Trump Order is Bad News for Retirement Savers

February 9, 2017

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On February 3, President Trump issued a memorandum to the Secretary of Labor regarding the “Fiduciary Duty Rule” that was scheduled to go into effect this April. Suggesting that the rule “may not be consistent with the policies of my Administration,” he directed the Department of Labor to reexamine the proposed rule and consider rescinding or revising it.

The Department of Labor has been working on this rule since 2009 with the aim of improving the quality of investment advice received by investors in retirement plans. With traditional pensions on the decline and participant-directed retirement plans like 401(k)s and IRAs replacing them, more people need investing advice than ever. This has highlighted a problem described in a Department factsheet:

Many investment professionals, consultants, brokers, insurance agents and other advisers operate within compensation structures that are misaligned with their customers’ interests and often create strong incentives to steer customers into particular investment products. These conflicts of interest do not always have to be disclosed and advisers have limited liability under federal pension law for any harms resulting from the advice they provide to plan sponsors and retirement investors. These harms include the loss of billions of dollars a year for retirement investors in the form of eroded plan and IRA investment results….

To put it bluntly, too many so-called advisors recommend the products that earn them big commissions, not the ones that offer the best value for the investor. When we buy a car, we understand that the dealer is just a salesperson who would love to sell us the most expensive car, whether we need it or not. When we go to a doctor, we expect the recommended treatment to be in our best interest, not what is most profitable for the doctor. The question is what is the appropriate standard of care when we depend on an advisor’s expertise for our financial health.

The proposed Fiduciary Duty Rule would require all those who provide retirement plan advice for compensation to adhere to a fiduciary standard, which requires “putting their clients’ best interest before their own profits.” This requirement would apply whenever advisors recommend an investment, if they are compensated in any way for doing so. It doesn’t matter whether the client is paying for the advice itself or whether a sales rep is earning a commission for selling a product.

Closing a loophole in the fiduciary standard

Debate over the fiduciary standard goes back a long way. I have discussed it before, especially in Section 11 of my “Sound Investment” series and in my review of Helaine Olen’s Pound Foolish, a critique of the personal finance industry.

Many people may not realize that the fiduciary standard is already well established in law. The Investment Advisers Act of 1940 required anyone giving investment advice for compensation to register as such and adhere to such a standard. So what’s the problem? The Securities and Exchange Commission made an exception for those whose primary business is trading securities, even if they also give some advice to their customers. In recent years, brokers and other sellers of financial products have expanded their financial advising functions and often receive compensation for them. Nevertheless, the SEC continued to maintain that they did not have to register as investment advisors nor adhere to a fiduciary standard because their advice was “incidental” to their job as brokers. So two types of advisors, those obligated to put their clients’ interests first and those without such obligation, have co-existed in the financial services industry, with the general public often unable to tell the difference. Brokers and insurance agents have been able to call themselves financial advisors, without being obligated to recommend the products that are best for their customers.

After the Great Recession, the Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) gave the SEC the authority to reexamine the issue and write a new regulation. After studying the matter, the SEC concluded that the loophole it previously created should now be closed: “The standard of conduct for all brokers, dealers and investment advisors, when providing personalized investment advice about securities to retail customers…shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer or investment advisor providing the advice.” The actual regulations that will implement this principle continue to be hotly contested. Meanwhile, the Department of Labor has finalized a fiduciary rule based on a different statutory authority, its authority to regulate retirement plans under the Employee Retirement Income Security Act of 1974 (ERISA). The DOL’s rule would apply only to financial advice relating to retirement plans, not to investments more generally. This is the rule whose implementation the President is now blocking.

Last month, the Consumer Federation of America issued a report, “Financial Advisor or Investment Salesperson?: Brokers and Insurers Want to Have it Both Ways.” The report documented the two-faced way that “transaction-based financial professionals” describe themselves:

When they are marketing their services to the investing public and enticing clients into handing over their hard-earned savings, these sales-based financial professionals present themselves as “trusted advisors” whose only concern is their clients’ best interest. But try to hold them legally accountable for meeting that standard, and those same “advisors” quickly change their tune. Because they are salespeople who are “merely selling” investment products, they claim, no fiduciary standard ought to apply.

In their marketing materials, brokers and insurance companies use terms like “financial advisor,” “financial consultant,” or “retirement counselor” to describe themselves. They characterize their services as “a comprehensive approach to total wealth management delivered by your most trusted advisor,” and claim to be “safeguarding the money of others as if it were our own,” to quote some of their websites. Surveys show that this kind of marketing is successful in getting the general public to confuse sales reps with the registered investment advisors who actually are held to a fiduciary standard. But when they are fighting that standard in legislative hearings or in court, they are quick to claim that they are just salespersons. They deny having the special relationship of trust that would justify classifying them as fiduciaries under existing or proposed law.

