The New Republic

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.

By Thomas K. McCraw

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