Submitted by Leo Kolivakis, publisher of Pension Pulse.
A past colleague of mine wrote an excellent article in the Montreal Gazette. Consultant Luc Vallée, the former chief economist at the Caisse de dépôt, thinks the system is still rigged:
The end of April marked the first 100 days in office of U.S. President Barack Obama; elected on the promise of change. Change we could believe in.
I believe that he meant it. However, by now, he met all these nice Wall St. types; powerful, quite smart, extremely charming and actually very convincing guys. Like President Obama, they want to re-establish trust in the system but they also want the system to keep working in their favour.
So how did the new president perform so far on reforming the financial sector? The approval of the markets during the last few weeks certainly suggests that he has done quite well. But let’s take a closer look at things.
In raising the rhetoric against free trade and bonuses, Obama definitively tried to side with the average guy. But that sort of populism won’t do it. Free trade was the backbone of global prosperity for the last few decades. Stopping it would put us on a destructive path. Moreover, bonuses are, unfortunately, legal contracts. However tempting it may be, nullifying these contracts certainly would be a trust buster. And who knows what might happen if America starts going down that path?
There are a lot of very tempting things that I refrain from doing in my life because I know they would come back to haunt me later. I choose, instead, to go see a hockey game if I need some release for my frustrations. I call this happiness by design! So far, the president has resisted his initial populist impulse but has not yet proposed viable alternatives.
Take the case of executive compensation. The problem is not with the bonuses themselves, but rather why and how some of these bonuses were awarded in the first place.
Indeed, I have nothing against flexible or performance-based compensation. It may actually be a very effective way to increase the flexibility of the U.S. economy and to help reduce unemployment in times of crises. The problem lies with the system of governance that awarded the bonuses and hence created their perverse structure. Many of those payment schemes would never have seen the day had they been designed by people held accountable for their actions. Making executives and directors personally liable for unpaid bonuses would certainly help focus their attention.
Obviously, when individuals have the power to design their own incentive reward system, abuses can be expected; all the while claiming that it is all in the shareholders’ interest. The privatization of gains and the socialization of losses suit many people just fine if they stand to gain more as bonus recipients than they stand to lose as taxpayers; perhaps not very ethical but human nonetheless. That is precisely why we have the separation of powers in so many of our institutions: to avoid such conflicts of interest.
Similar dynamics led U.S. banks to overlook the opportunity to recapitalize themselves more aggressively last year when there was still time to save the financial system and the economy. It was socially optimal to do so, but the optimal private decision for a banker was to avoid dilution and gamble that the system would survive or be saved.
By doing nothing, at least bankers stood a chance to avoid dilution if the system endured. Obviously, if all bankers had raised enough fresh capital, they would have increased the likelihood that the financial system would survive. However, each individual banker elected instead to do nothing as their individual private gain would have been maximized if “others” behaved responsibly. Obviously, every selfish banker, able to make the same reasoning, waited. In any case, they figured that, in the eventuality of a disaster, the government would come up with the money. And the money did eventually come. One must admit that the system does appear to be rigged in favour of the few and that it undermines the welfare of its citizens.
What should we then think of the latest plan proposed by Treasury Secretary Timothy Geithner to save the financial system? Private equity and hedge funds are to buy toxic assets from banks using government subsidies. Isn’t that the left hand selling assets to the right hand? The left hand gets to clean its balance sheet and gains access to fresh capital while the right hand stands to make a killing if the plan succeeds; while leaving the taxpayers to clean up if it does not. I get the feeling that both hands belong to the same banker’s body while the only taxpayers’ involvement is to finance the scheme and clean up the mess.
What else could be done? Reduce outstanding mortgages for those who need it the most, improve financial information and draft regulation that aims to get rid of conflicts of interests and sets the right incentives for executives. In other words, democratize finance! Wouldn’t that be a change we could really believe in?
Democratize finance? For that we need the unemployment rate to double from these levels and a social revolution. I doubt either will happen anytime soon but who knows, 2009 isn’t over yet and 2010 might bring some nasty surprises.