The high financial stakes

The Consumer Federation described how savers are being hurt by this situation:

Investors who unknowingly rely on biased salespeople as if they were trusted advisors can suffer real financial harm as a result. It is estimated, for example, that retirement savers lose $17 billion a year or more as the result of the excess costs associated just with conflicted retirement advice. The cost on an individual basis, in the form of lost retirement savings, can amount to tens or even hundreds of thousands of dollars over a lifetime of investing, money that retirees struggling to make ends meet can ill afford to do without.

Here’s a hypothetical example. Suppose you save $500 a month for 20 years in a tax-deferred retirement plan holding mutual funds, for a total investment of $120,000. With a 7% annual return after expenses, you would accumulate $260,463 over the 20 years. However, if you lost $25 of each $500 invested because of unnecessary commissions or fees, and then received only a 6% return because of higher annual mutual fund expenses, you would accumulate only $219,469, a shortfall of about $40,000. Multiply this by millions of savers and you begin to see the size of the problem.

Of course, every company that charges high fees, commissions or expense ratios will try to justify them as fair compensation for value provided. So the question is whether investors who are being charged more are receiving any added value. Although investment returns can be all over the map, most of the evidence does not support the contention that the investment products pushed by brokers and insurance reps outperform investments that are available less expensively elsewhere. In particular, index funds that you can buy directly from companies like Vanguard and Fidelity with no sales commissions and rock-bottom expense ratios outperform the majority of high-cost actively managed mutual funds. For more explanation of why so many aggressively marketed investments have such disappointing returns, see Section 6 of my “Sound Investing” series.

When I worked as a registered investment adviser (the kind who was legally bound by the fiduciary standard), many clients came to me for a portfolio review. Using standard measures of costs and risk-adjusted performance, I routinely found overpriced, underperforming, and often unnecessarily confusing products that had been recommended to them by brokers or insurance agents. In most cases, they would have accumulated more if they had gotten simpler and better advice.

What we see here is a massive and unearned transfer of wealth from middle-class savers to financial service companies that too often serve themselves at the expense of their customers. This is one reason why the era of self-directed retirement accounts has also been an era of increasing inequality in the distribution of wealth. The new regulations are intended to give middle-class savers a fighting chance.

Alleged adverse effects of the fiduciary rule

Businesses that oppose consumer protection initiatives rarely admit what really concerns them, that a new rule may interfere with a profitable business model. They almost always claim that it will hurt consumers in some way that consumer advocates and regulators fail to see.  President Trump’s order takes a pro-consumer stance by asking the Department of Labor to examine whether the fiduciary rule would “adversely affect the ability of Americans to gain access to retirement information and financial advice.” The implication is that retirement savers may be losing something if they cannot get the “free” advice offered by brokers and insurance agents, even if that advice is flawed by conflicts of interest that work against investors’ best interests.

Investors of modest means do need financial advice that doesn’t cost them much, and accepting the recommendations of sales reps is one way to get it. Investment advisors who do not make their money from sales commissions derive their income from flat fees for advising sessions or for writing financial plans, as I did, or from asset management fees based on a percentage of assets under management. Making a living while keeping these charges affordable for small investors is not easy. It is one thing to set a fiduciary standard, but another thing to make fiduciaries available at a price most savers can afford.

However, the fiduciary rule need not leave most retirement savers with no affordable advice at all. The kind of basic advice that small investors need to handle their retirement plans is already pretty widely available, and could be even more available if employers and schools made more of an effort to provide it. Most savers will do fine putting the bulk of their retirement savings in a single “target retirement fund,” or in a small number of index funds covering domestic and foreign stocks and bonds. (Of course, they need to follow other basic advice like getting an early start and saving 10-15% of income.) Financial professionals can still make a good living selling advice to people of means who are interested in playing riskier or more sophisticated investment games. But for the average worker, the present system relies too heavily on a business model that institutionalizes conflicts of interest and needlessly skims off too large a portion of the savings that people need for their retirement.

President Trump’s order is an anti-consumer measure shrouded in pro-consumer rhetoric. It purports to protect American savers, while really protecting businesses that charge them too much and deliver too little. It ignores years of research by the federal government’s own agencies as well as by professional financial planners, academics and consumer groups. It shows that the people who have Trump’s ear are the billionaires and bankers he has brought into his administration, not advocates for the general public. It is one more piece of evidence that–populist rhetoric notwithstanding– he intends to serve the economic elites rather than the people.



