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COLUMNISTS
TODAY'S STORIES
27.03.2008
The Key Part of Obama's Economics Speech

I just had a chance to read the economics speech Obama delivered in New York this morning. Overall, I thought it was in the right place substantively and ideologically. All the principles he outlined were prudent and intuitive-sounding, though there weren't a ton of specifics, and nothing that struck me as especially innovative. (Not that that's such a bad thing. Basic intuition gets you a long way here, I think.)

The most interesting passage in the speech was when he took after the Clinton administration's deregulatory efforts in the 1990s, some of which were clearly bad ideas in retrospect. (Or at the time for that matter.) Like when he said, for example:

A regulatory structure set up for banks in the 1930s needed to change because the nature of business has changed. But by the time the Glass-Steagall Act was repealed in 1999, the $300 million lobbying effort that drove deregulation was more about facilitating mergers than creating an efficient regulatory framework.

Agreed. It's tough to finger Glass-Steagall repeal--which allowed investment banks and commercial banks to merge, and therefore gave rise to behemoths like Citigroup*--as a direct culprit of the subprime crisis. But it definitely contributed. In two ways, as far as I can tell. The first is by bringing different stages of the subprime mortgage securitization process under one roof (lending, re-packaging, re-selling of the loans, etc.), which made the whole process somewhat less transparent. (You can get carried away on this point, of course: Even under Glass-Steagall it was possible to perform more than one step at a single firm. And Glass-Steagall didn't abruptly disappear in 1999. We'd been chipping away at it for years.) Second, the consolidation frenzy it made possible created banks so sprawling their collapse would threaten the whole financial system.

To my mind, the more directly-relevant Clinton administration mistake was their refusal to even consider tightening oversight of derivatives when they had the chance. Back in 1998, when the head of the Commodity Futures Trading Commission, which nominally oversees derivatives, wanted to study the possibility of regulation, Robert Rubin (and Alan Greenspan) used some pretty heavy-handed tactics to stop her.

Unfortunately, a lot of the investments that have gone bad lately are derivatives tied to subprime mortgages. (A derivative is basically a bet on the price movements of an underlying asset--like, say, pork bellies. An example of a derivative would be a pork bellies future--in which you agreed to buy several tons of pork bellies, or whatever, for a certain amount of money a year from now...) One problem with derivatives is that they allow speculators to use a ton of leverage, which magnifies their gains but also their losses. It's hard to imagine that serious scrutiny of derivatives wouldn't have resulted in some restrictions on this practice, but Rubin et al weren't even willing to study the problem...

P.S. For what it's worth, Hillary has implicitly criticized the Rubin position herself (though without linking it back to her husband's administration). Here's what she had to say in a speech back in November:

[D]erivatives also create new risks. They can swing wildly in value. It isn't always clear who owns them or how much they are really worth. Owners don't always understand the risks, which is why even the investment banks that created them are losing billions of dollars on these derivatives. And the ripples are being felt from Wall Street to Main Street.

I believe in our markets, but markets work best when there is information flow. And a lot of these new financial products are not transparent. The market doesn't have enough information about them, and certainly buyers don't. Today, we need a sensible middle ground between heavy-handed regulation and a hands-off approach to a risk that can hurt the innocent, as well as the sophisticated buyer.

I'm still trying to track down whether she's said anything about Glass-Steagall.

Update: Here's the transcript of an interview Obama did with CNBC's Maria Bartiromo today. I thought he held up pretty well amid some tough questioning.

Update II: Doesn't look like Hillary's said anything about Glass-Steagall on the campaign trail. But it's worth pointing out that she has some record of supporting banking and financial-market regulation in the Senate. For example, she recently sponsored a bill that would prevent banks from getting into the real estate brokerage business.

*A reader notes that Citibank had already merged with a securities firm before the repeal of Glass-Steagall. The formal repeal was necessary so that Citibank could merge with Travelers Group, an insurance company, a deal that had also been prohibited under the original Glass-Steagall law.

Still, from what I understand (see here, for example), commercial banks that owned securities firms were really able to ramp up their trading and underwriting activities (i.e., the kinds of things investment banks do) after Glass Steagall was repealed.

--Noam Scheiber

Posted: Thursday, March 27, 2008 6:46 PM with 11 comment(s)

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teplukhin2you said:

Glass-Steagall?! WTF? Good thing BHO's not a securities law prof.

The explosion in derivatives took place in the 1980s, at least a decade before the repeal of Glass-Steagall. Commercial banks led this drive through the investment subsidiaries they set up to get around G-S. In fact, the king of derivatives origination, sales and trading in the US was the old commercial bank, Bankers Trust, and in Europe, the old commercial bank, Societe Generale.

Look, Obama's a smooth guy who can manage to sound intelligent about almost anything, but he's simply out of his depth here.

March 27, 2008 7:11 PM

Noam Scheiber said:

I think you're confusing a couple of the things I was writing about here - consolidation of financial institutions on the one hand and regulation of derivatives on the other.

I conceded that companies had been circumventing glass-steagall for years before 1999. but it was still an important turning point. Certainly Citigroup wouldn't have been possible if not for that coup de grace...

March 27, 2008 7:20 PM

teplukhin2you said:

Also, derivatives have been around for at least a hundred years, if not centuries-- cotton futures etc. There's really nothing new in finance.

What needs to change is the way we tax capital gains and income. Stop treating hedge hogs' income as capital gains. And stop privileging capital gains over income. Start rewarding work, especially the (innovative, productive, value-creating) work performed by people in the real economy. As opposed to bending over backwards to reward the 2-and-20 scammers, the heads-I-win, tails-you-lose CEOs and the other moneyfiddlers.