Let’s look at the latest attempt to “democratize finance”. The vilification of credit-card companies—not entirely undeserved—has reached fever pitch. On Thursday, President Obama gave a speech in Albequerque, N.M. and shared some of his thoughts in an effort to help push through a bill, currently in front of Congress, that would overhaul the way the credit-card industry interacts with its customers, including the interest rates and fees it charges:
“You should not have to worry that when you sign up for a credit card, you’re signing away all your rights,” the President said. “You shouldn’t need a magnifying glass or a law degree to read the fine print.” (Read “The Real Problem with Credit Cards: The Cardholders.”)
The industry, naturally, is crying foul. Having the flexibility to change interest rates and charge all sorts of fees lets card issuers free up more credit for more people, they argue: folks with lower prospects for repayment pay higher interest rates, while good, credit-worthy customers don’t have to pay as much. Plus, they say, now is the exact wrong time to re-legislate the lending process. Thanks to the credit crunch and soaring default rates, card issuers are already reeling in credit limits and accepting fewer new applications. “There are two ways of managing risk—for a particular borrower and across a portfolio,” Ken Clayton of the American Bankers Association recently explained. “If risk-based pricing changes, lenders will have no choice but to contract credit.”
That sort of thinking, while valid, misses the larger picture. If one brackets the equally-as-legitimate notion that Americans probably should have less access to credit-card borrowing and simply dissects the bill before Congress, one starts to see that the proposed changes aren’t really about dictating what a card company can or can’t charge people who borrow money. There’s a way to do that—impose interest rate caps, as many states’ usury laws do. That isn’t what Congress is on track to do. Instead, the new law, which would build on regulations issued by the Federal Reserve and other agencies at the end of last year, would, above all else, inject transparency and fairness into credit-card contracts.
That goal is easily seen in the legislation’s key feature: limitations on how card companies treat customers’ existing balances. When you sign up for a credit card, you agree to pay a certain interest rate on the balance you carry—you enter into a legal agreement to that end—but historically your card company has been able to change that rate for all sorts of reasons. Maybe you charge up a greater chunk of your credit limit than normal. Maybe you’re late on a payment to some other company. In recent years, the difference between the interest rate folks sign up for and the average penalty rate imposed later on has skyrocketed, from 8.1-percentage points more in 2000 to 16.9 points more in 2008, according to the Center for Responsible Lending. (Read a brief history of credit cards.)
Tellingly, the proposed law doesn’t try to tweak those figures. If you go from being a good credit risk to a bad one, credit card companies can still take steps to make sure they continue to be adequately compensated. When you go to buy new things, they can charge you 30% a year if they want to. The thing they wouldn’t be allowed to do under the new law is go back and change the terms of your original agreement—that is, hike your interest rate on existing balances—except in a very few situations, such as you egregiously failing to pay your bill (for 60 days or more in the version of the bill before the Senate).
The approach therefore isn’t to smack down credit-card companies for high interest rates, but to hold everyone to the original agreement about how much credit will cost. “Virtually no other contract in this country allows a business to change the terms of an agreement once a purchase has been made,” says Travis Plunkett of the Consumer Federation of America. “That’s the main issue.” (One Senator did suggest an interest-rate cap, but that was shot down.)
Other provisions of the law are similarly set up. A card company can still change the terms of your contract. It just has to give you 45 days notice. It’s still possible for an issuer to assess a charge when you go over your credit limit. But you’ll have to have indicated that you want to be able to go over your credit limit in the first place, instead of having your card denied. Companies can still set minimum required payments however they see fit. But they’ll be required to tell you how long it would take to pay off your balance if you stick to that minimum amount each month.
A few of the changes would be more heavy-handed. Those phone-payment fees would be prohibited outright (unless a customer asks for expedited service—a genuine additional cost which the card company would be allowed to pass along). It could also be substantially harder to market or sell credit cards to young people (either those under 18 or 21).
But for the most part, the bill before Congress isn’t about changing the game on card companies. It’s about creating a fairer set of rules to play by.
Interestingly, some think cap or limit on fees will cause credit card companies to limit their exposure particularly to minority and inner-city areas, since those with low incomes are at higher risk for default.
[Note: According to Reuter, U.S. credit card defaults rose in April to record highs, with Citigroup and Wells Fargo posting double digit loss rates, as the recession slashed more than 2 million jobs since the beginning of the year.]
Others are not convinced that that the bill could cut access to credit for millions of Americans but worry that once new credit-card rules take effect next year, card companies might cut off consumer credit even more.