Postcapitalism (part 4)

May 18, 2016

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The last part of Paul Mason’s Postcapitalism discusses how the transition out of capitalism might unfold, with special attention to the role of the state in facilitating change.

To review, Mason expects information technology to liberate people from the capitalist market economy. We will be liberated as workers because fewer hours of paid work will be required to produce the necessities of life. We will be liberated as consumers because goods and services will be more abundant and less expensive. We will be able to devote more of our time to voluntary activity and sharing.

A rough road

If this sounds too rosy and idealistic, readers should take a close look at Chapter 2, “Long Waves, Short Memories,” and Chapter 9, “The Rational Case for Panic.” Mason does not expect a smooth, leisurely and pleasant transition beyond capitalism, but something more tumultuous. As the historical material in the book makes clear, the history of capitalism is not just a story of steady progress through technological innovation and rising productivity. It is a story of periodic crises as the profitability of existing industries wanes and capital has to find new opportunities elsewhere. The transition now underway is especially difficult because it calls into question the viability of capitalism itself. As production becomes more knowledge-based, the means of production become harder to own and maintain as sources of private profit. Since the 1970s, capitalists have been counteracting the tendency for profits to fall by holding wages down in the developed countries and exploiting the cheap labor of poorer countries, but at the cost of increasing inequality and social resistance.

To make matters worse, new environmental and demographic conditions are delivering “external shocks” to the economic system. The prime example is climate change, a problem that Mason does not believe the market can solve on its own. When the price of fossil fuels goes up, energy companies take that as a signal “that it’s a good idea to invest in new and more expensive ways of finding carbon.” When the price goes down, consumers conclude that they can drive more or buy less fuel-efficient vehicles. However the market fluctuates, the price does not factor in the externalities, the true costs of environmental impacts on the global economy.

Another shock is the “demographic timebomb,” the addition of another two billion people to the planet by mid-century, most of them in poorer countries. In the richer countries, falling birth rates and rising longevity are creating rapidly aging populations. With fewer working-age people to support more retirees, workers are under pressure to generate enough wealth to save for their own long retirement as well as contribute to the support of today’s retirees through payroll taxes. Demographic change puts additional stress on the economy in several ways: requiring the financial system to deliver high investment returns for retirement accounts, increasing the demands on public spending for the elderly, and increasing the flow of migrants from rapidly growing poor countries to slower growing but aging rich countries.

The world cannot afford a leisurely transformation to the postcapitalist economy Mason foresees. The world needs a rapid deployment of new technologies to produce as much as we can, but do it in a cleaner, greener way that mitigates environmental damage. The potential benefits are enormous, but the task of getting from here to there is daunting.

“Project Zero”

Because of the urgency of the situation, Mason believes that a spontaneous process of increasing information-based activity is not enough. The process needs to become a conscious project, based on the insight that “a new route beyond capitalism has opened up, based on promoting and nurturing non-market production and exchange, and driven by information technology.” He calls it “Project Zero” because “its aims are a zero-carbon energy system; the production of machines, products and services with zero marginal costs; and the reduction of necessary labour time as close as possible to zero.”

The state has a special role to play in Project Zero because only the state is “centralized, strategic and fast” enough to address the urgent problems. However, Mason rejects the old socialist idea of a centrally planned economy, arguing that a centralized bureaucracy cannot respond to new data fast enough to keep up with the pace of change in the information society. Recall the earlier point that the key agent of change will be the educated and networked individual, which implies a high degree of decentralization.

Limits on private capital

So what can the state do to facilitate the transition to postcapitalism? First, it can curb private economic power in industries where it has become a danger to the public good. The energy industry would be one, as the discussion of the climate issue illustrates. The state should actively discourage fossil fuel production and encourage cleaner sources of energy. Mason also sees a much larger role of government in the financial industry. One proposal sure to provoke controversy is that the state take control of the central bank in order to implement a monetary policy that helps debtors more than creditors. That would be a looser monetary policy that keeps interest rates low but allows the inflation rate to be somewhat higher. Over time, that erodes the real value of debt, in contrast to a strict monetary policy that protects wealthy lenders by placing primary emphasis on fighting inflation. Since government itself is a large debtor, that would help governments recover from the fiscal crisis resulting from demands for both low taxes on capital and high spending on social programs to assist struggling wage-earners.

Mason would also reorganize the banking system to make it less profit-driven, by encouraging non-profit banks, credit unions, peer-to-peer lenders, and “a comprehensive state-owned provider of financial services.” He would regulate the remaining profit-oriented banking to curb wasteful speculation and encourage its proper role of efficiently allocating capital to productive activities.

