The Casino Economy: How Wall Street is gambling with America's financial future

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.

—John Maynard Keynes

The General Theory of Employment, Interest and Money, 1936.

Starting in 2007 the U.S. financial system imploded. It was followed by a collapse of the economy into a recession that continues, with unemployment hovering at just below 9 percent. Recovery is moving along in the stock market, and consumer spending is reviving, aided by government fiscal policy. But two questions remain. First, how do we get unemployment down? And second, how do we keep a collapse like this from happening again? I have already discussed the first issue (America, 6/22/09); here I discuss the second.

Following the financial collapse that led to the Great Depression of the 1930s, the U.S. government passed the Glass-Steagall Act, which among other things separated commercial banking activities from riskier investment bank operations. Since 1980, however, one of the main thrusts of public policy has been to free up markets by deregulation (including repeal of the Glass-Steagall Act in 1999), cutting taxes and eliminating or reducing social programs. Both Republican and Democratic administrations have pursued these policies. The result has been constant federal deficits, a dramatic increase in income and wealth inequality, periodic financial scandals, decay of public services and infrastructure, the growth of large banks and finally the collapse of the financial services sector and the continuing economic recession. Throw in the cost of fighting two wars and the built-in escalation of so-called entitlement costs (Medicare, Medicaid, Social Security) and the prospects for normal economic recovery are less than rosy. The prospect of another financial disaster is all too probable.

When Big is Not Better

A key question demands attention in the midst of all this: Will the financial sector be reformed so as to reduce significantly the risk of future implosions? A key issue in addressing this question is the very large size of the major banks and the fact that they are seen as “too big to fail.” This has an unfortunate effect on bank executives if they believe they will always be bailed out, even if they are reckless. The insurance industry calls this a moral hazard. A person who buys auto theft insurance, for example, has less incentive to be careful, say, by locking the car doors. If the car is stolen, the insurance company will compensate. Likewise, bank executives will be tempted to take on more risk than is prudent when they know they will be bailed out by government, as they were in the most recent financial crisis.

In an article on the op-ed page of The New York Times (12/1/10), Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, wrote that despite financial reform legislation, the biggest banks still control our economy and pose a serious threat. After the last round of bailouts, “the five largest financial institutions are 20 percent larger than they were before the crisis. They control $8.6 trillion in financial assets—the equivalent of nearly 60 percent of gross domestic product. Like it or not, these firms remain too big to fail.”

“Too big to fail” is a threat that should not be ignored. The financial system is the lifeblood of the economy. Firms need to borrow for investment purposes from banks and other financial institutions. Consumers borrow from banks and credit unions to finance big-ticket purchases like automobiles, houses, appliances and the like. The financial system and the entire economy are deeply intertwined, and if a very large bank goes bankrupt it takes many other firms down with it. The political reality is that very large financial institutions will not be allowed to go under, whichever political party controls government.

If large banks and other financial institutions will not be allowed to go bankrupt, what can be done to reduce their incentives to take on excessive risk?

One possibility is to break up existing banks above some maximum size and enact regulations that will make it difficult for others to grow beyond that maximum. Then the much smaller banks can be allowed to fail when they overextend. This course, however, is unlikely. Neither political party has been serious about downsizing overgrown financial institutions. Why? Executives in the financial services industry are major contributors to both parties. The newly released report of the Financial Crisis Inquiry Committee notes that the financial industry spent $2.7 billion on lobbying from 1999 to 2008 and individuals and committees affiliated with it took in more than $1 billion in campaign contributions.

In addition, government regulators often move back and forth between the private sector and government. Goldman Sachs, for example, paid Lawrence Summers $135,000 for one speech just before he was appointed to be President Obama’s economic adviser. The Citizens United decision by the Supreme Court, which allows corporations to make unlimited political contributions, has magnified the banks’ political clout, making it even more unlikely that Congress or the administration will enforce a banking reform that breaks up large banks.

The case of Ireland should ring warning bells. There the banks and their executives became so strong that even after having been major contributors to the economic collapse they were still able to dictate the direction of national policies. I do not see any conspiracy at work here, just the reality that economic power translates well into political power. Individual banks in the United States are much smaller relative to the government than in Ireland. Still, it is worth noting that both Standard & Poor’s and Moody’s Investors Service in January 2011 published statements that the AAA rating of government bonds might be in danger of being downgraded, presumably unless government policies were changed.

