Financial Reform: Not happening but the need is clear

Submitted by Edward Harrison of Credit Writedowns

Say I’m a politician and I am concerned about my re-election prospects in 2010.  I have been a member of Congress for seven years now and have developed a good reputation as a reform-minded economic realist willing to listen to a number of competing economic ideas. However, right now I am a bit concerned about my likely 2010 rival, a respected district attorney known for being tough on crime and equally pragmatic ideologically speaking.

This past week, President Obama delivered a worthy speech on the need for reform in the financial sector. I agree with some of the broad strokes. But, quite frankly, the speech lacked in detail.  What’s more is my economic advisors have counselled me that the worst of the panic is over.  They tell me stimulus – fiscal and monetary – has worked and we are on the road to a welcome though weak recovery.

Meanwhile, I have been informed that a number of well-connected people in the financial industry are considering backing my potential 2010 rival. I have had enough money problems on my plate due to healthcare targeting my district. As I desperately need more money for my re-election campaign, getting on the finance industry’s bad side is something I do not want to happen.

What do I do?

The inside the beltway mentality

Well, unless the economy tanks between now and 2010, I would be a fool to support reforms in the financial sector, which could jeopardize my seat in Congress. Mind you, I am truly a reform-minded individual and it has been a part of my platform since I was elected in 2002. I don’t like Wall Street fat cats earning tens of millions each while people lose their homes and jobs. But, right now, everyone I respect says recovery is here. Retail sales in August just came in – up a massive 2.7%. Fed Chairman Ben Bernanke came out and said outright that recovery has arrived. I am no economist, but these guys make sense. I believe them. That’s why I am loath to even mention financial sector reform – presently being demonized by my 2010 rival as big government.

Earlier this year as things were falling apart, I had decided to inform myself. I read a number of well-respected financial blogs – some of which predicted imminent economic collapse if our big banks were not nationalized. These bloggers claimed that a depression was upon us and drastic government intervention was necessary – and, again, I tended to believe them. After all, one was a recent Nobel Prize winner and another was a winner just a few years ago.

But these individuals have since been discredited, as events have not played out as they suggested. So, as we head into 2010, I am much more interested in reining in uncontrolled government spending – as this is something about which my constituency seems to care. With recovery upon us, there is zero appetite for financial reforms in Washington and I am certainly not going to put a target on my back by trying to get some passed.

Edward here. A lot of politicians are probably thinking along these lines right now. And quite frankly, this makes sense from a political perspective.  If you are looking for reform in the financial sector, the moment has passed. And only to the degree that the underlying weaknesses in the global financial system are made manifest and threaten the economy will we see any appetite for reform amongst politicians. So, as I see it, the Obama administration has missed the opportunity for reform.

Another interpretation of events

Irrespective, I believe the need for reform is clear. Those gloom & doom economists were right because the economic model which brought us to the brink of disaster in 2008 is the same one we have at present and that necessarily means another crisis will come.

Steve Keen, an Australian economist whose theories are heavily influenced by Hyman Minsky, has a cogent analysis of the true structural deficits in the current economic model that I think bears repeating here. He warns that we are trying to kick the can down the road and this will lead to an even larger bust.

In his most recent post, he put it in terms anyone can understand.

You have just come from your annual medical checkup, where your doctor assures you that you are in robust health.

Walking jauntily down the street, you bump into a practitioner of alternative medicine. He takes one look at you and declares “You have a serious tumour! It must be removed or you will die”.

You ignore him as you always have, and continue your merry way down the street. One day later, a stabbing pain suddenly cripples you, and you collapse to the pavement.

In agony, your call your doctor, who initially refuses to send an ambulance because he knows you are well.

When you lapse into a coma and stop talking mid-sentence, your doctor concludes that perhaps something is wrong, and sends an ambulance to take you to hospital.

Initially the doctor waits for you to revive spontaneously, because he still knows there’s nothing really wrong with you. But as your pulse starts to weaken, he reluctantly calls a retired doctor who had experience of a similar inexplicable malady in the distant past.

She prescribes massive doses of tranquilisers, painkillers, vitamins, and oxygen—all substances that had been removed from the medical panoply due to recent advances in medical theory. Reluctantly, your doctor follows his retired colleague’s advice—and miraculously, you start to revive.

After a year of expensive medical treatment, you return to the same robust health you displayed before your inexplicable illness. Triumphant, if somewhat puzzled, your doctor declares you well once more, and releases you from intensive care.

As you stride confidently away from the hospital, you have the misfortune to once again bump into the practitioner of alternative medicine.

