An American Recession?

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Veteran market watcher Robert Kuttner and Wall Street insider William H. Donaldson give Bill Moyers their read of the current economic landscape and discuss the risks of the deregulation of the financial industry.


Bill Moyers: Welcome to the Journal. The stock market hit record highs this week, and while that makes some people giddy, it gives people my age the October jitters. To us October is still the month of the crash…

The crash of 1929, a seismic calamity. Share prices rose like balloons then fell through the floor. Investors panicked. Banks failed, their assets frozen. Savings disappeared. Business after business went bankrupt. Millions were thrown out of work for years. People went hungry and homeless.

I was born in the midst of that depression – among people laid low by it, their memories seared by it forever. Today even as the stock market booms, some people are asking if it could happen again.

In testimony before congress last week, veteran economic journalist Robert Kuttner talked about those parallels.

Robert Kuttner: I am chilled, as I’m sure you are Mr. Chairman, every time I hear a public official or Wall Street eminence utter the reassuring words “the economic fundamentals are sound.” Those same words were used by President Hoover and the “Captains of Finance” in the cold winter of 1929. They didn’t restore confidence. The fact is the economic fundamentals are sound if you look at the real economy. It is the financial economy that is dangerously unsound.

Bill Moyers: And in a talk at Princeton University, the 27th chairman of the Securities and Exchange Commission…William Donaldson talked about Wall Street malfeasance in the 1920s and the exuberance of more recent booms and busts.

Let’s find out now why both men have a case of the October jitters.

William Donaldson began his long and notable career in 1959 when he co-founded the international investment bank and stock research firm Donaldson, Lufkin and Jenrette. Over the years he served as Under-secretary of State in the Richard Nixon administration… the founding dean of Yale University’s school of management…. Chairman and CEO of the New York Stock Exchange. And in 2003, he was named chairman of the Securities and Exchange Commission by President George W. Bush. He resigned two years ago to return to private life as an investor.

Robert Kuttner has made economics and public policy his beat over four decades as a journalist, teacher, editor and public official. After a stint as a legislative assistant in congress he was a staff writer for The Washington Post, a columnist for The Boston Globe and Business Week and a founder and co-editor of The American Prospect magazine, which once had the financial support of the Schumann Foundation, with which I am associated. Among Bob Kuttner’s seven books, The Revolt of the Haves; Everything For Sale and this new one, to be published in three weeks, called The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity.

Thanks to both of you for joining me.

Bill Moyers: Thanks to both of you for joining me. All right, what worries you?

Robert Kuttner: I think there are three big parallels between what happened in the ’20s and what has been happening on Wall Street lately. One is insiders with conflicts of interest that are not fully disclosed to the public, generally. Secondly, there’s much too much borrowed money. There’s much too much leverage in the economy, and particularly in the financially engineered parts of the economy.

Bill Moyers: Which would be hedge funds?

Robert Kuttner: Which would be hedge funds and derivatives, which are instruments that hedge funds often use. And I think the third is the lack of transparency. The regulators —

Bill Moyers: What do you mean?

Robert Kuttner: Regulators and the public don’t get any kind of disclosure. And hedge funds, because of the loophole in the securities laws, they’re not regulated at all. And to the extent that there is a degree of transparency, regulators do get to look at the assets of banks. Sometimes they don’t know what they’re looking at. Now, you put those three things together, you have a risk of an economy based on asset bubbles where people —

Bill Moyers: Asset bubbles?

Robert Kuttner: Yeah. It’s what happened in the ’20s and it’s what happened in the ’90s. There’s a euphoria that sets in. Some of it’s engineered euphoria. If you cook your company’s books to make it look like your profits are higher than they really are, that’s gonna bid up the price of your stock.

And if you’re an executive who’s compensated on the basis of the price of the stock, that’s called a conflict of interest. And that was at the heart of what happened in the ’20s and what happened in the ’90s. That’s why we need the kind of transparency that Mr. Donaldson was promoting when he was head of the SEC.

