Inflation and the Discontents

The following is an excellent excerpt from the book “MAKERS AND TAKERS: The Rise of Finance and The Fall of American Business” by Rana Foroohar from Chapter 1: “The Rise of Finance” on page 48 and I quote: “Inflation and Its Discontents – The CD market and the growth of more complex securities had actually contributed to a cycle of rising inflation that was already well under way thanks to the Vietnam War and the growing number of social programs being offered to offset some of the pain of the slowing economy.  This is where the rebound in finance intersected with the political economy in ways that would once again foreshadow many of the crises of the future, including the one in 2008.  Since the end of World War II, the country had come to expect more and more affluence.  In order to keep Americans buying color TVs and shiny new cars, capital needed to flow more freely.  But the 1933 rules, in particular Regulation Q, acted as an emergency break.  That wasn’t accidental; the whole purpose of the regulation had been to deter unbridled credit growth–which led to speculation, bubbles, and, often, financial crises and subsequent slowdowns–by limiting credit via interest rate ceilings.

One of the unfortunate side effects of Regulation Q, however, was that it tended to hit average individuals harder than it did companies.  Firms and very wealthy people could always find clever ways to get cash and make higher returns (often via the methods devised by bankers like Wriston, who much preferred to lend to large, wealthy borrowers rather than average Joes).  But ordinary people who needed mortgages were the first to feel the effects of credit crunches.  During one such crunch, in the summer of 1973, a Texas homemaker named Vivian Cates wrote to her congressman complaining that her family could not find a bank to give them a mortgage, even though they had a 25 percent cash down payment and her husband was gainfully employed.  “I can feed my family meatless meals and more rice and beans, we can buy less clothing, wash it more often, and wear it longer, but we cannot postpone having a place to live,” she said.

Such public reaction was obviously a political conundrum.  But then, as now, it would have been politically difficult to prioritize lending to individuals over corporations, since the latter represented such an important lobbying block.  So, rather than tell people like Vivian Cates that things simply weren’t going to be quite as good as they had been in the past, at least until the economy could get back on its feet, the Nixon, Ford, and Carter administrations tried to pass the buck to the Fed.  In a sense, they left it to central bankers to make the big decisions on how much capital American banks could move around the economy.  In 1970, Andrew Brimmer,  a Federal Reserve Board member, suggested an idea that’s actually back on the discussion table today–namely, that the Fed should set reserve requirements in a way that would force financial institutions engaging in speculative activities to hold more money on their balance sheets, while allowing providers of simple Main Street credit to hold less.  But the Fed’s chairman at the time, Arthur Burns, rejected the proposal along with the entire notion that the Fed should take on the political hot potato of setting social priorities.  (Never mind that this was already happening, via the prevailing system of regulation, even if nobody wanted to admit it outright.)  So the Fed decided to fall back on the “markets know best” argument and let a laissez-faire attitude rule.  The upshot was that CDs were allowed to grow, as were other submarkets that were at least one step removed from the job of lending, like Eurodollar trading, which First National City also came to dominate.   Securitization, rather than plain-vanilla lending, was becoming the business of banks.  Slowly, the financial community began to claw back power over where and how capital flowed, funneling more and more of it away from middle-class Americans and toward finance itself.

A seminal moment in the rise of finance came in 1974, when Wriston convinced Secretary of the Treasury George Schultz that commercial banks, rather than government-backed institutions like the IMF or World Bank, should be in charge of helping recycle the petrodollars from oil-rich nations into emerging markets hungry for cash.  Some of those petrodollars were already parked at Citi; one of Wriston’s first overseas deals had been with the shah of Iran.  Pushing the “markets know best” approach, Wriston argued that Wall Street could do this lending much better and more efficiently than government.  He convinced Schultz to overturn a law that forbade US commercial institutions to make such loans to risky nations, and banks started lending to countries like Mexico, Brazil, Argentina, Zaire, Turkey, and many others.  Within five years, foreign loans to developing countries by private banks had risen from $44 billion to $233 billion.  Plenty of the deals were dicey, but inflation, which remained high thanks in part to all the complex deal making at a global level, helped keep these risky countries solvent for a while, by making their debt payments less onerous.

