Economists, Liquidity Mongers and the Banker Assault on Financial Reform

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Yves here. I’m posting a Real News interview with Gerry Epstein on the same theme, that of the dubious arguments and methods bankers are putting forward to stymie reforms, at the end of this post. If you have time, I’d suggest watching that as well as reading this post, since they don’t overlap much. Otherwise, pick your preferred medium!

By Gerry Epstein, Professor of Economics and a founding Co-Director of the Political Economy Research Institute (PERI) at the University of Massachusetts, Amherst. Cross posted from TripleCrisis

This has been a bad stretch for advocates of financial reform – and therefore for the economy as a whole. One after the other, new financial regulations contained in the Dodd-Frank law are being gutted or delayed by regulators and Congress, while the bankers – escorted by a phalanx of paid economists, lawyers and lobbyists – are squealing “wee, wee, wee” all the way home.

Bankers and their lobbyists and economists help grease the skids not just with money – but with terms of “econ-speak” such as “cost-benefit analysis”, and most commonly, “liquidity”. Used and manipulated by the wrong hands, such boring and innocuous sounding concepts can turn dangerous, even fatal in the banker battle against safer financial regulation.

The list of delays, loopholes and obstacles is too long to fully recount, but here are a few of the most important.

First, the Federal Reserve Board decided to delay by two years the implementation of the so-called Volcker Rule which was one of the stronger measures in the Dodd-Frank financial reform legislation that was signed into Law in July, 2010.While the regulators had been given the option for such a delay in the original Dodd-Frank legislation, the deed was done by the relentless lobbying by bankers that first filled the original Volcker rule with massive amounts of wiggle room and devilish complications, and then, over the next year made the rule more and more complex by filling it with even more loopholes and obscure language. Then – like the Republicans who cut taxes to bloat the deficit and then say the budget needs to be cut because the deficit is too large – the bankers demanded to “delay” the Volcker rule on the grounds that it is too complex.

A second set of potentially powerful Dodd –Frank rules – to bring unregulated derivatives, including credit default swaps (CDS) that were at the root of the financial meltdown as well as those that are used to speculate on commodities such as oil and food under oversight and regulation – are now being massively watered down. The Securities and Exchange Commission (SEC) and Commodities Futures Trading Commission (CFTC) are raising the “limbo” bar of regulation to a whopping $8 billion average worth of derivates each year, a figure so high that massive energy and financial speculators can easily slither underneath without being subject to serious regulation. The original maximum exception level proposed by regulators in 2010 was $100 million. Only an estimated 30% of traders would have made it under that bar; with the $8 billion threshold, an estimated 85% of the traders will go un-regulated, at least for the next five years.

Third, many of these exemptions and loopholes are dramatically extended in a bill before the House of representatives this week: HR 3336 entitled “The Small Business Credit Availability Act” which has nothing to do with credit to small business, but everything to do with exempting major energy companies like Koch Trading from oversight under the derivatives rules, virtually destroying any chance of derivatives regulation in the already weakened Dodd-Frank Law.

When the banks have not been able to kill or delay bills by stuffing them full of loopholes, as with the Volcker Rule and the rules governing regulations of derivatives, they have gone to court to block the implementation of the legislation. Perhaps most egregiously, the Securities Industry and Financial Markets Association (SIFMA) and the International swaps and Derivatives Association (ISDA) brought a lawsuit to block the implementation of “position limits” mandated by the Dodd-Frank Act to limit speculation in commodities such as food and oil.

The bankers and traders claim that the CFTC must do an extremely costly and time-consuming “cost-benefit” analysis to prove that the regulations will not do more harm than good. Lawmakers such as Carl Levin and analysts argue that in writing the law, Congress already determined that the benefits to society of limiting this destructive speculation outweighs the costs in terms of forgone profits by traders and speculators. The idea of subjecting each regulation to a “cost-benefit” analysis is being used as a tool to stymie the implementation of regulations of the egregious practices of corporations.