Ways to Reduce Risk-Taking

If breaking up the very large financial institutions is not on the table, what other policies might avert another implosion caused by the financial sector’s excessive risk-taking? One way to think about the “too big to fail” issue is this: When the government takes on an implicit liability for bailing out extra-large firms, that is a subsidy to those firms. This encourages smaller banks to get bigger so they, too, can benefit from the subsidy. Therefore, policies must reduce the banks’ incentive for risk-taking and/or discourage them from growing ever larger.

A partial, piecemeal approach would include minimum capital requirements for all financial institutions above a certain size. Switzerland, for example, mandates that their two largest banks, UBS and Credit Suisse, have 19 percent capital by 2019. This will give the banks a cushion during the next financial crisis so they can pay their debts and work out other arrangements to remain solvent. In contrast, according to the Financial Crisis Inquiry Committee, the five largest investment banks in the United States had only 2.5 percent in capital to cover potential losses. Regulations could also require that in a crisis some bondholders must accept nonpayment or have their bonds converted to stock. Even these proposals will be fought by the financial services industry, particularly by the largest institutions. And there is no guarantee that the Congress or the administration will strongly push them.

An Asset-Based Approach

A more comprehensive approach to re-regulating the financial services sector of the economy, one that might have a chance of being accepted by Congress and the administration, is known as “asset-based reserve requirements,” A.B.R.R. for short. Basically this shifts reserve requirements from a system based on banks’ liabilities (that is, on their checking account deposits) to one based on the assets (loans receivable) of all financial institutions.

Under an asset-based system, the Federal Reserve Board of Governors would require every financial institution to have on deposit in low- or no-interest-bearing accounts with the Federal Reserve, as reserves, fixed percentages of each type of loans receivable (mortgages, auto loans, credit card debt, etc.). The percentages of reserves required would vary depending on the riskiness of the loans. This would force the lending financial institution to be more aware of the costs of riskier loans. Since the deposits with the Federal Reserve accrue little or no interest, risky loans that require a greater percentage of deposits would cause an institution to give up the alternative income that would come from less risky categories of loans. This also means that the Federal Reserve could increase or decrease the reserve requirement for a particular category to either dampen a bubble or bolster a sagging sector.

This is not a new idea. It has been around at least since the early 1970s, when two Federal Reserve governors recommended the approach as a way to direct loans to communities in need. In the 1970s Lester Thurow, an economist at the Massachusetts Institute of Technology, argued for asset-based reserve requirements as a way to control the allocation of lending to various sectors of the economy. But the idea lost steam as the proponents of deregulation commanded center stage during the 1980s. In the early 1990s Robert Polin, an economics professor at the University of Massachusetts, developed the idea into a specific tool for economic stabilization. In the late 1990s, the economist Thomas Palley, founder of Economics for Democratic & Open Societies, developed the details of the regulatory mechanisms required to make the asset-based reserve system practical.

While a system of asset-based reserves would be far better than the outmoded liability reserve system we presently have, there will be opposition to any attempt to reregulate the financial system. This struggle will not be won overnight. Instead of hand-wringing in the meantime, ordinary Americans can take specific steps to further financial reform.

First, shift personal or family financial accounts from the big banks to a local community bank or credit union; this is a new application of a political tactic called “starve the beast.”

Second, do everything possible to keep the issue of financial instability and the promise of asset-based reserve requirements before the policymakers. Write elected representatives, donate money to Internet groups that keep the issue alive, write letters to the editor of the local newspaper and the like.

Third, urge your parish priest and local bishop to join the cause by reminding them that these financial implosions cause human suffering. That is the real issue—what happens to people, particularly the poor. For 30 years wages for most workers in the United States have been stagnant and poverty has worsened, while the income and the wealth of the richest 1 percent has grown dramatically. The economy has come to resemble a casino.

Political reform may be needed before the power of the financial sector can be restrained and our economy be reformed to serve all the people, including the poorest and least powerful. That too requires us voters to do what we can, letting our representatives know that we will hold them accountable, just as we expect them to hold the financial services sector accountable.