Incorporation as a Cause of the Global Meltdown?

I think Buce has a very good point.  There were many causes of the Global Financial Meltdown (GFM) in 2008 and it’s siamese twin, The Great Worldwide Recession That Won’t Recover (TGWRTWR).  Some causes are superficial and others are more systemic.  Certainly perverse incentives in the banking industry were among them.  This is the stuff of “institutional economics”.  One of the least-talked about changes in the last few decades has been that major Wall Street firms have converted from business partnerships (each of the senior managers is personally liable for the mistakes of the firm as a partner-owner) to corporations.  As a corporation, the shareholder-owner at most loses the actual cash they put in.  If they lose the borrowed money, there’s no consequence for them.  It’s heads-I-win, tails-somebody-else-loses.  Senior managers of these large Wall Street enterprises don’t even put any personal cash into the business since their “ownership” stakes are largely the result of stock options and stock grants they give to themselves as “compensation”.  No wonder they took outrageous risks and behaved irresponsibly.  Let Buce at Underbelly say it:

There is indeed something problematic about the asymmetric heads-I-win, tails-you-lose structure of non-recourse finance.

The trouble is, once you start looking for it, you find “non-recourse” under almost every rock in the capitalist garden. I’m sure Perry would be happy to show you how the same problem underlies the bankruptcy discharge, where the debtor gets to walk away from his just debts. I’ll bet (although I do not know) that he feels the same way about bank insurance, like the free-handed taxpayer guarantees that allowed the mischief-makers to bring down the Savings & Loan industry in the 80s/90s.

But it doesn’t stop there. When I buy a call option on LittleCo stock, I acquire the right to take the stock or throw it away–analytically no different from my right when I buy my home on a nonrecourse mortgage. I have not heard Perry howling for the abolition of the conditional claims market, and I am not holding my breath.

Or consider the corporate limited liability form itself, the greatest social invention, so Bertrand Russell is supposed to have said, of the 19th Century. Restated: the equity stake in a leveraged company is a call option on the assets–you can take or walk away, just as with stock options, just as with the nonrecourse mortgage.

Probably nobody ever understood this better than the bankers. Look at that picture above of Mr. Banker Himself, J.P. Morgan Jr. Why does he look like he is ready to explode? Because it’s his own skin in the game. He was a general partner. If the deals went sour, he stood to lose every penny. No wonder he was a prudent lender. No lwonder he staked so much on personal character.

Sadly, his successors appear at last to have grasped the full implications of his insight. What caused the late meltdown? Of course you can’t bring it down to one cause, but if you had to name just one, I’d say–incorporation of investment banks, the great tectonic shift from unlimited to limited liability.* That’s when the bankers stopped having skin in the game: when they shifted to heads-I-win, tails-you-lose. They bankers didn’t worry about taking lunatic risks because they knew the downside was yours, or rather ours (indeed, any first semester MBA student can show you, the greater your capacity to shift he losses, the greater the inducement to take a risk and the more lunatic the risks you take).

4th Qtr 2009 GDP, 1st Revision

From Calculated Risk and the government:

The headline GDP number was revised up to 5.9% annualized growth in Q4 (from 5.7%), however most of the improvement in the revision came from changes in private inventories. Excluding inventory changes, GDP would have been revised down to around 1.9% from 2.2%.

Not really any encouragement here.  Yes, the overall is revised up 0.2 points, but what really counts for a sustained recovery was actually revised down 0.3 points.   The risk of a stumble and falling into a double-dip recession is looking stronger.

Best Idea I’ve Read Today

from Angry Bear:

globalization–the idea that corporate entities should be able to operate their business world-wide without any “barriers” from the nations themselves–is at the heart of our systemic economic problems. The rage at the base of the tea party movement is real–it has been misdirected at government, as though government were the source of the problems, when it should have been directed against the Big Business mentality that casts morality aside and considers profit the only god–community, workers, and product quality/service be damned. The tea partiers’ rage itself is real, because people are so fed up with having no real choices, at being at the mercy of multinational corporations that set their own terms and, often, have near monopolies. This is especially true with health insurance, where the lightly regulated industry is made up of a few giants who often dominant their markets, leaving a typical person little ability to “shop” for a better deal. Even where you shop, once you create a business relationship you are in many ways at the mercy of the corporate giant. They change prices when they please, they charge ridiculous add-on fees for services that cost them only a small fraction of the fees they charge, they hide information and manipulate their clients–from cable providers to banks to mortgage lenders. They are no longer local, and they no longer care about your community or you as a client. It seems to me that if we want businesses that are more responsive to the typical person, we need businesses that are smaller, not businesses that are bigger. We need more Mom and Pop stores and less Wal-Martization of the country.

