Category: Commentary

The Road To Economic Serfdom

By Peter Boone and Simon Johnson

According to Friedrich von Hayek, the development of welfare socialism after World War II undermined freedom and would lead western democracies inexorably to some form of state-run serfdom.

Hayek had the sign and the destination right but was entirely wrong about the mechanism. Unregulated finance, the ideology of unfettered free markets, and state capture by corporate interests are what ended up undermining democracy both in North America and in Europe. All industrialized countries are at risk, but it’s the eurozone – with its vulnerable structures – that points most clearly to our potentially unpleasant collective futures.

As a result of the continuing euro crisis, European Central Bank (ECB) now finds itself buying up the debt of all the weaker eurozone governments, making it the – perhaps unwittingly – feudal boss of Europe. In the coming years, it will be the ECB and the European Union who dictate policy. The policy elite who run these structures – along with their allies in the private sector – are the new overlords. Continue reading “The Road To Economic Serfdom” →

The Mystery of Capital

By James Kwak

So the dust has settled on the Senate bill, and it remains studiously vague about capital requirements — no hard leverage cap, for example. This is what the administration wanted, for two reasons: first, they claim that regulators need ongoing flexibility to modify capital requirements; second, they claim that they need flexibility to negotiate a uniform international agreement.

There is one thing in there that is controversial enough to get the attention of the bank lobbyists: the Collins Amendment, which Mike Konczal has written about here. The main provision of the amendment is that whatever capital requirements apply to insured depositary institutions (banks), they also have to apply to systemically important financial institutions, including at the holding company level.

Sheila Bair of the FDIC is in favor of the amendment, on the argument that bank holding companies should not be able to evade capital requirements that are imposed on their subsidiary insured banks; she doesn’t want to regulate the depositary institutions but have all her work rendered irrelevant because the holding company collapses, triggering a mess of cross-guarantees.

This seems entirely unobjectionable, but as Konczal points out, the real threat to the banks is that it makes it harder for them to engage in financial engineering on the holding company level to evade capital requirements. According to the Wall Street Journal, not only the banks, but also the administration itself is planning to try to kill this amendment (at this point, in conference committee).

Continue reading “The Mystery of Capital” →

The VC Tax Break

By James Kwak

The House of Representatives is considering a bill that would change the tax treatment of venture capitalists’ income (and that of private equity fund managers as well). Currently, VCs typically are paid “2 and 20” — that is, an annual fee of 2 percent of assets, plus 20 percent of profits. For example, let’s say a fund starts out with $200 million. Most of that money is invested by the fund’s limited partners — pension funds, endowments, insurance companies, the usual suspects. After ten years (roughly the average life of a VC fund), the investments made by the fund are now worth $400 million — a pretty humdrum return of 7 percent per year (before fees). The venture capitalists themselves will earn about $14 million ($200 million x 2% x 7 years)* plus $40 million (20% x ($400 million – $200 million)) equals $54 million. (Note that they earn that $40 million even for doing worse than the stock market’s long-term average return.) The limited partners get what’s left over after those fees. And before you start crying for the VCs, remember that a typical VC firm will have multiple VC funds going at once.

Right now, the $14 million is taxed as ordinary income, but the $40 million is taxed as capital gains — that is, at a tax rate of 15%. The bill would tax the $40 million as ordinary income (actually, 75% as ordinary income and 25% as capital gains), for an effective tax rate of about 35%.

The current tax treatment has never made sense to me. The lower rate on capital gains is supposed to provide an incentive for capital investment.** This is why, if you buy stock and sell it more than a year later, you pay tax on your gains at a lower rate. So clearly the actual investment returns on money invested in the VC fund should be treated as capital gains — but not the VCs’ 20 percent fee, since that’s compensation for fund management services, not returns on their investment. (VCs typically invest their own money in a fund, but it is only a small fraction of the whole, and no one is debating how that money should be treated.)

Continue reading “The VC Tax Break” →

Focus On This: Merkley-Levin Did Not Get A Vote

By Simon Johnson

After 9 months of hard fighting, yesterday financial reform came down to this: an amendment, proposed by Senators Jeff Merkley and Carl Levin that would have forced big banks to get rid of their speculative proprietary trading activities (i.e., a relatively strong version of the Volcker Rule.)

The amendment had picked up a great deal of support in recent weeks, partly because of unflagging support from Paul Volcker and partly because of the broader debate around the Brown-Kaufman amendment (which would have forced the biggest 6 banks to become smaller). Brown-Kaufman failed, 33-61, but it demonstrated that a growing number of senators were willing to confront the power of our biggest and worst banks.

Yet, at the end of the day, the Merkley-Levin amendment did not even get a vote. Why? Continue reading “Focus On This: Merkley-Levin Did Not Get A Vote” →

The Very Bad Luck of The Irish

By Peter Boone and Simon Johnson

With the European Central Bank announcing that it has bought more than $20 billion of mostly high-risk euro zone government debt in one week, its new strategy is crystal clear: We will take the risk from bank balance sheets and give it to the central bank, and we expect Portugal-Ireland-Italy-Greece-Spain to cut fiscal spending sharply and pull themselves out of this mess through austerity.

