Possible Outcomes from the 2008 Financial Situation: Part II

Is U.S. Business Overregulated?Our last blog discussed three areas of likely political and regulatory change as the result of the financial crisis of 2007-2008. Here are four more areas for change.

4. The Organization of Regulation. Although functional regulation continues in the financial industries, the passage of deregulation through GLB permits financial companies to enter any financial area. This situation of inadequate oversight may have been a major element in the 2008 credit crisis and strongly suggests the need for consideration of a consolidated regulatory scheme similar to that used by the Financial Services Authority in the U.K. (For a more complete discussion, see James Sagner, Is U.S. Business Overregulated? How Government Destroys Our Ability to Compete Globally, York House Press, 2008, particularly Chapter 7.) The matching of the integrated strategy permitted by GLB to an appropriate regulatory structure has been suggested by Secretary of the Treasury Henry Paulson and others, and is likely to be considered in the next Congress as omissions and errors made both by the regulators and the companies are investigated.

5. Government Market Actions. The theory of a free market clearing supply and demand at an equilibrium price may not be working in certain situations, and governments will not stand back and watch chaos and instability destroy long-established consumer expectations and behaviors. The most obvious recent problem has been with commodities, from metals to energy to food, although the precise role of speculators and hoarders has yet to be definitively established. In any event, governments will stockpile, subsidize, set price floors and ceilings, prosecute and change the procedures by which these products trade.

6. Restrictions on Business. Congress is loath is interfere with the free market system and realizes that it knows less than business managers how companies should operate. (Most Congressmen have never worked in the corporate world; for statistics on the professions of the current Congress, see “Membership of the 109th Congress: A Profile,” CRS Report for Congress, pages CRS 3-4, at www.senate.gov/reference/resources/pdf/RS22007.pdf). The disastrous post-World War II experience in Great Britain with nationalization ended with Prime Minister Thatcher’s decision to privatize most of British industry, and we are not about to go back to the days of a Labour Party under Prime Minister Clement Atlee. However, there is considerable pressure on executive pay, particularly regarding disclosure and limitations.

It is possible that many companies could be subject to new rules as the asset-purchasing program of the U.S. Department of the Treasury begins. Executive pay is affected in several ways, including limitations on tax-deductible compensation (now $500,000). Board committees that approve executive compensation may be required to examine the risks a senior manager might be motivated to take on to meet his/her goals. Members of Congress have indicated that the current financial rescue package approach to compensation could be extended to all publicly-traded companies.

7. Government Senior Administratorship. One of the most unfortunate outcomes from this entire credit market disaster has been the growing recognition of the weak stewardship at certain of the regulatory agencies that should have been monitoring the situation. The country does have two strong leaders in Chairman Bernanke at the Federal Reserve and Secretary Paulson at the Treasury. Congress may begin to realize that awarding senior-level jobs to former colleagues, the relatives of former cabinet secretaries, or other political hacks is a poor method to choose Executive Branch senior managers.

Just as some states write qualifications for cabinet-level positions, the Congress may choose to insist on banking, accounting, legal or other relevant agency-specific experience for these critical positions. Furthermore, the old tradition of rewarding cronies who were defeated in a recent election must be very carefully examined; the voters probably knew what they were doing, and the framers of the Constitution never intended the Senate to be a rubber stamp in approving jobs for the pals of the President.


Possible Outcomes from the 2008 Financial Situation: Part I

We have discussed the financial crisis in previous blogs. Inevitably, several changes will be considered by government policymakers and the private sector as the result of the events of 2007-2008. Political considerations will drive these reforms regardless of issues relating to free markets and capitalism.

1. New Regulation. There will be new financial regulation, including rules to reduce leverage and to control markets that have been unregulated. The use of 30 to 35: 1 debt-to-equity financial leverage used by certain securities firms to enhance returns will be limited to the same rules as apply to banks, about 10:1. Unregulated instruments like the credit default swap market will be subject to controls, somewhat like the rules that exist for the futures markets. Banks may be limited in their securitization activities and could be forced to retain ownership of portions of loans as an inducement to better lending practices.

2. Existing Regulation. The operational regulator for banks is the Comptroller of the Currency, an agency that has been in existence since the American Civil War. (The Federal Reserve is a strategic regulator for the entire financial system as well as the central bank of the U.S.) The supervision expected of banking practices includes the appraisal of asset quality, including the terms and documentation of loans; the competence of management; and sensitivity to interest rate, operating and other risks.

New levels of examination will be required, including analysis to predict situations that may lead to non-performing loans, verification of the value of collateral, proof of earnings and assets, review of performance on loan repayment, and other steps to improve the balance sheets of banks. This should prevent future distressed bank sales like Wachovia Bank in 2008, but will inevitably deny credit to marginal borrowers who may be struggling to buy their first homes or keep a business afloat.