Explanation: “Core Inflation”

Krugman explains “core inflation” and the measurement thereof:

So: core inflation is usually measured by taking food and energy out of the price index; but there are alternative measures, like trimmed-mean and median inflation, which are getting increasing attention.

First, let me clear up a couple of misconceptions. Core inflation is not used for things like calculating cost-of-living adjustments for Social Security; those use the regular CPI.

And people who say things like “That’s a stupid concept — people have to spend money on food and gas, so they should be in your inflation measures” are missing the point. Core inflation isn’t supposed to measure the cost of living, it’s supposed to measure something else: inflation inertia.

For the full explanation, go to the link.

History: Chicago School Didn’t Always Support the Banks

In the previous montrous, global financial meltdown (the Great Depression), the leading economists at University of Chicago sang a very different tune from what they promote today.  They actually called for nationalizing the Federal Reserve Banks and giving total control of money creation to government.  They argued it was necessary to provide the proper environment for free markets.  Total opposite of today’s descended-from-Milton-Friedman-and-Hayek position.  Fascinating.   See – Chicago Plan for the full story.

Who Owns The Federal Reserve?

Some more detailed background on a common question asked by students in macro classes:  Who Owns the Fed?  This question and confused answers to it also form the basis of many conspiracy theories and misunderstandings of our monetary system.  To set the record straight, I quote from

Therefore most Americans would be surprised to learn that almost all of what we use for money is not issued by our government, but by private banks. They have been “allowed” to form erroneous assumptions about our money and banking system that are far from reality and that serves to shield from closer scrutiny, whether the Fed is truly operating in the public interest or advancing more private agendas, either on purpose or by default.

Organization And Ownership:

The Federal Reserve consists of 12 regional Federal Reserve banks, with boards of Directors, under an umbrella direction of the 7 member Federal Reserve Board in Washington, with the power to determine major aspects of banking activity, such as setting interest rates, and the reserve and other operational requirements. There are no shares of the Washington Fed Board organization; the only “ownership” of the Fed is in shares of each of the 12 regional banks which are entirely owned by the private member banks within their respective districts, according to a formula based on their size (they must subscribe to the shares with 3% of their capital plus surplus).  The ownership is highly restricted in that such ownership is mandatory; the shares can’t be sold; and they pay a guaranteed 6% annual dividend..

Thus the stories that the Federal Reserve is “owned” by foreign bankers (the Rothschild’s and other prominent banker names usually come up) are not accurate and these types of rumors have mainly served to discredit wholesome criticism of the banking system. While it is true that our first central bank, the First Bank of the United States, upon dissolution in 1811 was found to be three quarters owned by British and Dutch interests, that bank was structured simply as a private share company on the Bank of England model.* The control of the Federal Reserve System is more difficult to untangle and is not just a matter of counting shareholder votes. While foreign bankers might indirectly own shares of the regional Federal Reserve Banks through ownership of American banking companies, such ownership would be reported to the SEC if any entity held more than 5% of the American corporation. This however does not exclude strong, potentially undue foreign influence, for example through the Bank for International Settlements (BIS).

A “Non-Profit” Organization?

The Federal Reserve System puts itself forward as a non-profit organization that turns over its operating profits to the U.S. Treasury, after all expenses, including the 6% dividend to member banks. However this misses the point on several scores. First, the banking profits coming through the privileged money creation process mainly occurs at the member bank level of operation, and those profits are not turned over to the Treasury. That is, the net earnings from the member banks seigniorage privilege are not turned over to our government but kept by the private member banks. For England this amount has been estimated at 41 Billion Pounds per year. For the US we think it’s between $100-200 billion per year; but we need to know the amount more precisely from the Fed itself.

This money creation which is put into the system when the banks extend loans, eventually becomes a source of funding when our government’s bonds are sold to the public. Here is how Wright Patman, former House Banking and Currency Committee Chairman for 16 years criticized that process:

“I have never yet had anyone who could, through the use of logic and reason, justify the Federal Government borrowing the use of its own money….I believe the time will come when people will demand that this be changed. I believe the time will come in this country when they will actually blame you and me and everyone else connected with the Congress for sitting idly by and permitting such an idiotic system to continue.”

We think the time has come.

Secondly, how extravagant are the FED’s operating expenses? Reputedly quite high, but in order to determine that for sure a proper audit would be necessary. Just where did the extensive real assets of the Fed come from if all the earnings are turned over to the Treasury? (Fed capital as of June 28, 2006 was $29.462 billion) Perhaps some part of it comes from member bank subscriptions to the regional Fed shares. Another question for the audit to address. (If memory serves correctly, the Fed used to turn over 90% not all, of its earnings over to the Treasury; but now its 100%.


