Political Economy: Big-Government Socialisms, NOT Capitalism, Caused Economic Disasters in the 1930s, 2000-2002, 2008, and the 2020s (Second in a series)
Political Economy First Principles
The economic events of these periods seem different and unrelated, but watch how the dominos keep falling from one to the next.
The 1930s
In the 1930s and for long afterwards, it was said that Franklin Delano Roosevelt saved America from capitalism and saved capitalism from itself. Just the opposite was true, yet that attitude carries full strength into today.
Nobel Prize winners, including Milton Friedman, and other economists showed that in the 1930s, big government caused and prolonged the Great Depression, and capitalism took the U.S. out of it when allowed to do so.
Specifically, the Federal Reserve Bank tightened too much for too long, draining money from the economy. Then on the premise that capitalism had caused the Great Depression and couldn’t be trusted, Congress and Presidents Hoover and Roosevelt passed laws that put the government in charge of shaping many aspects of economic activity. This prolonged the Depression by interrupting the normal interplay of supply and demand in free markets that moves money and labor to where it can be most productive by being most wanted, therefore creating new prosperity.
Only after Imperial Japan’s attack on Pearl Harbor on December 7, 1941, was capitalism set free. Arthur Herman’s book Freedom’s Forge shows that President Roosevelt tried to build a wartime economy by Federal government fiat, but found that government people couldn’t do it. So he turned to private industry, especially to the auto industry—tanks, jeeps, planes, etc.—and most especially to Alfred Sloan, CEO of General Motors, to do it, and they did.
1996 to 2002 Dotcom/Telecom Crash, Enron, Arthur Anderson
The 1996 Telecom Act promised an information superhighway, but local regulators blocked getting high-speed broadband to people’s homes: the “last mile.” Huge investments by dotcoms and telecoms foundered when people couldn’t get access to dotcom products: Cue the 2000-2002 “dotcom” stock market crash.
Enron was invested as a telecom middleman and suffered badly beginning in 2000. It was also heavily invested in California’s “deregulated” energy market but foundered there too.
First, demand for electricity in California skyrocketed in the mid to late 1990s due to the explosive growth of server farms. Electricity suppliers then raised prices for the electricity they sold to utility companies. However, California’s deregulation law didn't allow utilities to pass on the higher production costs to electricity customers. So the utilities couldn’t pay the electricity suppliers. At least one major electric utility went bankrupt. That bankrupted electricity suppliers and hurt middlemen such as Enron.
The government prosecuted and convicted Enron officials for fraud, but the government’s actions involving Enron are both shocking and horribly prophetic.
The SEC—the U.S. government’s financial regulator—gave official permission to Enron in 1992 to switch to mark-to-market accounting for assets, income, etc. I have no idea what the SEC was thinking.
Pursuant to MtM, Enron eventually began to book “profits on the come,” meaning marking profits to amounts anticipated by temporarily high current market conditions but not yet received. And it looked very profitable. Then came the double hit to its income from the collapses in the telecom and energy markets, and it started to book terrible losses, again marking them to current—temporarily low—conditions. Top executives at the time chose to hide those losses in off-the-books ways. That’s what got them convicted of fraud. And the term “Enron accounting” became a term of condemnation. Yet none of that presumably would/could have happened if the SEC had not approved MtM in the first place.
Arthur Anderson was Enron’s accounting firm. Clinton holdovers in Bush’s Justice Department prosecuted and convicted the entire Arthur Anderson firm and forced it to disband. Judges later threw out Arthur Anderson’s conviction because of gross abuses by the prosecution—too late to save the 40,000+ jobs at Arthur Anderson.
(The same group of Federal prosecutors also prosecuted and convicted U.S. Senator Ted Stevens of Alaska, causing that seat to go to a Democrat in 2008, giving Democrats 60 votes in the Senate to pass whatever they wanted, including “ObamaCare” and “Dodd-Frank.” Courts later threw out that conviction due to gross misconduct by the prosecutors—too late for Senator Stevens, Republicans, and the people they represented.)
Before all this, Arthur Anderson was operating under depression-era regulations that have carried forward to today. Publicly owned companies today must get their books checked annually by auditors who are approved by the SEC. AND the companies pay the auditors for the work done. That is a terrible conflict of interest. It just invites corruption. Moreover, the public, to my knowledge, does not get easy access to the audits.
