July/August 1989 - VOLUME 10 - NUMBERS 7 AND 8
E C O N O M I C S
Speculation and Debt
by Patrick Bond
"This whole system is like the Titanic. As it crossed the Atlantic, it hit an iceberg and ended up at the bottom of the ocean. The international system created at the end of World War II is in the same situation: The engine room, and the second class decks (that's us in the Third World) are already flooded - but the First Class passengers still have not grasped what is happening and keep on partying as if there were no problem..."There is a rising tide of speculation and debt in global and national economies which, since the mid-1970s, has undercut international financial stability. This instability has, in turn, led to the destruction of several major financial institutions. Continental Illinois and First Republic Bank of Texas, hundreds of smaller banks and savings and loans (S&Ls), securities dealers like Drysdale and stock brokers like E.F.Hutton and Texas insurance firms are among the damaged institutions. Outside of the United States, debt has grown to unprecedented proportions. Third World debt stands at $1.3 trillion. Domestic and foreign debt of our allies in the industrialized world is approaching $10 trillion.
The United States has the biggest foreign debt--with about $500 billion owed to foreigners--and also owes an extraordinary amount to internal creditors. At year-end 1988, the $11.4 trillion U.S. domestic debt was divided between government ($2.7 trillion), consumers ($3.1 trillion), corporations ($5.5 trillion) and farmers ($142 billion). In 1982, total U.S. debt was $5.6 trillion, or 178 percent of the gross national product (GNP). Today total U.S. debt is 225 percent of the GNP.
Ironically, as many financial institutions are going under in record numbers (see box - omitted here), those that remain are gaining power over other companies, consumers and even over sovereign nations. The source of this power stems from the high levels of national and international debt.
Indebtedness diminishes borrowers' independence and gives creditors increased control over economies. Evidence is everywhere: the power of banks and the International Monetary Fund (IMF) dictates national economic strategies to Third World nations; and banks and Wall Street firms force corporations to opt for short-term profit-maximizing strategies.
Unfortunately, industry officials, policy-makers and the media often ignore the larger, structural economic problems, suggesting that isolated cases of fraud and mismanagement or technological overreach are the primary cause of financial failures. Even when structural problems are cited--for example, rising interest rates or the collapse of the energy and agriculture sectors--commentators explain that such problems are symptoms rather than causes of the travails of high finance.
Crying "fraud" (and hence laying the blame on lax regulation) or pointing to seemingly uncontrollable economic forces, allows the industry to avoid discussion of fundamental problems such as: 1) The tendency now apparent in the economy toward unproductive use of resources and redistribution of wealth from debtor to creditor; 2) The question of who is to pay for cleaning up after the foolhardy financial speculators--taxpayers and small depositors, or instead the institutions and individuals who profited; and 3) The prospect that without a complete overhaul-- the kind of full-scale re-regulation of finance that took place in the 1930s--it is likely that overzealous financial speculation will just reappear.
The Third World debt build-up and other international financial problems began shortly after economic stagnation gripped the U.S., in the late 1960s. A similar economic slowdown followed in Europe and Japan only a few years later. These developments are at the root of the debt problem. For example, Robert Pollin of the University of California/Riverside says that corporate debt is a direct function of declining corporate rates of profit, starting in 1965. In order to keep up with increasingly fierce competition, Pollin explains, corporations were forced to borrow more to grow, rather than relying on profits. They also began to shift more of their liquid funds into financial assets rather than reinvesting them in less immediately profitable new plants and equipment. That tendency also helps to explain the rush of huge amounts of capital into speculative markets, from real estate, to art, to stocks and bonds.
Pollin also says that while corporate financing strategies undergird the debt mountain, the recent unprecedented spate of consumer borrowing can be traced to two phenomena: 1) the 14 percent decline in real (after inflation) wages of lower- and middle-class earners from 1972 to 1985, combined with a 9 percent rise in housing costs, which forced consumers with below-average incomes to borrow 60 percent more than they had historically just to maintain a 1970s standard of living; and 2) the rash of speculative investments (mainly real estate and stocks and bonds) made by the wealthiest 5 percent of the population.
In other countries, debt has had a similar impact. Japan has an even more speculative economy than the United States, characterized by excessive inter-corporate stock acquisitions, exploding housing costs and a financial scandal that unseated P.M. Noboru Takeshita in April. In the Third World, billions of poor people are made to feel the debt crisis through the policies of a new set of financial-managerial elites from the IMF. The IMF typically orders debtor countries to produce more cash crops and raw materials for export. In addition, IMF austerity measures include removing price supports, an unpopular measure which recently led to the tripling of oil prices and riots in Venezuela. Venezuela's President Carlos Andres Perez, said that the March 1989 riots (which followed the subsidy cuts) in which police killed more than 600 people were "the consequence of the dramatic deterioration of the economy due to a crisis whose name I write in capital letters: FOREIGN DEBT."
