POLITICS MARCH 18, 2009
As the United States faces its biggest economic crisis since the Great Depression, Barack Obama and his team have been looking to Franklin Delano Roosevelt for help. The influence so far is obvious: The stimulus measure passed by Congress in February includes money for building infrastructure, strengthening unemployment insurance, and helping state governments--all reminiscent of FDR's New Deal.
It is now necessary for Obama to take the model one step further. In addition to spending, there was a less visible but equally important element of FDR's program: stringent financial regulation to drive what the president called "unscrupulous money-changers" from the temple. While Obama recently spelled out some admirable principles on that score, there are still obstacles to success. His pick to head the Securities and Exchange Commission (SEC), Mary Schapiro, is far better qualified than her Bush-appointed predecessor. But she seems less formidable than any of FDR's first three SEC chairmen: Joe Kennedy, whose stellar performance laid the foundation for the Kennedy political dynasty; Jim Landis, the chief draftsman of the major securities laws (and later dean of Harvard Law School); and William O. Douglas, who went from the SEC to become the longest-serving Supreme Court Justice in the nation's history. What's more, Obama will face stiff opposition from a political party that has depended very heavily on contributions from the industries he needs to regulate.
Putting money into people's pockets and into institutions is politically easy and economically sensible. But, if we don't reinvigorate regulation as well, the credit system will remain sick, banks won't fully recover, and investors and borrowers will keep on believing--correctly--that they've been hoodwinked and fleeced. Only a thorough repair of the agencies that handle securities and banking regulation--a repair FDR's model can help us achieve--can prevent new crises down the road. Without this reform, other shady financial practices will emerge, just as they've done throughout history, and the money poured into stimulus will have been wasted.
Like Obama, FDR inherited his economic problems. The 1920s were prosperous but were also wild and free-wheeling, a time when dubious mergers and rickety holding companies multiplied. The stock market, almost wholly unregulated, soared to record levels, and a self-satisfied Herbert Hoover predicted that "poverty will be banished from this Nation." Then came the Great Crash, and, by 1933, the task confronting the New Deal could hardly have been more daunting: The Dow Jones hovered in the fifties, down from a high of 381 in 1929. Issues of new corporate stocks and bonds totaled only $161 million for the entire year 1933, a decline of 98 percent from 1929. Unemployment stood at 25 percent.
In this state of emergency, the New Dealers quickly set out not only to stimulate the economy but also to create an effective regulatory system. Their goal, above all, was transparency, which FDR understood as the key to restoring consumer and investor confidence. Without that confidence, consumers would keep their money out of banks and, as FDR put it, "under the mattress." Investors, too, would refuse to buy stocks and bonds to finance business expansion. So FDR called for a Banking Act to assure depositors that their money would be safe, and securities legislation that, in his words, "adds to the ancient rule caveat emptor the further doctrine, 'let the seller also beware.'" Sellers who did not beware could end up in jail.
Both the Banking Act and the Securities Act were passed during the New Deal's first hundred days in 1933. The Banking Act, known as "Glass-Steagall," created the Federal Deposit Insurance Corporation (fdic), which protected bank deposits and, almost by itself, stopped the epidemic of bank runs. Glass-Steagall also forced the separation of commercial banking from investment banking, thereby reducing bankers' ability to speculate with "other people's money," as FDR called it, quoting Louis Brandeis.
The Securities Act compelled all companies issuing new stocks or bonds to disclose hitherto secret information: their balance sheets and income statements, the pay and perquisites of their top managers, and reams of other data. This was a radical move toward transparency, the more so because the act required that all reports be certified for accuracy by independent public accountants. Next came the crucial Securities Exchange Act of 1934, which extended these same requirements to every company whose shares were already being traded on exchanges--essentially the several thousand most important firms in the country. The 1934 act also created the SEC to enforce the new laws and to regulate the New York Stock Exchange and all other exchanges. Drafted with meticulous care, the Securities Act and Securities Exchange Act thrust the affairs of corporate America into the sunshine for the first time in the nation's history. The strategy of transparency was now firmly in place.
Four years later, Congress also brought under SEC control the "over-the-counter market"--that is, trading not done through an exchange. This informal operation had been run by thousands of brokers and dealers, many of them swindlers. Under SEC sponsorship, the industry created the National Association of Securities Dealers (nasd, which set up its own effective regulatory branch and, later, the nasdaq exchange). With all this legislation, administered by the elite civil servants who enforced it, the New Deal created the finest system of financial regulation in the world's history.
The obstacles to change, however, had been substantial. The new laws were very technical, and Wall Street and most other players fought regulation every step of the way. The easiest opponents to bring into cooperation were the accountants, whom the SEC courted aggressively. At first, accountants were terrified by the new legislation, which imposed criminal penalties for misrepresentation of "material fact" not only by corporations submitting reports but also by accountants who certified their accuracy. Historically, accountants had been cowed by corporate executives into shading their numbers according to the executives' wishes. The SEC pointed out that the new laws gave the profession its first chance to achieve real independence, and accountants embraced the opportunity with great enthusiasm.