You might well ask: What else can be done? Shouldn’t companies get audited according to government regulations to prevent companies from lying? The free market offers a better solution.
In a free market without government manipulation, companies with healthy businesses and good accounting practices would be glad to be audited by high-credibility auditors who sold their audits to any and all private investors wishing to get the data. Companies that didn’t get such audits would become suspect and suffer lower prices for their stocks and bonds in financial markets, making them vulnerable to being bought out by competitors or turnaround-style investors, or going bankrupt due to higher costs of capital. Moreover, it would all be self-regulating with investors in charge. But that doesn’t happen now.
How We Got Regulators’ Disastrous Use of Mark-To-Market Accounting in 2007
After Arthur Anderson was shut down, other big accounting firms lobbied the Financial Accounting Standards Board to change the rules of accounting so they would never suffer Arthur Anderson’s fate. Instead of the long-standing practice of valuing a company’s specific assets, the FASB in late 2007 instituted mark-to-market accounting for all companies’ assets.
This meant that every company’s capital assets would be valued at what the market sets for other similar-sounding assets that are being bought and sold at that particular time. The clear precedent from Enron about the dangers of MtM was ignored by regulators and surviving accounting firms precisely when it should have been known and heeded.
What’s Wrong with Marking Mortgage and Other Capital Assets to Market
All “mark to market” means is that assets in possession should be priced at (marked to) what similar assets are being bought and sold in open, free markets. To be clear, this may very well work fine for money (e.g., foreign currency exchange), and fine for evaluating commodities such as iron ore on a timely basis. MtM can even be useful for a private investor trying to estimate a company’s future earnings. The problems arise elsewhere.
First, there is no such thing as a general market in mortgages as if they were commodities, indistinguishable from each other. Each mortgage is unique. It’s value depends on a host of variables such as the quality of the home, changes in the neighborhood, homeowners’ income prospects (highly dependent on large and local economic events and personal health), payment performance, changes in interest rates for adjustable-rate mortgages, etc. So the whole notion of applying MtM to mortgages is illegitimate, even if one believes MtM has legitimate regulatory uses in other matters.
Second, capital assets are fundamentally different from ordinary inventory, receipts, and the like. The latter are expenses or incomes that derive value from immediate use and are entered in accounting books to trace costs, sales, profits, losses, etc.
Capital is wealth that has been invested in assets that need years of operation before the wealth it actually created can be fully valued. For example, your home is a capital asset in that it supports your life and family; the money you paid or borrowed to buy the house, and repairs or additions, are capital investments. What you pay monthly for electricity is an expense; or, if you rent, the rent is an expense. An investment in a factory is a capital asset that will need years to bear fruit; but wages, electricity, etc. are expenses. Accountants generally keep separate books for capital entries and have traditionally allowed each capital asset a lifetime of 20 years, with 5% marked down each year as depreciation. It’s the best a bookkeeper can do.
Mortgages are capital assets held by banks and other investors. Money went to the homeowner, and the homeowner is expected to pay interest and principal over many years so that the mortgage investment eventually bears profitable fruit. If the homeowner fails, then the mortgage becomes worth less, gets marked down, and may even be written off as a capital loss in the capital books. (In that case, a capital loss is not considered an operating loss. It is not reported as a loss in the profit&loss statement for the year’s income. Instead, when a company takes a capital loss, it is usually announced separately, at the time the loss is booked. So when you hear that a company has lost, say, $11 billion dollars, that is usually a capital loss. The company may still be very profitable, and its stock might even rise if investors had been expecting an even larger write-off.)
When regulators mark capital assets to minute-by-minute market prices, that is as wildly procyclical for the economy as a whole as it was for Enron. In economic booms, when everything becomes overvalued, MtM raises the value of assets above time-averaged value; then, in recession, MtM crushes assets’ values below time-averaged value, and regulators swoop in for the kill; killing a lot of global economic activity in addition.
Carried to its extreme, marking the value of a capital asset such as a mortgage to “market” amounts to liquidating capital, potentially marking a good asset to zero value! That makes capitalism itself impossible.
In other words, the whole U.S. financial system in 2007 effectively adopted the very “Enron accounting” that it had so recently condemned.
Leading Up to the 2007-2009 Financial Meltdown
Starting no later than 1992, a host of government policies dangerously lowered lending and borrowing standards. I counted 14 different actions of this sort. Some include:
1. Subprime mortgages, “liar loans,” and other dicey mortgages were allowed by the SEC to be rated as high as the top rate of AAA.