William Donaldson: Well, I think we’ve created a number of instruments in this country in particular derivatives and so forth and so on. I think these instruments are not necessarily understood in their entirety.

Bill Moyers: Let me tell you, I don’t understand them.

William Donaldson: Well I’m not sure that many of the people that buy them understand them. I have a feeling that somewhere there’s an institution that’s just bought a derivative and they don’t understand what they bought.

Robert Kuttner: You know, the problem is that in the old days when a bank examiner went to a bank and looked at its portfolio of loans, the examiner could tell which of the loans were performing. Was interest being paid on the loans? Was the principal being paid back? Which ones weren’t? And the examiner could direct the bank to reserve assets against the risk of a loan default.

Well, today it’s a kind of a regulatory black box. The regulators are relying on the banks’ own so-called stress models, which make certain assumptions about human behavior. And we just had a full field test of this in the sub-prime mortgage meltdown. The models didn’t work. Behavior wasn’t supposed to occur along these lines.

And a lot of this turned out to be junk. And a lot of innocent people got hurt. And the only reason the economy didn’t crash was the Fed, which was not inclined to do this before the sub-prime meltdown — the Fed opened the spigots. And so even though the sub-prime sector is a complete mess, the stock market, as you pointed out in your introduction, hit new highs.

Why? Because the more alarmed the Fed is about the economy, the more the Fed is gonna lower money. And that’s good for the stock market.

Robert Kuttner: I mean Alan Greenspan, is one of the revered public figures of our time. I think he made one huge mistake — he did not use a lot of the regulatory power that he had. Every time there was a credit crunch, he would race to the rescue.

Bill Moyers: By putting in cheap money?

Robert Kuttner: Yeah. So it seems to me, if you’re gonna bail out — problems after the fact, you have an obligation to prevent some of them before they start. And for 13 years, Greenspan’s Fed and now Bernanke’s Fed has had not just the authority but the mandate from Congress to look at mortgage loan origination standards.

Had they issued regulations under that authority, you never would have had a sub-prime crisis because they would have gone in and noticed that loans were being made that people couldn’t possibly pay off. And the only reason they were being made was that somebody at the end of the daisy chain was willing to buy the paper.

William Donaldson: I don’t, you know, I don’t know about the Federal Reserve system and why they didn’t do what they should have done. I do know about the SEC and I do know the efforts that we made to anticipate where things were gonna go wrong. We formed an office of risk control and risk management.

And the idea was to assess where risks were growing up. And we did that with our inspectors that go out into the firms under our jurisdiction. And we basically tried to look over the hill and around the corner and see what was coming down the path. Instead of arriving at the scene of the accident after it’s happened, and mopping up we were trying to anticipate where problems were gonna come from.

Bill Moyers: But you know, you are a conservative, and yet you believe — you’ve long believed in managed capitalism. When you went to the SEC, you took with you a belief that government had a role, even though you were conservative. That capitalism, to save itself, needs to be managed. What’s happened to that idea, that government does have a role to protect even capitalism from itself?

William Donaldson: Well, first of all, Bill, I think you have to stop using the words “conservative” and “liberal.” I would hope that I would be called independent in thought, and not adopting a conservative or liberal — clearly what’s needed is an independence of thought, if you will. And an approach to regulation. Markets don’t regulate themselves. Clearly. Anymore than you can have an intersection and no stop signs and red lights.

Robert Kuttner: What drives me crazy, Bill, is the assumption that this is a linear set of choices. Either the Fed does nothing and lets the economy go down the drain, or the Fed cheapens money and bails the economy out and then invites the next round of speculative excess.

There’s a third choice that nobody’s talking about. That’s regulation. It’s what we had between the New Deal and the late ’70s. There are certain things that are illegal because they’re too risky.