It presumes, of course, that the default option should be the unregulated market. Instead, with many presumably dangerous practices –such as the marketing of dangerous financial products – a more sensible default option may be strict controls unless the financial instruments can be shown to be safe and useful: a financial precautionary principle.

But perhaps the most over-used economics term, and most pervasive economic scare tactic, used to fight financial reform is the term “liquidity”. Bankers doing battle against Dodd-Frank routinely get economists – some of them quite prestigious such as Stanford’s Darrell Duffie – to write papers claiming that regulations such as the Volcker Rule prohibitions on proprietary trading will reduce the ability of banks to act as “market makers”, thereby reducing “liquidity” in financial markets. This, Duffie and other economists such as those at the ubiquitous consulting firm Oliver Wyman say, will harm pension funds, corporate borrowers, and governments who will find their costs of borrowing increasing.

Duffie and Wyman economists admit that the Volcker Rule, in fact, has a massive exception to its ban on proprietary trading allowing for banks to hold plentiful inventories of securities that will allow them to “make markets” and provide plenty of liquidity. They simply claim that banks will be afraid that the regulators will penalize them if they cross the line into proprietary trading. Oh yes: bankers are known as shrinking violets who quiver at the thought of straying over a line where a regulator might slap their wrists. This banker timidity will surely cause liquidity to dry up.

To prove their point about the dangers of dry liquidity, Duffie and Wyman almost laughably cite data from the great financial crisis of 208 – 2009 where liquidity did dry up and yes: this was very costly. But they fail to mention that a major reason the illiquidity crisis occurred was that the banks engaged in massively dangerous proprietary trading that crashed the system in the first place, and at the first sign of trouble, instead of providing liquidity to their customers, the banks massively withdrew liquidity from the system and dumped assets just as fast as they could.

And we can be certain that if the banks’ proprietary trading is not controlled by a robust Volcker Rule of some type, the next time around, these banks will again generate massive cycles by providing excessive liquidity to the system so they can speculate and trade on complex and opaque bets during the upswing. Then, when these crash the system, they will destroy the liquidity before their customers can get their hands on it by dumping securities into the market just as fast as they can. Do these economists really not understand this?

Some economists do. Find them at“>Americans for Financial Reform, Better Markets, SAFER, and Finance Watch among other places.

More at The Real News

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  1. F. Beard

    Then – like the Republicans who cut taxes to bloat the deficit and then say the budget needs to be cut because the deficit is too large – Gerry Epstein

    Call their bluff. Federal borrowing is corporate welfare:

    The US government issues its own currency and, in intrinsic terms, never needs to fund its own spending in US dollars. The issuing of public debt is an entirely voluntary act by the US government and provides the bond markets with “corporate welfare”. Just imagine what the uproar would be from the bond markets and investment banks if the US government announced it was cutting off this source of corporate welfare.

    It happened in 2001 in Australia when the Australian government had virtually caused the official bond markets to dry up when it used the surpluses it was running to run down outstanding debt. The Sydney Futures Exchange led the charge and demanded that the Government continue issuing debt, which gave the game way – if debt-issuance was to fund net government spending (deficits) then why would they be issuing debt when they were running surpluses? from [emphasis added]

    1. Susan the other

      How does this work with exports v imports? Corporations can export less than they and retailers import and who pays? Conversely our off-shored corporations can export a bunch of stuff to us that we cannot absorb by our own exports. And So there is a deficit accrued to us.

      1. F. Beard

        And So there is a deficit accrued to us. Susan the other

        Yes, but there is no need to pay interest on that deficit.

  2. Conscience of a Conservative

    The big banks simply cannot support their infrastructure on plain vanilla services, and would much rather trade and profit off of government programs while taking the implicit and explicit federal subsidies. And if they have to spend a few hundred milion to protect their right to maintain that business model, so be it.

    1. Conscience of Foodstamps

      The Pentagon’s nearly unprecedented, wildly irrational spending binge perhaps?
      Gov’mint welfare program recipients (in billions): CACI, L3, Halliburton, Bechtel, Northrup, Lockheed, so forth and so on.

