Returns Without Risk - The Republicans Vision of Banking Reform And How It Makes Recessions Worse

Matt Yglesias at Vox reports on the extent to which Republicans are changing laws to profit them and their donors. In the midst of this list he reports on something hugely important.

Banks - or more broadly, the financial system that creates credit - are essential to an economy. If credit markets suddenly collapse, they bring down the economy with them.

Once upon a time, a bank would fail and the folks with deposits in that bank would lose all their money. Folks with money in other banks would panic and make a run on their bank to withdraw deposits. That could quickly put that bank under. And then more people would make a run on their bank to withdraw their money. And on it would go until the economy in that region was destroying jobs and wealth. Bank runs led to recessions.

In the first 33 years of the 20th century - from 1900 to 1933 - the US suffered from a recession 48% of the time. There were 10 recessions between 1900 and 1933 and the final one was such a doozy that it got the label of depression; during it GDP dropped by half and unemployment hit 25%.

After the Great Depression, legislators decided that they would protect depositors in banks so that a bank failing wouldn't automatically bankrupt its depositors. This helped to stop the runs on banks after one bank failed so that one bank's failure did not spread like a virus to take down other banks and communities.

Given the size of banks, it became increasingly difficult to bail out depositors and ignore failing banks. So legislators decided to offer what was essentially insurance to banks - bailout money - in return for those banks following certain rules. For instance, a bank would have to keep on hand a certain number of deposits, follow certain lending guidelines, etc. The government would protect the banking system and in return the banks would follow certain rules that lowered returns but also lowered risk.

Before the regulation that came in the wake of the Great Depression, the US was in recession half the time. 48%. After the regulations, it was in recession only 14% of the time. Then the Bush Cheney administration deregulated - lifting the rules that banks complained were too restrictive - and within just a few years the country plunged into the worst recession since the Great Depression. Banks got their higher returns. They also created more risk to the entire economy.

Dodd-Frank put back in place some regulations and quite simply reached the same conclusion the country reached after the Great Depression: a community cannot afford to let the financial system collapse so it will offer a combination of rules that keep banks out of trouble and insurance to keep the larger economy out of trouble. We will bail out banks but they have to follow certain rules that make that bail out less likely.

At the time, some Republicans said that this was ridiculous. Banks should be treated like any other business and simply allowed to fail, arguing that all those rules only inhibit smart bankers from making money. Let banks do what they want and let them fail if that turned out badly, these Republicans said. They were, essentially, asking for a return to how things were regulated before the Great Depression, the world that plunged the country into recessions about half the time.

Now the Republicans have full control of government. What have they chosen? Deregulation that allows banks to act more freely, even if that adds risk. Oh, and they've left in place the bailout money. What does that mean? Banks are more likely to take risks that raise returns and we the taxpayers get to bail them out.

One of the few certainties in finance is the link between risk and returns. The investments that offer the most return offer the most risk (think junk bonds or stock in a startup) and the investments that offer the least risk offer the least return (think bank savings account). The Republicans are now moving us closer to a world in which banks get the returns and we get the risk.

Banks are essential to a modern economy. They can be regulated by market success or failures, although that can plunge an economy into recession half the time. Or they can be regulated by government rules, something that cuts the odds of recession to about one quarter of what they would otherwise be but puts the taxpayer on the hook for bailouts. Or, as the Trump administration has chosen to do, they can be freed of market consequence with the promise of bailout money AND free of the  regulation of government rules. Thanks to the 2017 GOP, banks will be able to operate without the discipline of regulators or markets.

Let's be clear. With these rules, the rational strategy for bankers will be to take excess risk (and the excess returns that - at least temporarily - come with it). This type of legislation is guaranteed to trigger recessions more frequently and more severely. It makes the banking system more vulnerable and taxpayers liable twice: they'll suffer from the layoffs and drop in value of their pensions and 401(k) accounts when recessions hit with more severity and they will pay for the bailout of these banks.

I bet that works out well.

The Biggest Danger of the GOP - Or What The Comey Hearing Drowned Out

Thursday, the House GOP passed a bill to repeal Dodd-Frank. Friday, the NASDAQ fell nearly 2%. Meanwhile, the world fixated on a UK election essentially won by the party already in power and a Comey testimony in which we learned that Trump lies. The news of the day was good cover for bad legislation. Really, really bad legislation.

A little story

A little town is divided among three groups. One group is pro-football, the other is anti-football and the third group is mostly neutral.

The anti-football group got that way because a couple of kids were seriously injured. One will be in a wheelchair for life. The anti- group simply argues that no sport is worth this risk.

The pro-football group are simply fans. They love the sport, point to the tradition, the way it gives the kids something to come together on and cheer for, the way it builds a sense of community, and how it calls young men to excellence. 

The problem is, the pro-football group has been hijacked by a sub-group so repulsed by the idea of rules to make the game safer that they've gone in the opposite direction. Call this group the football fanatics. They think that kids shouldn't even have to wear helmets if they don't want to - or can at least wear the old leather helmets that were good enough for players in the 1920s.

Here's the problem. The pro- group is only one or two spectacular injuries away from losing football altogether. And given the way the fanatics are approaching this - eliminating "silly rules that just slow down the game" like flags on late hits or tackles that involve helmet to helmet contact, etc., they have greatly raised the risk of serious injury.

