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Looking Backward

Rest assured. The Obama campaign is on the issue of the financial crisis.  They campaign sent out a memo to reporters to this effect:

Senator Obama did a call this morning with some of his key economic advisors including Paul Volcker, Bob Rubin, Lawrence Summers and Laura Tyson about the state of the financial markets.  They discussed what to expect from financial markets today and over the course of this week, how these events would impact the overall economy, and what steps should be taken to address the problems in our financial markets and economy more broadly.

The only person missing from this list of advisors is Alan Greenspan.  I don’t want to generalize about these advisors, but I think that Democrats, and the Obama campaign, would be wise to make a distinction in their mind between neo-liberal and liberal economics.  The ‘90s were the heyday of neo-liberal economics, which attempted some accomodation with the conservative laissez-faire variety. And part of that accomodation consisted in opposing new government regulations of the financial industry and attempting to remove old ones like Glass-Steagall. Under Bob Rubin, the Clinton Treasury Department took the lead.

Anyone who wants to be reminded of this history should look up the story of Brooksley Born, the former chair of the Commodity Futures Trading Commission under Clinton.  In Jaunary 1999, Born decided not to seek second term because of opposition from Rubin to her attempt to regulate derivatives – the kind of unregulated financial instrument that even then was undermining the stability of the financial system.   

Here is an excerpt from an interview with Born where she described her experience trying to regulate over-the-counter trading instruments during the second term of the Clinton administration:

Weren’t derivatives also responsible for the collapse of a large hedge fund?
Yes. During the time that I was at the commission, Long-Term Capital Management had to be bailed out by a number of the large OTC derivatives dealers because it had $1.25 trillion worth of derivative contracts at the same time it had less than $4 billion in capital to support them.

I became enormously concerned about OTC derivatives and thought the market was a nightmare waiting to happen. About three months before we knew about Long-Term Capital Management, the commission came out with a concept release in the Federal Register asking for input from the industry and other interested people concerning the need for more oversight of the over-the-counter derivatives market. I was particularly concerned that there was no transparency. No federal regulator knew what kind of position firms like Long-Term Capital Management and Enron had in the derivatives markets. These instruments can be used to reduce economic risk, and they are certainly very valuable and useful economic instruments, but they can also create enormous risks, as they did at Enron and Long-Term Capital Management. Warren Buffett has recently called them financial weapons of mass destruction.

Nominally and statutorily, OTC derivatives were under the CFTC’s jurisdiction, and the CFTC had exercised its discretion to partly exempt the market, but kept some powers and responsibilities that it had no ability or possibility of exercising or enforcing. Although I was willing to be persuaded otherwise, I felt strongly that while heavy regulation was not required, transparency was needed, and some federal regulator should have information before a disaster occurred rather than only afterwards.

How was the concept release received?
There was a firestorm of criticism from the large OTC derivatives dealers, and they were supported by other financial regulators.

What was the ultimate outcome of the regulatory effort?
It wasn’t a regulatory effort. We were just asking questions! The concept release didn’t propose any rules. Alan Greenspan, Arthur Levitt, and Robert Rubin all said that these questions should not be asked and urged Congress to pass a bill that would forbid the commission from taking any regulatory steps on over-the-counter derivatives. There were no hearings on that bill, but during a congressional conference committee meeting on an appropriations bill, an amendment was added preventing the commission from taking any action on over-the-counter derivatives for six months. This occurred within a month after Long-Term Capital Management’s collapse!

I thought it was very bad policy, but on the other hand it was Congress’s decision to make, and having made that decision Congress relieved the commission of its responsibility, so that Enron, for example, became the Congress’s responsibility, not the commission’s.

What is the relevance of all this?  First of all, derivatives are part of the same problem as subprime mortgages – they are part of what Paul Krugman calls the “shadow banking system.”  Ignoring them, and letting the market rule, was part of the neo-liberalism of the ‘90s..  Secondly, and more to the point, Wall Street is now worried about derivatives.  Writes The Washington Post today, “What worries regulators and Wall Street is a massive, multitrillion-dollar lattice of interlocking financial instruments known as derivatives.”  

Perhaps, those neo-liberals like Rubin who opposed regulation in the '90s have changed their mind.  Certainly, some of them have.  But just to be safe, Obama might consider looking for advice to some of the people who were critical of Rubin et al. during these years, people who thought that more rather than less regulation was needed.

--John B. Judis