  3. lifeafterdebt

    Exactly the same is happening in the UK. Cameron tells us banking reform is on its way and then we hear its not until 2019. Next its being watered down again and again because the banks are using scare tactics by insisting regulation will make the economy worse. The reality is we are in a global economic recession because the banks were given a free reign and chose abused it with greed driven strategies which lined their pockets and the expense of the individual and the global economy. If my personal case is anything to by regulators will continue to favour the banks until the courts make them do otherwise. A prime example of this is PPI miss selling, which, after years of fighting, is finally being addressed. The banks tried to overturn this ruling time and again but have finally been forced to cough up in full. This single scandal is estimated to be costing UK banks 7bn in compensation. There are more and more individuals standing up to the banks riding rough shod over us but its time our governments stopped paying lipservice to these errant institutions and insisted on proper reform immediately and not leave to the 99% to mae all the running. banks

      1. JEHR

        Thank you, Mansoor H. Khan, for giving the public all of these important links. I hope everyone will be educated eventually about the monetary system.

    1. LeonovaBalletRusse

      Now they’re trying to discredit Mervyn King into oblivion. He ain’t in the Club no more?

  4. craazyman

    Economics in Action

    let’s say I live up the creek from my neighbor, If I pee in the creek rather than on the tree, that adds to his liquidiy!

    If I go to the pub and have about 7 beers and have to pee, if I pee back into the keg, that adds to liquidity!

    So now I wash my pigs and chickens, why put the muddy runoff in a ditch? wouldn’t want to be chincy with liquidity! har har

    see how easy this is! I bet everybody has some liquidity they’re keeping to themselves. Maybe best to consult a financial economista, like a barista, and get some advice about how to share your liquidity with your neighbor. hahah

  5. Dan Lynch

    If you can’t regulate them, then tax them.

    Beowolf has pointed out that the Fed has the authority to levy a “fee” on financial transactions. Hence the Fed could unilaterlly impose a stiff FTT to dampen speculation.

    Of course the financial sector would scream bloody murder. Good ! Say, “if you agree to regulations, we might be willing to consider lowering (not eliminating) the FTT.”

    That’s what I would do. But then, I’m not owned by the 1%.

    1. Stanley Grinch

      Your link is an unsubtaintiated critique – nothing wrong with that in of itself. Correction – the tea party was quickly co-opted by “Wall Street”. Whom was/is threatened the most wtih cramdown for millions of underwater homeowners?

      1. beowulf

        “Your link is an unsubstantiated critique..”

        “The services which shall be covered by the schedule of fees under subsection (a) of this section are—
        (1) currency and coin services;
        (2) check clearing and collection services;
        (3) wire transfer services;
        (4) automated clearinghouse services;
        (5) settlement services;
        (6) securities safekeeping services;
        (7) Federal Reserve float; and
        (8) any new services which the Federal Reserve System offers, including but not limited to payment services to effectuate the electronic transfer of funds.”

        “In 2009, DTC settled transactions worth more than $299 trillion, and processed 299.5 million book-entry deliveries. In addition to settlement services, DTC brings efficiency to the securities industry by retaining custody of more than 3.5 million securities issues worth almost $34 trillion, including securities issued in the US and more than 120 foreign countries and territories… DTC is a member of the U.S. Federal Reserve System”.

        1. Sammy

          Well that was substantial. (?) The circular argument is that if regulation fails, then taxation should be used. Free reign tempered by taxation, has that ever worked before?

        2. LeonovaBalletRusse

          b, thanks. The “fee rackets” are between the lines, and all co-conspirators must be getting something out of it, including the IRS. How else is a fee considered a “capital gain” in the real world? We’re not even talking the “carry trade” grift.

          Follow the money and the DNA, over generations. It’s “family.” Bring RICO.

    2. Gangsters

      Occupy is on the ground squaring off against increasingly miliarized police forces sent to take houses. Is that up to snuff? This is taboo for the US Press, if they ever honestly covered the foreclosure crisis, it is now reported even less.