2. Simultaneously, the SEC allowed lenders to drastically lower their capital reserves. This means that if ordinarily a bank must keep 10% of its capital assets in reserve to cover losses from bad loans/mortgages, which means a loan to reserve ration of 9 to 1, some banks were reported to have ratios of 50 to 1, so that if very little went wrong, regulators would declare the banks to be insolvent and would take over them.
3. Meanwhile, such mortgage banks as Countrywide originated mortgages (lent money to homeowners in return for the mortgage contract to repay the debt), and then sold the mortgage contracts to the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which bought the mortgages heavily, kept the best, and sold the less desirable ones to investors. Further, as GSEs, Fannie Mae and Freddie Mac enjoyed lower borrowing costs than private banks had.
Just the above three conditions effectively crowded out responsible banks from the mortgage-issuing business and, paradoxically, created new room for reckless or corrupt mortgage banks, investment banks, and other lenders, such as Countrywide and Bear Stearns. Recall that Chris Dodd (who coauthored “Dodd-Frank” banking regulations in 2010 as a U.S Senator from Connecticut) was named a “friend of Angelo,” Angelo Mozilo then being CEO of Countrywide.
The 2007– 2009 Financial Meltdown
As bad as all this was, far worse, and what really set 2008 apart, was the improper regulatory use of mark-to-market accounting that was imposed on financial assets in the latter part of 2007. MtM created a liquidation of financial assets generally, not just of mortgages, that accelerated exponentially. Stocks soon started declining and didn’t bottom until regulatory “mark to market” accounting was discontinued by Barney Frank around 3 PM, March 9, 2009, as I heard reported by Ray Hoffman on WCBS radio at 3:25 PM. After that, stocks began a huge new bull market. Some details:
In regulators’ use of MtM accounting, good mortgages were deemed to be “bad” or “troubled” when other mortgages were sold at discounts due to non-performance or fire-sale needs of the seller. So, because of this drop in the MtM paper value of banks’ assets, even some well capitalized banks were deemed to be insolvent, labeled “bad” or “troubled,” and taken over by government regulators. That pushed the U.S. and the world’s economy into a progressively reinforcing, pro-cyclical collapse as each bank takeover removed more money from the system, worsened financial conditions, and led to more government takeovers—a financial black hole. (More detail on this can be found here.)
Bear Stearns was the first big name to get into big trouble in early 2008. It was an investment bank, meaning it supported stock and bond offerings and other financial transactions between companies and big investors, or else traded and speculated with its own funds, or managed hedge funds. Evidence clearly showed it was speculating at extremes of risk.
Still, we have to ask how did the combined effect of
1) regulators’ improper use of MtM to take over private companies,
2) the relaxation of capital reserve requirements,
3) being crowded out of safe mortgage investments by the GSEs,
4) and the economic turmoil caused by the change to MtM
contribute to Bear Stearns’ appearance of, or actual, insolvency.
Talk of Bear Stearns being a “bank” gave the public the false impression—and fear—that all retail savings and checking accounts of small businesses and ordinary people were in danger. They were not, however. Their accounts were primarily in commercial banks that had FDIC account insurance and weren’t putting their money to any serious risk.
So how did “big-banks” JPMorgan Chase and Bank of America get blamed? They were commercial banks whose main business was lending directly to companies. President Bush’s Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke (reported in the Wall Street Journal) asked these well managed, richly solvent, commercial banks to buy ”troubled” mortgage banks and investment banks in order to restructure their bad mortgages and other debts, starting with JPMorgan Chase’s purchase of investment bank Bear Stearns in early 2008, followed by Countrywide, Merrill Lynch, and others. This resembles the precedent of how the Resolution Trust Corporation (a U.S. government agency) in the late 1980s acquired and restructured mortgages of failing Savings and Loan banks.
I put the word “troubled” in quotation marks because these were the government’s words, after applying MtM accounting, which muddies the waters completely. Some banks surely were not troubled at all, as the subsequent events regarding the Troubled Assets Relief Program “bailouts” showed.