It was a bubble, one that was destined to pop.  By the late 1970s, Wriston and other US bankers were lending emerging markets money just so they could pay back the interest they owed on their existing obligations.  Risky loans that Wriston had made both in the United States and overseas started going bad.  In 1977, for the first time since the Depression, Citi posted a loss.  By early 1982, both Standard & Poor’s and Moody’s had downgraded its credit rating.  In August of that year, Mexico went into default, one of the first in a series of emerging market debt crises predicated on bad lending by US commercial banks.  Fed chairman Paul Volcker helped put together a $1.5-billion bailout package for the country, in large part because he feared that Mexico’s default would sink a number of large American banks, in particular Citi, that were holding so much of that bad debt.  Volcker, who’d been wary of the growing clout of banking and finance, hated bailouts, but he felt they were necessary to avert a broader recession.  In some way, Volcker was the first to declare these institutions Too Big to Fail.

Yet just like the financiers who in 2008 successfully argued that banks must be bailed out during crises, so that they could lubricate the economy, Wriston found a way to turn disaster into opportunity.  Volcker’s strategy of combating runaway inflation with higher interest rates had once again made it hard for banks and thrifts to attract deposits, since they couldn’t offer competitive rates.  Wriston became the leader of a cross-industry lobbying effort to overturn Regulation Q once and for all.  Along with big commercial institutions, he cleverly brought together diverse interest groups, such as smaller banks that wanted to grow, mortgage brokers that wanted to expand into other areas of finance, and individuals who wanted to access higher-yielding investments, not to mention ensure that they could get the mortgages they needed.  Even the Consumer Federation of America and consumer advocates like Ralph Nader were persuaded that repealing Regulation Q would be a good thing, The Gray Panthers, a group advocating for retirees filed a suit arguing that Regulation Q discriminated against small-time savers.  There were of course concerns that without the cap on rates and limits on how much credit could flow around freely, unexpected shifts in the economic climate could ruin livelihoods.  What would, say, a steel-worker or a schoolteacher with a fluctuating rate on a thirty-five-year mortgage do when the rate changed?  The answer, according to the financial industry, was more consumer education about issues like credit and responsible spending (no matter that such campaigns had been conducted at the state level with no success).  It’s a diversionary tactic that is still used today, via calls for “financial literacy” in lieu of a secure retirement system (a topic we will return to in chapter 8).

Of course, politicians and policy makers could have decided to recraft rules to support the economy more broadly, making sure that businesses and individuals deserving of capital got priority over speculators.   Instead they opted for the easy way out: deregulation.  Little by little, the financial industry chipped away at the Glass-Steagall regulatory framework.  In 1980, Wriston got his ultimate prize when President Jimmy Carter deregulated interest rates and banks were allowed to offer whatever rates they liked to attract funds.  Regulatory Q was history.  The door was open to a whole new world of variable-rate mortgages, ever more complex securities, derivatives to hedge them all, and the rapidly swelling financial institutions that would make vast fortunes on them, wreaking havoc on the country’s economic stability in the process.

Reaganomics and the Rise of Finance – The financialization of the economy was turbocharged in the 1980s, fueled by the laissez-faire policies of the Reagan era that strongly favored Wall Street.  The 1981 tax reform, for example, dramatically lowered the capital gains tax (Wriston played a part in crafting it), and a 1982 measure allowed companies to start buying back their own shares.   While Reagan has a reputation as having been a fiscal conservative, he was really anything but; he accompanied tax cuts with increased government spending, a cycle that deepened the national deficit.  That in turn had the effect of encouraging inflation, which Volcker continued to manage with higher interest rates.  Traditional economic theory held that as interest rates got higher, companies and individuals would eventually stop borrowing, which would become a check on inflation, bubbles, and an overheated economy.  But it didn’t happen that way.

