The repeal of a Depression-era banking law and the economic crash of 2008

The causes of the 2008 financial crisis are multiple and complicated. Minor deities of finance and even presidential candidates such as Bernie Sanders argue over whether the repeal of the longstanding GlassĀ­ Steagall Act laid the groundwork for the financial meltdown. Those who don’t think it did overlook one major unintended consequence of repealing Glass Steagall: the excessive use of leverage.

After the 1929 stock market crash and the onset of the Great Depression, Congress passed the iconic Glass-Steagall Act in 1933 to help ensure safer banking practices and restore faith in the financial system. Before the Great Depression, banks had engaged in imprudent stock speculation. In addition to their traditional staid banking services such as taking in deposits and making loans, they also used depositor’s funds to engage in high-stakes gambling on Wall Street.

The act was passed to halt a wave of bank failures and rein in the excesses that contributed to the 1929 Crash. Among other things, Glass-Steagall separated the more stable consumer-oriented commercial banking from riskier investment banking and set up the bank deposit insurance system to protect small savers against bank failures. The business of accepting deposits and making loans was to be kept separate from underwriting and peddling stocks, bonds, and other securities.

The movement to deregulate the American economy began in the 1970s. It spread to air travel, railroads, electric power, telephone service and other industries, including banking. The sustained bull market of the 1990s supported arguments that financial markets could regulate themselves, and bankers lobbied Congress to further emancipate the financial sector.

Citigroup forced Congress’s hand in 1998 when the firm announced it would join forces with the Traveler’s Group in a corporate merger. The $70 billion deal would bring together America’s second largest commercial bank with a sprawling financial conglomerate that offered banking, insurance, and brokerage services. The proposed transaction violated portions of the Glass-Steagall Act, but Citigroup obtained a temporary waiver, completed the merger, and then intensified the decades-old effort to repeal Glass-Steagall.

Just a year earlier, Travelers had become the country’s third largest brokerage house with its acquisition of the investment banking firm Salomon Brothers. Touting the pressures of technological change, diversification, globalization of the banking industry, and both individual and corporate customers’ desire for a “one-stop shop” -a financial supermarket- both firms lobbied hard for approval of the merger.

In 1999 a Republican Congress passed and a Democratic President signed the Gramm-Leach-Bliley Act, essentially repealing Glass-Steagall and removing regulatory barriers between commercial banks, investment banks, and insurers.

Advocates of the universal bank model argued that customers preferred to do all their business – life insurance, retail brokerage, retirement planning, checking accounts, mergers and acquisition advisory, underwriting, and commercial banking lending -with one financial institution.

The universal bank created an uphill battle for the major investment banks like Lehman Brothers and Bear Steams. For example, it was believed that the investment banking arms of universal banks would move into the lucrative securities underwriting business, using loans as bait to get the inside track on underwriting engagements, essentially using depositors’ money to drive investment banking fees.

As public companies, these investment banking firms faced pressure to deliver returns on equity comparable to that of the universal banks. To stay competitive,  they resorted to excessive leverage or borrowing to juice their returns.

In 2004 they received approval from the Securities Exchange Commission to increase their leverage from 12-1 to better than 30-1. The numbers were indeed worrisome. For instance, Bear Steams was leveraged 33 to 1 and before crashing in September 2008 Lehman Brothers had a 35 to 1 leverage ratio, meaning they borrowed 35 dollars for every dollar of capital.

By the winter of 2008, excessive leverage would ravage the investment banking industry, leading to the downfall, merger, or restructuring of all major investment bank firms and unleashing a global recession. And the American taxpayer would learn that free markets are not free.

Originally published: April 30, 2016

Free trade doesn’t work for most American workers

The aphorism “A rising tide lifts all boats” has become entwined with a basic assumption that free trade results in economic wins for all players in the global economy. Of course this assumes you are lucky enough to have a boat that has not run aground.

The classic case for free trade was made nearly 200 years ago by economist David Ricardo. This static argument relies on the principle of comparative advantage; that trade enables countries to specialize in goods and services they produce more efficiently than do their trading partners. This increases overall productivity and total output.

The conclusion follows from countries having different opportunity costs of producing tradeable goods. The opportunity cost of any good is the other goods that could have been produced by the same resources. Each country focuses on what it does best and everyone gains. This notion of free trade has a hallowed status among the cheerleaders for globalization.

Another way to understand comparative advantage is to consider the opportunity cost of undertaking a certain activity. Let’s assume that Lady Gaga, the famous entertainer, also happens to be a world-class typist. Rather than entertaining and typing, she should specialize in entertaining, where her comparative advantage is greatest and she could maximize her income.

In this example, Lady Gaga has a much higher opportunity cost of typing than does her secretary. If Lady Gaga spent an hour typing while the secretary spent the hour running the business, there would be a loss of overall output.

The real world is much more complex. Free trade has a downside: while its benefits are broadly distributed, costs are often concentrated. Consider the case of American textile workers. In the aggregate, American consumers gain by having access to cheap clothing, but unemployed textile workers bear the loss.

