The 28th Amendment to Solve, Finally, a Major Defect to Current Capitalism: Manias, Panics and Crashes Proposed Amendment first published May, 2007 The 4th Branch of the US for Financial Safety W. Curtiss Priest, Ph.D. Editor, CITS Capital & Debt Watch Reissued: 2/20/2008, 4/16/2009, 5/7/2009 Preface: a US Constitutional Amendment for Financial Safety As readers know from my prior newsletters(1), I am quite sure there is little to be done to provide any remedy for our current US/World predicament, as, the time to have provided the remedy was starting about 30 years ago, when the first little flames of unsafe financial practices began, and then by using a repeated pattern of snuffing them out, just as they become visible to folk well trained to see such flames. So I speak here anyone interested in contemplating the remedy to prevent *all* future crashes, and it is not what my MIT colleage, Kindleberger(2) imagined -- as keeping "the lender of last resort" hidden and elusive. That didn't work -- indeed, that lender was so elusive and dumb as to repeatedly invite greater and greater hazard. In this article I've pulled together an edited statement of our proposed 28th Amendment for the 4th Branch of the Federal Government for Financial Safety (and it is somewhat like what Elizabeth Warren(3) has proposed, except she suggests it be a "Commission" and I say why that also is unlikely to work, as a commission). W. Curtiss Priest, Ph.D. Editor, CITS Capital & Debt Watch Principal Research Associate Emeritus, MIT Member, American Economics Association (1) CITS Capital & Debt Watch: issues and responses http://www.google.com/groups?q=cits+debt+watch http://groups.google.com/groups?q=cits+debt+watch (2) Charles P. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises. New York: Basic Books, 1978. (3) James M. Stone, "A new rulebook for financial regulations." Boston: The Boston Globe, 2/5/2009, p. A15. *** There are some who remember the US coming out of WWII as the strongest economy on the earth. Plus, we were on a technology roll that NO ONE could match. That war was funded by both taxes and war bonds. There are various interpretations of what happened. Some saw the war as "the shot in the arm" that ended the Great Depression. But others note that there were ample signs that the depression was ending prior to when the US entered the war. Those who saw the cure as "spending into debt" still embrace the solution as a Keynesian result. Today? We are a third-world country by many definitions. And, every third-world country that has tried to improve it lot by spending inevitably end up devaluing there currency and go into hyper-inflation. Some, today, fear deflation ... but ... with Summers and Bernanke -- these guys are just smart enough to think they can pull something off in the way of labels of 'stimulus' and 'bailout,' but neither is smart enough to see the consequences. The bottom line is (and has always been), if one or two generations receive huge boom incomes, etc., riding on debt, then at least one generation (now), pays the consequences. The "intergenerational equity" of this generation-based disparity is horrific. Why should perfectly well trained children, now coming out of college, etc., be greeted by an economy that can't hire them? It is this intergenerational equity that the proposal for a 28th Amendment is oriented to cure. But, lots of oxen will be "gored" -- the money for nothing game must never be allowed to be played again. For the sake of all future generations, I am hopeful that some important "rules" as voiced by Mr. Stone (below) help guide the shaping of this branch. Two things must happen now that we are in a crisis: 1. remedy, as we can, the current situation 2. prevent a recurrence of such crises, hopefully for all future generations If you look at the history of this country, we find that there has been, cyclicly and regularly, six financial crises of very large magnitude. This simply should not be permitted to happen as the grief is large and the innocent are hurt. Attached is my Boston Globe published letter of May 1, 1998 -- where I expressed this strong sentiment. And in that letter I suggested taking notes on identifying the features and causes as only then "will the next generation be able to avoid yet another catastrophe." President Obama, in his early aired address, spoke of a looming catastrophe. As I expressed in this letter (attached below), now eleven years ago, I would not be caught up in the mania, but, rather, study how and why it occurs. My conclusions are that the most important change to our country's government is to add a fourth branch for financial safety. It must be a branch, not an agency or commission, as I have seen how such parts of government are frequently and regularly, politically co-opted by those holding office and those elected to serve. And this is proposed as a 28th amendment to the US Constitution. After first proposing this, in May of 2007 (on several Internet Lists) a James M. Stone published his fine op-ed piece, "A