“But they haven’t removed the tumour!”, he declares.

One shouldn’t have to spell out the details of such an analogy, but in times of widespread denial, one has to:

  • You are the economy;
  • The tumour is a massive accumulation of private debt;
  • Your doctor is Neoclassical Economics, and the retired colleague is a so-called “Keynesian” Economist — who doesn’t know it, since her medical textbooks were poorly written, but he’s actually following another economist called Paul Samuelson, not Keynes (and your doctor’s textbooks are so bad they don’t warrant discussion);

Case for reform

I have removed the end of Keen’s post which you should most definitely read here. In it, he warns that the tumour collapse occurred in 1987 and that today we have finally reached a level of debt which is so great that another reflation is impossible.  The collapse is now.

But what if it isn’t?  For the sake of argument, let’s say that, just like in 1987, 1990, 1994, 1998, and 2002, there is indeed the ability to reflate the bubble – albeit on a diminished scale. Isn’t that what we see at present with equity prices up between 50-100% globally, with some commodity back at record high prices, and with oil up over 100% from its 2009 lows?

Why would any politician back reform if we seem out of the woods then? Reform doesn’t stuff campaign coffers. Reform doesn’t get your constituents jobs. Reform doesn’t pump up the economy in your district. And reform doesn’t get you elected.  Without imminent economic disaster to sharpen the mind, the case for reform just isn’t there for most politicians.

So, stop spinning the doomsday tale and develop a prevention plan. I happen to buy in to the doomsday scenario as the likely outcome. But unlike Keen, I am not convinced the time is now – it could be in one year.  It could be in two years – or four. Of course, others say, it isn’t coming at all.

Nevertheless, the case for real reform can be made even if it is divorced from the financial crisis, the present economic environment and the upcoming election cycle.

You are kidding yourself if you think real reform is coming to the financial sector before the mid-term elections, especially with health care, two wars and the need to ensure recovery still on politicians’ plates. Obama could go for real reform in 2011 – or in a second term in 2013. But, unless economic crisis is at our door, there isn’t a convincing argument which says reform is necessary. The same is true in Europe, by the way.

What I would like to see is economic thought leaders developing a blueprint of a financial crisis strategy which tackles both the immediate crisis issues (liquidity) and the structural, regulatory and monetary issues that create financial volatility (solvency). When crisis does occur, I believe it will be systemic in nature due to the forces Keen so lucidly explains. Therefore, a blueprint which is 1) heavy on tactics and, 2) if implemented in a real systemic crisis, is likely to work, builds credibility. This is political capital which will carry over to longer-term preventive strategies and reforms.

On the other hand, if Keen is right, we are on the verge of a very nasty relapse which will mean depression and debt deflation. And I reckon such a scenario means the political will should be there in spades.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. DABbio

    Reform only comes after disaster– think, Challenger– not before or even during it. At this point, I would settle for a little revenge. But that too will probably have to wait.

  2. Ed

    “But what if it isn’t? For the sake of argument, let’s say that, just like in 1987, 1990, 1994, 1998, and 2002, there is indeed the ability to reflate the bubble – albeit on a diminished scale.”

    So we reflate the bubble every four years? What type of system is that?

    What you seem to be saying is that we’ve reached the point the Soviet Union was at in the 1970s, when the negative factors in the system have become so entrenched that they can’t be reformed without pulling the whole thing down.

  3. Robert

    All throughout those previous reflations, interest rates were falling. It’s easier to roll-over debt when the rate falls. Actually, it’s required for the rate to fall, otherwise you wont be able to roll the debt over. It’s simple:

    Income growth = g% = GDP growth
    Debt to Income multiple = M (=4 or 5? I forget, but who cares)
    Debt Service costs = r%

    Debt rollover possible only if r < g/M

    Additional reflation to M+1 only possible if r < g/(M+1)

    So interest rates need to keep falling in order to allow the Debt to GDP ratio to grow. So, what do you think happens when income growth slows down, and rates are already near zero?

    One option is to default, the other option is called Japan.

    At rate near 0, you can keep rolling over the debt, regardless of the debt/GDP ratio.

    Then you are effectively stuck:

    First, there is so much debt that people don’t want to spend. Next, as soon as they decide to spend, the money velocity increases, interest rates go up a bit, and all of a sudden people start to default again, and the economy slows down, and rates fall again.

    So this could be in our future, but a 1987 or 2000 boom is no longer on the table. Japan is our best hope — and from their unemployment rate, they are looking pretty good.