I happen to think that banks, credit card companies, insurance companies, hedge funds, private equity funds, mutual funds – not to mention HMOs – have been raping people with fees for such a long time that it’s time we reintroduce usury reform.
[Note: Read Illinois Progress, Durbin on Congress: The Banks “Own the Place”.]
Go back to read my comment on banking with hedge funds and bailing out alternative investments. Public pension funds investing in hedge funds that then turn around and charge desperate businesses outrageous fees to extend them a loan during a credit crisis. Not only is this risky, it’s a scandal and it should be illegal for public pension funds to invest in these type of “asset-based lenders”.
Earlier this week I listened to Charlie Rose interviewing Elizabeth Warren, Naomi Klein and William Greider. If you didn’t listen to these interviews, take the time to watch the entire show.
There is a crisis of leadership and while millions worry about losing their pensions, including retired autoworkers here in Canada, nobody is hatching a survival plan for retirement plans.
Finally, I don’t know or care if the world’s power elite is meeting Athens plotting to sink the global economy. I have been reading Charlie Skelton’s Bilderberg files, mostly for amusement, but my thoughts are that any attempt to stop rigging the system and truly democratize finance will have to come from the bottom-up, not the top-down.
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My suspicion is this credit-card proprosal will mainly help harried college students who forget due dates on their bills.
Not that I’m complaining: I paid more than my share of those late fees and jacked-up rates. Revenge is sweet.
But will it help lower-income people who can’t keep up with their payments, or simply don’t understand concepts like compound interest?
Then there are the arbitrary deadlines and different rates for different balances.
Queue P.T. Barnum.
Not that some less onerous terms and conditions on credit cards wouldn’t be great for lots of people, but…
If that’s the best we can come up with in terms of “democratizing finance,” then it seems to me we’re dealing with something you often and rightly criticize with respect to executive compensation – a peripheral reform masking the lack of any genuine structural change.
i don’t understand the problem with rates changing on credit cards. we have variable rate mortgages why can’t we have variable rate credit cards.
Were people and the world, better off before credit cards[?] I sure think so, its like the sugar in Doc’s cereal, big rush for awhile, then time to lie down in the sun, eh doc (snicker).
No really think about it, no impulses to fend off (bloody human weakness), is it better to go with out than clip on the plastic ball and chain of quick debt, and think of all the people that_should_really_not_ have_one to begin with (come on thats how they primed peoples spending habits before feeding every one a house mortgage).
Skippy…I’m an adult and can have what I want, when I want right, well that is what the advertising told me at least, I’m an American consumer that will not be denied my God given right to spend as much as I want phffft.
Interest rate caps are what is needed so interest rate caps are not what will happen. Interest rate caps alone would destroy the need for a lot of other complex regulation which does not work anyway since the regulators are captured.
Would (sufficiently stringent) interest rate caps reduce credit availability? Yes, of course. Caps are not sufficient unless they make it unprofitable to lend to people who are unlikely to be able to repay the principle. Lending to people who cannot repay the principle is the preferred business model for credit cards, payday loans, certain personal loans and originate to securitize subprime mortgages. With the exception of mortgages it is profitable because of the people who soldier on making the minimum payments combined with those who repay more than they ever borrowed before defaulting on a still-large balance. Insert moral judgement if you wish, but either way, we must agree that it is not healthy for our society or economy to operate under this business model.
Interest rate caps fix that and replace a whole lot of ineffective regulations that can be skirted or turned to the lender’s advantage. It would take pressure from citizens on the government to enact something this sensible however because it carries two non-starters from the ruling class perspective. First, it reduces profit to the financial sector, which is obviously a big no-no. Second, it will force us to deal with the working poor who rely on high-interest credit in lieu of adequate wages.
Universal default has forced two of my clients into bankruptcy. It’s a ridiculous practice and I hope whatever legislation is enacted puts an end to it.
I'm afraid all systems are rigged, Leo, even NC.
I realize that organized reality should provide equitable fairness within a modern democracy, but no — and yes, this gets back to the roots of Capitalism and people like John Locke who wanted to provide theoretical foundations for Laissez-faire structure, but alias, the good people that speak of freedom are often the first to control it and rig their system.
