FIXING THE ECONOMY tools for a new economy Proposals for a financial regulatory system Robert Pollin he collapse of the housing bubble ing families. Banks created opportunities and the speculative market for sub- for families with less-than-stellar credit Tprime mortgages demonstrates, records to obtain mortgages and buy their yet again, the simple point that financial own homes. By bundling thousands of markets need tight regulation. Since Sep- mortgages into securities that were freely tember 2008 a series of massive bailouts traded on global financial markets, banks by the U.S. Treasury and Federal Reserve enabled subprime borrowers to purchase have prevented financial markets from ex- houses that would otherwise have been periencing a1929-style collapse. These ex- off limits. This kind of financial engineer- treme measures, however, have not solved ing, operating on a global scale, could not ENZO R the broader problems at hand. As of this O have been possible under the Glass-Stea- L _ S writing, we are experiencing the most se- O gall system. vere economic downturn since the 1930s. arl The idea behind bundling mortgages American politicians—Democrats into marketable securities is that the local and Republicans alike—began deregu- .COM/C bank or S&L that lends you money to buy kr lating the U.S. financial system in the IC a home does not hold onto your loan once L 1970s. Their premise was that regula- you get your money. Rather, it sells your tions devised during the 1930s—specifi- loan to a big financial institution, such as ENZO / F R cally the Glass-Steagall system, which O the government-sponsored Fannie Mae L S defined separate spheres for commercial O or Freddie Mac, which, in turn, bundles arl and investment banks—would hinder C thousands of individual mortgages into the effective workings of contemporary securities. Fannie or Freddie then sells financial markets. The 2001 Economic specializing in finance—disintegrated in Similar regulations were imposed on these mortgage-backed securities to banks, Report of the President, Bill Clinton’s last, that crisis, requiring a $4 billion bailout Savings & Loans (S&Ls) in 1932, and hedge funds, and other market players. unequivocally dismissed Glass-Steagall: from other Wall Street firms to prevent continued to operate through the 1970s. With thousands of mortgages packaged “Given the massive financial instabil- a market meltdown. In particular, under the old regulatory re- into one security, the dangers of lending ity of the 1930s, narrowing the range of The most severe crash of an over- gime, mortgage loans in the United States to higher-risk borrowers are supposed to banks’ activities was arguably important wrought financial market, the 1929 Wall could be issued only by S&Ls and related decline; within a large portfolio of mort- for that day and age. But those rules are Street crash, produced an economic ca- institutions. The government regulated gages, the losses lenders incur from the not needed today.” lamity, which led in turn to a collapse of the rates S&Ls could charge on mort- small share of delinquent borrowers are The chorus of politicians and econo- the U.S. banking system. Between 1929 gages, and the S&Ls were prohibited from offset by the much larger proportion of mists who for a generation advocated and 1933, nearly 40 percent of the na- holding highly speculative assets in their borrowers in good standing. financial deregulation were right about tion’s banks disappeared. In their wake, portfolios. Market players became convinced one thing: the financial system has be- Roosevelt’s New Deal government put But even during the New Deal years that “securitizing” loans made subprime come infinitely more complex since the in place an extensive system of financial themselves, financial-market titans were mortgage lending a much safer bet. For a 1930s. Something that had been as sim- regulations, many of which persisted already fighting to eliminate or at least time, optimistic expectations became self- ple as a local Savings & Loan making a beyond the conclusion of the Great De- defang the regulations. Since the 1970s, fulfilling. Money rapidly flowed into the home mortgage in their community— market. Housing prices rose, seemingly recall Jimmy Stewart in It’s a Wonderful creating wealth out of thin air for home- Life—is now part of a speculative global owners. Market bulls grew rich while bears market. The old regulations had indeed These proposals need not make the seemed out-of-step. Loan officers earned become outmoded, but it never followed handsome commissions by bringing new that financial markets should operate economy less innovative. The dynamism of customers to their banks. These officers unregulated. had large incentives to approve subprime The historical record makes this clear. a leashed financial market would emerge in mortgages—they did not have to return In the classic text