Bill Moyers: Yeah, but when Bill Donaldson went to head the SEC after the Enron, the scandals, and set out to regulate wrongdoing, you became the skunk in the garden, right? Big business, the US Chamber of Commerce, the right-wing circulated rumors that you were a Stalin-like planner. I mean, they didn’t want to be regulated, right? They don’t want regulation.

William Donaldson: Well, I think a lot of people realized that we needed regulation. You just had to look at where public opinion was and where investor sentiment was after Enron and WorldCom. A very dangerous situation. And the people were asking “Where were you, the SEC, when all of this stuff happened?” And so I think that they welcomed the firm action that the SEC took.

Bill Moyers: Well, The New York Times, when you retired, gave you credit for restoring faith in the markets. And you did it by strong enforcement.

Robert Kuttner: But, you know there was a window that lasted maybe two years. It took a calamity like the meltdown of ’01-’02 — 2000-01, rather, to get support for regulation. As soon as that calamity passed it was business as usual. And I think the people who gave you such a hard time didn’t want any more regulation. I mean what really occurred was that the sub-prime crisis was the result of the Fed’s failure to enforce lending standards.

The game was give a loan to somebody who may be at risk of not being able to pay it back. And then an investment bank turns the loan into a security, and some hedge fund or pension fund buys the security, and a private rating agency certifies that it’s a safe security. No one knew what in the heck these things were worth until people got a little bit skittish. And then it turned out that a lot of them were worthless. But anybody who talked about the idea that maybe this should be regulated was another skunk at the garden party.

Bill Moyers: But you were one of the first that I remember calling for regulation of the hedge funds, when you were at the SEC. Why did you want hedge funds regulated? What’s dangerous about them?

William Donaldson: Well, these are private pools of capital. They originally started out as a way of investing by both going long and short stocks, supposedly market neutral, as they say. But through the years, the name “hedge fund” has been applied to any pool of capital that is not registered under the SEC —

Bill Moyers: Unregulated?

William Donaldson: Well, it — yes. And this has grown, like Topsy. Latest figure’s $1.7 trillion of money in hedge funds today versus — that’s ten times growth in less than 10 years.

Through a quirk in the regulatory structure hedge funds are not regulated like mutual funds are, or like investment advisors are, or like investment management and brokerage firms are. This is, I believe, just crazy, that we can have, you know, $1.7 trillion. On some days, hedge funds account for 50 percent of the volume on the New York Stock Exchange. So it seems like we ought to at least understand what’s going on in the hedge fund business.

Bill Moyers: So what’s at stake? Why should people care about what happens to hedge funds?

William Donaldson: Well I would start by saying that we can’t condemn the whole hedge fund industry. There are certain hedge funds, many of them, that are well run by professionals, et cetera, et cetera, et cetera. On the other hand, I think that if you just look at the compensation structure in the hedge fund business where they receive two percent fee on the assets under management, and 20 percent of the profits, and anybody can go into that business and set up a hedge fund. Now, in order to achieve a return, if you’re taking 20 percent of the profits and two percent of the assets under management, you have to reach for spectacular returns.

Robert Kuttner: And big risks.

William Donaldson: And big risks. And the problem — the thing that I think people don’t understand is the impact that hedge funds can have on the marketplace itself. People were saying – that George Soros doesn’t need —

Bill Moyers: “Leave him alone, he’s a big guy. He — he’ll take care — ”

William Donaldson: — guy, he understands what’s —

Bill Moyers: — “of himself.” Yeah.

William Donaldson: — going on. That’s not the point. That’s a slight point. I mean, we do have to assure, even wealthy investors, that the way the funds are priced, the way the fees are gathered, et cetera, et cetera, is being done. That there’s no inside trader, trading, all that sort of stuff.

But the real issue is every time a hedge fund buys or sells something, it’s doing it with the public, with institutions, with the market. And I think we need to know a lot more about the techniques that are being used in the marketplace itself.

Bill Moyers: And the bottom line, is that the gov — is that the SEC’s job to make sure we know?