    1. Edward Harrison Post author

      Robert, I agree with your conclusions i.e. that a Japanese outcome is a best-case scenario. Beside the unemployment which you address, there is also the debt problem. Japan was a net creditor, while the U.S. is a net debtor and that makes it vulnerable to a disorderly unwind.

      This whole house of cards was unsustainable from the word go. The fact that policy makers have enabled the accumulation of a mountain of private debt to maintain the status quo is both awe-inspiring in the resiliency of the system and frightening in the recklessness. It can’t give you a warm and fuzzy feeling about the likely outcomes as largely the same policy makers are still at the table.

      Because the status quo has been so tenacious – we seem to be back to business as usual already – I too think it is probable that only an economic disaster will force a change of course.

  4. DownSouth

    Edward Harrison said: “What I would like to see is economic thought leaders developing a blueprint of a financial crisis strategy which tackles both the immediate crisis issues (liquidity) and the structural, regulatory and monetary issues that create financial volatility (solvency).”

    It cannot and will not happen as things stand in America today.

    First, from a political perspective, as you allude to, the true constituency of the modern American politician is money. Until this changes, there is no hope for reform.

    Second, from an academic perspective, the academe now plays the same role that the Church played in the Ancien Régime. The path to research grants, publication in professional journals, tenure and Nobel Prizes is certainly not to be found in espousing genuinely subversive ideas. From Adam Smith to Milton Friedman, those things are only available to those who formulate theories that give greed and plunder the aura of respectability and lend it moral and intellectual legitimacy.

    However, as George Orwell observed, the efficaciousness of all this moral an intellectual whoremongering “fades away” if one can only see “the struggle of the gradually awakening common people against the lords of property and their hired liars and bumsuckers.”

  5. ARGeezer

    The core impediment to reform of the financial system is the capture of the Congress by “Wall Street”, as hammered on repeatedly by Simon Johnson. Former Senator Fritz Hollings, (D. S.C.), explained the problem in lurid detail in his book, MAKING GOVERNMENT WORK, and on Bill Moyers’ Journal on July 25, 2008. Hollings couldn’t find enough money in South Carolina to support a campaign, so he had to spend more time on Wall Street and in Hollywood than in South Carolina while fund raising. This is far from just Fritz Hollings’ problem.

    The average citizen, asked about public financing of political campaigns, responds: “I don’t want to pay for THAT!” The don’t realize that there is no shortage of wealthy individuals and corporations that are willing to pay, and that what they want in return is far more expensive to the average citizen than the total cost of federal elections. The policies that have led us to the current GFC were bought and paid for by Wall Street and this one instance has and will cost us many times the cost of every election ever conducted in the USA. So, congratulations, citizens of the USA, on your astute judgement.

    The Supreme Court will likely strike down any limitations on campaign contributions that are enacted, so the most viable approach is to simply unconditionally fund all candidates out of public funds up to the amount spent by the winning candidates in the previous campaign. If this sounds expensive, how does $10-20 Trillion sound? Were such a reform put in place then, in time, reasonable restrictions could be placed on private contributions.

    Such a reform would probably only come about, if ever, as a result of a political realignment and the emergence of a new political party. There may be scope for such a new party when the second dip occurs, but darker outcomes seem more probable.

  6. DownSouth


    Please forgive me if I keep harping on the academe and more specifically on economists. But the idea is certainly not original to me:

    There are without a doubt many highly principled economists, just like there are many highly principled preachers. However, it’s just that the whores garner all the media attention, all the accolades and are the ones that move up the professional ladder.

    I suppose it’s not all that much different from what we saw during the lead-up to and execution of the Iraq War. The smart and honest guys were banished from the air waves, while the hawks were given prime time billing with their cookie cutter theories and analyses, which have proven to be, with few exceptions, all but universally wrong.

    But of course it’s not entirely the economists’ fault that shit floats to the top in modern-day America.

  7. Francois T

    “Meanwhile, I have been informed that a number of well-connected people in the financial industry are considering backing my potential 2010 rival. I have had enough money problems on my plate due to healthcare targeting my district. *As I desperately need more money for my re-election campaign*, getting on the finance industry’s bad side is something I do not want to happen.”

    Therein lies the kernel of the whole problem. The very notion of democracy is twisted beyond recognition by this refusal of the very elected representatives to enact campaign finance reforms that would, at least, partially insulate them from the wishes of the biggest pockets in town.

