The impact of the financial crisis rippled through my community this weekend yet again. One of the area’s oldest automotive dealerships closed six of its showrooms, laying off an estimated 400 people. The action so upset General Motors it has sued.
Everyone around here is now wondering when the next manifestations of the crisis will hit. A talking head on local TV said he expects there will be more dealers shutting their doors. All I could think of is what do you do if you sold cars for a living all your life or where does a highly-skilled GM mechanic find a place to practice his trade? Finally, I wondered what dumping the vehicles from six dealerships would do for other nervous auto dealers.
The Systemic Impact
Those layoffs represent yet another manifestation of this economic crisis which is rippling through local communities. My wife who is a nursing professor says area hospitals are already feeling the impact as patients put off elective procedures and the uninsured clog emergency rooms. My local school district is close to statutory operating debt, which in my state is the equivalent of bankruptcy.
All these impacts ate turning all of us into systems thinkers as we begin to see how everything really is interrelated. If we were system dynamics modelers we could probably plot how these ripples are taking out one business after another as people struggle to keep from drowning in this tidal wave.
Take the hospitals. All of them are owned by HMOs whose local clinics also are seeing fewer patients. If an HMO is taking a loss what does it do? What other corporations do: close and consolidate, which means patients will have to travel further for health care. But you don’t have to be a systems thinker to see that will have the unintended consequence of further lowering patient visits because rather than travel longer distances, patients just won’t travel. And there will be more questions: what does a doctor do who has been laid off?
The Impact of Consolidation
When economist and Nobel Prize winner Joseph Stiglitz testified before Congress, he told them this crisis represented the end of top-down economics likening it to how the fall of the Berlin Wall symbolized the end of communism. But there is another even more troubling systemic lesson communities across the country are learning: when an economy where everything from health care to auto sales to restaurants has become owned by big conglomerates with offices in faraway places it causes some pretty big ripples.
The chains are already starting to go down. Circuit City filed for bankruptcy. If consumers cut back their spending this Christmas, as they are predicted to do, more bankruptcies will follow. Sears, for example, is in trouble.
In a less-concentrated economy you would have had lots of independent retailers, some of whom might fail, but their fates would be more tied to local factors than the decisions of some multinational corporation. Those six dealerships closed as much because General Motors was in trouble as because of acts by the dealerships. It is said one reason Circuit City went down is due to decisions by top-level management to locate stores in lower-rent, but less traveled malls.
The Financial Plague
Yet nowhere is the systemic impact of the crisis more visible and more devastating than in the place where it started–the financial industry. As FDIC head Sheila Bair testified, what we have is a liquidity crisis–lending has frozen because institutions do not have confidence in each other.
Curiously this is identical to a reaction seen in a type of system dynamics model two of my friends have worked on for two decades. It is called the infection model, which they first used to explore the impact of large disease outbreaks like the Black Death. What they found explained much about the impact of these outbreaks on society. One common theme that runs through their investigation is quite similar to the lending crisis–when a disease such as fear of lending spreads, people try to isolate themselves from the “infection.”
The Infection Crisis
Infection outbreaks are classic compounding growth scenarios. I infect two people, they infect two more and just like that the crisis has doubled. This “doubling” continues as more and more people infect others. If the right conditions are present you can have the equivalent of the Black Death or the 1918 flu epidemic.
The variables are the seriousness of the disease, the percent of the population with natural immunity, the quickness with which authorities act with the right interventions such as vaccinations and how concentrated is the population. Both the Black Death and the 1918 epidemic were a function of increased mobility, so it spread more quickly from town to town.
The Need for Systemic Cures
If how quickly an infection spreads is a function of concentration whether of people or institutions then we have the makings of an economic plague for we have already seen how economic concentration has contributed to this crisis in the closing of those six auto dealerships. So what can we do?
In the simple infection model Jeff Potash and John Heinbokel developed, there are three keys: time (how long it takes the infection to travel and for someone to come down with it), space (how easy is it for people with infections to come in contact with each other) and intervention (how many people can you cure and how quickly). Curiously these are functioning in the “infection” our economic system has sustained.