TARP I failed because Treasury Secretary Paulson offered to buy well-performing mortgages at defaulting-mortgage prices, but most banks refused to sell because they knew their mortgages were performing well. So, according to a front-page report in the Wall Street Journal that was never denied, Paulson and Bernanke summoned the heads of all the major banks to a meeting and didn’t let them leave the room until they agreed to take the TARP II “bailout” money, which they did; but only well-politically-connected Citigroup reportedly needed the money, and the excuse offered for making all the banks take the money was to avoid stigmatizing any “troubled” bank. I kid you not.
Then, in 2009, the Obama administration blamed and punished JPMorgan Chase and Bank of America as they were the legal owners of the liabilities that had been originated by the mortgage and investment banks.
2020s
It’s fundamentally different today in the U.S. and the world.
A whole host of governments, institutions, big businesses, private organizations, and social shock troops are coordinating to centralize power.
This is not capitalism, because markets are constrained and warped in major ways by government actions, whereas capitalism requires free markets to create the new high-quality information that is needed to keep producing new, better, and/or cheaper products. Nor should it be called “crony capitalism.” “Crony capitalism” is not capitalism at all, for the same reason, that free markets are not free from massive government interference. And the notion of “regulatory capture” conjures the image of private businesses corrupting government agencies, whereas they are in it together, with government and political interests in charge, while richly rewarding the private businesses that collude with government; that’s not capitalism either.
This new regime operates primarily as fascism (private businesses allowed and rewarded as long as they serve government ends), but with Marxist and one-world goals woven in.
In other words, a business might operate in some ways in free markets (capitalism) and in other ways as a colluder with government or political interests (fascism), but if the latter is substantial, fascist interests eventually destroy much more throughout society than the capitalist activity creates in goods and services.
Further, this high involvement of key private institutions (businesses, schools and universities, hospitals and medical societies, etc.) with government makes fascism a form of big-government socialism, though historically it has been viewed incorrectly as an extreme form of capitalism—which, to repeat, it cannot be, because markets in essential areas are not free.
Unfortunately for us all, even for all the coming-out-of-the-closet would-be Masters of the Universe, Power Corrupts, and the greater the power, the more it corrupts, corrupting most the most powerful people themselves. Bill Clinton put it succinctly, “because I could.” They get all those grandiose ideas of what they think they can do, and no one has the nerve to tell them they are wrong, so when they “do,” they screw up royally, precisely because their power allowed them to deviate farther and farther from foundational realities, to become debased, unbalanced, and to cause enormous harm.
Witness Vladimir Putin being blindsided by Ukrainians’ fierce resistance and his own forces’ incredible ineptitude.
Witness Mao-emulating Xi Jinping of Communist China harming his own country by locking down major parts of China in order to combat Covid viruses that can be treated early and effectively by cheap, well understood off-patent drugs and nutrients, such as ivermectin, hydroxychloroquine, zinc, vitamins C and D, green tea, etc. (plus the fact that reducing obesity would all by itself greatly reduce deaths and hospitalizations).
Witness the Masters of the Universe at the World Economic Forum threatening Europeans with mass death this coming winter because of their extremist cuts in their own nuclear and fossil-fuel energy production—while yet depending on Vladimir Putin for Russian natural gas.
And witness America’s new ruling class consciously breaking down America as if it were the source of all evil in the world, and cheering “the fundamental transformation of America.” Whereas, more than any other entity in the history of the world, America has fostered freedom and prosperity for a large part of the human race—through its Constitutional exercise of democracy and capitalism.
Witness too how clueless are the shock troops of America’s new ruling class that theirs is a revolution that eats its own. It takes; it doesn’t build; and the more it takes, the less remains to be taken. They will suffer as life worsens, the circle of power shrinks, and ever more INs become OUTs fearful for their lives, as happened in the French Revolution, the Russian Revolution, and every such revolution in history.
Opposition to this new Fascism is growing as the damage and suffering it causes become ever more apparent.
Nevertheless, complaining about the harm this new Fascism does is not enough. Getting a few electoral victories is not enough. New, ever more destructive “blue waves” follow “red waves” when the red waves are composed of mere discontent. Real, positive, enduring alternatives are necessary.
The only antidote is a full-throated advocacy for capitalism. Operating in the overlap of private enterprise, free markets and strong but limited government, capitalism is a freedom-loving, economic engine of prosperity that can rally large numbers of people, in their self-interest, to fight for freedom.
A rich development of the above can be found in my post "Capitalism Makes Life Better. Big-Government Socialisms Make Life Worse." It’s compact, and it’s dynamite. I strongly recommend everyone read it.