new rulebook for financial regulations (2/5/2009, A15)" in the Boston Globe. The rules mentioned -- such as reducing financial leverage, risk assessability, sales practices and disclosure are extremely well thought out. Yet, even the fine minds of the 30's were unable to anticipate all the ways clever people would and did get around the best of rules and regulations they could imagine. And they were as equally determined to make sure the pain of the Great Depression was never felt again. Mr. Stone mentions Elizabeth Warren's proposal for a "Financial Product Safety Commission." And we agree with her that only an active part of government can keep up with cleverness as we've had afoot -- a 'cleverness' that will reappear in another 6 decades or so -- to cause yet another wave of suffering. Another suggestion, for a Monetary Security Agency, by Gelles, suggests an agency like the US NSA. However, this places too much power under the Executive Branch. As the author of the book "Risks, Concerns and Social Legislation" I have seen first hand how each and every "safety" and "protection" agency and commission was political compromised and neutered over the last 29 years. Their actions were 'not to the liking of many businesses with sway on the hill.' So, I suggest neither fixed rules nor a commission will be enough to prevent the next crash, and we have proposed a 28th Amendment to establish a fourth branch of the Federal Government, with specified Congressional relationships and tailored more like the risk assessment unit of the SEC under Donaldson, a unit he described to Moyers on PBS last year. Donaldson's unit could see the risk taking, but were powerless to stop it. Further, I would take Stone's fine rulebook and make it the cornerstone of a guidebook for those appointed to this branch (see a reprint of the article below). *** So what we needed is an extension of State and can be said so by declaring a 28th Amendment to the US Constitution that says the following: The 4th Branch of the US for Financial Safety Section 1. In an age of increased reason and knowledge, the people of the United States declare a more specific approach to achieve Life, Liberty and the Pursuit of Happiness. Section 2. As shown via the process by which nature created life, it is the responsibility of all people to not only perpetuate life but to sanctify all forms of life in their practices, activities and actions. Specifically, various virtues that constitute the good life, and similar instrumental values shall be celebrated. Section 3. A fourth body of government shall exist with the purpose of reviewing all laws and practices as called for in the form of a Rawlsian social contract as defined and regulated by the Bureau of Social Contract. Section 4. With respect to the other three bodies of US government, the Bureau has the power to introduce, and see through to a deciding vote, legislation when requested by five Senators in the Senate or twenty representatives in the House. With respect to the Judiciary, decisions of the Supreme Court, found to be disrespectful of Section 1 or Section 2, shall be formulated into law and entered into the appropriate legislative body within ninety days of such decisions. Similarly, Executive Orders by the President found to be disrespectful of Section 1 or Section 2, shall be formulated into law and entered into the appropriate legislative body. Section 5. To avoid delays for time-critical situations the Bureau shall have the power to enforce injunctions on any issues that arise under Section 4. Such injunctions shall require the concurrence of a Federal Judge and shall be subject to powers as determined by Congress. Section 6. In situations where it is deemed that actions within a single State may manifest into disrespect for Section 1 and for Section 2, the Bureau may seek redress as provided under Section 4 and Section 5. ------------------------------------------------------------------- Letters to the Editor The Boston Globe May 10, 1998, p. C6 WARNING: DEBT IS WHAT CAUSES DEPRESSIONS There is certainly a madness in our midst. Ravi Batra's new book, "Stock Market Crashes of 1998 and 1999" talks about how those hawking mutual funds based on strong fundamentals neglect to say that the fundamentals in 1929 were also very strong days before a depression that spread worldwide. As best economists can tell, what precipitates an economic catastrophe is debt. We are probably not going to avoid a depression, the depths of which will likely be greater than that of the '30s. Why? Because our level of indebtedness in relation to total domestic revenues is nearly twice the amount of debt we had when this contry was ravaged by the last depression. But perhaps we can do what the banking regulators of the '30s failed to do. They failed to put in place a foolproof mechanism to prevent future depressions. We need to take special note of what and why the euphoria preceding a depression occurs. For only if we fully identify its features and causes will the next generation be