Systemic Cure One: Cut Concentration
Economic concentration is one of the roots of the crisis. If we extend the infection model, economic concentration is to the economic infection as population concentration is to a disease infection. Perhaps the biggest admission of this systemic failure is the idea of “too big to fail.” Too big to fail is the definition of a dinosaur–and we know what happened to them.
The huge financial firms that dominate today’s markets are the equivalent of today’s dinosaurs. They make the liquidity crisis even more disastrous because there are fewer of them, so mistrust spreads quickly and has large consequences. It’s one thing if a locally owned bank tightens up its credit, but when all the banks in the Bank of America system or Wells Fargo tighten their credit it reverberates throughout the country.
Economic concentration is the equivalent of the changes in mobility that made both the Black Death and the 1918 epidemic so catastrophic. In 1918, for example, one vector that helped to spread the disease was soldiers returning from the war to their home towns. One returning soldier could quickly infect an entire community. At that time the dominant means of travel between communities was still the railroad, which meant one flu carrier on a train could infect other travelers who brought it to all the stops on the route. With economic concentration the tightening of liquidity quickly engulfs the entire country.
So step one is to cut concentration, especially concentration that is in violation of the law as are Bank of America, JPMorgan Chase and Wells Fargo who currently are operating illegally by ignoring a provision that requires that no financial institution control more than 10% of the market. Not only has the Bush Administration refused to take action against the big three, it has rewarded them by giving them bailout funds which they can use to increase their market share.
Step two in cutting concentration is to bring back the Glass-Steagall Act that was gutted in 1999, leading to the present mess. Joseph Stiglitz described the current financial world in his Congressional testimony:
We need to begin by observing that there are important distinctions between financial institutions that are central to the functioning of the economy system, whose failure would jeopardize the functioning of the economy and who are entrusted with the care of ordinary citizens’ money, and those that provide investment services to the very wealthy. The former includes commercial banks and pension funds. These institutions must be heavily regulated in order to protect our economic system and the individuals whose money they are supposed to be taking care of. Consenting adults should be allowed to do what they like, so long as they do not hurt others. There needs to be a strong ring-fencing of these core financial institutions—they cannot lend money to or purchase products from less highly regulated parts of our financial system.
Those institutions Stiglitz identifies as “central to the functioning of the economy system, whose failure would jeopardize the functioning of the economy and who are entrusted with the care of ordinary citizens’ money” should once more be subject to the provisions that were stripped from Glass-Steagall. In essence we need to reestablish the regulation the Supreme Court favored in it decision Investment Company Institute v. Camp. In that complex case the Court issued one of the most ringing and unequivocal defenses of Glass-Steagall:
Congress was concerned that commercial banks in general and member banks of the Federal Reserve System in particular had both aggravated and been damaged by stock market decline partly because of their direct and indirect involvement in the trading and ownership of speculative securities.
The legislative history of the Glass-Steagall Act shows that Congress also had in mind and repeatedly focused on the more subtle hazards that arise when a commercial bank goes beyond the business of acting as fiduciary or managing agent and enters the investment banking business either directly or by establishing an affiliate to hold and sell particular investments.
By severing the interrelationships in the current system that too readily mix investment banking and what we might term “traditional banking” we cut one of the main vectors of the transmission. It is the financial version of quarantining the infection.
Systemic Cure Two: Interventions
Just as the cure for disease outbreaks is interventions that slow or stop the spread of the disease, so is the cure for our financial infection. If liquidity is at the root of the problem, then the government needs to put in place steps that will reduce the fear of making loans whether to individuals, businesses or other banks.
The liquidity crisis is rippling through the economy so people cannot get loans to buy cars, college students cannot get loans for their education, and homeowners cannot get loans to buy homes. Automobile dealers close down because they buy cars on credit, stores take out loans to buy inventory (the reason Circuit City is in trouble is that manufacturers refused to make financial arrangements for getting their products to the retailer), and factories across the country cannot get loans to buy new equipment or replace aging machinery. As for things like venture capital which has been a huge driver of innovation, that has become yet another casualty, since many of those firms rely on stock investments and loans.
