Few of the developments I‟ve described could have happened without the triumph of neo-classicism and its effects on American law and public policy from the 1980s through the 2008 collapse.
The legal story begins with a variety of measures designed to deregulate the banking industry, starting with savings and loan institutions in the 1980s and culminating in the virtual liberation of commercial banks from New Deal restrictions with the passage of the Gramm-Leach-Bliley Act in 1999. Banking deregulation began with efforts to permit institutions which had distinctly local or regional business to grow nationally, and increasingly removed restrictions on the businesses in which the regulated institutions could engage. This, along with attractive inducements from states like North Carolina, paved the way for substantial bank consolidation in the 1990s and early 21st century.
Traditional small lending institutions thus became further removed from their clients, and banks sought greater profits in the process of securitization, which brought higher profits than mere lending and allowed banks to evade capital restrictions. Securitization, which of course is represented most publicly by mortgage-backed securities and other forms of consumer-debt backed derivatives, allowed loan officers to pay less attention to the safety of their loans, since they were promptly to be sold off and removed from banks’ balance sheets (although not entirely from the risk assumed by the banks).The Commodities Futures Modernization Act of 2000 ensured that these instruments would not be regulated.Despite their profound effect on the real economy, these instruments mushroomed in growth while providing financing not for production but simply for more finance.
This process paralleled what happened in the stock market under the capital asset pricing model and its progeny, largely separating (on paper and in practice) the responsibility for, and consequent monitoring of, risk from the real economy that nonetheless was exposed to that risk. The story of credit derivatives has been told many times, and I only mention it here in order to show how it fits into the rest of the story of financialism, and how the law consciously adopted the ideology of free markets in order to permit financialism to develop.
I would be remiss in ignoring the regulatory failings of the Securities and Exchange Commission, and especially its fateful decision in 2004 to permit largely unregulated investment banks to dramatically diminish their capital requirements (and its inverse, to increase their leverage),eliminating one of the very few regulatory tools available to the SEC to limit the activities of investment banks.
In addition, bank regulators, misplacing their trust in the prudence of bankers, also significantly diminished capital reserve requirements. This allowed banks to borrow and gamble with enormous sums of money while maintaining little available cash to help them through financial distress. As the U.S. implemented an international agreement to lower banks’ capital requirements in 2007, New York Senator Charles Schumer said: “There need not be a conflict between being the safest and the most competitive, and this fine agreement proves it.” The echoes of economist Irving Fisher‟s famous early October 1929 statement: “Stock prices have reached „what looks like a permanently high plateau,”are all too resounding.
The highlight of deregulation and, I believe, the most foolish piece of economic legislation ever to be passed by Congress and signed by a president, is the Gramm-Leach-Bliley Act of 1999. Its most important consequence was the merging of commercial banking and investment banking functions to permit the growth of enormous financial institutions whose role in protecting the nation’s credit system and money supply was now compromised by the huge profits available from speculation in securities and derivatives. This growth was accompanied by increased incentives of well-compensated bankers to earn fortunes from engaging in the creation of new financial instruments and proprietary trading which, just as in the years preceding the Great Depression, exposed that credit system to the possibility of collapse.
It is unfortunate to note that, despite some recognition of these failings, the course of “reform” points in the direction of continuing to institutionalize financialism, which I believe will eventually succeed in destroying American capitalism. Such reforms will do nothing to shift financialism back to capitalism, but rather maintain financialism on perhaps a slightly safer plane.
Restoring American capitalism in the face of growing financialism is urgent, both as a function of American economic well-being, and as a matter of national security, as financialism pushes the production of essential goods abroad. Faced with this urgency, it is short-sighted and irresponsible for lawmakers, regulators, financial professionals, lawyers, and even the investing public, to fail to understand our shift to financialism and the long-term destruction it promises for America’s economic well-being.
How do we fix this? I have some preliminary suggestions, some of which have emerged in the reform debate. It is critical to re-enact laws separating investment banking and commercial banking, pass tax law reform to diminish market volatility, consider financial reform that would require demonstrated economic utility before the offering and sale of new financial instruments, create accounting reform that would require all corporations, including financial institutions, accurately to reflect their debt exposure, ensure full tax parity of capital gains and dividends in order to encourage long-term investment and re-introduce the notion of patient capital into American investment practices, restrict the types of compensation contracts corporations, and especially financial institutions, can award their employees (principally accomplished through tax laws), and create disincentives to proprietary trading and incentives for financial institutions to return to their former financing practices (again, most likely through tax changes). All of these changes could be made without unduly aggressive government restructuring of the basic economy. More aggressive suggestions include the use of antitrust law and perhaps new legislation to encourage the development of smaller and more localized financial institutions that monitor their risk because they remain in relationships with their customers, restrictions on the amount, if any, of a financial institution’s assets it can securitize, and law and policy statements that disavow the acceptance of institutions that are too big to fail, including a reconsideration of the role of the Federal Reserve in financial disasters.
The need to end financialism and restore capitalism is underscored by the special moral role a sound economic system plays in our society. Perhaps the most important benefit of capitalism is its ability to stimulate economic growth, the creation and distribution of wealth, and the sustaining of that wealth over time. Whatever benefits financialism may have, it lacks these essential characteristics. Indeed, as I hope I have at least preliminarily shown, financialism is a system in which the present generation robs future generations of their economic patrimony and national security and thus is intrinsically immoral. We owe to our children, and our children’s children, the benefits of a system that allowed the United States to become the world’s most successful and prosperous democracy from its founding until the present. We must destroy financialism for the sake of capitalism.