      1. Mic Check 2012

        When the people say Obama, the people say Bank of America, Wells Fargo, Citigroup, JPMorgan Chase, Ally Financial

          1. LeonovaBalletRusse

            Bank Obamerica. NC has the Marines and other high-value/power M-I content, Research Triangle Park “for God and cuntry” in a fascist fix, they have Confederate Nobility ranches holding White Trash captive, with Uncle Toms aplenty in tow, they have Amway Nuremberg rallies to generate hope and greed, and they have Bank of America headquartered in The South, to finally put “those Yankee Jews” to shame when it comes to “wealth creation.”

            This is waaay better than ham hocks, grits, and Hoppin John. Now they have their Uncle Tom C.21, “Bank Obamerica,” on a leash “in his place.” NO American descendant of slaves who had risen to the Presidency could have so little dignity. His wife, a descendant of slaves, has sold them both down the river, for the Massah’s gold. The “Angola Plantation Penitentiary” should become their final place for repentance. For shame. Bring RICO. Justice.

    3. digi_owl

      And the standard banker/CEO response to that, “lets take our business elsewhere”.

      It is the same old story that has been doing the rounds in Europe regarding the so called Tobin tax.

      Unless the world plays ball, or basically dismantle cross border trade deregulations (also known as globalization), this will be a race to the regulatory bottom.

      This in much the same way as how the US corporations played the various states against each other until a couple basically threw out all corporate regulations.

      1. Lambert Strether

        If the tapeworm in my stomach said “I’ll take my business elsewhere,” I’d say “Yeah, in a heartbeat!” Or a peristaltic contraction, as the case may be.

        1. digi_owl

          Except that thanks to the liquidity claim and similar, the politicians (economically educated or not) will likely see this more like the medicine killing the patient than getting rid of some parasite.

          Our main issue is that economics, at least the kind running the show at the moment, i seen as a objective science on par with physics. But it is more on par with a religion masking as a science. Until the science image is broken the bankers and such can parade one pedigree economist after another in front of the politicians.

  6. sissy

    You wash your pigs and chickens crazzyman? That’s hysterical, I don’t even wash my cats. It’s business as usual for Obama and it will always be business as usual. He’s a sell out, that’s all. It really disgusts me who he has turned out to be, yet the real rulers of the world, as Matt Stoller calls them are holding Obama by the puppet strings and he’s such a coward.

    1. Lambert Strether

      Obama’s not a coward, or weak. That meme really needs to die. He believes deeply in what he’s doing; all you have to is watch who he insults, and where the money goes. The rest is projection.

      Adding… One reason the “weak” meme needs to be tied up and then buried with a stake through its heart and plenty of garlic is the implication: That there is some one person out there, who is “strong” and “good” who is going to, oh, improve matters, or act as if “public purpose” were meaningful to them. Empirically, that’s not so: Look at the leadership of both legacy parties; look at the candidates.* And since “strong” is the rhetorical flip side of “weak,” be careful what you (implicitly) wish for: The “strong man” in Latin America, Africa, and other second- and third-world countries makes elite impunity open and explicit. The only strength comes from we ourselves and truly democratic processes. Yeah, FDR would be nice, but FDR had a lot of help being FDR.

      NOTE * Warren me no Warrens. When Warren says something about putting banksters in jail, we can take her seriously. And the whole “middle class” thing: What middle?

      1. chitown2020

        Sorry, but we have all been had. Again, we are looking for some Politician to fix the manufactured problems that were allowed by the Politicians. The Politicians are corrupt traitors who are not going to save America. Only we can change the course we are all on.

  7. digi_owl

    What is really ugly about all this is how brazenly they behave. Like nothing can touch them in any way what so ever.

  8. Tim

    The one regulatory initiative no one is talking about are the problems implementing so called FATCA rules(at least in the US yet). This piece of legislation WILL bring Obama down largely because the people who oppose its outside the of the US tend to be largely on the left such as Canadian NDP. FATCA will be the October suprise if the G20 doesn’t gang up on Obama in June.