Popular unrest throughout Latin America, including the prospect of a leftist victory in Brazil's November presidential elections, is pushing Treasury Secretary Nicholas Brady and the Bush Administration into a slightly new posture on Third World debt. The banks' reaction to government-sanctioned "voluntary debt reduction," according to bank analyst Raul Madrid of the Washington-based Investor Responsibility Research Center, is positive. "The banks as a whole are very supportive of this move. Of course, they would love it if they [could] have guarantees on their debt. They would love it if they [could] have tax incentives that would encourage them to do what they're doing already." Those incentives will be paid for by taxpayers from the industrial countries, mainly through last year's $85 billion recapitalization of the World Bank, and by this year's IMF funds.
As with the Third World debt, efforts to stabilize the domestic financial situation require a huge infusion of taxpayer funds. But rather than encourage reform-minded ideas put forward by the consumers and workers most affected by financial speculation, the Bush administration, Congress and government regulators rely almost solely on establishment experts. This pool of experts is dominated by such free market theorists and orthodox financial practitioners as George Benston of Emory University and FDIC Chairman William Seidman whose proposed solutions reflect the narrow perspective they represent. Their unswerving faith in the financial system blinds them to the waste of spending tens of billions of taxpayer dollars to keep the speculation-driven finance sector afloat.
Deregulation advocates want to remove the barriers between different financial institutions (including the shaky S&Ls), and between finance and commerce more generally. A congressional proposal nearly approved in 1988 would have permitted banks to sell stock, to sell insurance and even to fund real estate development projects. Turf wars between the House Banking and Commerce Committees temporarily blocked such changes, and so the Federal Reserve Board took unilateral steps to permit banks to invest in more risky ventures like junk bonds.
The danger of deregulation in the current environment is clear. "Financial time bombs are ticking away," says Doug Henwood of the Left Business Observer. "The Texas insurance industry is already unravelling. GM and Ford are suffering unprecedented defaults on auto loans. The Northeast real estate market is going soft. And bankers have been lending furiously to finance leveraged buyouts. Should a recession make these loans go bad, all hell could break loose."
The worst examples of deregulatory mistakes can be found in the S&L industry. To help S&Ls survive the 1970s decline in consumer deposits and the locked-in, low-rate 30-year mortgages, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (which lifted the 5.5 percent interest cap on S&L savings accounts and let S&Ls bid for deposits at the market rate of interest) and the Garn-St Germain Act of 1982 (which let S&Ls pay higher interest rates and make commercial loans). S&L regulators like M. Danny Wall, Chairman of the Federal Home Loan Bank Board, then allowed highflying S&Ls to pay extremely high rates to attract deposits, and make far too many risky loans and investments, especially in commercial real estate markets in the Southwest.
In Congressional testimony, Wall, who designed the 1982 deregulation, was forced to acknowledge that the nation's healthy S&Ls "remain heavily committed to the residential mortgage market ... [while] insolvent institutions have dramatically and rapidly increased their commercial mortgage lending in recent years.n A 1989 Bank Board study asserted that S&L commercial investments of a direct "equity" (ownership) nature "do not generate returns sufficient to cover the costs of funding them."
But die-hard free market proponents like Benston tell a different story: "In my studies of California S&Ls, the higher the level of direct investments (by the S&Ls), the lower the risk. The new investment powers allowed a more diversified portfolio, and that meant a higher rate of return." The solution to the S&L crisis, Benston concludes, lies in forcing S&Ls to be better capitalized (i.e., make fewer loans per S&L shareholder dollar) and in having the government close failing S&Ls down earlier. "This is where public policy should go, rather than asset reregulation," says Benston. Indeed, on Capitol Hill, this argument caught on so quickly that there was no serious effort to end the S&Ls' direct investment powers, despite evidence of the need for full-fledged financial industry reregulation.
Welfare for wayward financial institutions
There are others in the policy-making establishment who represent the antithesis of deregulatory market discipline. They look to government involvement to solve the crisis. Policy makers like Seidman put the banking system's interests above those of the public and of non-financial corporations, advancing the "too-big-to-fail" policy.
"Too-big-to-fail" proponents argue that there are some 50 banks and 30 S&Ls which are so large and so tied into the domestic financial power centers (through interbank deposits and loans secured by bank stock), that the failure of any one of these would quickly cause the whole system to cave in. Consequently, proponents of this theory argue that the failure of such institutions must be prevented at all costs.
The real effect of this policy is that big depositors in large banks gain access to federal deposit insurance normally provided only to small depositors, thus prompting capital flight from small-or medium-to large-sized banks. The beneficiaries of such a government subsidy are the largest banks, which now, in essence, have unlimited deposit insurance at no extra cost, and the corporations and rich individuals who keep more than $100,000 in their accounts. The policy has been formally applied in three near-failures--Continental Illinois (1984) (see box - omitted here), First City of Houston (1987) and First Republic Bank (1988)--whose ultimate total cost to the FDIC is estimated at $5 billion.
These enormous bailouts are only the worst of a run of bank failures that began in 1982. Prior to 1982, the FDIC was only authorized to help keep a bank open only if its operations were deemed "essential." For example, regulators considered the $1 billion Commonwealth Bank of Detroit essential to the urban community in 1972, and agreed to lend it $35.5 million in capital notes. (Commonwealth needed a second FDIC bailout in 1976.)