3. Government Political Actions. Government helped create the current financial problems largely for political reasons. Some examples:

· To satisfy homeowners: deductions for homeowners on mortgage interest and property taxes on residential real estate
· To appeal to those at lower incomes: encouragement to Fannie Mae and Freddie Mac for loans to borrowers with questionable credit histories
· To induce borrowing activity: unrealistically low interest rates as set by the Federal Reserve
· To placate business managers: the business deduction for interest on debt

Political decisions will again be made to satisfy angry constituents and place blame. It is difficult to know who will bear the brunt of this anger, but a reasonable forecast is that the financial industry will be the target. The restoration of the pre-deregulation regime is unlikely – the period before the Gramm-Leach-Bliley Act of 1999 (GLB) – but some changes are inevitable; see the following section on the organization of regulation. However, we must remember “the law of unintended consequences” which basically states that passing new regulations inevitably causes other (and possibly worse) problems.

Additional possible changes will be discussed in our next blog.


The year 2008 has been tumultuous, with economic changes that would have required decades in normal times. It required years of lobbying for the two major financial deregulation laws to be enacted; it took less than a month in early Fall to nationalize Fannie Mae and Freddie Mac; rescue and seize control of AIG, the world’s largest insurer; extend FDIC coverage to money-market funds and to increase bank deposit guarantees; temporarily ban short selling in nearly one thousand stocks in the financial industry; commit to the continuing liquidity of the commercial paper market; and provide $700 billion to assume control of non-performing bank loans, primarily mortgages.

The major investment banks have disappeared, with Bear Stearns and Merrill Lynch now owned by commercial banks, and Goldman Sachs and Morgan Stanley becoming commercial banks. Of course, smaller investment banks exist for regional transactions, but the securities industry has been transformed in ways considered unthinkable even a year ago. How could this happen and what will be the new look of the financial system, both with regard to the financial companies providing the services and the corporations that depend on credit and equity to conduct their business operations?

Financial markets are probably inherently unstable, as banks and other institutions seek new methods to enhance the fairly small return from lending or fee-based activities. It is a struggle for a bank to earn one per cent on its asset base even in prosperous times, and the innovations developed by the quants were largely intended to enhance these fairly puny returns while limiting the amount of equity capital required to support normal activities.

Can government develop a better system to improve stability while avoiding the chaos that has recently been experienced? The history of federal law on finance has been uneven, with Congress often ready and willing to find a scapegoat rather than getting to the real sources of a problem. A positive result was President Roosevelt’s creation of the SEC (through the Securities Act of 1934), and for many years, it did a very credible job in supervising the investment banking industry.

A negative result was the Glass-Steagall Act of 1933 that separated commercial and investment banking for two-thirds of a century, on the theory that these institutions somehow caused the 1929 stock market crash. However, we now understand that there were other far more important causes, including the use of margin to buy stocks (as much as 90% of a stock’s cost could be margined or borrowed in those years), and the decline in farm prices throughout the Midwest and West Coast in the 1920s, due largely to mechanization, the use of fertilizer and overproduction, that eventually destroyed banks and small businesses in those areas.

In my next blog I’ll review likely government actions as changes are debated on the regulation of the financial markets.

If, “It’s the Economy, Stupid!” Where’s the Plan?

Is U.S. Business Overregulated?There is no more critical issue facing America than its ability to compete in the global economy. The loss of manufacturing jobs to countries with five to twenty times lower labor costs may be the most important economic problem of our times. The U.S. has become a service economy that is heavily dependent on the goodwill of two classes of market participants:

• Foreign holders of dollars who keep buying our stocks, bonds, real estate, and other assets

U.S. consumers whose spending drives some 70 percent of our gross domestic product


So, what do our Presidential candidates suggest? What structural changes would their administrations propose? Unfortunately, one of the problems in following the candidates’ economics positions is that they don’t have any specific long-term plan. The composite position is some kind of short-term economic stimulus package totaling about $100 billion. While economists never agree on much of anything, there seems to be a consensus that a $100 billion stimulus applied to a $13 trillion economy will accomplish almost nothing. (It would take a $130 billion stimulus just to equal one percent of the size of the U.S. Gross Domestic Product [GDP]!)


We need some real discussion among the candidates about the long-term: changing laws, eliminating regulations, stimulating job growth, reducing corporate tax rates, etc. The closest to this probably has been Mitt Romney in Michigan who promised to revitalize the auto industry and restore jobs … although, to no one’s, surprise … the details are vague. (Hint to Mitt: Those auto jobs are now in Japan, South Korea and other countries, and they aren’t coming back.)