The FDIC is already implementing steps to ease this crisis with its Temporary Liquidity Guarantee Program. FDIC head Sheila Bair described these:
The program has two key features. The first feature is a guarantee for new, senior unsecured debt issued by banks or thrifts and bank holding companies and most thrift holding companies, which will help institutions fund their operations.
The second feature of the new program provides insurance coverage for all deposits in non-interest bearing transaction accounts at institutions unless they choose to opt out. These accounts are mainly payment processing accounts such as payroll accounts used by businesses.
As the program’s title indicates these measures are only temporary. The systemic problem is that we do not know how temporary they should be. In the disease model, you can reasonably predict at what point your interventions will cause the outbreak to subside, but Bair gave no indications in her testimony that the FDIC has any modeling in place that will help them get a grip on the financial infection.
The interventions all seem to have picked an arbitrary time limit which is a bit like picking how many people to vaccinate in a disease outbreak by drawing a number out of a hat. The second feature, for example, expires at the end of this year, which judging by how things are going will not be long enough.
A vaccination permanently prevents an outbreak of a particular disease from recurring in individuals who receive it. The current liquidity crisis is in dire need of a vaccination, which means Congress should consider making the FDIC interventions permanent. In her testimony, Bair explained:
It is important to note that the TLGP does not rely on taxpayer funding or the Deposit Insurance Fund. Instead, both aspects of the program will be paid for by direct user fees. Coverage for both parts of the program is automatic for the first 30 days, without charge. After that, the FDIC will begin assessing premiums or user fees for the coverage unless an institution opts out of one or both elements of the program.
This is how we make the FDIC plan permanent much as we did with the backing of bank deposits in the 1930s. In return for guaranteeing unsecured debt, institutions would have to agree to contribute the the permanent Loan Guarantee Program in return for additional oversight by the FDIC. The program would be voluntary, but institutions that did not enroll would be ineligible for future bailouts, nor could they join after getting into trouble.
The second intervention is one recommended by Joseph Stiglitz in his Congressional testimony and several recent articles and interviews: a Financial Products Safety Commission, which would be the loan equivalent of the FDIC. Stiglitz described how it would work:
This would assess the risks of particular products and determine their suitability for particular users. Many of these products were allegedly designed for managing particular risks, but the people buying those products did not face the risks for which they were designed. They thus increased the overall risks which they faced. There should be a presumption that financial markets work fairly well, and as a result there are no free lunches to be had. Financial innovations that are defended as reducing transactions costs, but instead lead to increased fees for financial institutions, should be suspect. The Financial Products Safety Commission would also look at the pricing of these products. Many new financial products (derivatives) were sold as lowering transactions costs and providing new risk arbitrage opportunities, but pricing was based on information provided by existing assets, and they succeeded in generating huge fees.
While reinstating Glass-Steagall would prevent future crisis by traditional banks, Stiglitz’s idea would take care of more speculative institutions. Think of it as a kind of public health agency charged with monitoring the financial health of our system just as public health agencies monitor the health of our communities.
The Total Package
Essentially the second, systemic part of the recovery package I call Dollars for Democracy includes four key components to prevent the spread of the liquidity crisis:
1) Reinforce current laws against concentration,
2) Bring back Glass-Steagall,
3) Create a loan equivalent to the FDIC, and,
4) Create Stiglitz’s Financial Products Safety Commission
It is important to recognize the systemic, interrelated nature of these four interventions, without one, the other three fail. For example, if we bring back Glass-Steagall but do not also ease the liquidity crisis, then it will be like quarantining people in an epidemic and then letting them starve to death. Without the long-term watchdog of the Safety Commission it will be easier for another crisis to emerge.
The Final Result
It is also important to recognize that these must be combined with the solution already suggested for the first part of the three-legged stool that makes up Dollars for Democracy: bottom-up relief that was described in the previous essay in this series. The next essay focuses on the final part of Dollars for Democracy: the level playing field.
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