Many free trade cheerleaders confuse it with off shoring jobs, which is simply substituting, cheap foreign labor for more expensive American labor when nothing is in fact being traded. Moving production overseas has nothing to do with comparative advantage; it simply reflects wage and price competition from countries seeking jobs and economic growth.

If a firm shifts production to low-wage countries, its profits improve, driving up share prices and senior management performance bonuses. To paraphrase one-time presidential candidate Ross Perot: If you can build a factory overseas, pay about a dollar an hour, have little or no health care or retirement benefits and no environmental controls, then you are the greatest businessman in the world

But when many firms move overseas, American workers lose their incomes. So when do the costs of lower incomes resulting from job losses and government revenues exceed the benefits to consumers of lower prices? Put differently, do the costs of exporting good-paying American jobs outweigh gains from cheaper imports and contribute to a shrinking middle class.

Free trade advocates contend that the Americans left unemployed have acquired new skills and will find better jobs in “sunrise” industries. In reality, how many steelworkers do you know who have become computer software engineers?

This is one reason why Americans’ real incomes have stopped growing as manufacturing jobs have been moved offshore.

As then-presidential candidate Barack Obama said in 2008, “You go into these small towns in Pennsylvania and like a lot of small towns in the Midwest, the jobs have been gone now for over 25 years and nothing’s replaced them. And it’s not surprising, then they get bitter, they cling to guns, or religion or antipathy to people who aren’t like them or anti-immigrant sentiment or antitrade sentiment to explain their frustrations.”

A former General Motors CEO allegedly said “what is good for GM is good for America.” But offshoring challenges the conventional wisdom that American firms generally advance the nation’s economic interests. When they employ a large foreign workforce but few people within the United States, it certainly is good for the firms, but not for the American worker.

Originally Published: April 16, 2016.

Trump and Sanders may be right: Free trade is costing U.S. too much

Opposing so-called free trade deals has been an important part of the rhetoric of presidential candidates in both parties, especially polar opposites Donald Trump and Bernie Sanders. They blame free trade for the loss of American jobs, the decline in workers’ real wages, increased income inequality, and a shrinking middle class.

From their opposing ends of the political spectrum, Sanders and Trump have ignited an important debate about just who benefits from free trade. Sanders criticizes free trade as a proxy for corporate greed, while Trump says such deals serve politicians who put the interests of corporate contributors over those of ordinary Americans. Both candidates roll out the full Monty of free trade criticisms and argue that the U.S. needs to be smarter about sustaining a global trading order that supports America’s workers and economic interests rather than playing the victim for trading partners who steal jobs and play by rules that don’t reflect American social and environmental values.

They are fed up with being out-traded and out-negotiated in deals that are the serial killers of American jobs. They believe other countries engage in managed trade, not free trade, and play the game in a way that produces trade surpluses for them and fewer lost jobs for the U.S .

Opposition to free trade is a major vote getter; a way to leverage voter anger and bond with ordinary Americans. In some parts of the country, it has served as an organizing principle in a deeply divided electorate.

The typical American family saw its wealth decline significantly in the wake of the Great Recession and many voters have begun to question the fairness and adequacy of past trade policies. Deals such as the 1994 North America Free Trade Agreement (NAFTA) have been blamed for massive job losses.

Barack Obama repeatedly criticized NAFTA during the 2008 Democratic primary battle, noting that “we can’t keep passing unfair trade deals like NAFTA that put special interests over workers’ interests.” Trump and Sanders, hoping to win support from working class voters who are not fans of globalization, fervently oppose the ambitious 12-member Trans-Pacific Partnership pact the president supports.

Manufacturing’s contribution to U.S. employment has fallen steadily for more than half a century. Over the last 20 years, tens of thousands of factories have closed and many have moved to lower wage countries like Mexico, China and Vietnam. The sword of additional plant closings hangs over the heads of workers as companies pursue the classic go-to move of chasing cheaper labor.

Both Trump and Sanders cite the Carrier Corp.’s recent announcement that it will close its Indianapolis manufacturing plant and move all 1,400 jobs to Mexico. The move comes after the company was awarded $5.1 million in taxpayer money in 2013 under the Clean Energy Tax Credit Program. The funds were supposed to be used to “expand production at its Indianapolis facility to meet increasing demand for its eco-friendly condensing gas furnace product line.” Carrier says it has not received the money and will not claim it despite having been awarded the funds.

Carrier is another example of how low-wage countries can raise their living standards and impoverish American workers by importing American jobs and industries. You could argue that Carrier and other firms are really engaging in the exploitation of cheap labor, a form of economic arbitrage rather than trade, but this would not accrue to the political advantage politicians pursue.

While Carrier’s move will in theory reduce the cost of its products in the U.S., who will compensate the 1,400 workers losing their jobs or the community’s tax base? Is it any wonder that large numbers of voters prefer protecting domestic jobs from low-wage countries over lower prices for consumer goods?

To hold the line, Trump and Sanders contend it is time to rethink free trade and advocate for quotas and tariffs that protect and defend American interests and values rather than those of special interests such as multi-national corporations. On that issue they may have a point.

Originally Published: April 2, 2016