William Donaldson: Absolutely. The SEC is — that’s its role: investor protection. And a protection of the markets themselves, to make sure that they’re being run properly.

Robert Kuttner: And I would add that there are two purposes to regulation. One is to protect investors; the other’s to protect the whole system from systemic risk, from meltdowns. And when people talk about George Soros can take care of himself, people forget that other purpose of regulation, it’s to protect the whole system. And the other problem is that pension funds and university endowments and — the endowments of charities are now investing in hedge funds. So it is funds that sort of —

Bill Moyers: That scare you?

Robert Kuttner: — little — terrifies me.

Bill Moyers: Terrifies you.

Robert Kuttner: The other day, it was reported that Yale’s hedge fund — Yale’s endowment, which is heavily invested in this stuff, had a return last year of 26 or 28 percent. There’s a Lake Woebegone problem, you know? Everybody can’t be above average. And when you have 9,000 hedge funds, and all the investors want their hedge fund to be above average, as Bill Donaldson was saying, it puts pressure on these hedge funds to take outlandish risks with borrowed money. And also to cross over what’s legal and engage in insider trading, trading ahead of markets. All the same kind of stuff that we saw in the ’20s that we thought was prohibited under the New Deal is creeping back in.

Bill Moyers: Let me ask both of you, ’cause I get so much mail, emails and letters from people who say, you know, you and your guests are talking about the world as it is, but I’m depressed. I’m discouraged. What can we do? Are there some positive things you would like that could happen right now that would make you both feel better about what’s happening?

Robert Kuttner: Well, I’d like to see much tougher policing of conflicts of interest so that if somebody is a middle man on Wall Street takes a company private, pays himself a huge dividend, goes public again, gets fees on both ends and in the middle, and takes assets out of the real company there should maybe be a windfall profit tax on that. I’d like to see the loophole that allows hedge funds to escape disclosure be closed. American capital markets used to be the envy of the world

Bill Moyers: After the crash of ’29 —

Robert Kuttner: Be —

Bill Moyers: — when all of those reforms were put in, those safeguards were put in, right?

Robert Kuttner: Right, because they were so clean and so transparent. There were no meltdowns in the ’50s and ’60s because there were certain practices that you just couldn’t do. And the economy grew at four percent a year. You don’t have to indulge a corrupt middleman economy in order to have the real economy grow. I think it will be better for the real economy, not to mention the preventive effect it would have on heading off — the next crash.

Bill Moyers: What do you mean by “real economy”?

Robert Kuttner: I mean everything other than the financial economy. And the purpose of the financial economy is to connect entrepreneurs and users of capital with investors. And when the middleman has his thumb on the scale, or extracts too much of the proceeds, or takes too big a risk, that’s bad for the rest of the economy.

Bill Moyers: But does capitalism ever agree that enough is enough?

William Donaldson: No, I don’t think so. I mean — I think that — not to get into a political diatribe here. But I think the sharing of the benefits of a society are increasingly disproportionate. You talked about people being upset and feeling — That’s because, you know, they read every day about the fantastic profits being made by hedge fund managers and so forth.

And yet they’re out there, two-family, two — mom and dad both working. They say there’s no inflation, but they’re paying more for gasoline and paying more for the everyday necessities of life, and so forth. So in effect, the great middle class in this country has not gotten it — it’s tough. They have not really shared in what’s going on now.

Bill Moyers: Are you saying that this insecurity that you sense in the market has something to do with inequality in America? That is —

Robert Kuttner: Directly. I called my book The Squandering of America because I think the promise of the economy as an economy of shared prosperity is being squandered because the middlemen in the financial markets —

Bill Moyers: And the middleman is?

Robert Kuttner: Well, it can be a banker, it can be a trader, it can be a broker, it can be someone who’s running a hedge fund.

Bill Moyers: So he or she is doing what that you don’t like?