able to avoid yet another catastrophe. W. CURTISS PRIEST Melrose The writer is director of the Center for Information, Technology & Society, and a member of the American Economic Association ------------------------------------------------------------------- A new rulebook for financial regulations By James M. Stone February 5, 2009 Boston Globe Since insufficient regulation is considered a contributor to the 2008 financial crisis, one might expect that better regulation will soon be implemented to prevent a recurrence of the bubble. However, those who supported the extreme deregulatory policies of the last 20 years - respected free-market theorists as well as many large campaign contributors who gained from the permissive policies - remain powerful and may be able to block any effort. They will surely contend that increases in regulation should be minimal, that the "fruits of financial innovation" must be protected, or that what is needed is better regulators rather than more government. It is time for those who believe we have tasted enough of the fruit of reckless finance to offer an agenda for regulatory change. What is needed is neither an industrial policy substituting political preferences for the invisible hand nor a new ocean of paperwork. Instead, we should think about financial regulation as mainly a set of prohibitions on harmful practices, more a rulebook than a bureaucracy. Here is a checklist of subjects for the debate agenda. Leverage. The 2008 crisis couldn't have occurred if regulators had heeded the most obvious lesson of the Great Depression. Speculators buying stocks on loose margin helped create a bubble in equity prices that burst in October 1929, and tore the fabric of the economy. Since then, it has been understood that excessive leverage in financial markets is hazardous to participants and bystanders alike. Leverage for common stock investors was limited after that time to around one-to-one, but few if any leverage limitations were applied to the new derivative instruments that emerged in the last 20 years. By 2008, banks and brokers were leveraged as much as 30-to-one. A financial institution with that much leverage is necessarily jeopardizing itself and its counterparties. Far tighter leverage restrictions are needed, and, for banks, that should include restrictions applied to large loan customers, including hedge funds. Complexity. A substantial share of the damage in 2008 was caused by stunning overuse of derivative securities such as credit default obligations and securitized mortgage tranches. Some of these instruments were so convoluted that they can not be unwound without congressional help, and their risk profiles can't be parsed by Wall Street's brightest bankers. These are examples of the "financial weapons of mass destruction" Warren Buffett warned about years ago. Policymakers should consider forbidding any insured institution from trading derivatives too complex for risk analysis and limiting the menu to instruments collateralized with modest leverage, traded on exchanges, or approved as contracts of insurance. Cyclical Robustness. Institutions of finance used to help the country get through inevitable economic cycles. Profits from good years were retained as capital in banks and brokers, thus available to cushion the lean years. By shifting much of their risk and reward to hedge-fund clients, banking institutions inadvertently moved profits into businesses that sent them home in personal compensation - forfeiting the cushion. Then, as banks and brokers grew increasingly envious of their clients' economics, they ramped up their own leveraged trading activities to mimic the hedge funds . . . and supercharged compensation to compete for talent. Regulation should assure that cyclical gains are not paid out in compensation by a taxpayer-backstopped financial sector. While we shouldn't be quick to assign blame to individuals for accepting the pay they were offered, the notion that the good years belong to the management and the bad years belong to the taxpayers deserves a deep burial. Scale. Congress has gone too long without debate on the basic questions of anti-trust policy. Policymakers used to wonder if bigness could indeed be badness. In recent decades, however, consolidation in the financial sector has gone largely unchallenged. Some in government seem to think huge scale is actually a public benefit; others accept it as an irresistible force. It is neither. Most of the giant firms taxpayers are bailing out were small fractions of their current size and market shares a few decades ago. Some degree of consolidation may have been justified by underlying economics, but it is time to ask if the scale of the troubled behemoths serves anyone well. It is fair to query whether any firm can be too big to fail without being too big to manage or whether financial companies with inexhaustible lobbying budgets are compatible with pluralist democracy. Nobel Laureate Joseph Stiglitz has said that when "a firm is too big to fail . . . it should