DRAFT: Diana Henriques: Taming the Street

The length of review of "Taming the Street" I wish I had been allowed to write...

"Unscrupulous money changers stand indicted.... Faced by failure of credit they... propose... lending... more.... Stripped of... profit... to [enable]... false leadership, they... plead... tearfully for restored confidence.... They have no vision, and when there is no vision the people perish. The money changers have fled from their high seats in the temple of our civilization. We may now restore that temple... apply[ing] social values more noble than mere monetary profit..." That was newly-inaugurated President Franklin Delano Roosevelt on March 4, 1933. And, yes, the direct reference to John 2:15 and the consequent High Protestant rhetorical implication that he was going to do the work of the LORD in cleansing the Temple of impiety and immorality was very deliberate. Roosevelt's words mattered. Supporting him In March 1934 were overwhelming majorities of the 318 Democratic and allied members of the House (out of 435 total) and of the 60 Democratic and allied Senators (out of 96 total). What he and his team proposed, Congress would past—and the still-Republican Supreme Court would think hard before blocking.

Thus Roosevelt kicked off his New Deal. And key to the New Deal was regulation to try to make American finance work for the people and the economy, rather than for the plutocrats. Diana Henriques's _Taming the Street_ is the extraordinary readable narrative story of how New Deal financial regulation was accomplished. The Pecora hearings beforehand to expose corruption and fraud; the Glass-Steagall Act separating out investment banking and insuring bank deposits; the creation of the SEC; strengthening the Federal Reserve's authority and making it independent by getting the Treasury Secretary out of the Chair's seat; regulating futures contracts for commodities—all these steps were aimed at creating a financial system that was fair and impersonal, rather than rigged in favor of those who knew secrets and were owed favors by the right people.

I assure you: Diana Henriques has sweated gallons of blood to make this story readable. And I assure you: this is history you need to read. It, as Mark Twain said, rhymes with what is going on in our own time. As my friend Dan Davies likes to say: "Any kind of problem solving is based on making mental models of the problem.... [and] creating a mental model from scratch is a very expensive cognitive operation." It is much easier, mentally, to check whether an analogy is actually relevant. And thus we get to the value of history: high.

The system the New Deal created was supposed to be fair in that all investors played on a level playing field, and potential grifters would be fined or jailed if they kept their potential counterparties un- or mis-informed. "This is neither an offer to sell or a solicitation of an offer to buy securities. Such an offer is made only by the prospectus" is a short paragraph that appeared thousands upon thousands of times a year as those creating and selling new stocks and bonds dotted their regulatory i's and crossed their regulatory t's by directing potential customers to where comprehensive information could be found. The idea was to avoid episodes like the one in which Robber Baron H.H Rogers whispered that he was on the verge of establishing a global copper monopoly with his Amalgamated Copper and then sold out his shares to investors who stampeded in, only to discover that the only thing in the bag that was Amalgamated was Anaconda Copper—a big and profitable mining company, but far from a global monopoly, and worth only perhaps 1/3 of what Rogers had sold it to the suckers for.

The system the New Deal created was supposed to be impersonal in that no single individual's thumb up or thumb down could either make or break your business, but rather that in high finance you would always have a range of counterparties, and if you did not like one offer you could go down Wall Street or up Park Avenue and find someone else willing to offer you terms almost as good—or better. Hence no firm was to use its commercial bank deposits to grease its investment-banking business, or direct its investment-banking customers to clear their payments through their commercial-banking partners, or use controlled insurance premiums to provide the ooomph to turn a no-go deal into a go. The idea was that no businesses and no entrepreneurs were to find themselves in the situation that Samuel Insull and his admittedly overleveraged did in 1932, when J.P. Morgan, Jr. made it clear that he would regard it as extremely unfriendly if any other financiers were to offer Insull any alternative emergency loan terms to the ones the House of Morgan was offering.

And the system the New Deal constructed... worked, and worked rather well. Finance in the 1950s and 1960s cost the rest of the economy perhaps 3%—one dollar in 33 went to the financiers, the bankers, and their support staffs. Investment money flowed through stocks and bonds into companies and then back out again as dividends, interest and principal payments, and capital gains. Stock prices served as indicators, even if not perfect ones, of in which sectors and companies investment in American industries would be profitable, and hence hopefully for the public good.

The flaws in the system seemed to be three: (1) CEOs were overpaid because in absence of powerful outside financiers they were hard to leverage out of their chairships and presidencies, and so the only real constraint on CEO power and lifestyle was that too much opulence would be a big PR negative at the next union bargaining session; (2) exorbitant profits flowed to financial firms with the knowledge of how to actually cleanly and effectively work the levers of the regulatory system; and (3) regulatory-system red tape limited effective competition and kept fees and commissions high.

And so from the 1970s on there arose the neoliberal movement to cut back the New Deal red tape and bring back cowboy finance. Eliminate restrictions that disfavored bonds classified as too risky. Let companies buy back their shares without limit if they thought that was the best use of cash. Allow commercial banks and insurance companies to buy investment banking arms to add more competitors to the small oligarchy that knew how to pull the levers of the SEC machine. Let financiers throw CEOs whom the stock market saw as ossified and ineffective out the door via "hostile" takeovers. Allow wild experimentation with "derivative" securities in the hope of finding ways to slice risk into tranches that investors would be happier holding. To many up through the 1990s—including me—the risk to the system seemed low: the Federal Reserve was powerful enough to construct a firewall to keep financial chaos from leaking over and causing a serious depression. Moreover, the potential gain for the economy seemed high: the very large persistent average gap of 5%-points per year in rates of return in favor of risky stock investments seemed to tell us that investors in the aggregate were too averse to risk in general, and would benefit in aggregate from being induced to hold less-safe portfolios.

Thus now we have a post-New Deal financial system. It has brought us the greatest financial crisis ever in 2007-9, one that failed to bring on a second Great Depression by an uncomfortably small margin. We have a financial system that swallows not 3% but instead 8% of national income: no longer 1/33 but instead 1/12 of income in the country flows to financiers and their support staffs. The allocation of investment across firms, industries, and sectors does not seem to be conspicuously better than it was to justify that increased bill. Nor am I impressed by the superiority of today's corporate managers over the CEOs of the New Deal financial system era. In addition, far too many people's 401k's have been emptied because they succumbed to market psychology waves of overoptimism and over pessimism, and bought and sold at the wrong time. (That is, after all, where a good chunk of the 1/12 of national income captured by finance comes from.) Yes, everyone did it voluntarily. No, they were not being their best selves when they did so. And you cannot dodge the responsibility a system has for helping be their best selves as much as possible.

We must find ourselves in the position of Sisyphus: We need to roll the boulder back up the hill. Again. We might have gained that political capital in the fall of 2008, had then Treasury Secretary Hank Paulson, then Federal Reserve chair Ben Bernanke, and Bernanke's then-deputy about to become Paulson's successor Tim Geithner taken the illiquid too-big-to-fail financial institutions into receivership as they had taken Fannie Mae and Freddie Mac earlier, in the summer. Instead, they loaned out government money at 5% per year nominal at a time when Warren Buffett was insisting on 10% plus serious equity kickers. The gridlock of Washington set in.

And so, right now, we are not even in the position of Sisyphus.