We have had to struggle with the old enemies of peace—business and financial monopoly, speculation, reckless banking, class antagonism, sectionalism, war profiteering
   — Franklin Roosevelt, 1936

Rolfe Winkler wrote some good stuff in the wake of the Make Markets Be Markets conference held in the Imperial capital last week. I’ll get to that in a moment.The purpose of the get together, which was hosted by the Roosevelt Institute, was to push for much needed financial reform. Many of the usual suspects were there, including Simon Johnson and Elizabeth Warren. Rob Johnson, Senior Fellow and Director of the Project on Global Finance at The Roosevelt Institute, wrote the introduction to the conference report (big pdf).

Eighteen months after the most devastating financial crisis since the Great Depression, our financial system remains critically flawed. The United States has not yet enacted the financial reforms necessary to repair the broken financial system.

We have a financial system that continues to be sustained by taxpayers through the fiscal side door of the Federal Reserve’s balance sheet. All legislative proposals offered by the Administration, House and Senate fall far short of what is needed for proper reform. Independent experts across the political spectrum have clearly identified the dangers of large complex financial institutions that are intertwined through the proliferation of derivative instruments. Those experts have also prescribed remedies that are concise, clear and well developed. Many of the fault lines in the current system and their remedies were well known long before this latest crisis unfolded…

With the reforms suggested in this volume, another crisis is preventable. Without them, another crisis – a bigger crisis that weakens both our financial sector and our larger economy – is more than predictable, it is inevitable.

You get the idea. What then follows is a series of papers by conference participants pointing out the need, as Winkler writes, for all of the following—

Banks need more capital [i.e larger capital requirements], Fannie and Freddie need to be wound down, banks’ risky activities must be corralled, tax incentives that encourage borrowing must be done away with. Most importantly, perhaps, we need to end the cycle by which the financial system lends too much and too easily only to be bailed out by a compliant Fed when things go wrong.

Etc. I’ll focus on the housing market here. This is where things get tricky for Winkler and the rest of us.

But said another way, the reforms reduce credit. Like a lot. And that means deep and prolonged recession. Crucially, it means higher unemployment.

Just for instance, try to imagine winding down Fannie and Freddie. Doing so means housing finance — all of it — goes away. The economic implications are so dire no one is even contemplating how to do it, even though all know it must be done

Even now the housing market is at death’s door. See my post Housing Market? What Housing Market? Only agency (Fannie & Freddie) mortgage-backed securities (MBS) purchases by the Fed are preventing a complete collapse of the housing market. But just imagine if there were no Fannie or Freddie at all! That’s what Winkler invites us to do. The implications are so dire no one is even contemplating how to do it, even though it must be done.

No Way Out. Winkler winds up his remarks—

A reason we got substantive financial reform in the mid ’30s is that folks had nothing left to lose. Real output fell 30% peak to trough during the Great Depression.

During last year’s recession, output fell just 3%. If you compare debt levels today with those leading up to the Depression — and consider that de-leveraging is the proximate cause of the decline — we’ve much further to fall.

That’s not to suggest that reform isn’t necessary. It absolutely is. But it will cost jobs and output. The speakers at Roosevelt Institute’s conference did a disservice to their audience by not discussing these costs. Some even suggested the credit engine can magically be made to run at close to full speed even as it’s in the shop for repairs.

Luckily, Roosevelt is led by the very capable Johnson, who has no illusions about the costs of bank reform. He acknowledges that financial fixes will reduce lending and output, but speaks about the need to control the velocity of that decline…

The important illusion we must overcome now is that we have something left to lose. As Rob Johnson said at the top, “we have a financial system that continues to be sustained by taxpayers through the fiscal side door of the Federal Reserve’s balance sheet.” The present course is clearly unsustainable.

The crisis in Finance did not start in the fall of 2008 when the big banks melted down. It started 25 years before in the early 1980s when America decided to grow its economy through debt-financing and gambling. Some have called this a 25-year credit bubble. It has always been an illusion that there was an easy, pain-free way out of this extraordinary mess, that the “Great” recession was just another blip, albeit unusually large, in the Business Cycle.

Let’s look at the Decline of the Empire alternatives.

  • Carry out the necessary financial reforms (e.g. get rid of Fannie & Freddie) and muddle through the ensuing depression

No doubt this first alternative will be extremely painful in terms of output (GDP) and jobs. But there is another way—

  • Wait around for the financial system to blow itself up again, this time on a much bigger scale, and kiss your ass goodbye.

Under the illusion that we can determine our own Fate, the choice is ours to make.