Also see: Pantone, the global authority on color and provider of professional color standards to the design industries, has announced that Pantone #14-0848 Mimosa, is the color of the year for 2009. The color is a warm, engaging yellow. The color was deemed perfect for this year of change – hopeful optimism that the economic and political atmosphere will clear and provide upmost reassurance.
> Apparently Pantone was influenced by The Ridiculous pillbox hat, worn by The First Lady (current and past):
"Michelle Obama is certainly one of the biggest fashion icons of recent times, and now a new book describing her fabulous fashion choices is set for release in the US tomorrow. The book, which has been titled 'Michelle Style: Celebrating the First Lady of Fashion', is authored by former fashion magazine editor-in-chief, Mandi Norwood, and chronicles Mrs Obama's signature looks."
> How pathetic that The First Lady is attempting to rig the fashion world …. utterly pathetic and out of touch, out of step, out of mind, outlandish, out-dated and obviously a journey down a path of mindlessness. Can we please see the next round of rigged presidential contests please, please, please!!!
* See & Hear (feel):
Leopard Skin Pill Box HatAlso see and think about:
SleeperFull Disclosure: The Author seeks to have a mocha and then phase into cereal; hope everyone is naked.
DH,
You reminded me of Orwell's classic:
ALL ANIMALS ARE EQUAL, BUT SOME ANIMALS ARE MORE EQUAL THAN OTHERS.
When the animals take over the farm, they think it is the start of a better life. Their dreams is of a world where all animals are equal and all property is shared. But soon the pigs take control and one of them, Napoleon, becomes the leader of all the animals. One by one the principles of the revolution are abandoned, until the animals have even less freedom than before.
>>The problem with modern day capitalism is that its logic is self-destructive.
You can't have a fraction of the world's population controlling all the wealth and resources and not expect a reaction from the restless masses.
For years the debt fueled U.S. economy grew and people were happy and totally oblivious to how the system was rigged.
Now that the bubble imploded, and those people are losing their jobs and their pensions, they are starting to ask themselves "why are we bailing out these banksters when nobody is helping me?".
I think Elizabeth Warren is right, we need free markets based on the principles of transparency and fairness.
But we also need to start seriously considering legislating compensation caps on corporate cronies who try to rig the system by awarding themselves ludicrous comp packages that they certainly do not deserve.
Americans have to stop believing that left to its own devices, the "free market" (whatever that means) will self-correct.
That is pure nonsense and it is absurd to claim otherwise.
Regards,
Leo
I think it’s time to introduce the “Simple answers to simple questions” riff.
The writer asks: “Is the system still rigged?”
Simple answers to simple questions: Yes.
Nothing is simple when you have an opaque system that deliberately tries to deceive people so that the few at the top can profit while the many at the bottom get royally screwed.
Cheers,
Leo
At what point will people finally stop paying on their debt? The Titanic is sinking. We’re headed for a world where a credit rating is irrelevant. Don’t people see this? Think of all those things that you think you need credit for–a house, a car, a college education and luxury items at the shopping mall and ask yourself, is there any other way that you can get these items without credit?
A house could easily be replaced by a rented apartment or a mobile home that you could save money for. They could say that people who don’t pay their bills on time would find it hard to find an apartment. So, we’re just going to have people who have money to pay for rent and are working just live out on the street because they didn’t pay their light bill five years ago? Right.
What’s wrong with moving closer to work, walking, a bicycle or public transportation?
I happen to think that I shouldn’t have to pay for a college education. I think that should be paid for with tax dollars.
And do you REALLY need to buy luxury items at the shopping mall?
So you see….we don’t need credit to survive. All of this credit was introduced into the economy as a means to help facilitate globalization. The long credit-fueled consumer binge in the United States has helped to give billions of jobs to third world countries, but it has also perpetuated the stagnant wages that has existed in the American economy since the 1970’s. We now have people in Walmart making low wages helping to sell items that are made by people…making low wages. You only get what you give. This is the future.
So consumers should stop worrying about the fine china. The Titanic is sinking and it’s only a matter of time before the rumors are confirmed. Consumers should stop trying to save their credit record because we’re headed for a world where a credit rating is irrelevant.
Moreover, bonuses are, unfortunately, legal contractsNo. If they are legal contracts, they are not bonuses. A bonus, by definition, is something extra. Anything in a contract is pay, and should be added in when total pay is reported.