In the economy as a whole, the state would act to insure that what profits remain would be a reward for entrepreneurship, and not just a “rent” based on ownership. Creators of new knowledge would get the rewards of intellectual property rights, but those rights would be short-lived to encourage the flow of knowledge and the continued incentive for further innovation.

Liberating workers

Another thing the state can do is strengthen the legal rights and protections of workers to give them more bargaining power in their relationship with capital. This will indirectly encourage the fuller application of new technologies that can produce economic abundance. “If we legally empowered the workforces of global corporations with strong employment rights, their owners would be forced to promote high-wage, high-growth, high-technology models, instead of the opposite.” Owners would try to make each worker as productive as possible if they could no longer profit from paying such low wages.

An obvious objection is that higher wages and productivity would have the downside of less employment. But for Mason, less employment in capitalist workplaces where owners profit by overworking and/or underpaying workers is ultimately a good thing. Ideally, workers would be better paid for the hours they worked, but also have the option of working fewer hours. They could then experience the decline of paid employment as a liberation, not an involuntary displacement.

The other side of the transformation of work is the increasing opportunities for work outside of traditional profit-centered firms, such as in non-profits and co-ops. Mason recommend that the state “reshape the tax system to reward the creation of non-profits and collaborative production.”

Liberating consumers

The replacement of millions of workers by automated systems is unlikely to be experienced as a good thing unless it has benefits for people as consumers, not just as workers. Here the state can facilitate the transition by providing a basic income to all households, to support those who are voluntarily or involuntarily outside the system of paid employment. That can improve the safety net for those who are displaced by new technologies. It also “gives people a chance to build positions in the non-market economy” by subsidizing participation in volunteer work, co-ops and adult learning opportunities. Market work would still be rewarding as long as minimum wages were higher than the basic income.

In the long run, the abundance of things made available by hi-tech production methods would bring the monetary cost of living down and reduce consumers’ dependency on earned income. People could rely more heavily on non-market forms of sharing, since they would have more time for unpaid but socially useful activity. As the income tax base became smaller, government’s ability to pay a basic income would decline, but so would people’s need for one.

Can democracy survive the transition?

Just about every one of Mason’s political suggestions goes against conservative thinking, which sees the free market as the creator of wealth and the limited state as its supporter. In the conservative view, the state should tax and regulate capital as little as possible, protect wealth against inflation with tight monetary policy, and keep people dependent on paid employment by providing only the most meager welfare benefits. Mason ends his book by warning that if the democratic state tries to facilitate a transition beyond capitalism, the economic elite may decide that preserving capitalism is more important than preserving the democratic state!

How long will it take before the culture of the Western elite swings toward emulating Putin and Xi Jinping? On some campuses, you can already hear it: “China shows capitalism works better without democracy” has become a standard talking point. The self-belief of the 1 per cent is in danger of ebbing away, to be replaced by a pure and undisguised oligarchy.”

We can already see the beginnings of an alliance between right-wing autocrats and blue-collar workers fearful of losing their jobs, especially in doomed occupations like coal mining or pipeline construction. If such alliances succeed in taking over the governments of developed countries such as the United States, then things could get pretty ugly in the next few decades.

In the last great transition of capitalism, in the early twentieth century, authoritarian politics had to be defeated before the democratic state could help create a broader-based prosperity. (Third-world peoples and racial minorities remained excluded however.) We should not be surprised if the same turns out to be true of the twenty-first century, as we struggle to create a more inclusive and sustainable prosperity.

Rewriting the Rules of the American Economy (part 2)

March 10, 2016

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The central message of Stiglitz’s latest book is this: “The American economy is not out of balance because of the natural laws of economics. Today’s inequality is not the result of the inevitable evolution of capitalism. Instead, the rules that govern the economy got us here.”

We have been operating under a set of rules that were inspired by the largely discredited “supply-side” economics. The aim was to free up capital by cutting taxes, regulation, and wasteful social spending. That would promote more investment and economic growth, with the benefits flowing to all levels of society (what critics call “trickle-down” economics). This was in contrast to the traditional Keynesian approach preferred by liberals, which stressed the importance of maintaining aggregate economic demand through government spending beneficial to the middle class and the poor. Stiglitz and his co-authors regard the supply-side approach as a failure. “These policies increased wealth for the largest corporations and the richest Americans, increased economic inequality, and failed to produce the economic growth that adherents promised.”