The U.S. has to change its vision of the 21st century economy. We have to consider repealing laws that seemed reasonable as long ago more than 100 years ago (for example the Sherman Act of 1890 concerning antitrust), and as recently as 6 years ago (the Sarbanes-Oxley Act of 2002 concerning corporate governance). America has never developed a comprehensive public policy toward global competition. In fact, the Department of Commerce, the agency charged with the promotion of international business, did not begin to emphasize sales to foreign markets until the 1970s, some 300 years after countries like Great Britain and Holland were actively developing world trade relationships.

<>If foreign holders of dollars and/or U.S. consumers ever falter in their support, the result could be a decade-long recession. This is no idle threat; by 2007, housing was in a slump with prices likely to be down for the years 2007 – 2009. And in recent years housing “wealth” was what sustained the consumer and supported all those trips to Wal-Mart <>and to Orlando or Las Vegas. Although there are no quick fixes, the argument of my new book Is U.S. Business Overregulated? (York House Press, 2008) is for a new look at our regulation of business to level the playing field against foreign competitors. We may well be our own worst enemy in limiting America’s ability to compete in the global economy!

The theme of this book is that there are “positive” regulations … and “negative” regulations, where government officials substitute their judgment for that of the market in situations when such substitution is inappropriate and may result in the suboptimal allocation of the factors of production….society cannot survive without laws to protect individuals and the environment against the corrupt or criminal actions of business.


Whatever Happened to the “Giant Sucking Sound”?

Is U.S. Business Overregulated?The 2008 Presidential campaign has been underway for months (some say years), but economics and global trade are not getting the top headlines and sound bites. Although it takes some digging to discern the candidates’ positions, the Democrats have generally supported free trade and fiscal responsibility, although the campaign of John Edwards has somewhat strangely attacked free trade agreements while Hillary Clinton, Barack Obama and the leading Republican candidates seem to support them. On October 27, Mr. Edwards issued a very critical statement on the proposed bilateral free trade agreement with Peru (which is similar to the North American Free Trade Agreement or NAFTA); however, it was approved a week later by the House Ways and Means Committee.

Free trade has been kicked around in the Americas since debate began on NAFTA well before it came into operation on January 1, 1994. Some of you may remember 1992 Presidential third-party candidate Ross Perot’s prediction of a “giant sucking sound” of jobs leaving the U.S. for Mexico, where the labor cost has been significantly lower. Although Perot clearly touched a nerve (he received 18.9% of the popular vote but no electoral votes), his forecast of massive job losses were wrong. In fact, trade and employment has increased significantly among the three participating countries (the U.S., Mexico and Canada), although specific industries have lost jobs (e.g., textile, apparel). The debate about free trade in the Americas is now fairly quiet, and the Clinton and G.W. Bush Administrations have strongly urged the extension of NAFTA to other developed countries such as Chile, Brazil and perhaps, Argentina.

Because of Mexico’s unwillingness to extend NAFTA until progress is made on normalizing immigration, the U.S. has developed bilateral trade agreements with Western Hemisphere countries, including Chile, Colombia and Panama, as well as the Peruvian agreement noted above. (Note: the U.S. has also entered into such arrangements with Australia, Bahrain, Israel, Jordan, Malaysia, Morocco, Malaysia, Singapore and the UAE.) The jobs issue that became a centerpiece of the 1992 election seems to have vanished. As a nation, we are at full employment (typically 4.5% of American workers are unemployed in any reporting period but currently 4.7%), with nearly 5% annualized growth in workers’ output per hour and a five quarter record of positive growth in real wages (that is, inflation adjusted).

No candidate has made American competitiveness and global trade major campaign issues. Regardless, we need to hear about these concerns and what the next President will be doing to change the regulatory system that is strangling American business.

Churning is for Butter, not for Business Managers

An essential element in managing an organization is continuity: the idea that the same people will function in their jobs for an extended period of time so that their corporate responsibilities are conducted efficiently and effectively. Naturally, any business experiences some turnover, whether from new opportunities, departures or other events. However, this process should proceed with the minimum of disruption to the conduct of the company’s affairs. The regulatory environment has become so difficult for many managers that even 6-figure salaries are insufficient compensation to motivate them to stay in their current positions.

A recent survey by Liberum Research reports that the trend of recent years in finance continues to show high levels of management change. For example, more than 2,300 chief financial officer (CFO) positions turned over in 2006, with fastest rates of “churn” in businesses with $1 billion or more in revenues. The average time in position was 30 months, about one-half of the 5 year tenure in 2002. A major cause reported by Liberum is stress from such sources as regulation and global competition.

