Fiancial Reform and Its Real Starting Point: Looking in the Mirror

Last Thursday’s newspapers were full of news.  Above the Wall Street Journal’s crease, for example, readers learned about violence in Greece, where three people were killed in a firebomb attack during a national strike that was paralyzing the country. Above the crease, we could also see that the US Senate had overwhelmingly, and accordingly bipartisanly, approved a plan to expand government powers to break up “failing” financial firms.  Below the crease, some of us noted that Freddie Mac said it needs $10.6 billion in additional funds from America.

All of this is serious news.  What’s even more important is the connections among the stories.

Let’s start with Greece.  Why was there violence in Athens, and why are there strikes across the nation?  Because the European Union (EU) and the International Monetary Fund (IMF) announced that strings are attached to the  $140 billion in bailout money they’ve committed to loan Greece.

Greeks have been told that the government cannot continue to live beyond its means.  With public wages and pension plans comprising 51% of government, the belt-tightening of necessity involved the unions taking a hit.

Government–employee unions led the strike, a protest against austerity measures imposed by the new creditors, who are properly alarmed by deficit and debt levels currently 13% and 124.9% of GDP, respectively. Greece has promised its creditors to reduce public-sector pay, decrease pensions and increase retirement age, and deregulate the labor market.  The government also pledges to deregulate industries and privatize some state industries, raise value-added taxes and excise duties, and crack down on tax evasion.

Even so, Greece projects debt levels rising to 149% of GDP before they start to decline.  Greece is not known to over-estimate problems. Last year’s actual deficit of 12.7% was more than triple the 3.7 % the government had publicly predicted.

Across the Atlantic, the US Senate voted 93-5 in support of a financial-reform amendment submitted by Christopher Dodd (D-Connecticut).  The goal of Dodd’s provision is to eliminate the possibility of any financial company becoming “too big to fail” and therefore a candidate for taxpayer bailout funds.  Accordingly, it creates new tools and broad new powers to break up failing financial companies.   A $50 billion emergency pool is not among those tools.  Instead, liquidation costs incurred by the government will be recouped from the financial-services industry in general and creditors of the failed entity in particular.

Scrapping the $50 billion bailout fund was a concession to the Republicans, who worried that its existence would actually encourage both banks and their investors to take more risks.  Reassured, they signed on, en masse.

Meantime, Freddie Mac has requested another $10.6 billion from the government. This quasi-government organization reported losses of $8 billion in the first quarter of 2010 and says it needs the funds to shore up its balance sheet. Freddie has already received $52 billion from the government to pay for earlier losses. Through the end of 2009, Freddie Mac and its sister organization Fannie Mae lost a combined $126.9 billion.  This figure makes the twins by far the biggest losers in the financial panic.  Even so, it’s a gross underestimate of the total carnage Freddie and Fannie wreaked on economies across the world.
Both Fannie Mae and Freddie Mac are government-sponsored entities (GSEs), in the business of making sure that funds are consistently available to institutions that loan money to home-buyers.  The main difference between the two appears to be Fannie’s greater age, having been born during the Great Depression. Both are now owned by stockholders.  Both buy mortgages on the secondary market, pool them, and sell them as mortgage-backed securities.  Hm.  Aren’t these derivatives?  Has the same government who decries the evils of  derivatives actually been subsidizing some through these two GSEs?

Although “transparency” is one of government’s favorite reform bullets, Freddie’s and Fannie’s operations are so opaque they’re even off budget.  They’re so opaque the two were able to hide how much they were gambling on subprime and Alt-A mortgages, thereby making it hard to discern how large and risky these markets truly had become.  Additionally, by implicitly guaranteeing their products, the US government made it possible for them to sell market-backed securities across the globe.  By attracting more capital than investors would pledge if there’d been more transparency in their products than just the government guarantee, Fannie and Freddie made the housing bubble bigger and its popping more catastrophic.