The pigs knew that they were slurping undeserved amounts of money, but to hide it, they called some of it a bonus and pretended it was for good performance. Performance has been crappy, but they still want the money. Ironically, their strategy of misnaming part of their compensation as bonuses has now come around to bite them in the ass.
Good! I say. Let this bite draw blood. By defending the bonus payments (if not the way they are determined) on the grounds of “legal contracts”, you are slapping in the face every working man and woman who has seen their equally legal employment contracts abrogated.
The Luc Vallée commensts were incoherent. Obama believes in change, which is why he is pursuing a business as usual course. The thinking behind bonuses is perfectly fine although this is the same kind of thinking that produced the financial meltdown and keeps the system rigged.
Maybe incoherence is the theme. The credit card legislation addresses but does not fix the credit card problem (by capping rates). In that sense, it is just like all the other efforts to date which address our financial and economic disasters without dealing with a single one of the fundamental problems which underlie them.
Hugh,
Defending bonuses on a contractual basis was the weakest part of that article. No doubt about it. When you are receiving taxpayer money, all bets are off and contracts should be revised.
But other parts of the article were excellent, especially on allowing individuals to design their own incentive system, which is why the system is so corrupt.
On credit cards, I agree with you, just cap the interest rates and fine the companies if they cut credit to low income households.
When I saw the documentary Maxed Out, it made me realize just how evil credit card companies have become. Their borderline criminal means to get people hooked on credit disgust me.
Regards,
Leo
Leo,
Re: Animal Farm (Wiki)
The novel addresses not only the corruption of the revolution by its leaders but also how wickedness, indifference, ignorance, greed and myopia destroy any possibility of a Utopia. While this novel portrays corrupt leadership as the flaw in revolution (and not the act of revolution itself), it also shows how ignorance and indifference to problems within a revolution allow the horrors to happen.
Re: “Americans have to stop believing that left to its own devices, the “free market” (whatever that means) will self-correct.”
That also reminds me of the delusional Three Little Pig economic theory that GDP is self-correcting, e.g:
“The term unemployment did not exist until the late nineteenth century. The classicals (Smith, Ricardo, Mill, Marshall, Pigou) saw remedies for unemployment in remedies for wage stickiness, not in fiscal or monetary stimulation, which would have been thought unnecessary, had they been thought of at all.
Keynes’ objection to the first channel is the possibility of a liquidity trap, in which an extremely low interest rate causes people to hold any additional money instead of purchasing interest-bearing assets. The liquidity trap corresponds to a perfectly flat money demand schedule and LM curve so that interest rates — and thus output — will not respond to the increase in real money supply resulting from the deflation (fall in P). Keynes’ objection to the second channel is the possibility that planned autonomous expenditures are very or totally unresponsive to changes in the interest rate. This implies a very steep or vertical IS curve and AD curve, so that output will not respond to deflation. Because both of these demand-side problems are the result of the failure of flexible prices to influence real output (Y) through the real moneysupply, they are called the problem of monetary or deflation impotence. In response to Keynes’ criticisms, the classicals responded with the argument of the Pigou or real balance effect (the direct stimulus to aggregate demand caused by an increase in the real money supply; doesn’t require a fall in the interest rate), where the increase in real money balances caused by a deflation stimulates autonomous spending, and thus the IS curve directly.
Don’t yah hate this stuff?
From:
Business Cycle Theories
http://www.agsm.edu.au/bobm/teaching/MM/lect15.pdf
Also see:
Bluto’s Advice
As far as credit cards problems as part of the rigged system are concerned:
let’s try to do our share to not be part of it.
Skippy and John Feier above alluded to this as well.
What about making a personal/family financial plan to start saving, pay off the credit card debt, and start using a debit card/cash only. I do realize that this may be very hard, especially in these times with a lot of economic hardship, but paying outrageously high interest rates is even harder. Also, by not having a credit card, i.e. by not paying these outrageous interest rates, you do not contribute to the payout to bonus bankers.
Wall Street does not want to change, and as far as financial politics is concerned WashDC will not change, hence we the people have to change.
“Capital is therefore not a personal, it is a social power,”-Karl Marx.
The question is not whether the credit card companies should have the right to gouge poor witless consumers, but whether the government has the right to regulate personal capital. I think not.