But the bank’s head, Jean-Claude Trichet, faces a potential major issue: the task assigned to the profligate nations could be impossible. Some of these nations may be stuck in a downward debt spiral that makes greater economic decline ever more likely. Continue reading “The Very Bad Luck of The Irish” →

The Middle Ground On Financial Reform

By Simon Johnson

In Politico this morning, I question whether the president should really be seen as “centrist” or “moderate” with regard to financial reform. His staff goes to great lengths to make this claim, including both the specific quotes and general tone in the Financial Times on Tuesday (May 18, p.7).

Treasury Secretary Tim Geithner:

“I would say [the president] is fundamentally at the centre and pro-market. But he recognizes the market cannot solve all problems.”

Larry Summers:

“Sometimes the most courageous thing to do is not to take the largest and most sweeping course of action.”

But if this is the correct way to frame the president’s position, how can we explain the fact that it is moderates – not left-wing radicals – who are pushing (against the White House, among others) for stronger reform both within the administration and in Congress? I suggest another interpretation: On financial reform, the president does not hold the middle ground.

Fire Up Twitter

The White House has over 1.75 million followers on Twitter.

The latest presidential tweet is a bit stale (17 hours ago), but right on target.

“Obama to Senate GOP blocking increase in oil company liability: “stop playing special interest politics” http://bit.ly/d65jfY“

The White House needs to send out the exact same message, but replacing “increase in oil company liability” with “financial reform”, and then linking to the Merkley-Levin amendment and the imminent failure of the Volcker Rule and meaningful financial reform.

How hard can that be?

Update (12:40pm): at about 10:30am, the president’s staff put out this tweet (@BarackObama; i.e., http://twitter.com/BarackObama, with nearly 4 million followers):

“It’s time for Wall St. reform that gives greater security to folks on Main Street. Call your Republican Senators today: http://j.mp/cwhtg7“

Good tweet – but the president should call explicitly for Merkley-Levin to pass; this is his own Volcker Rule, after all. Here’s Senator Jeff Merkley, to the point: http://twitter.com/senjeffmerkley

In Defense Of Europe’s Grand Bargain

This guest post is by Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics. He is more positive than the current consensus on recent economic and political developments in the eurozone.

The frantic spectacle of European leaders struggling to avert a financial crisis caused by Greece has seemed unsettling and at times amateurish. It is certainly easy to point fingers at policy makers patching solutions together solutions that immediately unravel under pressure from the markets, and to do so again and again over the last several weeks.

But if you look less at the sausage-making process and more at the final result, you have to be impressed. There are of course many painful steps that still need to be undertaken by all sides – the Greeks, the weaker European economies, the European banks and the European governments. But the derision of some commentators and the uneasiness of the markets seems overstated.

Recall the disdain, for example, when the TARP was introduced in late 2008 or the bank stress-tests were carried out last year. Today most would argue that they ultimately played a large and constructive role in containing the immediate crisis contagion. In time, Europe’s response to the Greek crisis will be viewed in a similar positive light. Continue reading “In Defense Of Europe’s Grand Bargain” →

Finally, The Republicans Come Out To Fight. Where Is The President?

The Senate Republicans are refusing to allow a vote on the Merkley-Levin amendment, which would put a meaningful version of the Volcker Rule into law (splitting off proprietary trading from major banks).

After weeks of dancing around, the Democrats finally have a signature issue on which to fight. Senator Carl Levin frames it exactly right: “It’s a sad day when the power of Wall Street can overwhelm the power of the American people in the US Senate.”

This is the opportunity that White House claims it has long sought – to have an intense fight on a financial reform issue that everyone can understand. Paul Volcker made his determination long ago: the big banks are too big and must, in this fashion, be broken up. Senators Merkley and Levin negotiated the precise language of their amendment in good faith. The Republicans have made their answer clear: No way.

Time for President Obama to make the call. Continue reading “Finally, The Republicans Come Out To Fight. Where Is The President?” →

Constructive Populism

By James Kwak

I don’t expect to get a holiday card from Tim Geithner this winter. Nor do I expect one from Larry Summers. Or even Michael Barr, despite everything I’ve written in favor of consumer protection. (I probably will get one from Barack Obama, since I donated money to his campaign.) But they might want to consider putting me on their lists.

“Populist” has mainly been used as a smear over the past year and a half, to connote irresponsible pandering to . . . well, to the people, actually. Simon and I have been written off by many people as populists, as if that alone were enough to settle the argument. But if and when financial reform does finally get passed by both houses of Congress, the administration will owe a major debt to the recent resurgence of anti-Wall Street sentiment, which can only be called populist.

