One day after the loss of Ted Kennedy’s senatorial seat to the Republican Party, President Obama has turned his administration upside down. Thrust into the background on economic and financial matters are his Secretary of the Treasury and chief economic adviser ”“ Timothy Geithner and Larry Summers. Resurrected from policy limbo is Paul Volcker, who has been counseling a completely different approach to the banks.
Obama has a reputation for a cool demeanor and deliberate, consultative decision making. Unless he is acting out of character, this change is not a panicky reaction to the Massachusetts election. He’s thought it over, discussed it at length with his advisers, and used the loss in Massachusetts as an opportunity to announce this about-face. On the other hand, senior Democratic leaders in Congress seem not to have been aware of this policy shift, and there are many critical details not yet thought through or announced by the Administration, making it difficult to judge whether Congress will even pass enabling legislation.
One thing stands out for sure. The liberal wing of the Democratic Party has been calling all year for Obama to get tough on the banks and stop feeding them bailout billions. Month by month, the banks have benefited from taxpayer largesse, built up their profits and bonus pools, and politely attended White House meetings without making any commitment to changing their behavior. In fact, in one instance several bank CEOs didn’t even bother to show up at a meeting Obama himself chaired. The President, in short, has been dissed by the big banks, and today was the first time that Obama acted in frustration at this behavior. In so doing, he sided with the liberal wing of the Democratic Party, and judging from many public opinion polls, he sided with an angry and disillusioned public.
This may or may not put to rest an argument that has been begun within the Democratic Party over the correct interpretation of the Massachusetts results. Blue Dog congressmen and turncoat independents like Joe Lieberman insist it is time for the party to move to the ”œmiddle”, which usually means start negotiating with the Republicans on their terms and ultimately give in to them. Liberals, and now Obama seems to be acknowledging this, say that the voters are furious over the administration’s constant concessions to the banks while the average person is suffering grievously in this recession.
You’ll read and hear from the pundits in the media that Obama has nothing to lose by taking on the banks. This is a concession to the liberal view that the bank bailouts and their subsequent profits and bonuses are terribly unpopular in the country. In fact, one thing that may tie together the Tea Party activists and the liberals is their fury at the banking industry. Obama therefore has a chance to buttress his dwindling support among liberals, and at the same time at least neutralize some of the disdain he receives from the Palin-Limbaugh-Hannity wing of the Republican Party.
He has another hurdle to overcome, however, and that is the gulf that tends to exist between his rhetoric and his actions. President Obama has disappointed his supporters time and again with actions that are completely different from what he promised in the campaign. For the moment, we have only a broad outline of what this banking reform proposal is, and we don’t know what the inevitable pushback is going to be. We only know that Obama is aware he has a big fight on his hands over any banking reform, and that he says he relishes the battle.
He has a chance with this struggle to establish his bona fides as a politician, or dare we say a leader, who has the interests of the average person at heart before those of corporations and fat cat lobbyists. Just think, though, of the forces that will be arrayed against him. He will be taking on powerful Congressional committee chairmen who derive their power, and most importantly their campaign contributions, from the financial industries within their committee purview. They have their potential survival in Congress at stake if they offend the banks.
Coincidentally, the Supreme Court today granted extraordinary powers to corporations to advertise and potentially determine the outcome of elections. Citigroup, JP Morgan Chase, Goldman Sachs and other banks flush with taxpayer bailout money can now spend it on endless commercials opposing any banking reform. They can also target any Congressman who supports such reform, and make Obama’s life doubly difficult.
To win this fight, Obama is going to have to corral all the major Congressional committee chairs into his corner. He will have to give them simple, understandable talking points describing what he wants to accomplish, and it will be important they all stay on message. He will have to show that banking reform is essential for economic recovery. He will need to brush any Republican who instinctively says no to any reform initiative as a corporate tool and enemy of the people. He should already have the Democratic Party, as of this morning, preparing a multi-million dollar campaign budget for commercials damning the banks, and spelling out the importance of his reform program. He will have to show leadership, leadership, leadership ”“ something not much in evidence so far in his presidency ”“ and he will need to do all this while worrying about health care, wars in Iraq and Afghanistan, unemployment, foreign crises, and deficit spending. He will need to understand he is in a fight for his presidency.
One good thing in his favor is the simple fact that we are not talking about the banking industry as a whole in this reform effort. We can count on one hand the banks involved: JP Morgan Chase, Citigroup, Bank of America, Morgan Stanley, and most of all Goldman Sachs. The stocks of all of these banks took a beating today, though interestingly Wells Fargo did not, because the stock market was busy buying the regional banks that they think are going to benefit from breaking up the big banks. Wells Fargo does not have the deep bond trading, securities issuance, asset management, proprietary trading, hedge fund, and leveraged buyout businesses the other banks have and which puts them in a league all their own within the financial industry.
In its essence, it appears the Obama reform initiative is going to give these big banks a simple choice: if you want to stay a bank, as members of the Federal Reserve System with access to taxpayer funding and bailouts, you must get rid of all of these extraneous investment banking businesses. This is very much in keeping with the philosophy of banking Paul Volcker has always had: if banks are going to be protected by the public purse, they are going to be fundamentally in the business of making loans to businesses and individuals, and managing their credit risks with great prudence and under strict regulation. There is no room in this philosophy for proprietary trading, securitization schemes, derivatives innovations, or hedge fund activity.