Greater wealth at the top does not necessarily translate into greater productive capacity for the economy. Wealth becomes capital only when it is invested in productive activity, but wealth that is not so invested can still produce an economic gain. Property owners in a hot real estate market can collect rents and/or capital gains without making anything or creating any jobs. If the rules of the game encourage it, those with wealth and power will devote too many resources to “rent-seeking,” that is, “obtaining wealth not through economically valuable activity but by extracting it from others, often through exploitation.” The rule changes inspired by supply-side economics shifted the balance of power toward the wealthy and made it easier to make money without serving society very well.

Deregulation of industries such as airlines, railroads, telecommunications, natural gas, and trucking, as well as legal rulings limiting regulation in general, made it easier for big companies to accumulate market power and ultimately limit competition. Some public policies have contributed directly to that accumulation, such as intellectual property rights laws that favor the rights of pharmaceutical companies to profit from a drug over the rights of other companies to make it and sick people to obtain it at a reasonable cost. International trade agreements that failed to include proper safeguards made it too easy for corporations to locate their operations wherever worker bargaining rights and environmental laws were weakest.

The rapidly growing financial sector was allowed to shift “away from its essential function of allocating capital to productive uses and. . .toward predatory rent-seeking activities.” Never had so many people become so rich by producing so little of real value. Market power became enormously concentrated, with the share of assets held by the top five banks increasing from 17% to 52%. The complexity of modern finance puts ordinary consumers at a disadvantage to begin with, but the lax regulatory environment made it worse, allowing predatory lending, fraud and discrimination to run rampant. Meanwhile, the financial industry became less efficient at performing its basic function of providing credit, since the cost-per-dollar of credit actually went up.

Within corporations, the “Shareholder Revolution” increased the pressure on CEOs to generate quick profits. CEO compensation was increasingly tied to rising company stock prices. “The idea that corporations exist solely to maximize current shareholder value and that all other goals are secondary reversed decades of management theory that prioritized firm longevity and saw corporations as more broadly advancing societal interests.” This encouraged several unfortunate corporate practices: favoring shareholder payouts over long-term investments, taking excessive risks (since executives with stock options could profit from financial bubbles), paying executives much more than their productivity could justify, and treating employees “as short-term liabilities rather than as long-term assets.” The bottom line: “Corporate profits are at record highs, with no increase in investment.” Here, corporate culture is as much to blame as public policy, a reminder that the relevant rules of the game include private social norms, not just public policies and laws.

The Reagan and Bush tax cuts favored the wealthy by reducing both the upper-bracket income tax rates and the taxes on dividends and capital gains. This contributed not only to greater after-tax inequality, but surprisingly, to greater pre-tax inequality as well. It increased the pressure on companies to pay out more in executive compensation and dividends, since the payments would be more lightly taxed. International comparisons show that such tax cuts increased economic inequality but failed to boost per capita income. US Federal Reserve policy also contributed to inequality by prioritizing fighting inflation over reducing unemployment, although both goals are mandated by law. The impact of unemployment on family income varies by social class, reducing income by a higher percentage at the lower end of the income scale. In addition, “episodes of below-full employment do lasting damage to productivity, equity, and opportunity.”

During this period, US employers were generally successful in resisting any expansion of worker rights. Within the 30 democracies in the OECD, “an average of 54 percent of the workforce is covered by union collective bargaining agreements, 4.5 times more than in the US.” Companies increasingly used outsourcing and franchising to circumvent labor laws, while continuing to set the terms of employment. Wage growth fell far behind productivity growth (19% vs. 161% between 1973 and 2013), and the federal minimum wage failed to keep up with inflation. To make matters worse, one study found that about a quarter of low-wage workers were getting paid less than the minimum wage, and three quarters weren’t receiving the overtime pay they were due. One major goal of public policy was to reduce dependency on government by creating jobs and cutting social welfare payments. Instead, spending on programs like Medicaid and food stamps remained high as more working families found themselves unable to make it on their own. Conservatives deplore this, but generally oppose efforts to raise wages or strengthen the bargaining position of workers.

The final post will cover the book’s recommendations for rewriting the rules.



After the Music Stopped (part 3)

February 26, 2013

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Having discussed the origins of the financial crisis and the government efforts to end it, Blinder turns to the issue of financial reform. The centerpiece of the reform effort was the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, named for the chairs of the Senate and House banking committees. All but three of the Republicans in Congress opposed it, making it “the most partisan vote on major financial-market legislation in memory.” The bill required a lengthy and complicated process of issuing specific regulations, leaving the opposition with many opportunities to delay or obstruct the process of implementation.

