“Happy Halloween: Pay Curbs are a Trick on the Taxpayer, Not a Treat”

By Marshall Auerback, an investment strategist and analyst who writes for New Deal 2.0.

How appropriate that with Halloween just around the corner, the Fed and Treasury have announced a coordinated effort that will put the central bank at the forefront of pay regulation on the zombie firms now kept alive courtesy of US government largesse. Trick or treat for the US taxpayer?

The new pay regulations are ostensibly designed try to align the financial incentives of managers with the longer-term performance of their firms. The Federal Reserve will have direct oversight over the pay of tens of thousands of executives, bankers, and traders. The oversight is being justified as a “safety and soundness issue“, according to Fed Chairman, Ben Bernanke.

Had the Fed and Treasury demonstrated similar concerns about the overheating housing market, the degeneration of lending standards, and the proliferation of dangerous Over The Counter (OTC) derivatives during the past 10 years, it could have done much to alleviate today’s still profound financial instability.

This measure, by contrast, reeks of bogus populism. In the words of Reuters’ columnist, Jeffrey Cane:

By making executives at seven companies wear hair-shirts, some of the populist anger over bonuses and Wall Street may be assuaged – anger that should rightly be channeled into calls to prevent banks from engaging in risky activities. There’s no reason that banks that are back-stopped by the government should be in the securities business. Taxpayers – voters – should ignore the media fascination with pay and urge that Congress heavily regulate and tax such risky activities.

As Cane acknowledges, the curbs only apply to the newest wards of the state, the likes of AIG, Chrysler, GM, Bank of America, and Citibank. The more than 700 banks and other companies that have directly benefited from the government’s largesse are not affected – even those who are minting profits from credit markets propped up by trillions of dollars of the taxpayers’ money, and who continue to benefit as a consequence of the FDIC guarantees of their commercial paper, which substantially reduced borrowing costs at a time of uniquely high financial stress. Yet we’re still neither proposing any kind of serious regulation, nor any kind of resolution mechanism to deal with the problem of “too big to fail” banks.

The Fed has other big ideas: Federal Reserve Chairman Ben S. Bernanke has also called on Congress to ensure that the costs of closing down large financial institutions are borne by the industry instead of taxpayers. He has called for a “credible process” for imposing losses on the shareholders and creditors, saying “any resolution costs incurred by the government should be paid through an assessment on the financial industry.” That would be the very same financial industry that has already received trillions of dollars in financial guarantees and aid by the Federal Government, wouldn’t it? The left hand giveth, and the right hand taketh away. It’s all a big shell game. Given the absence of structural changes in the industry, this will simply increase the cost of credit, so the taxpayer will end up paying again.

What’s with the Fed’s new-found populism? It’s as if Ben Bernanke has started to channel his inner Huey Long. There could well be other motivations at play here.

The Federal Reserve, as we know, is now under uncomfortably high public scrutiny and its hitherto secretive actions are being subject to the greatest degree of Congressional and press scrutiny that the institution has experienced in its 96-year history. True, in the 1970s, the then-Chairman of the Committee of Financial Services, Henry Reuss, sought to challenge the constitutionality of the Federal Open Market Committee’s ultimate decision-making power on monetary policy, but he was denied standing. The Supreme Court never ruled on the issue. But now, like so many other things, the Fed’s privileged status in our society is again being queried. A healthy dose of skepticism in regard to their actions is well merited.

And what of the Obama Administration itself? It demonstrates a similar kind of cognitive dissonance evinced by the Federal Reserve. Having left open the gates of the asylum, the President and his main economic advisers profess shock, (”shock!”) that the sociopaths who run our investment banks are back to their old tricks, daring to gamble in a totally uninhibited manner with the taxpayers’ dollars. These are the same dollars which have been all but guaranteed by Treasury Secretary Geithner, who promised that there would be “no more Lehmans”. These are the very same tax dollars now being deployed to lobby against financial reforms, which will mitigate the practices that created the mess in the first place. The next time, these same banks are likely to leave a catastrophe far scarier than any Halloween costume. Having been duped, the President now seeks to deploy a cheap political trick. He is attacking an easy political target, but as usual, doing nothing concrete to ameliorate credit conditions. Indeed, his actions will likely increase the cost of credit.

Just over the weekend, the President again lambasted the banks for failing to enhance credit availability. During his weekly address, the President said banks should “return the favor” of their recent taxpayer-financed bailout by lending more money to small businesses. As a taxpayer, I don’t recall ever granting this “favor”, but that aside, the President still demonstrates huge conceptual confusion when it comes to the economy. Under the guidance of Larry Summers and Timmy Geithner, policy has continued to preserve the interests of big financial companies, rather than implementing government programs that directly sustain employment and restore states’ finances. To make matters worse, the Obama Administration is already preoccupied with “paying for” additional spending through tax hikes or spending cuts elsewhere. It does not appear to be willing to let the fiscal position of the federal budget grow as needed to meet current challenges.

All of which collectively will serve to cause incomes to stagnate and personal balance sheets to deteriorate, thereby diminishing creditworthiness. Repeat after me, Mr. President: “Enhance creditworthiness and improved credit conditions will follow; personal balance sheets before bank balance sheets.” You improve aggregate demand, and incomes will rise, as will the borrowers’ capacity to borrow. All of which makes it easier for lenders to lend.

It’s so simple that even a banker can figure it out.

And here is why the whole model of securitization itself precludes improving credit conditions. In the words of L. Randall Wray and Eric Tymoigne in “It isn’t Working: Time for More Radical Policies“,

When a commercial bank makes a loan, the loan officer wonders “how will I get repaid”. Because the loan is illiquid and will be held to maturity, it is the ability to repay that matters-and it is most prudent to rely on income flows rather than potential seizure and forced sale of the asset at some time in the possibly distant future and in unknown market conditions. On the other hand, when an investment bank makes a loan, the loan officer wonders “how will I sell this asset”. The future matters only to the degree that it enters the value of the asset today because it will be sold immediately.

It’s Halloween at the end of this week, so it wouldn’t be right to conclude this post without a bit of Halloween imagery. Last week, I described the bankers as vampires (with full tribute to Matt Taibbi ) and the banks as zombies. I have also noted (as has my colleague, Anat Shenker) the tendency of many deficit terrorists (many of whom are the largest beneficiaries so far of taxpayer bailouts, but who still claim we “can’t afford” to help the vast majority of Americans) to deploy imagery relating to our government spending as something unnatural or unhealthy. We hear characterizations of the budget deficit as a “national cancer” (former Illinois Senator, Paul Simon), or government spending as something akin to a heroin addiction (a description I heard last week at a Financial Forum in Denver, Colorado). True to my love of Hammer Film horror classics, I prefer a different image to describe our government spending. It’s a necessary blood transfusion, without which the patient (in this case, the US economy) dies.
But like any blood transfusion, you want to give it to a sick patient who has a chance to get better, not a terminally ill one (i.e. like our TBTF banks), who are being propped up by phony accounting (what we might call a life support system, where the government steadfastly refuses to pull the plug).

Unfortunately, these “blood transfusions” have hitherto been misallocated. No amount of populist grandstanding by the President or the Fed can change that. When we aid banks in this way, it is like using our blood to feed vampires instead of giving that blood to people who could genuinely use a transfusion. This causes those vampires, in turn, to prey on the rest of us. By the same token, introducing pay restrictions on the likes of AIG, BofA, or Citi is akin to complaining about the quality of the clothing being worn by the zombies as they rampage and munch away on the living.

Happy Halloween everybody.