In a similar case in 1980, the FDIC gave a $325 million loan to First Pennyslvania, an $8 billion Philadelphia bank, calling First Pennsy "a significant provider of financial services to minority and low-income residents of the inner-city." (The Philadelphia bank subsequently shut down many inner-city branches and was harshly criticized by Philadelphia community development groups for discriminatory 'redlining' practices against black neighborhoods.)
The "essentiality" argument was dropped in 1982. The FDIC makes bailouts available today if keeping the bank open at government expense costs less than shutting it down. This was the rationale for government giveaways such as the July 1988 bailout of Texas' First Republic Bank by NCNB Corporation which will cost the government well over $5 billion and the rash of S&L deals made by the Federal Home Loan Bank Board in the waning days of 1988. In both instances, there are disputes about the government's reasoning, since the FDIC did not seriously consider running First Republic Bank on its own and since even the Bank Board's own commissioned study questioned the accounting by which the S&L deals were calculated.
As a result of the new guarantees for big banks, according to Robert E. Litan of the Brookings Institution, "The FDIC is on its way to joining the FSLIC in bankruptcy." In 1988 the bank insurance fund recorded a loss: $4.2 billion. It was the first time in its history that it had a deficit. This development makes one of President Bush's "band-aid" proposals for the S&L mess--merging the FSLIC with the FDIC--much less appealing.
President Bush's proposal to solve the S&L crisis involves both kinds of establishment remedies. The plan, which he describes as "the fairest system that the best minds in this administration can come up with," calls for leaving the deregulatory environment intact and maintaining FDIC support for what economist Robert Kuttner calls "the most lethal combination of all, entrepreneurship without risk." While the worst violators are being shut down, many other S&Ls continue to use depositor funds to buy junk bonds and take equity positions in speculative commercial real estate projects.
The administration's plan shifts S&L oversight responsibilities from one industry captive, the Federal Home Loan Bank Board, to another, the FDIC, which was criticized by the House Government Operations Committee in October 1988 for failing to halt extensive commercial bank fraud. Bush initially estimated that his plan would cost $90 billion, a fraction of the $335 billion that House Banking Committee Chairman Henry Gonzalez, D-Tex, now says the plan will cost over 30 years. Faulty arithmetic aside, Bush's attempt to keep the costs "off-budget" through bonding authorizations for a new "Resolution Funding Corp." has also been attacked because it adds $4.5 billion to the expense, due to the higher interest rates that the government must pay. Henwood objects that "These days, the only conceivable cure for busted credits is the creation of more credit in ever more exotic forms."
Populist financial reform
Though politicians and the media have by and large ignored them, alternatives to the establishment experts' thinking and to the Bush S&L rescue plan do exist. Ralph Nader recently issued a report on the S&L crisis which included a proposal, and some general principles for reform of the financial system are being circulated nationally by a new "Financial Democracy Campaign" (FDC) led by the Rev. Jesse Jackson, Texas Agriculture Commissioner Jim Hightower and other populist thinkers in the national community group ACORN (Association for Community Organizing and Reform Now) and the Durham-based Institute for Southern Studies.
The FDC principles call for the S&L cleanup costs to come from the very richest part of the U.S. population, who have received excessive interest income in the 1980s, and from money market funds which brokered "hot money" (especially $100,000 certificates of deposit) to risky S&Ls. Both Nader and the FDC call for taxes on speculative financial activities like leveraged buyouts and stock purchases.
Populist critics of the financial system suggest a variety of ways to integrate a required housing component into S&L portfolios. The FDC emphasizes the problem of "redlined" inner- city neighborhoods and the need for a national low-interest housing fund to which all financial institutions would contribute. Nader calls for the Federal Home Loan Bank System to fund community development by investing 20 percent of the system's capital in non-profit housing. Housing experts led by Michael Stone of the University of Massachusetts at Boston say that bankrupt S&Ls should be reconstituted as mutually-owned, locally-oriented housing finance institutions that would emphasize socially--rather than individually--owned housing.
The thrift industry and housing are not the only concerns of populist critics. The FDC has also criticized other sour financial gambles that have haunted the global economy since the early 1970s such as Real Estate Investment Trusts and downtown office buildings, Third World loans, currency speculation, precious metals and commodity speculation, stock purchases and leveraged buyouts and exotic instruments such as interest rate futures and options swaps. The FDC condemns these speculative machinations as unproductive for workers, farmers, small businesspeople and consumers in the United States.
Populist critics are questioning the financial industry's power structure, both by attacking laissez faire economics and by challenging the rights of the financial system to police itself at taxpayers' expense. The FDC notes that "a banking license that is guaranteed by the public requires public obligations from the bankers."
Although the reform agenda was mostly ignored in the S&L bailout this year, other opportunities for populist intervention against the financial industry are on the horizon including the IMF funding request, increasing congressional concern over leveraged buyout loans to over-indebted companies involved in takeovers, and the decline in the ability of the United States to borrow in international credit markets without ever-higher domestic interest rates.