If Obama proposes raising the marginal rate on income, he'll be toast in the fall-- even McCain seems more attractive on economics to level-headed yuppies in the $150k-250k bracket. The man really needs to up his game on economics.

March 27, 2008 7:24 PM

teplukhin2you said:

Noam - I see your point; I think we're on the same page. Obama's the one who's confused.

March 27, 2008 7:25 PM

aref_j said:

While you're technically correct; as someone who works in Finance, I can tell you that the growth rate in derivatives has been mind-boggling since '99.  The amount of derivatives traded (i.e. not even including OTC derivatives) has grown by something like 30% p.a. over each of the last 5+years.

As Noam's noted, clearly Glass-Steagall repeal wasn't the cause of this, but it did help facilitate it.

March 27, 2008 7:55 PM

dbhuff said:

And while derivatives have been around, this is really a development of the repeal of Glass-Steagall:

cartegic.typepad.com/.../from-risk-to-un.html

The complexity, level of derivation if you will, has substantially increased with a corresponding DECREASE in transparency, and so a fair evaluation of risk.  Sub-prime CDOs were rate AA and better until last summer!  And the trading of derivatives, and more importantly, the use of derivative, esp CDOs as helping to fulfill lending institutions reserve requirements is a real problem.  (On its face, it is a 'laundering', if you can't hold the original mortgage because the risk is too high, how come you CAN hold a derivative of it?)  Back to Noam's point about consolidation, and the resulting lack of transparency.

March 27, 2008 8:21 PM

teplukhin2you said:

Fair enough, you guys are closer to this than I am. Sorry, I was too quick on the trigger.

Still, I don't see how restoring G-S will get the horse back in the barn. In any case the swing voters are going to pay a lot more attention to taxation issues than to regulatory ones, and unless/until our party weans itself off of Hedge Hog money and comes out foursquare in favor of treating their carried interest gains as income, I think we're vulnerable to GOP attacks on the taxation front.

March 27, 2008 8:40 PM

rempelschul said:

Obama's comments are right on track regarding regulation of reserves.  Below is a quote from a letter to the NYTimes from a friend who follows this carefully and thinks Obama has the right take:

"In a 16 March 2008 comment in the Financial Times, Alan Greenspan lays much of the blame for this current crisis on the fact that econometric models do not yet adequately represent the full complexity of the economy, particularly the human nature motivating economic decisions.

However, at this point many of our largest economic decisions are made by institutions using their own econometric models.  It is hopeless for any model used by the Fed to ever adequately model the economy, since the complexity of the economy increases with the complexity of models used by these large institutions.

In fact, the increasing complexity of the economy means that the human ability to understand it is decreasing.  This is illustrated by the degree to which the current crisis has surprised economists.   It is futile to try to prevent future crises by improving the accuracy of econometric models, since all major market players use similar models.  Our

economic future will include a series of increasingly severe crises unless we adopt regulations that damp the amplitude of economic shocks.

A major cause of economic instability is leverage.  If an institution invests 100 borrowed dollars for each of its own dollars in mortgage securities, then even a small rise in foreclosures will wipe out its capital.

Institutions are encouraged to take such risks by the expectation that the government will bail them out with loans in order to prevent their bankruptcy.  And institutions become overconfident in the accuracy of their models when they lead to successful decisions over a few calm years.  It is a classic case of failing to appreciate their own ignorance.

An economy driven by a large number of similar but competing models simply defies modeling or human understanding. The combination of unlimited leverage, faith in a

government rescue and incomprehensible complexity will inevitably lead to a series of crises.

The government mandates cash reserve requirements for commercial banks, limiting the amount of leverage they can employ, and in return promises to provide liquidity to prevent runs on those banks.  It is time to mandate limits on leverage for all financial institutions whose size would require a government bail out, and mandate strict accounting standards to prevent institutions from hiding leverage off their balance sheets."

March 27, 2008 10:08 PM

epicciuto said:

Why are pork bellies *always* the standard econ example? I'm in philosophy, so I shouldn't talk (what with our trolleys and swampmen, and all), but it seems a little funny that complex economic ideas are always described in pork bellies, as if that is clearly the way to make it understood to those of us who have to look up online how to calculate an interest rate.

Funny thing is, it works...

March 28, 2008 7:28 AM

mpintar2 said:

Noam, the real point of Glass-Steagall was to shield the deposit-taking and loan making commercial banking activities from the investment banking activities that were subject to market fluctuations. The reason why the dismantling of Glass-Steagall is so damaging today is because the losses that banks are taking on their subprime residential mortage-backed securities, commercial mortgage-backed securities, leveraged loans, municipal bonds and proprietary credit and rate portfolios coupled with increases in their contigent liabilities such as Structured Investment Vehicles has and will cause them to contract their lending activities. This is because the losses are causing their capital to decline at the same time that their increasing contingent liabilities are causing their balance sheet to expand. The impact of this is a contraction of credit throughout the entire economy at a time of slowing economic conditions. This is exactly what used to happen prior to Glass-Steagall and it caused massive economic swings. We have not yet felt the impact of this throughout the real economy yet as the transmission mechanism is not immediate but it is coming. The Fed is desperately trying to offset this by doing everything it can to ease collateral shortages in the banking system and by reducing rates to absurd levels given the current level of inflation. But even they are running out of ammunition.

March 28, 2008 8:43 AM

Daily Intelligencer - New York Magazine said:

There are differences in the candidates' plans — and the pundits are eager to highlight them.

March 28, 2008 1:23 PM

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