Manias, Panics and their commissions years later when, for Crashes, Charles Kindleberger called fi- the way credit moves into productive areas. example, the loans, now held by a Swiss nancial crises a “hardy perennial” within hedge fund, went sour. the context of unregulated financial sys- The logic here is deeply flawed.M arket tems. He documented that, from 1725 pression. The most important initiative they have almost always gotten their way. players believed that the riskiness of sub- onward, financial crises have occurred was the 1933 Glass-Steagall Act, or, as This led cumulatively to the dismantling prime mortgages would diminish when throughout the Western capitalist econo- it is officially known, the Banking Act. of Glass-Steagall. The final nail in the cof- pooled. In fact, the opposite turned out mies at an average rate of about one every Commercial banks were limited to the fin came in 1999 when President Clinton to be true. The fortunes of most subprime eight and half years. relatively humdrum tasks of accepting signed the Financial Services Moderniza- borrowers rose and fell together with the There is an awful lot about the cur- deposits, managing checking accounts, tion Act. He did so with the strong sup- housing market’s boom and bust. In the rent financial crisis that is familiar. In and making business loans. Commercial port of then-Senator Phil Gramm, later a bust, the problems borrowers faced in 2001 the the U.S. stock market crashed banks would also be monitored by the top advisor to John McCain’s Presidential meeting monthly payments became per- after having been driven during the late newly formed Federal Deposit Insurance campaign; then-Federal Reserve Chair vasive, not limited to isolated cases. This 1990s to unprecedented levels of specula- Corporation (FDIC), which provided Alan Greenspan; and top advisors Rob- is why major financial institutions such tive frenzy by the dot-com boom. A global government-sponsored deposit insur- ert Rubin and Lawrence Summers, both as Citigroup, Merrill Lynch, and Bear financial crisis originated in East Asia in ance for the banks in exchange for close of whom would later counsel the Obama Stearns, which were holding huge pools 1997-98 and spread rapidly. The sure- government scrutiny of their activities. campaign and transition team. of subprime mortgages, experienced un- thing investment then was securities mar- Investment banks, by contrast, could While the current crisis resembles its precedented losses in 2007, setting off the kets in developing countries. The U.S. freely invest their clients’ money on Wall predecessors in many ways, it also has some collapse of U.S. financial markets.T oday’s hedge fund Long Term Capital Man- Street and undertake other high-risk ac- novel characteristics. Its most prominent crisis is thus the direct consequence of the agement—its board of directors guided tivities, but they had to steer clear of the distinction is that it has resulted from ac- generation-long project of deregulating by two Nobel Prize–winning economists commercial banks. tivities that were supposed to benefit work- financial markets. 10 B O S T O N R E V IE W tools for a new economy e need a new regulatory framework percent, and a tax on a fifty-year bond, 0.5 I propose the reverse: accountable and em- labor, consumer, and community repre- Wthat is capable of both stabilizing percent. The tax would be adjusted on a powered district banks. sentatives. markets and, correspondingly, channel- comparable basis for derivative financial When the Federal Reserve system was Strengthening the Fed’s policy toolkit ing financial resources toward productive instruments, such as options, futures, and formed in 1913, the twelve district banks is a third crucial component of any plan to and socially useful investments and away credit swaps. Brokers would be responsible were supposed to disperse the central increase democratic accountability. Spe- from the speculative casino. What follows for collecting the tax from the sellers at the bank’s authority broadly and respond to cifically, theF ed must be able to promote is a series of proposals to guide the new time of sale. regional needs. This remains a valuable the channeling of credit to productive pur- framework. They offer a decisive break Since the IRS already imposes trade- idea, but it has never been seriously imple- poses over speculation. Without this tool, from the deregulatory agenda of the past reporting requirements, a securities trade mented. Bank presidents are currently ap- extending democracy within the institu- generation, yet they are all feasible within tax would entail little additional admin- pointed by the banks’ boards of directors. tion will be largely symbolic. the existing set of political and regula- istrative apparatus. Nor would it have a These are businesspeople, mostly com- A system of “asset reserve require- tory institutions.