Continue reading “Constructive Populism” →

Sam Brownback’s Staff Are Amateurs

By James Kwak

Senator Sam Brownback has been pushing an amendment in the Senate that would exempt auto dealers from regulation by the Consumer Financial Protection Agency. The auto dealer exemption has gotten a lot of press. The House version of the exemption was the focal point of a Huffington Post story back in December on how the House Financial Services Committee was loaded with moderate Democrats who are weak on financial reform. (That amendment was introduced by John Campbell, a former auto dealer who is no longer an auto dealer but who owns real estate that he rents to auto dealers.)

The argument for the exemption is that regulating auto dealers will — you guessed it — reduce access to credit.* The arguments against are: (a) auto loans are a major source of financing for consumers, along with mortgages and credit cards, so people need to be protected; (b) auto loans provide even more opportunities for ripping off customers than most bank loans, because of the auto dealer’s privileged market position and its ability to shift money back and forth between the sale price and the loan fees; and (c) if you open up this loophole, you will have regulatory arbitrage.

Continue reading “Sam Brownback’s Staff Are Amateurs” →

Senator Ted Kaufman: Financial Reform Against The Odds

By Simon Johnson, an excerpt from my latest column on Project Syndicate

America’s financial sector has shown renewed strength in recent months – political strength, that is – by undermining most of the sensible proposals for banking reform that remain on the table. If we are still making any progress at all, it is because of the noble efforts of a small number of United States senators.

Most notable has been the work of Senator Ted Kaufman, a Democrat from Delaware (yes, a pro-business state), who has pressed tirelessly to fix the most egregious problems in the US financial sector. Kaufman understands that successful reform requires three ingredients: arguments that persuade, the ability to bring colleagues along, and a good deal of luck in the form of events that highlight problems at just the right time. On two fronts, Kaufman has – against long odds – actually managed to make substantial steps.

The rest of this article is available (free) on Project Syndicate.

ABA Argues That Black Is White and Must Stay That Way

By James Kwak

I wasn’t sure if I was going to write about the Whitehouse Amendment, which would allow states to regulate the interest rates charged to their residents. According to a 1978 Supreme Court decision, financial institutions are governed by the law of the state that they reside in, not the laws of the states they do business in; the result was the current situation, where the big credit card issuers are based in South Dakota, because Citibank basically wrote South Dakota’s consumer credit laws. In its essence, the amendment says this: “The interest applicable to any consumer credit transaction [not a mortgage], including any fees, points, or time-price differential associated with such a transaction, may not exceed the maximum permitted by any law of the State in which the consumer resides.”

Obviously I’m in favor of it, as the current system just allows the worst kind of regulatory arbitrage. (Note that administration officials like to oppose strict legislative measures, like a hard leverage cap, on the grounds that these things need to be negotiated internationally so that banks won’t just set up shop in the most lightly-regulated jurisdiction — yet that’s exactly what happens with credit cards.) But I wasn’t sure what there was to add, since Mike Konczal and Bob Lawless have already weighed in.

Then I read the ABA’s argument against the amendment, that gave me all the motivation I needed.

Continue reading “ABA Argues That Black Is White and Must Stay That Way” →

Agreeing on the Problem

By James Kwak

Over the past month, Simon and I have become very closely associated with the Brown-Kaufman amendment to break up big banks, and that’s an association I welcome, especially given the last chapter of 13 Bankers. The fact that the amendment came from basically nowhere and got thirty-three votes in the Senate is, to me, an encouraging sign. But while this solution looks like it is unlikely to pass in this session of Congress — and there is debate about whether it is the right solution to begin with — the more encouraging sign is the amount of agreement on the problem to be solved: a financial system that is too big, too concentrated, and too powerful.

I wrote a guest post for the Harvard Law School Forum on Corporate Governance and Financial Regulation, a group blog, on this broader issue and some of the other solutions that have been floated. As we’ve said many times, as long as debate moves in this direction, that’s progress.

Thinking About Financial Reform

By Simon Johnson, co-author of 13 Bankers

There are three contending narratives regarding the financial reform legislation that this week approaches its final hurdles in the US Senate.

The first narrative is “the reforms would make things worse.” This view, advanced recently by some Republican leadership, seems to have receded in recent weeks – at least with regard to systemic risk – particularly after Senator Ted Kaufman dealt with it rather brutally on the Senate floor. For the most part, this line has sunk down to the level of sneaky astroturf campaigns.

There is still a rear-guard action by special interests against consumer protection on financial products, but here the administration started out with a sensible vision and – with strong support along the way from the likes of Elizabeth Warren – reasonable safeguards will eventually emerge. The biggest remaining item is probably the Whitehouse Interstate Lending Amendment, which would definitely help – call your senator, but only if you don’t like being gouged by credit card companies.

The second narrative is “Obama administration as heroes.” Against the odds, in this view, the administration has prevailed in the teeth of tough opposition. Continue reading “Thinking About Financial Reform” →