Requiem for a dream

A lot has been written in the last few days about President Obama's plans to hit the industry many mostly blame for the current economic downturn: the banking sector.

Already on January 14, Mr Obama proposed a new tax on big financial institutions to pay for the 2008 bailout (see article in The New York Times). Then, just a week later, and right after a surprising and devastating loss at the Massachusetts special election for the Senate (see article in The New York Times), which meant the Democratic Party will no longer control the 60 votes needed to overcome filibusters, Mr Obama declared he will propose prohibiting commercial banks from making trades for their own accounts and owning or investing in hedge funds or equity funds, as well as implementing tougher rules aimed at limiting bank mergers and consolidation (see article in CNN.com).

This legislation proposal, widely called the Volcker Rule in honor of the now independent economic adviser of the Obama administration, who has been repeatedly calling for tighter regulation of the banking system since the fall of Lehman Brothers, has certainly made headlines all over the world, as well as wreaking havoc on Wall Street and most stock markets overseas. Bank shares plunged for 3 consecutive days, in most cases losing more than 10% of their previous value. Even institutions such as Goldman Sachs, whose last quarter profits beat all estimates by a wide margin, were hard hit by the news.

As it was to be expected, positive albeit uncoordinate reactions could be heard all across the EU, as European politicians saw it as a perfect backing for their crisis-long theories about the roots and reasons for the downturn: America and its reckless banks were to blame, and they should be therefore punished by means of tighter regulation. They had known it all along. Of course, European banking institutions would not be spared of such reprisals: several top lawmakers expressed their desire to imitate Obama's initiative. However, and also not surprisingly, no paneuropean measures will be taken, as the EU and the BCE have no power to directly regulate their members' financial sectors.

The seemingly sudden turn in the priorities of the White House and the current backing of Mr Volcker's theories has also spellt trouble for current chairman of the US Federal Reserve, Ben Bernanke, who is up for reelection this week (update: he was finally reelected on Thursday by a 70-30 vote by the US Senate). Although he is widely credited for swiftly acting once the bubble burst and thus saving world economy from a new depression, he has also spurred critics for his inability–or lack of desire–to tackle the high levels of unemployment and to trigger much-needed financial reforms (I recommend a couple of interesting articles in The New York Times: one by Paul Krugman and an older one by David Leonhardt).

After having the upper hand during the first year of Mr Obama's presidency, a sharp decline in approval ratings, soaring unemployment, widespread disapproval of the health care reform (or, at least, at the way it has been handled by the President and leading congressmen) and the disappointing loss of Democratic supermajority in the Senate have Mr Bernanke on the hot seat: several senators voiced their concerns last Friday (see article by Reuters), thus adding a new element of uncertainty to world stock markets.

Although it can be seen as a populist measure, the banking system clearly needs extra, tighter regulation if further bubbles and crashes are to be avoided. Moreover, it is also true that the huge size and economic clout of some banking institutions pose a risk for global the economy: an unfair precedent has already been set by bailing them out once, yet history could repeat itselft if no regulating policies are adopted, be it the reimplementation of many aspects of the Glass-Steagall Act, as Mr Volcker defends, or the drafting of entirely new laws.

However, another recent piece of news has not been nearly so popular but could be seen as almost equally important in marking the demise of the American Dream of this past decade: also on Friday, Democratic Congress representative Barney Frank announced he will lead a committee that will recommend replacing Fannie Mae and Freddie Mac, the behemoth and deeply troubled mortgage financing companies sponsored by the US Government (see article in Bloomberg) whose main goal is to lower the cost of homeownership, as they buy mortgages from lenders, freeing up cash at banks to make more loans, thus making it more affordable for millions of Americans to buy a house.

It is by no means a coincidence that Mr Frank's announcement came just a day after President Obama's disclosed his own plans to reshuffle the banking landscape, albeit hardly a month after, on December 24, 2009, the Treasury Department made an unprecedented announcement that it would be providing Fannie Mae and Freddie Mac unlimited funds for the next three years despite losses in excess of $400 billion so far (see article in the Wikipedia). The idea of doing away with Fannie and Freddie, two institutions with several decades of existence –Fannie Mae was already created in 1938 as part of Franklin Delano Roosevelt's New Deal– would be an important step towards denying one of the main dreams of the decade that just ended: the belief that all families could own a home.

This optimism, which we could easily link to the bold predictions detailed in Francis Fukuyama's acclaimed book The End of History, has probably triggered some of the most dangerous creations of modern financial engineering, subprime mortgages and asset-backed securities. Since the mid-90s, people bought houses at ever rising prices because they thought it would be the single biggest investment they would probably make in their lifetimes. Consequently, this developlement was lauded as extremely positive and as a trend that should hold on moving forward (for instance, see this old article on the LA Times website).

 

While the rise in home ownership has its fair share of prositive effects, both at the community and the family levels, it also has its downsides: according to The Economist, America's internal migration rate, both inside the states and between them, is currently at historical lows. This mobility has tipically been one of the strong points of the US workforce. However, Americans are now losing this competitive edge because they are stuck in the houses they bought during the boom years, saddled by negative equity and with foreclosure as the only other alternative.

 

After a "lost" decade of stagnating salaries, diminishing leverage among the middle class (see article on the Cato Institute website) and zero employment growth in the US and many other rich countries, millions of foreclosures and widespread negative equity now remind us that maybe this very commendable hope was a misguided one. As Janet Albrechsten argued in an article published a few months ago in The Wall Street Journal, America needs to realize that not everyone can own a home (see relevant article). And, may we also add, citizens, banks and, most importantly, lawmakers of many other countries should also face this harsh reality and start shaping future growth based on a more sustainable housing market.

It can certainly be argued that globalization has indeed increased inequality in most countries, accelerating a rise driven –since the liberalizing and deregulating policies of the 80s, led by Ronald Reagan and Margaret Tatcher– by the ever-growing income of the top earners and whose speed is correlated with the local pace of integration into global markets. In this sense, tighter regulation of financial institutions will hopefully help achieve a healthier market and protect many customers from unrealistic expectations. Rising inequalities will still be a cause of concern, but at least we should be able to face it sincerely: acknowledging what it implies is the first step towards correcting it with the adequate policy responses.