  9. Glen

    That title on the RNN video needs to be changed from “President Obama Talks To Paul Volcker” to “President Obama Uses Paul Volcker For Votes Prior To Sucking Wall St Cock”

  10. Susan the other

    It’s hard going from balanced books to free-floating books. But it could work if it were paced. When you can successfully pretend you have enough money to survive all shocks, you are cool; you do in fact survive them with a little help from creative accounting which uses procrastination with impeccable finesse. Impeccable here meaning deadly complex and boring. Even when in truth the banks really don’t have any “money” to claim. Our banks are unabashed however. THey claim “positions” on commodities futures with abandon… that is, on “positions” way beyond a marketable pace. The regulation of this frenzy, banks say, interferes in their god-given right to do their proprietary trades which are impossible to de-link from the rest of their “banking.”

    But in order to protect the engine from flooding we really have to do some kind of real-time accounting – for the sake of trust. Just a minimum: Control capital flows to match the true real-time growth of any economy (Ann Pettifor); control the creation of credit, i.e. no shadow banking in CDS; and therefore keep interest rates very low – no unconscionable usury and double standard credit allocation.

    Forget Capital. Liquidity can replace morality, politics, best-guess accounting, and sanity. But that isn’t a productive use of liquidity, aka taxes.

  11. Phichibe

    I was a doctoral candidate at Stanford when Duffie got his tenure (different departments, I was in Decision Sciences, Duffie was a Finance prof) back in the late 80s. I’m familiar with his work. It is the mathematical equivalent of TNT. The details are fairly recondite (martingale calculus, stochastic control) but here is the bottom line: this stuff works brilliantly until it doesn’t, then it causes events like LTCM and the 2008-2009 implosion. Robert Merton got a Nobel prize for pioneering the details, and he was a founder of LTCM (along with Myron Scholes, another prize winner). That alone should tell you all you need to know about the inherent danger of this type of finance.

    As it happens, the fact that the martingale models work so well most of the time only encourages the financiers to increase their leverage. Then a 12 sigma event occurs (the words of John Merriweather, managing partner of LTCM, describing the Russian bond defaults in 1998 that triggered LTCM’s collapse) and there is no safety margin in the system: a 3% decline in value wipes out equity, and the regulatory authorities are confronted with a Hobson’s choice of bailing the financiers out and saving the broader economy or letting them fail and taking the rest of us with them.

    THis is IMHO the great underreported story of the financial debacle(s) of the last 15 years, and we have yet to learn the lesson. Men like Duffie make enormous consulting fees to quant hedge funds, yet are still quoted as disinterested experts by reporters like Louise Story of the NY Times. The worst part of what happened in 2008-9 was that we were forwarned by the example of LTCM and yet the financial deregulation continued apace in the last years of the Clinton administration, and of course accelerated under W.

    As for improved liquidity, the ultimate utility of a financial innovation is the growth of the broader economy. By this measure the improved liquidity due to Black-Scholes/martingale finance has been a complete bust. The glory years of the US economy were in the 1950s-1960s, when there were not the mathematics to do this let alone the computers to run the necessary algorithms to exploit such mathematics. Paul Volker has said for the record that the last financial innovation to be socially useful was the automatic teller machine, and Volker’s credibility on financial matters is, or at least should be, second to none.

    PS: A note to F. Beard. I hate the ad hominem level of criticism to which Internet discussions quickly descends, and I hope this is not taken as such, but on almost every discussion of finance on NC, you add numerous comments descrying debt qua debt and cite scriptural authority for this, along with a number of policy prescriptions that, whatever their moral merits, have absolutely no chance of being implemented in anything approaching the real world. Debt and credit are concomitants of modern economies; if you abolish them, you’ll only have to re-invent them under different names.

    Before credit was widely available to the mass of consumers, capital-intensive purchases where deferred until the would-be purchaser had saved up the purchase price. In your credit/debt free world, what would substitute for this? I have no doubt that your positions are sincere and well-intentioned, but I’m afraid that so far I see nothing that you have advocated (up to and including the idea posted above that governments do not need to pay interest on borrowings) that is not Panglossian. I would welcome a fairer and more equitable financial system, but until more practicable reforms are proposed I fear I must fall back on the final thoughts of Candide on the speculations of Dr. Pangloss: That may well be true, but now we must go work in our garden (not exact quote, but you get the drift).