Of all the big banks, the one that stands in a class all its own is Goldman Sachs, which has refused to do any lending despite now being a bank, and which is really a massive hedge fund with enormous funding and informational advantages as a bank. Goldman Sachs stands to be booted out of the banking universe and left to fend on its own without any government apron strings, so it’s no surprise their stock was down over 4% today.
Reforms of this nature are very much like restoring the Glass-Steagall separation of commercial and investment banking. In addition, the concept of limiting the size of the big banks through controls over their deposit taking activity will have enormous consequences, because it says that these banks will no longer be in the business of growing through buyouts of other banks. This will strike at the core function of the hedge fund industry, which relies for its leverage by borrowing enormous sums from big banks. Similarly, the leveraged buyout industry and its rapacious appetite for equity extraction will be constrained in a world of small banks.
We are already hearing criticisms of this reform initiative being expressed by various business reporters and commentators. It is said that banks cannot differentiate proprietary trading from their trading activity with their customers, which often requires the bank to maintain some position in the market. This is merely a canard. It is simple work to insist that any trader be connected to a team of marketers funneling customer business to the trader, and that trading positions be limited to a certain size and maturity and maintain a defined percentage of business relative to trades done for customers. Proprietary trading desks have none of these features and can easily be shut down without any consequence for the bank’s customers.
A more serious criticism is that corporations do need big banks to handle the financing of mergers and acquisitions. It is going to be the case that some of these deals will not be done in the future if Obama’s initiatives take place. It should be asked, though, whether the economic consequences of smaller and fewer mergers and acquisitions is all that great. Most of this business in the past decade has involved enormous amounts of debt that now we find cannot be paid back. It may be a good thing if companies were limited to mergers and acquisitions that were paid for mostly by cash.
What is ironic about this reform program is that these changes are inevitable anyway. The big banks have destroyed their franchises, and with this they have closed down or severely crimped the hedge fund and leveraged buyout businesses, which rely on high amounts of leverage. The banks are going to take years to recover their ability to lend billions of dollars in a single loan, and they are not going to be able to revive the securitization business except for the sorts of deals which are demonstrably of high credit quality and low risk.
Goldman Sachs has its own troubles to resolve. Traditionally this firm was managed by the investment bankers, but ten years ago management power shifted for the first time to the traders. Lloyd Blankfein is the first CEO to come up through the trading side. Trading represents around 75% of annual revenue at Goldman Sachs, but the cost to their franchise has been so high that they are facing the choice of going off into the wilderness as a hedge fund, or restoring their firm to a traditional investment bank. It will be interesting to watch them resolve this conflict.
Unsaid in these proposals is anything about the future role of the Federal Reserve. The public lumps the Fed in with the banks and the administration as all part of the financial industry complex, but the Fed is in a peculiar position all its own. It is not part of either the Executive or Congressional branch, and has always operated independently and secretly. Many of the bailout actions taken in 2007 and 2008 were done with some consultation with the Treasury Department, but largely as independent initiatives of the Fed.
President Obama is going to have to figure out how to influence the Fed. He has already reappointed Ben Bernanke to the chairmanship of the Fed, and unless he quickly withdraws that appointment he is going to be saddled with someone who acts on his own. Moreover, there is growing evidence that Bernanke doesn’t really have the competence for the job. He gave a speech a week ago insisting that the Fed’s low interest rates in the early 00’s did not contribute at all to the housing bubble. You can bet any amount that Paul Volcker thinks this idea is completely fatuous.
Finally, looking at all this with a long term perspective, Barack Obama has just taken away the biggest credit punch bowl ever placed before the American public. For almost 25 years US companies and consumers have feasted on a cornucopia of cheap credit, accentuated by securitization, derivatives, home equity lines of credit, and other tools that made it impossible to resist taking on debt. The public became gluttonous and we are now suffering the consequences. Every instinct and every action so far of men like Ben Bernanke, Timothy Geithner, and Larry Summer has been to restore that cornucopia to its ”œrightful” place at the center of the economy. What Barack Obama, and in particular Paul Volcker are doing is bringing the economy back to a simpler time. They are doing this because they perceive they have to, and because they can. The amount of credit circulating in the economy is a fraction of what it was two years ago, so an idea that would have been deemed crazy and irresponsible in 2007 is now possible and rational today.
Even though these ideas are certainly going to come to pass over the next 10 ”“ 15 years, because the US simply has no more room for debt binges, Barack Obama has now set the stage for a more rapid change. He will be able to define the debate over what banking should be in this country (and all other countries will be taking cues accordingly), but he will have to fight aggressively and cleverly because the big banks have no intention of going into a quieter and far less lucrative world unless they have no choice.
Nor does President Obama have any allies of importance in this fight, unless you count ourselves, the voters. The public needs President Obama to show guts and leadership, but he in turn needs an outraged public to keep the pressure on Congress and the media. This is a battle that will define our economic circumstances for the next 25 or 50 years. Does the US have what it takes politically to do what our ancestors in the 1930s did after learning the same bitter lessons we are experiencing every day?