If people are not wary of their own capital, there will always be someone to steal it. Obama’s comment that one would need a law degree to understand the contract is mute: no one should enter into a binding contract without understanding.
Are we all children?
Luc provided me with these comments:
“Leo,
Thanks for the reference. Good discussions. I read some criticisms about my defence of respecting contractual obligations to pay bonuses and your reply that this was the weak part of my article. I disagree. Actually, if I had been given more space I could have explained this point in more details. Let me try here.
Let’s say bank ABC lost $ 1,10 billion last year but that the three divisions of the bank had different outcomes: Divisions 1 and 2 each lost $1 billion for a total of $2 billion and division 3 made a profit of $900 million. Total profits were negative as stated above but the bank has contractual obligations to pay bonuses to people in division 3 who made tons of money. What would you do? In fact , deciding ex-post not to pay bonuses to people in division 3 maybe tempting but they just saved the company from loosing even more; and in the case of a bail-out like the one we are having today they saved taxpayers $900 million.
You could decide to screw these good workers and keep the money losers on your payroll for next year. Great move! Moreover, you could be stuck in litigation with the winners for years. I would like to see you as part of the ones who did good and who have to pay for the mistakes of the others. Especially that the money losers had their full bonuses the previous years when they made money. You have to think of bonus as wages (of the flexible variety). If wages are payable, so are contractual bonuses.
As I said in the article, making directors and directors personally responsible for paying such bonuses would have prevented them from designing such a scheme in the first place. Alternatively putting the previous years’ bonus money in an escrow account for a full ten years could also have help financed the bonus for division 3 this year. Or, as you suggest, freeze the current year bonuses for a certain number of years (to be paid later) is politically smart. But the fact that not paying bonuses is politically popular has nothing to do with the legality of the issue (although postponing the payments is politically smart). You can easily think of situations in many countries were bashing on minorities is very popular and allowing it is a way for the government to stay in power. But that does not make it right. The rule of law has to apply first. Otherwise the system breaks down (as it is the case in the countries I am referring to).
Once you have agreed to something based on a certain outcome, you are legally obligated to make good on your promises, especially to performing individuals. The question remains why did the banks promise what it promised and why were they allowed to do it? Something should be done about this in the near future. But once it is done, it’s too late. Otherwise, we all lose our reputation, no legal contracts remain valid and business as we know it will ceased. We will then all look like idiots.
With that kind of logic why pay wages after all? The hell with suppliers! Mortgages? Forget it! Let’s also forget about respecting the law. I am broke. I’ll stop paying my taxes and my kids’ tuition. The hell with system. Let me call my banker right away and I will tell him that he can forget about me paying my loans, including my credit card! I am broke, I am not going to pay anybody.
Sorry, but if this does not work for me, it can’t work for Citigroup. Citigroup spelled in writing that they would pay their workers according to a certain formula. Well, let them pay. Wages and bonuses in full. I agree that top bosses (those who designed the system) should not be paid (and maybe held responsible) but everybody else has the right to see the contracts they signed in earnest be respected and honoured. Otherwise go live in China!
Is this so difficult to understand?
Luc”
Regarding Luc’s letter to you, obligations are settled for less than the original promised value all the time, in all industries, across all types of monetary and non-monetary obligations. The “respect the law” fantasy of most theorists is not helpful. The transactions costs of enforcing any obligation completely overwhelm the benefits in the vast majority of situations. Obligations are settled by the relative leverage of the parties (which is, yes, partially motivated by the fear of litigation) and their incentives to do business again or to *appear* to be people who make good on their promises. This is why my first suggestion to any client is to make sure that you are the one holding the “money” in any situation. Having the money and controlling who gets what share is in the long run a lot more valuable than having a promise to get your share. This is simply the way of the world. It would be impossible for any society to eliminate this completely because transactions costs are reality. Only in theory can one say “Well, let’s just ignore transactions costs for the moment and let’s assume that people are fully informed and honorable.”
Anyhow, I’m all for people making good on their promises. We should encourage this as a societal value. But please, I’m not interested in hearing someone’s self-serving rant that obligations are sacred and that “everyone else is forced to make good, you should too.” If the moon were made of green cheese, I’d eat some with crackers for dinner.