Wednesday, April 8, 2009

Shufflin' Off to South Dakota

How did the country end up with the a financial system too big to fail? As part of the current economic discourse everyone has a favorite guilty party. Barney Frank, George Bush and Alan Greenspan all have had their moments in the crosshairs. Perhaps it goes back even further.

During the 1970's one of the oldest legal constructs was dismantled during the Carter administration. The concept of usury laws goes back thousands of years even to Babylonian code and biblical passages. The link to Democracy Now with Amy Goodman's interview with Thomas Geoghegan gives food for thought. Societies have long held that excessive interest rates on borrowing was immoral, but is it more? Was it a public policy decision gone awry?

In 1978 the U.S. Supreme Court found, in the case Marquette National Bank v. First of Omaha Service Corporation, that states could not regulate interest rates on interstate credit transactions based on prior federal law signed by Abraham Lincoln. In that decision lay the basis for the financial industry to become far and away the dominant sector of american commerce. Where industry and manufacturing might produce competitive returns of 5 or 6% the profit found in shuffling paper far surpassed other endeavors. Companies like General Motors (GMAC) and General Electric (GE Capital) opened finance companies to provide profits far in excess of their manufacturing activities. The sky was the legal limit.

Companies loaned aggressively, put the loans on the balance sheet as assets and grew enormously. While a bank writing a loan at 6% would scrupulously underwrite the credit worthiness of the borrower with the expectation of return of its capital, the credit card lender at 18% was much less interested in the loan being paid off as long as the loan was serviced.

Adam Smith in his The Wealth of Nations and John Maynard Keynes in his, The General Theory of Employment, Interest and Money cautioned again excess interest rates.

The moral hazard implicit in excessively high real rates of interest has the dual effect of shifting capital to non-productive activity from manufacturing or other service sectors. It also accumulates assets on the balance sheets of the financing companies without due diligence and strict underwriting procedures. Focus on transactional income has results we now see. Borrowers are excessively burdened by interest and unable to pursue more economic activities, and lenders accumulate poor quality assets until economic conditions force writedowns and capital impairment.

When two human natures, greed and hope meet, the ensuing mix has public policy results that are now expressing themselves to our collective detriment.

John Barnyak