And yet, the twins have not been part of the financial reform packages so far discussed by the Senate.  They keep getting more money from the government, and the additional gifts guarantee additional losses.  The Congressional Budget Office (CGO) estimates that the red ink from 2008 through 2020 will total $380 billion.  Wall Street has paid back most of its government money, with hefty rates of interest.  Fannie and Freddie are still at the trough, appetites ever growing.

Around the world, governments are spending more than their income.  Greece shows us that they, too, can fail, and being considered “too big to fail”, get bailed out at taxpayer expense.

In Greece’s case, the taxpayers initially come from other countries in the EU, some of which have major fiscal problems of their own.  Greece is likely to need more bailouts in the near future as more bonds mature.  Will it really reform its economy and its government, or will it cave to vested interests like its unionized government workers, who seem not to understand the basic economics or choose to make others suffer rather than reduce their comfortable standard of living.

The United States is also on an unsustainable course of ballooning deficits and debt.  The federal government has extended its management to the health industry, the (unionized) auto companies, and the financial, energy and environmental sectors.  In assuming responsibility for 1/6 of the economy with health-care “reform”, our government claims fiscal restraint by acting as if increased Medicare taxes and decreased Medicare waste pay for expanded health-care.  Instead, if real, they could have been enacted as part of Medicare reform, paying for some of the mounting deficits in Medicare itself.

The federal government deals with some of its fiscal problems by pushing them off into the future or over to the states.  Obamacare again illustrates the strategy. Two other reasons it’s billed as economically sound are that the CBO could only project out ten years, during which decade the revenues come in four years before the payments go out; and that some federal Medicare responsibilities have now been fobbed off to the states.

The US should make politically more difficult decisions like the austerity measures creditors are imposing on Greece.   They should allow contract competition from non-union labor.  They should reduce the benefits from public-servant pensions and private-servant Social Security.  And to make financial reform basic and real, they should eliminate Freddy’s and Fannie’s lines of credit and other special perks.  Without make these hard decisions and many more, the US is likely to be in Greece’s desperate situation.  Even with these measures, the US is likely to be in the EU’s position.  Just replace “Greece” with “California”, “New York”, “New Jersey” or “Illinois” –  states that may not be able to persuade investors to buy new issues when old bonds come due.

Unifying all these sad stories is a world that wants other people to take the hit for financial irresponsibility.  How do the state unions and pensioners think Greece can reduce its deficits without cutting the 51% of government spending they comprise? Doesn’t the US understand that we too are on a path to fiscal bankruptcy, on both the federal and the state levels, with many localities also in dangerous financial straits?  How does the Senate think it can reform finance while failing to acknowledge or change the roles of Fannie and Freddie in creating and prolonging the crisis?

It’s so easy to blame Big Banks and Other People.  But responsibility for feckless behavior should be shared by everyone who takes on a mortgage with minimal deposits and monthly payments that are affordable only under the sunny assumption that unexpected problems will never arise and incomes will always rise.  It should also be shared by every politician who angles for special projects or supports more spending without more revenue.

Regulation should start with individuals regulating themselves, in and out of government.  We must look in the mirror and see ourselves as people who refuse to acknowledge scarcity, respect budgets, and distinguish between needs and wants.  We must stop spending as if there’s no tomorrow.  We must grow up and stop shifting responsibility to other shoulders and other times.  We must stop electing politicians who cater to our weaknesses.

Republicans John McCain, Richard Shelby and Judd Gregg have introduced another amendment to the Senate financial-reform bill.  Scheduled for a vote on Tuesday, it calls for reform of Fannie Mae and Freddie Mac.  Among other things, the three Senators recommend ending the government conservatorship that has enabled the twins to be so financially irresponsible. An amendment on these lines is an integral part of financial reform.  The votes it attracts will show just how serious we are about achieving not only financial but fiscal sobriety.

The best example politicians can set for the rest of us is to look into the mirror as well and see that they are part of the problem and must be part of the solution.  They should represent the best, not the worst in us.