Here are some of the issues the legislation addressed:

  • “Too big to fail”: Reformers wanted to stop large financial firms from assuming that Washington would come to their rescue if they made high-risk financial bets and lost. Some advocated just letting them fail, while others said they should be prevented from growing so large that their failure would devastate the economy. Dodd-Frank took a moderate approach, forbidding taxpayer bailouts but giving the Federal Deposit Insurance Corporation new authority to oversee an orderly liquidation of those failing companies designated as “systemically important financial institutions.” They could still be big, and still fail, but hopefully not as messily.
  • Systemic risk regulation: Reformers wanted an “agency charged with the responsibility of scouring the financial landscape for hazards that could, under adverse circumstances, become systematically important–and perhaps taking action when it finds them.” Dodd-Frank created a new Financial Stability Oversight Council for that purpose.
  • Glass-Steagall: Some reformers wanted to reinstate the Glass-Steagall separation of commercial banking from investment banking, in order to protect depositors’ money from being invested in high-risk securities. Glass-Steagall had been repealed by the 1999 Gramm-Leach-Bliley Act. Blinder himself, however, believes that most of the behavior that got banks in trouble would have been permissible under Glass-Steagall anyway, since it involved commercial banks and investment banks doing foolish things separately rather than within the same institution. In any case, Dodd-Frank did not reinstate the Glass-Steagall barriers.
  • Capital and liquidity requirements: Reformers wanted to prevent banks from becoming over-leveraged–putting too much money at risk with too little capital in reserve to cover losses. Dodd-Frank set higher capital and liquidity requirements, especially for “systemically important financial institutions.”
  • Rating agencies: The problem here was the cozy relationship between rating agencies and the companies whose securities they rated. Reformers suggested that companies not be able to choose their rating agency, or that the agency have greater legal liability for mistakes. Dodd-Frank only required that the problem get further study. It did put an end to legal provisions requiring that rating agencies be used.
  • Proprietary trading: Proprietary trading is trading for a bank’s own profit rather than as a service to its customers, although the distinction is sometimes hard to make in practice. It can increase the risk for customers, as well as taxpayers if the accounts are government-insured. Dodd-Frank adopted a version of the “Volcker rule” prohibiting proprietary trading, but with many exceptions. The law prohibited banks from running a hedge fund or a private equity fund.
  • Regulatory reorganization: Reformers complained that the US had no federal insurance regulator or nationwide mortgage regulator. Dodd-Frank required little regulatory reorganization. It did fold the Office of Thrift Supervision, which had been ineffective during the crisis, into the Office of the Comptroller of the Currency.
  • Consumer protection: Dodd-Frank created the new Consumer Financial Protection Bureau. The law did not require some of the things reformers wanted, such as “plain-English” disclosures and “plain-vanilla” financial products (for example, a well-diversified mutual fund of stocks and bonds as the default choice within a retirement plan), but it gave the bureau the authority to order them. The law exempted auto financing from the bureau’s authority.
  • Derivatives: Dodd-Frank increased the authority of the SEC and the Commodity Futures Trading Commission to regulate derivatives. It required that more derivative transactions be conducted through central exchanges and clearinghouses, rather than private transactions. “Standardization and exchange trading breed transparency, competition, and lower trading costs.” The bill did not ban the most speculative use of derivatives, to make bets on the price movements of securities one doesn’t own.
  • Mortgage finance: Dodd-Frank set stricter standards for mortgage loans. It also required securitizers–firms that pooled mortgages for investors–to hold at least 5% of a mortgage pool themselves, so they would have some “skin in the game.” Hopefully they would then concern themselves with the quality of mortgages they securitized. It also called for more study of mortgage-backed securities and who would issue them. Having so many mortgages securitized by government-sponsored but private agencies (Fannie Mae and Freddie Mac) “made it too easy to privatize gains and socialize losses” by creating expectations of government bailouts.

Overall, Blinder characterizes Dodd-Frank as a regulatory success, hardly perfect but pretty good.

So where do we go from here? According to Blinder, the government will need to continue the financial reforms, but phase out the measures designed to respond to the national financial emergency. For the Federal Reserve, that means gradually tightening monetary policy before economic recovery leads to inflation. The Fed’s purchase of securities in its “quantitative easing” program has held interest rates down and given banks a “mountain of excess reserves” to lend out whenever they choose to. Raising the interest rate it pays on these reserves would be one way of discouraging excess lending and too rapid growth of the money supply. For fiscal policy, the challenge is to reduce the federal deficit at a measured pace without derailing the recovery. The Congressional Budget Office projects short-term deficit reductions as crisis spending declines, but serious long-term problems if health-care spending continues to rise. Some of the future deficit reduction “will take the form of higher taxes–sorry, Republicans. Most of it will be lower spending–sorry, Democrats.”