    Best wishes….


    1. Mansoor H. Khan

      Phichibe said,

      “In your credit/debt free world, what would substitute for this? ”

      There are always two ways of financing anything. Debt or Equity.

      F. Beard is not proposing the debt be eliminated. He is simply proposing that currency should not be issued as debt (lent into existence) but only as equity (spent into existence). Once spent into existence the currency can then be lended or re-lended but the lending of it should never be government insured.

      mansoor h. khan

    2. F. Beard

      In your credit/debt free world, what would substitute for this? Phichibe

      The reforms I advocate would:

      1) Abolish all new credit creation. Genuine loans of existing money could still be made.

      2) Replace ALL credit-debt with legal tender by bailing out the entire population equally at a rate just equal to the repayment of existing debt till all credit-debt is paid off.

      The above would allow a smooth transition to 100% reserve lending with plenty of existing money to lend. New fiat spent into existence would allow for interest to be paid. The use of genuine private currencies for private debts only would add additional liquidity.

      It’s certainly doable and it’s not like we have much of a choice but reform. The last Great Depression was a (the?) major cause of WW II.

    3. F. Beard

      Debt and credit are concomitants of modern economies; if you abolish them, you’ll only have to re-invent them under different names. Phichibe

      First, I don’t advocate that the lending of existing money be banned though all government privilege for it should be abolished. Credit creation should be banned though since it is a form of counterfeiting.

      Second, common stock spent, not lent, into existence would allow the necessary consolidation of real capital for economies of scale without the need for borrowing.

    4. JurisV

      Much appreciateed your 5-Star comment on Duffie. Plus you included the bonus features of “recondite” and a reference to “Candide.” A truly rare treat in comments on the blogosphere.

      I knew nothing of Duffie until this comment and I had to go to Google to look up his bio. I am shocked that one of his areas of “expertise” is credit risk! After the explosive growth of private credit from 1970 to 2008, with the subsequent crash, I am surprised that he didn’t predict the implosion and work to prevent it.

      Private credit creation — Maybe I’m not very clever, but I am surprised that in all the worry and talk about Government deficits and debt, there is no parallel alarm and discussion over the MUCH larger risk of private credit creation. Especially since Keynes, Irving Fisher, Josef Schumpeter, Hyman Minsky, and a host of others (including Keen, Bezemer, Stiglitz) have trumpeted the risk of too much private sector credit for over a hundred years. They all have said that a small amount is very valuable for the overall economy, any more is harmful, and even more will lead to catastrophe. We wound up well into the “catastrophe” regime in 2007. I feel like I’m missing something important — why the lack of general discussion about excessive private credit creation from so-called credit-risk experts like Prof Duffie?

      1. JurisV

        I just looked outside and realized that I need to get off the blog world, and the all of its word-salads sprinkled with a few flecks of genuine understanding — and get outside and tend to my garden…….

    5. F. Beard

      but I’m afraid that so far I see nothing that you have advocated (up to and including the idea posted above that governments do not need to pay interest on borrowings) that is not Panglossian. Phichibe

      Since the debt of a monetary sovereign is ITSELF a form of money then it serves no purpose as far as preventing or delaying price inflation. In theory, it is even worse since interest must be created and paid on the debt whereas fiat pays no interest.

    6. F. Beard

      I see nothing that you have advocated (up to and including the idea posted above that governments do not need to pay interest on borrowings) that is not Panglossian. Phichibe

      Be specific, please. Maybe I’ll hear something new.

  12. sheri

    The federal reserve is pretty much done. A new financial system is about to go online. Democrats and Republicans are all the same.
    They both are bought out…
    Hopefully, President Obama is not one of those. I pray that his earlier objectives have changed due to the fact there were horrid people running this country before.
    Go to Youtube. Lord Blackheath spells in out 2/2012.
    That is why I know there is a new financial system. It will be nice to hear the real news again.

    President Obama, thank you for all of your hard work, and I pray for your safety.

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