Private ownership does not guarantee private control – they can be two different things. Although ownership of the fed is admittedly private in a restricted way, it is control which is the more important factor in regarding the Fed as private, not governmental. Remember the question is whether the control rests more in private or governmental hands, not whether it rests directly in shareholders hands.

It will be clear from the following points that the Fed is definitely not part of the US Government:

* The Fed is not organized within the Executive, Legislative or Judicial branches of our government.

* Who pays the Fed’s bills and determines its budget? Not any part of our government. The Fed gets its funding from its own specially privileged operations. The Fed Board determines Fed budgets.

* Who monitors and oversees Fed activities? Again the Fed itself. While some important elements of proper auditing have taken place, there has not yet been a comprehensive independent audit, by the Government Accountability Office as proposed in a recent letter from Ralph Nader to new Fed Chairman Ben Bernanke, calling for greater monetary transparency.

* Federal Reserve Employees are not part of the US Civil Service System and are not covered by government employees’ health insurance or pension programs. Who does the hiring and firing? Except for the highly publicized Chairman and 7 member Washington Board, this is in private, unelected hands.

* Federal Reserve Banks are not listed as government organizations by the telephone companies, a small but telling fact.
Here is how the Fed describes the Control situation, in the FAQ’s on its website:

“As the nation’s central bank, the Federal Reserve derives its authority from the U.S. Congress. It is considered an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, it does not receive funding appropriated by Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. However, the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute. Also, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government. Therefore, the Federal Reserve can be more accurately described as “independent within the government.”

We’d suggest the phrase “independent within the government” is much too ambiguous and has the effect of conveying great power while avoiding responsibility.

The Fed’s FAQ’s continue regarding control:

“The Federal Reserve’s ultimate accountability is to Congress, which at any time can amend the Federal Reserve Act. Legislation requires that the Fed report annually on its activities to the Speaker of the House of Representatives, and twice annually on its plans for monetary policy to the banking committees of Congress. Fed officials also testify before Congress when requested.

“To ensure financial accountability, the financial statements of the Federal Reserve Banks and the Board of Governors are audited annually by an independent outside auditor. In addition, the General Accounting Office, as well as the Board’s Office of Inspector General, can audit Federal Reserve activities.”

We agree with Mr. Nader that it is time for the General Accountability Office to carry out this full audit of the Federal Reserve System. We take at face value the Fed’s statement that the only way for our government to exert necessary societal controls on the Fed is through legislation altering the Federal Reserve Act.

The Federal Reserve Act

Reading the Act with the question of control in mind, what one finds are primarily an enumeration and description of vast powers over our monetary system being ceded to the non – governmental Federal Reserve. Primary among these are the powers necessary to administer a fractional reserve banking system in which the creation of money – what we use for purchasing media – is in private hands.

One is struck by the general absence of governmental controls over Fed activity, and lack of requirements toward our elected representatives.

One is struck by the lack of accountability of the Fed to our governmental officials or bodies.

One is struck by the lack of any specified penalties should the system be found to not be promoting governmental public policy at all.

One is struck by the lack of formal oversight procedures to determine whether that is happening or not.

The Act requires the Chairman to appear before Congress and Congressional committees four times a year, and requires the Board to submit two written reports to Congress annually. To understand that this is not sufficient oversight, one need only read Congressman Bernie Sanders questioning of Chairman Greenspan, from the Congressman’s website. When tough questions were put to the Chairman, as Congressman Sanders did, forms of stalling non-answers came back until the announcement, “Your time is up Mr. Congressman.”

While the act specifies that the Comptroller of the Currency has the power to directly examine any member bank in the system, he is not empowered to examine Federal Reserve Regional banks – that is in the hands of the Washington Board. 14 year appointments – a one time event for them – places them outside the influence of our elected officials, in other words outside the democratic process.

Probably this “independence” was sold as a good thing! From the time of Adam Smith, there has been a growing attack against government, as being incapable of managing the monetary system. Despite the evidence that government has a far better record controlling money than private bankers have*; despite the fact that government is the only organizational form with ability to stand between the people and the “Enrons” of the world. It is time to rethink this “independence” question and examine the actual evidence, rather than to continue relying on free market ideology – really a form of elitist propaganda. It would be smarter to examine mankind’s actual experience with government controlled money systems – especially in America.  For what reason did the Federal Reserve Act envision that it would be saints serving on the Fed Board?

more details at the link above.