by nearly 100% but has now gained about half of that loss back. How much of this actually relates to supply and demand, we no longer know. I did see a report in the last two weeks--one I unfortunately failed to save--to the effect that US businesses are now forced to spend far more money on futures contracts for their energy supplies. That, to me, is an example of how our new financial institutions are become parasites on the more productive sectors of the economy that remain.

The government's suit against Goldman Sachs, which turns out to have cooperated with a hedge fund manager named Paulson (no relation to the Treasury Secretary) to bet against securities it had packaged and marketed itself, is another example of how bad things have gotten. I am intrigued that while the SEC has charged Goldman with fraud, they have not charged them with insider trading--perhaps because the insider trading laws do not apply to credit default swaps. Yet surely Goldman's actions were equivalent to those of a corporation shorting its own stock in anticipation of a bad earnings report? And surely the opportunity to float an unsound investment with the right hand, while shorting it with the left hand, is an opportunity too promising for anyone to miss? Credit default swaps are a form of insurance, but the resources of the megabanks are so enormous that they can, in effect, raise or lower the value of assets they have just chosen to insure, according to what will benefit them and their partners the most. This is even easier as long as the Federal Reserve continues allowing them to borrow at near-zero interest.

Brokers, traditionally--like bookies--are supposed to make money on every transaction while declining to gamble themselves. (The journalist Larry Merchant, author of a book on betting on football, described bookies as gamblers who had decided they would rather pay the rent.) But that tradition was destroyed by the repeal of Glass-Steagall, which allowed the big banks to trade on their own. I am beginning to think that we have turned the economy into a huge casino, one in which the house not only takes a percentage of every bet, as in the past, but also rigs the heaviest action. Other evidence is surfacing that major market players understand the game is rigged. I recently heard an interview with Harry Markopoulos, the whistle-blower who vainly warned the SEC for years that Bernie Madoff must be running a scam. He is convinced that Madoff's clients knew that he could not possibly be generating such returns within the rules and must be cheating somehow--they just didn't understand exactly how he was doing it.

The big banks have only existed in their current form for about a dozen years, and one would have to go back to the Third Reich, it seems to me, to find an institution that did so much damage in so short a time. Yet because they have not killed people, they are still standing and making nearly as much money as ever. These are the institutions which, I am convinced, we need to tame. Paul Krugman wrote tellingly yesterday that President Obama should not have said his reforms would be good for Wall Street: effective reform will indeed reduce the profits Wall Street earns, as well it should--and like Franklin Roosevelt, the President should not be afraid to say so.

All this has another, very sad dimension. Beginning in 2003, as many of you know, the late Bill Strauss and myself, together with about ten other classmates from the Harvard Class of 1969, began campaigning against the multi-million dollar bonuses paid to managers of the Harvard Endowment, which had become a hedge fund. We were not too surprised by the reaction of the financial press, which unanimously argued (as did President Lawrence Summers) that the managers had earned every penny, but we were certainly disappointed to find that many current Harvard undergraduates sided with them as well. I began to realize that our whole elite educational system had become a large funnel whose small aperture emptied annually into Wall Street. Twenty years ago, in my book Politics and War, I wrote that the cataclysm of the Napoleonic era occurred because war and diplomacy were the main spheres of activity of ambitious young men, and commented that the industrial revolution had come along just in time to provide them with a healthier outlet for society. Alas, the financial revolution has not done the same.

An army of lobbyists is now trying either to block financial reform completely (an endeavor in which the Republican Congressional leadership has joined) or to deprive it of any significant meaning. This week procedural votes in the Senate will begin and we shall find out whether the Republicans will once again unanimously follow their leaders. (Charles Grassley broke ranks in the Agriculture Committee, but without promising to vote for an eventual bill.) Yet in any case these new monsters will be very hard to slay. It took many decades to put a real dent in the power of the huge corporations that emerged from the Gilded Age, and it has taken about 30 years to undo the work of the New Deal and (in some respects) the Progressive Era. If President Obama manages to reverse the trend, he will have done well.