Stress has always been a component of any job, but current pressures far exceed past demands for profits and growth. The Sarbanes-Oxley Act of 2002 (Sarbox), passed in response to such fraud cases as Enron, WorldCom and Tyco International, establishes a large body of mandatory actions by public companies. Sarbox broke new ground by mandating that U.S. publicly-traded corporations regularly assess their processes to ensure transparency and protect shareholder value. The law was enacted to restore investor confidence by requiring actions concerning financial reporting, conflicts of interest, corporate ethics and accounting oversight. Heavy fines for senior managers and their corporations, and even imprisonment, are available remedies under Sarbox; the idea was to construct a strong enough incentive for business executives to be good citizens.

Sarbox makes new law in several important areas, some of which may create havoc for corporate managers, accountants and regulators. As one example, chief executive officers are now required to certify that a periodic financial report “fairly represents, in all material respects, the financial condition and results of operation of the issuer.” A knowingly false certification can result in a fine of up to $5 million and imprisonment of up to 20 years. Although Sarbox does not contain any clarification for this process, many public companies are requiring finance managers to “sub-certify” the sections of the financial reports for which they are responsible. One survey noted the following areas as the most common areas where financial professionals were being asked to sub-certify, leaving them with unresolved issues of liability:

· disclosures in management’s discussion and analysis or in footnotes

· specific account balances in banks

· compliance with company policies and procedures

· adequacy of internal controls in their department or business function

· compliance with company code of conduct

The answer to the fraudulent actions of a few very bad actors is not to pass expensive and overly punitive legislation. This solution contributes to the enormous cost of operating business and stresses managers to the point of their leaving their positions after only a short term of service. Sarbox should be repealed and other existing law used when fraud is detected. Incidentally, this was how the chief executives of Enron – Ken Lay and Jeffrey Skilling – were successfully prosecuted.

We Have to be Economic Pragmatists — Like the Founding Fathers

    This blog is about economics, trade and global business. In deciding the best course of action for the U.S., we should recall how our Constitution – the document that has guided our government since ratification – came into existence. The leading causes of the decision to meet in convention in Philadelphia in 1787 were the political and economic weaknesses of the Articles of Confederation. Evidence of the political problems was the inability of Congress to support the new government and to raise funds for the Continental Army during the Revolutionary War. This powerlessness continued after the war and threatened the security of the U.S. in the form of Shay’s Rebellion and the presence of foreign powers and Indian tribes at America’s Western and Southern borders.

The essential economic problem facing the colonists after the war was continuing quarrels over commerce and the inability of the federal government to manage interstate and international trade. The framers came to recognize that, because of their own self-interests, individual states would not bring themselves to conduct their affairs in the manner outlined in the Articles of Confederation, to “… enter into a firm league of friendship … on account of …trade…” The new federal government needed to be assigned the responsibility to protect commerce from the interference of any state.

Such measures took various forms, including taxes, laws on trade, and fees at ports of entry. Alexander Hamilton, James Madison and John Jay wrote 85 Federalist Papers to explain the intentions of the framers. Federalist comments on these matters appear in Nos. 6 (Hamilton), 7 (Hamilton), 10 (Madison), 11 (Hamilton), 22 (Hamilton) and 42 (Madison). For example, states with access to navigable ports taxed goods shipped from their neighbors, which resulted in retaliation and attempts at special trade arrangements with foreign governments. This is no particular surprise given the divergence of regional economic interests: shipping and fishing in New England; small farming, manufacturing and finance in the Mid-Atlantic States; and slave-based agriculture in the South. As the result, the South depended on exports and free trade, while the Northern states needed import tariffs to protect their infant industry.

Compromise was required to get to Philadelphia and then to reach consensus. During the period before the Constitutional Convention, there were at least four separate pragmatic actions that leading founding fathers used to move the process along.

· George Mason (a Virginian) negotiated with a delegation from Maryland over navigation rights on the Potomac River, even though he had not received formal instructions on his duties from his governor (Patrick Henry).

· George Washington invited these delegations from Maryland and Virginia to his home (Mt. Vernon) to conclude the Potomac River compact, ignoring clear restrictions on such actions without Congressional authorization.

· The two delegations agreed that the river would be a “common highway” allowing free access, despite the wording of the 1632 charter issued by King Charles I that ownership belonged to Maryland.

· The success of this agreement led to proposals to call a convention, the excuse for which was New Jersey’s instructions to its delegates to an Annapolis MD meeting of the States in 1786 to address commerce “and other important matters.”

Not one of these events was consistent with the rule of law (such as it was in 1785 – 1786), and any one, if voided by appropriate authority, could have prevented the Convention from ever meeting. We’ll talk more about “revolutionary” changes in future blogs. However, it is a given that we must be similarly pragmatic in the beginning of the 21st century in fixing our restrictive laws and regulation on business activities.