In my first post on Blinder’s book, I said that he didn’t deal as much as I would like with underlying causes of the financial crisis. I think that also affects his expectations regarding the future. He seems to regard the Great Recession as an unfortunate interruption on the path to prosperity, but one that we can put behind us with some temporary economic measures and some reforms of the financial system. He paints a fairly positive picture of the economy in the decades leading up to the crisis, emphasizing the relatively low unemployment rate. He sees no reason why we can’t get back to economic growth and low unemployment within a few years.  If, on the other hand, the previous economic growth was unsustainable because of fundamental imbalances in the global and domestic economy, the path to prosperity may be longer and harder. The US has the dual challenge of improving its global competitive position and allowing a larger portion of its citizens to share in the growth of income. We weren’t achieving either goal very well before the crisis, despite low unemployment, so we may have to do some things very differently if we’re going to achieve more sustainable growth now.

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After the Music Stopped

February 20, 2013

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Alan S. Blinder. After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. New York: Penguin Press, 2013.

The title of Blinder’s book refers to a quote from Chuck Prince, Citigroup CEO, in 2007: “When the music stops…things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Dancing meant making as much money as you could in the overheated markets for housing and mortgage-backed securities before the bubble burst, which it did shortly thereafter.

Economist Alan Blinder has written an exceptionally lucid and readable account of the financial crisis and its aftermath. He has a knack for taking complicated financial concepts like collateralized debt obligations and explaining them simply. His book is a good place to start for non-economists trying to make sense of it all. He addresses three key questions:

  • How did we ever get into such a mess?
  • What was done to mitigate the problems and ameliorate the damages–and why?
  • Did we “waste” the financial crisis of 2007-2009…or did we put it to good use [that is, did we learn to do things any better]?

Having recently discussed The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It, by Peter Temin and David Vines, I did not feel that Blinder did as good a job as they did putting the financial crisis in a larger macroeconomic context, especially a global context. Although Blinder does discuss some global fallout from the crisis, his account of both its causes and its solutions focuses primarily on problems within the American financial system and its regulation. He doesn’t explore the connections between those problems and the competitive position of the United States in the world. As a result, his solutions may not be fundamental enough to cure what really ails the American economy. I’ll return to that issue after summarizing Blinder’s account of how the crisis occurred.

In Part II: “Finance Goes Mad,” Blinder identifies seven key weaknesses in the US financial system before 2008, which he also calls seven “villains”:

  1. Inflated Asset Prices: Bubbles often occur when buyers overreact to some trend that increases the value of an asset. After the tech-stock crash of 2000, housing seemed a relatively safe investment, and the Federal Reserve’s efforts to stimulate the economy by lowering interest rates made it more affordable. Once home values were rising and interest rates falling, owning was much more profitable than renting, and owners could pocket some of the benefits by borrowing against equity or refinancing at lower rates. A boom also occurred in mortgage-backed securities (pools of mortgages sold to investors), which paid higher interest than Treasury bonds but seemed almost as safe as long as the risk of default was believed to be low. Low interest rates on the safest government and corporate bonds encouraged investors to “reach for yield,” accepting what they hoped were reasonable risks for the sake of a higher return.
  2. Leverage: Consider a house that appreciates 10%, from $100,000 to $110,000. If you paid cash for it, your gain is 10%. But if you leveraged your investment by putting down $20,000 and borrowing the rest, the gain on your investment is 50%. The flip side is that if the house depreciates by $10,000, your loss is also 50%. During the housing boom, many home purchases were more heavily leveraged, often with only 5% down. Between 2000 and 2008, total household debt rose from about 100% of GDP to about 140%. Banks and investment firms also acquired assets using more leverage, often by using accounting gimmicks to circumvent financial regulations.
  3. Lax Financial Regulation: The major regulatory agencies mostly looked the other way as banks and mortgage brokers became increasingly aggressive, pushing riskier loans to borrowers with shaky credit. The expanding market for “derivatives” largely fell through the regulatory cracks, partly because of an explicit Congressional exemption. A derivative is a security whose value depends upon the value of an underlying asset, like a stock option whose value depends upon the price of the stock when the option is exercised. Derivatives can protect against risk, as when a manufacturer purchases the right to buy a commodity at a given price, to protect against a future price increase. But derivatives can also be used to make speculative bets on assets one doesn’t own. Insurance companies like AIG made huge bets that housing defaults would remain low when they agreed to protect financial firms from losses on mortgage-backed securities. But because the contracts were classified as derivatives rather than insurance policies, the regulations that would have set cash reserves to back the policy didn’t apply.
  4. Banking Practices: Within this climate of lax regulation, lenders lowered their lending standards and increased their subprime lending. Many of these loans were traps for unwary borrowers: “Many subprime mortgages were ‘designed to default.’ The most popular such example was the ‘2/28 ARM.’ These were 30-year adjustable-rate mortgages (ARMS) with, say, a barely affordable “teaser rate” like 8 percent for the first two years that would reset to a presumably higher rate…after that.”
  5. Securities Complexity: Why didn’t lenders seem to care as much whether borrowers could make their payments or not? Because of mortgage securitization. Lenders sold their mortgages to financial firms that packaged them for sale to other investors. These mortgage-backed securities became increasingly complicated and difficult to value. Collateralized Debt Obligations were pools of mortgages that had been divided into slices called “tranches,” which carried different degrees of risk. Buyers of the riskiest tranches had to absorb more of the losses from any defaults in the pool, while buyers of the safest tranches would only be hurt if the rate of default reached a very high level. Sometimes the tranches were repackaged and divided into their own tranches, creating a so-called CDO². “The Wall Street financial engineers who created the CDOs and CDO²s were performing mathematical exercises with complex securities; they had no clue about–and little interest in–what was inside. And the ultimate investors, ranging from sophisticated managers to treasurers of small towns in Norway, were essentially clueless.” Blinder characterizes this complicated edifice as a house of cards, ready to collapse once the word got out that the underlying mortgages were shaky.
  6. Rating Agencies: The companies responsible for rating securities did a terrible job, often giving AAA ratings to securities with substantial risks. “To put the rampant grade inflation into perspective, on the eve of the crisis only six blue-chip American corporations–names like GE, Johnson & Johnson, and Exxon Mobile–and only six of the fifty states merited the coveted Triple-A credit rating.” Rather than being truly independent, the rating agencies were paid by the firms whose securities they rated, and those firms could take their business elsewhere if they didn’t like the ratings they got.
  7. Compensation Systems: Financial firms often had compensation schemes that rewarded employees for making big bets with other people’s money. They got paid even if the bets went bad, and they got paid much more if the bets paid off. Merrill Lynch CEO Stan O’Neal led the company into make heavy bets on mortgage-backed securities, which ultimately resulted in huge losses for shareholders. When he was forced out, he received a “colossal golden parachute package worth over $160 million.”