The people who should be most grieved by the fanatics are the fans who care less about any specific rules of football than they do about just having the game in town. Because what the fanatics are doing is making it probable that the anti-football group will get their spectacular injuries that lead to cancelling the program.

The real story

Which brings us to capital markets.

Thursday, buried beneath the tsunami of coverage of the Comey hearing and UK election - the House passed a bill to repeal Dodd-Frank. Two major provisions of this bill set us up for another Great Recession: one provision exempts financial institutions from capital and liquidity requirements to allow them to take on more risk and another provision puts in place bankruptcy provisions in lieu of "orderly liquidation." So, financial institutions are free to take on more risk and when that risk leads to bank failure it won't be treated systematically. That is, it sets up the conditions for a run on the banks like the one that lead to the Great Depression. People will need to withdraw capital to protect themselves at the exact moment that the banking system would need more liquidity. 

Capital markets are one of the great inventions of mankind. Credit can finance the construction of high-speed trains or a cup of coffee, finance your education that launches your career or your house that becomes your home. Credit can finance research that cures an old cancer or a new product. The capital markets that have emerged since about 1700 have transformed our world, giving us longer lives, and making us more productive and happy. The joy football has brought into Americans lives is microscopic in comparison to what capital markets have brought. 

The Republicans are philosophically opposed to regulations. They are the pro-football fanatics who believe that the game of capitalism would be made better if only we removed all those troublesome rules that just get in the way of a good game. And while it's true that the game goes slower with rules and regulations, it also saves people from serious injury that comes from the failure of one or two big institutions becoming catalyst for a Great Recession. 

Real fans of football would shut out the fanatics who try to eliminate rules. Real fans of capital markets would do the same to the anti-regulation fanatics who - just years after the worst recession in nearly a century - are working to eliminate the regulations that save us from serious injury. Anyone who wants to see capital markets survive, evolve and prosper to continue to enable prosperity, will come out against this deregulation inspired by ideology. 

The biggest danger of the GOP's approach to repealing Dodd-Frank is that it will enable anti-capital market forces to make more coherent arguments against them. We now have a president who supports dictators; we can easily have a president in a decade who supports communists. If you love football, you would shut down the fanatics arguing against making it safer; if you love capital markets, you would shut down the fanatics working against making them safer. 

We're Uncertain Just How Much Economic Uncertainty Trump Has Added

"There are known unknowns and unknown unknowns," Rumsfeld famously said. With the incoming Trump administration we might now say, "There are certain uncertainties and uncertain uncertainties."

The stock market has rallied since Trump's election. Presumably, the reasons for this include expectations of tax cuts, stimulus spending, and deregulation. All of these add to uncertainty, though.

If Trump gets a stimulus package in the form of infrastructure spending, it will boost GDP more than if the stimulus comes in the form of tax cuts. (The tax cuts will overwhelmingly go to the rich. A guy making $500,000 a year is less likely to change his spending in response to a tax cut that puts $1,000 more in his pocket than will a guy who makes only $5,000 a year.) 

Will the stimulus - the assumed rise in deficit spending - boost the economy by 1% or by something negligible? It's uncertain because we don't really know what form the stimulus will come in.

Further complicating this, Trump has appointed Mick Mulvaney to head his Office of Management and Budget (OMB). He'll be responsible for crafting the budgets proposed to Congress. Mulvaney is a fiscal hawk who has voted against raising the debt ceiling and seems committed enough to a balanced budget that he'd shut down government for this. By contrast, Trump has promised tax cuts and boosts to defense spending and infrastructure, which will drive a big increase in the deficit.

Paul Ryan and Mick Mulvaney's desire for balanced budgets will be at odds with Donald Trump's "deficit be damned" policies. Will Trump's proposed budget deficit shrink or even become a budget surplus? It's uncertain.

Deregulation adds the most uncertainty of all. Before the Great Recession, banks were leveraged about 30 to 1. For every dollar they had in deposits, they had loaned out about $30. That gives you great returns but it makes you vulnerable to a credit crunch. Since Dodd Frank,that ratio has dropped to about 10 to 1, which makes for a much safer banking system. Now, the expectation is that a Trump administration will lower regulatory requirements and allow banks to raise that ratio again. Will the ratio go up to just, say, 12 or 15 to 1? That ratio might still be reasonably safe but raise profits nicely. Or will the ratio be allowed to rise all the way to 20 to 1 or even 30 to 1 again? That ratio will greatly raise profits .... and risk. Financial stocks could look really healthy even as the financial system gets sick. 

Will Trump deregulation give finance a little nudge or a dangerous shove? That's uncertain.

Add to this the uncertainty inherent in Trump's trade policies. Will he actually put 35% and 45% tariffs in place against Mexico and China? If he does, WTO will probably slap on retaliatory fines and this could set off a trade war. That path would cost us millions of jobs. If he only talks about trade wars but doesn't actually impose tariffs, it could "just" result in a slowdown in trade. It's uncertain.

And then there is the policy with undocumented workers. Will he actually deport 11 million people? If so, that will crush growth in aggregate demand here in the US and crash house prices. It's uncertain.

Economics is always uncertain but the Trump Administration has added more uncertainty to that than any that I can remember. And perhaps inherent in that uncertainty is an uncertainty about what Trump's victory will mean for the future identity of the Republican Party.