The New Deal's conquest of the accounting profession and the over-the-counter market was far easier than its victory over Wall Street, investment banks, and exchange-traded corporations. For both the Stock Exchange and the big investment banks, opacity was the tradition: Their money and power came from their virtual monopoly on information about companies' operations. If the monopoly on information were broken, then individual investors--and, later, mutual funds, pension funds, charitable trusts, and university endowments--could make their own informed judgments about securities, and the expensive advice of investment bankers would be less necessary.
After three years of struggle, the SEC finally won this fight in 1937, with the help of a major scandal. Richard Whitney, an aristocratic pillar of Wall Street and the former president of the New York Stock Exchange, was found to have embezzled millions of dollars from his clients to cover losses from his own speculations. In a matter of weeks, he was sent to Sing Sing prison. With Whitney's disgrace, as SEC Chairman Douglas put it, "the Stock Exchange was delivered into my hands." The revolution in financial regulation was now complete.
Over the next four decades, the SEC built a reputation as the most effective of all federal regulatory agencies. It was respected and feared by nearly everyone involved in the trading of stocks and bonds, the issuance of new securities, and the governance of corporations. Even the Reagan transition team reported in December 1980 that "the SEC, with its 1981 requested budget of $77. 2 million, its 2,105 employees and its deserved reputation for integrity and efficiency, appears to be a model government agency."
But no revolution lasts forever. Starting in the 1970s, the New Deal's regulatory triumphs were systematically undermined. As a result, we have witnessed one scandal after another: Michael Milken's junk-bond operations; the savings-and-loan fiasco of the 1980s; the collapse of Long Term Capital Management in 1998; the failure in 2001 of Enron, whose house of cards not even its own lawyers and accountants could understand; the uncontrolled growth of the real-estate bubble; the invention of ever more complex derivatives--sliced and diced mortgage securities, collateralized debt obligations, credit-default swaps; the Bernard Madoff affair; and, finally, the meltdown of the whole financial system in 2008.
Many elements were responsible for the backsliding that led to these scandals, not least the Republican Party. The decline of regulation began in earnest with Ronald Reagan's inaugural address, in which he famously noted that "government is not the solution to our problem; government is the problem." Guided by excessive faith in "the free market," regulators in the SEC, the Fed, the nasd (which merged in 2007 with the regulatory arm of the New York Stock Exchange to form the Financial Institution Regulatory Authority), and other agencies had simply stopped doing their jobs. Even during the Clinton administration, the craze for deregulation had so worked itself into the national culture that Congress blocked major accounting reforms pertaining to stock options, and, in 1999, Clinton's financial advisers supported the very ill-advised repeal of Glass-Steagall. Worse, in 2000 they accepted the catastrophic exemption of credit-default swaps from any regulatory oversight at all. By the time George W. Bush became president in 2001, the SEC's strategy of transparency had been thoroughly undermined. The return of opacity was in full swing. The elements of a perfect storm were in place, and, by 2007, Bush's policies had brought them all together for the explosion of 2008.
While all this deregulation was going on, the financial services industry had found even more new ways to circumvent transparency. An unregulated shadow banking system arose, through hedge funds, private-equity funds, off-balance-sheet operations, offshore tax havens, and the widespread trading by money managers in completely opaque instruments, especially credit default swaps. Because of the enormous profit potential in these securities, the movement of vast sums from the regulated sunshine to the unregulated shadows became inevitable.
Today, banks and other institutions have a very uncertain idea of what their holdings of the new instruments are actually worth. Therefore, they cannot accurately calculate their own assets and liabilities, let alone those of others. This is why they are so reluctant to lend, and why the nation's credit system remains in gridlock despite the $700 billion bailout. Opacity has thus turned inward upon the very institutions that created it, which would be an ironic farce if its consequences weren't so tragic.
Obviously, there is much work to be done. The SEC still has an acceptable structure, but it needs robust infusions of talent, expertise, and money. The staffs of both the Fed and its twelve regional banks are far more sophisticated now than they were during the 1930s, and the fdic is working well under Sheila Bair, one of the few people who began warning years ago of potential catastrophe. But banking regulation remains extremely fragmented, with far too many players: the Fed, the fdic, the Comptroller of the Currency (a part of the Treasury Department), dozens of state banking commissions, and still other agencies. They are in desperate need of better coordination and, possibly, consolidation. What's more, the regulatory talent emblematic of the New Deal is not gone altogether, but it is thinner to the point of anorexia. After years of ideological hiring, large clusters of ineptitude bedevil the SEC, the Commodity Futures Trading Commission, the Department of Justice, and many other federal bodies. Nearly every important agency has long been starved of resources--and even of the elementary belief that regulation is necessary.
The political opposition to reform will be stiff. The Republican Party will likely fight every step of the way. So will the financial services industry, some of whose stalwarts are Democrats. Even now, Wall Street remains in deep denial: The lavishing of billions in executive bonuses by firms that received federal bailout money is all we need to know about this industry's feral determination to protect its outrageous pay scales.
Fiscal stimulus is the first priority now, but only with reinvigorated regulation can the economy operate effectively over the long term. Capitalism depends on credit, credit depends on transparency, and transparency depends on illumination. It's that simple. If the new administration can accomplish what the New Deal did in bringing finance into the bright light, it will be one of Barack Obama's greatest legacies, just as it is one of FDR's.
Thomas K. McCraw is a Pulitzer Prize-winning historian and the author of Prophet of Innovation: Joseph Schumpeter and Creative Destruction.