Blinder explains these points well, and together they give readers a good idea of what was wrong with the American financial system before the crisis. But other analysts of the US economy before 2008 have convinced me that larger macroeconomic factors were involved. I would summarize these factors by saying that economic growth was proceeding in ways that were very unbalanced and unsustainable. One imbalance was the trade deficit that had turned the United States into the world’s largest debtor nation. Some foreign countries, especially in East Asia, based their economic growth heavily on exports. They exported to us far more than they imported from us, maintaining this pattern partly by keeping their currencies weak relative to the dollar. The demand for dollars remained high not so much because foreigners used them to buy our products, but because they used them to invest in American securities they considered safe. The availability of all that foreign capital was one reason why Americans could take on more debt. Foreigners were building for the future by selling, saving and lending, while Americans were living on borrowed time by buying, borrowing and spending.

A second imbalance was the widening income gap in the United States. Most of the gains in income were going to the top, while wages in the middle or below stagnated or even declined, especially for men. In part, this was because technological change was raising the skill requirements of jobs, and globalization was putting more workers in competition with inexpensive foreign labor. Some authors, however (see my posts on Kalleberg and Stiglitz, for example), see US inequality as too extreme to be attributable just to the same forces affecting economies everywhere. The US made inequality worse than it had to be by relying so heavily on cost-cutting as a competitive strategy, underinvesting in human capital, attacking labor unions, and so forth. The expansion of wealth at the top, aided and abetted by generous tax cuts, provided still more capital that went in search of lending opportunities. Meanwhile households with stagnating wages could at least buy cheap imported products, but they went more into debt to obtain the things that weren’t getting cheaper–housing, education and health care. Government under the George W. Bush administration also became more indebted by cutting its tax revenue and then borrowing to finance its rising expenditures, primarily the wars in Iraq and Afghanistan. Government debt was heavily enabled by foreigners willing to buy safe US Treasury bonds.

The large supply of domestic and foreign capital available for lending made it hard for lenders to command a high-interest return. It was in that context that lenders started to “reach for yield,” and financial firms found it profitable to offer securities with higher returns but disguised risks. Subprime housing loans that could be repackaged as safe-looking investments thrived in that environment. The bubbles in housing and mortgage-backed securities developed in a situation where some people were unusually eager to lend, while others were unusually willing to borrow. In retrospect, we can see how tricky it is to sustain economic growth on the assumption that one part of humanity will become increasingly indebted to another.

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