    It’s all wonderful and far out to believe that, as a nation, we can always survive the next crisis just because we’ve survived the last one. Do we find this repetitive pattern of behavior so wonderful in the alcoholic who, after getting out of the hospital with liver problems, will drink binge 2 days later no matter what?

  8. Hugh

    So I guess the plan is re-election 2010. Depression in 2011. I think it is problematic to say that Obama missed an opportunity for reform when he was so plainly uninterested in reform in the first place. I agree with DownSouth that most economists are a waste of oxygen, but I have been thinking along lines similar to yours. It would be good to get some of the more aware, reality based ones together to address specifics.

    As for debt, the choices are inflation and default. I’m leaning much more to eventual default nowadays.

  9. anarkst

    “What I would like to see is economic thought leaders…”

    “Thought leaders,” how Orwellian can you get?

  10. Greg

    You dont need everyone to do fin reg, and you’ve already got everybody who matters: Geither/Summers, Frank and Dodd. The only possible spoliers is Shelby, but other than that bills will go to the floor by next summer….and who wants to be the guy who voted against reform?

    Listen to Frank here for a clear statement of what is liekly to happen.

  11. jest

    All hope was lost for reform when Geithner & Summers were anointed saviors of the universe.

    Do we really want “reform” from these two clowns? Even if we got our wish, it wouldn’t prevent the next disaster.

    A political purging might be required before we can get regulations that make any sense.

  12. Michael

    Keen’s analogy is very poor. It is actually difficult to understand since it treats medicine as a belief system when it isn’t.

    Medicine is based on evidence and science. These still have trends and fashions but when new evidence comes along it is adjusted to suit. Alternative medicine is not based on science or evidence. You would be right to ignore the advice of a quack as it is demonstrably not based on facts. His notion that procedures based on facts like ‘oxygen use’ would fall out of fashion is simply absurd.

    Economics isn’t evidence based science. All but the most trivial of economic systems are far too large and complex to perform double-blind trials for instance, even if they were practical. And even when you do have a result no science can provide any irrefutable answers to why.

  13. ftt

    To reduce the argument to the simplest.
    ‘They manage to reflate?’ or not. Will a reflation equate to another bubble or not? It is clear that ‘they’ hope so.
    I’ve been reading this site for three years, and never posted. I would like to say it is the most consistently informed site in the financial blogosphere. But it cannot determine the direction the economies take. It just comments acerbically. It snaps at the heels of the hounds… and I approve. Long may you/it continue.

  14. fergerst

    In terms of dealing with this financial crisis Bernanke was right but not for the reasons many believe. It is somewhat funny that people toss around comments he made about the printing press and a sufficiently determine government can all ways create inflation. Well, he is right and zimbabwe is proof. But folks that’s not going to happen here because the amount created via quantitative easing is minuscule compared to total credit.

    The thing Bernanke sufficiently solved was the impact of the credit shock caused by the financial sector being afraid to lend to each other – and rightfully so. Steve Keen on debtwatch has a wonderful piece called the “roving cavaliers of credit” (it was posted here and is how I discovered the guy). Which models depression like macro phenomenon as a result of a credit shock. Real beast to solve was the collapse of available credit. Without the special alphabet soup of facilities, the crisis would have been far more severe than it currently is. We could have potentially lived through something that made the great depression look like a recession. So now the question is the fed balance sheet.

    Let us assume that another crisis of this magnitude occurs 75 years from now. Yellen also believes 2% annually is the idea inflation rate. Let’s also assume 1% of that is used to reflate the fed. That means the Fed is down 50% on the assets taken on. One of the ways to restore a fed balance sheet is via inflation (or tax, I prefer inflation). Inflation in our future is guaranteed because we all hate tax. It’s not happening now cause we’re still on the backside of deflation wave.

    The conservatives balk at that, saying that’s equivalent to saying it’s ok to have 50% less purchasing power 30 years from now. The reason inflation is needed is to prevent hoarding of the money stock itself and to promote investment. We all know that it is possible to hoard a limited asset and create artificial value via scarcity. We got rid of the gold standard for it’s inflexibility. So if you decided to hoard money, well that’s not going to work out for you in the long run.

    Sometimes you need money and there is no one to extend you credit, what do you do? We’ve all played lender of last resort to family. In fact you don’t even earn interest or get the principle back on most cases.

    The world would exist without bernanke’s interventions but living in it would be far more painful. By avoiding some cataclysmic bank failures, which would have bankrupted the FDIC in one fell swoop. Which in turn would have caused us to go into debt anyway to restore insured accounts, our alternative just let the cards fall where they may, was Mayhem.

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