be broken up." Congress and the president should force an examination of the question and reconsider its 1999 repeal of the Glass-Steagall Act, which had long separated banks from brokers. Sales Practices. Irresponsible mortgage lending also played a role in the crisis. Much of the harm was done at the point of sale, where families were encouraged to take on obligations only marginally realistic even in good circumstances and impossible to honor in a declining economy. Documentation grew ever weaker as the bubble enlarged, just when it needed strengthening. Well-meaning but exaggerated public policies to favor home ownership contributed to this problem, as did securitization that allowed sloppy underwriting analysts to pass off the risk bearing to others, but some measure of blame belongs to downright ugly practices. In the first 50 years after 1929, securities regulators established an admirable tradition of sales oversight, including broker-dealer licensing and testing, suitability rules, and compliance and conduct examinations. These standards were weakened in recent years and never matched in mortgage origination or derivative sales. A uniform high standard of protection is presumably what Harvard law professor Elizabeth Warren was seeking when she called for a Financial Product Safety Commission. Government needs to take a fresh look at sales practices in the financial service industry and raise the bar throughout. Disclosure. The least controversial pillar of financial regulation should be the requirement of full disclosure. Sadly, even the simple principle that financial institutions should reveal their metrics to a public dependent on their soundness was diluted in the tide of deregulation. The emerging hedge-fund industry was subjected to virtually no reporting requirements, and banks were permitted to pack liabilities into opaque special-purpose entities omitted from balance sheets. Some policymakers were fooled into thinking that less than full disclosure was a new global imperative or that there were no widows and orphans to protect in sophisticated markets. It should be clear by now that pension investments and the ability of a financial failure to catalyze more general economic maladies justify intervention even by the widows-and-orphans standard. The coming regulatory reform should restore maximum transparency as the inviolable objective of financial reporting, and large debtors and counterparties of guaranteed institutions should be subject to the same standards as the institutions themselves. This is not a call for an industrial policy, for red tape, or for nationalization of the financial sector. It is a common-sense call to prohibit behaviors that produced a terrible outcome. The crisis we find ourselves in, one that will scar millions of American families, never needed to occur. The turn in the real estate cycle that fomented the crisis would have been manageably absorbed had adequate regulation of financial institutions been in place all along. The regulatory cure implied here may seem Draconian to those who profited from under-regulation, but it is no larger than the harm that regulation's laxity has engendered. James M. Stone, former chairman of the Commodity Futures Trading Commission and prior to that commissioner of insurance for Massachusetts, is CEO of the Plymouth Rock group of property and casualty insurance companies. c Copyright 2009 Globe Newspaper Company. ["fair use," "teachable moment," "archival," Section 107(a), 1976 Copyright Act and 1998 Digital Millennium Act] ------------------------------------------------------------------- Appendix A: 11/13/2008 -- further thoughts about applying constraints The overall problem backs into the thorny area related to any and all activities that are intended to induce purchases. Advertisements are created, for example, induce purchases. So, with respect to economic stability there are socially efficient advertisements which induce a "more appropriate" product or service, where consumer surplus may even be increased. As there are often economies of "scale" "scope" that result from higher volumes resulting due to advertisements, the pareto optimality is increased by such advertisements (yet, still ... commonly ... at the expense of causing smaller businesses to fail). There is often debate about, for example, the geographic locating of a Walmart, precisely because community-oriented people fear that "local business" will be hurt, and thus, overall pareto optimality may go down to the extent that this harm is greater than the economic benefits of the savings due to a higher volume retailer. There are many who believe that there are negative externalities when advertisement becomes so controlling of human behavior, that it creates a level of materialism that overly displaces other socially desirable goods (family activities, use of leisure, say for exercise or socializing, etc.) And, the most invasive of these negative externalities is in the accrual of financial debts that become too great a risk