Robert Kuttner: They are taking risks that put the whole economy at risk, and they are cutting themselves too big a slice of the pie at the expense of little people. The biggest hedge fund operators make over $1 billion a year. A normal CEO pay packet now is $40 million or $50 million a year. And the median worker in this country hasn’t had a raise. Just barely keeping even.

So, what I want people to appreciate is that the risks in the financial economy, and the increase in security in the rest of the society, are two sides of the same coin. We’ve given up on a form of managed capitalism that produced board prosperity. And we need to get it back.

William Donaldson: I’m not quite as pessimistic as Bob is on this. I think when you step back the economy is working pretty well.

Robert Kuttner: For most people.

William Donaldson: For a lot of people. But —

Robert Kuttner: Yeah, I agree.

William Donaldson: — as I said before, I think it’s disparate sharing of the wealth. I think we need to pay more attention to — as you said, the negative aspects of this. I think we need to understand what’s going on globally in terms of our markets.

I’ll put in a plug for the people at the SEC. It was and is one of the finest agencies in the country, known for its independence. Known for being nonpolitical. I think that’s changed a little bit in recent years, just as everything’s become more political. I don’t think there’s any room for political thought on the SEC commissioners. I think they have one charge and that is to protect investors and to make sure that the rules work. And I think that we’ve got to give the SEC the horsepower to do its job.

Again, as we were talking earlier, some of these instruments — they’re extremely difficult to understand. Some of the Ph.D.s that devise them, I’m not sure they really understand them. And you’ve got people at the SEC who are trying to keep up with that. Trying to understand it. It’s a big job.

Robert Kuttner: But the SEC does have a wonderful tradition as an independent regulatory agency. However, the commissioners are appointed by the President, they’re confirmed by Congress. And the budget is legislated by Congress.

Whenever Arthur Levitt, who was the distinguished predecessor of Bill Donaldson, tried to be an aggressive regulator, Congress threatened to cut off his budget. So the forces against regulation in the public interest, as good as the SEC is, are stronger than they had ever been. I don’t know if that makes me an optimist or a pessimist.

Bill Moyers: Are we courting a repeat of ’29?

William Donaldson: Well, I think that’s a little strong. Again, I think that the Federal Reserve, the Central Bank, has an ability to reverse a downturn, but at great cost. I mean, we haven’t mentioned the where the dollar is overseas. We haven’t mentioned —

Bill Moyers: We can’t see it.

William Donaldson: Well it’s disappearing.

Bill Moyers: Through the floor.

William Donaldson: So I think that the central banks have a greater technique and ability to meet this problem. But insofar as they do — we run into a moral hazard, i.e., we bail out the people who made bad or devious, or whatever you wanna call ’em, investment decisions. So you sort of are saying, “Go ahead and do whatever you want, and you can count on the good old Fed —”

Robert Kuttner: Right, and the risk —

William Donaldson: “— to bail you out.”

Robert Kuttner: The risk is that every time we repeat this cycle, we get bigger and riskier bubbles. And with the dollar being in the tank — it’s not a costless kind of bailout. One would have thought that if the dollar were down to 140 Euros there’d be a run on the dollar. We’re gonna see inflationary pressures as a result of the cheap dollar. So it’s not as if the Fed can simply print more money to bail out these excesses, and there be no cost to everybody else.

Bill Moyers: Do you agree with Bob Kuttner’s thesis that our politics is undermining our prosperity by squandering America?

William Donaldson: Well I think that we are seemingly paralyzed on a number of issues that face the country. Not just in the financial markets, but the resolution of Social Security system, the resolution of the health care system, the rebuilding of our infrastructure, the attention to the environment. All of these things seem to be taking a second seat to issues that have nothing to do with making sure that this great economy we have continues for the benefit of everybody.

Bill Moyers: William Donaldson, Robert Kuttner, thank you very much for joining me on the Journal. I’ve enjoyed this discussion.

William Donaldson: Nice to be here.

This transcript was entered on May 22, 2015.

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