to the individual, the family and to the economy. Finally, there is advertising and other inducing behavior, such as "stimulus packages" that bring great evil upon an economy. While Keynesian inductions of spending are beneficial when, for example, the Federal Government has run a surplus, and the Keynesian inductions are simply addressing minor cycles where, if treated, overall welfare increases ... such inducing and stimulating purchases where none of the parties can afford the added spending is criminal. While these inducements are born out of relatively "good intentions" -- 1.) on the side of businesses, surplus inventory may be ameliorated by such inducements -- it will be the case there are times when these surpluses should not be purchased and consumed, almost at any price; 2.) and on the side of the Federal Government -- it is always "politic" to prop up an economy ... as voters want jobs and goods -- it will be the case that when the Federal Government's use of debt to provide the inducement will cause an overall reduction in welfare to the current generation and will cause an overall reduction in welfare to the current generation and their children's generations. In hindsight, of course, if the purposes of the 28th Amendment are achieved, a good deal of this inducement behavior will simply disappear, as it will be unnecessary. However, there still remains the problem of advertising, and related social behaviors caused by and around all of the advertised goods and services, "asks" that households take on spending in excess of income, or prudence in general. For example, in a consumer/materialistic-based society, events such as Christmas and birthdays become judged by the extravagance of gift-giving. Those who adhere to price guidelines, in the spirit of keeping the activity affordable, are seen as Scrooges and spoil-sports. Often, the grandmother, say of a large family, seems only able to express her love and caring by spending beyond her means ... but cherishing the smiles and hugs of all the recipients. Ask most anyone in such a society whether "things have gone overboard" and they are likely to nod, quickly in affirmation. But, then try to take such a socially-ingrained issue any further and one is met with general resistance. This is a classic case of a "race to the bottom" and it occurs regardless of whether, stepping back, it is seen as wise or provident. At this time I would require the 4th branch to further study how human behaviors (as are currently documented by the field of behavioral economics) can be assisted in curbing the appetites for overspending on goods and services. Such study shall lead to programs, such as illustrated by smoking cessation programs, to provide financial safety related teachings in schools, public addiction cures, and appropriate labeling and controls of advertisements for goods and services. Appendix B: 4/16/2009 -- further thoughts about a Social Dividend The father of the theory of Social Credit is C. H. Douglas. Buried in obscure prose and elucidated by others with yet more obscure prose, there is a theorem called A + B. This theorem relates to an imbalance in the ability for consumers to purchase all goods and services based on their wages. Later authors, such as Shakespeare and Ashford, in Binary Economics have also, based on the work of Kelso, spoken to the advantages of worker-owned companies. Their work suggests that a further underlying cause for consumer debt is an imbalance, i.e., that monies siphoned off as profits by companies do not incur to workers, and yet goods and services reflect both the actual cost of goods plus these other sums. Knurland and others are also convinced that ownership is required for a stable form of capitalism. Their views are disseminated by the Internet list, "Global Justice Movement." Most recently, Richard C. Cook has proposed a dividend to solve such problems in "We Hold These Truths." I, as a co-author of the book, "Technological Innovation for a Dynamic Economy," am perplexed about these approaches. As I have witnessed how the ownership of capital "engines" called companies often requires ownership by CEOs with a commitment to profit, at almost any cost, I am reticent about the viability of worker ownership. I believe that in a better world, such ownership is kinder and more fair, but impractical in this world. As for a transfer payment to remedy the "A + B" problem, I don't see how a financial system can both pay profits to investors and pay the same sums to consumers as dividends. This strikes me as a "having your cake and eating it, too, problem." At this time, I would require the 4th branch for financial safety to further study the problem as pressures occur for unreasonable levels of consumer debt. If, indeed, to put a lid on unreasonable lending is to cause an imbalance in the supply of goods and services and their demand, with the result that sellers constantly tempt buyers to borrow beyond their means, this 4th branch shall devise the most practical remedy to this behavior.