To be fair, it was impossible at that point to predict that these emerging trends would change the way monetary policy worked.  Volcker’s strategy of using nosebleed interest rates to try to tame the financialization of the economy made sense in many ways; he feared that Reagan’s deficit spending would set back his fight against inflation, and so he refused to lower rates and allow that inflation to curb the debt.  The Fed chiefs who succeeded him have rarely shown such conviction in the face of political pressure.   But high rates turned out to be irresitible bait to foreign investors, who could now get super-high yields in the United States.  The Japanese, and later the Chinese and other emerging-market investors, became huge purchasers of US Treasury bills.  This inflow of foreign capital allowed the cycle of financialization to continue, bolstering assets of all kinds and making people eager to engage in more and more speculative ways with the financial markets.

Foreign cash had the additional effect of raising the value of the dollar, which, perversely, hurt the US economy by suppressing demand for US goods.  In 1982, the Business Roundtable, led by Caterpillar Tractor chairman Lee Morgan, began to complain about this.  Unfortunately the solution they proposed–deregulating global financial markets further to try to push capital back to places like Japan–didn’t work.  Treasury didn’t mind, though.  The influx of foreign capital was allowing the Reagan administration to maintain large deficits, even as it was pushing up asset prices to record highs.

The technology revolution that began in the mid-1980s did nothing to democratize this increasingly dysfunctional system–in fact, it had the opposite effect.  In 1984, the Nobel Prize-winning economist James Tobin, a former member of Kennedy’s Council of Economic Advisers and mentor to current Fed chair Janet Yellen, gave a talk on the “casino aspect of our financial markets,” in which he lamented both the trend of financialization and the way in which technology was facilitating it, rather than actually strengthening the economy as a whole.  “I confess to an uneasy Physiocratic suspicion. . . that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity,” he said.  “I suspect that the immense power of the computer is being harnessed to this ‘paper economy,’ not to do the same transaction more economically but to balloon the quantity and variety has so far yielded disappointing results in economy-wide productivity.”

This witch’s brew of globalization, technology-driven trading, and the growth of finance boiled over in the October 1987 stock market crash, during which the Dow lost 22.6 percent of its value in a single day.  It was just one of many crises that would follow.  Through the 1980s, every few years saw the classic stages of boom and bust depicted by Charles Kindleberger in his famous book, Manias, Panics, and Crashes.   A novel offering (be it the CD, the adjustable-rate mortgage, or a hot new IPO) would be followed by credit expansion, then speculative mania, distress, and ultimately a meltdown (usually followed by frantic government efforts to stem panic).  By the time Volcker’s successor, Alan Greenspan, took over control of the Fed in 1987, the government had gotten into the habit of lowering interest rates to jump-start markets each time they weakened.  It was kerosene for finance, adding both reward and risk.

“What happens when you give a bunch of financiers easy money and zero interest rates is that they go out and try to make more money.  That’s what they are wired to do,” says Ruchir Sharma, head of emerging markets for Morgan Stanley Investment Management and chief of macroeconomics for the bank.  (He is just one of many experts who worry about the market-distorting effects of the Fed’s unprecedented program of asset buying and low interest rates, which reached an apex in the wake of the 2008 crisis.)  “Easy money monetary policy is the best reward in the world for Wall Street.  After all, it’s mainly the rich who benefit from a rising stock market.”

Although markets boomed under Greenspan, they also went bust more than ever before.  The crash of 1987, the S&L crisis of 1989, the Mexican peso collapse of 1994, the Asian financial crisis of 1997, the larger emerging-market crisis of 1998, and the dot-com boom and bust all happened on his watch.  Each time the economy faltered as a result, Greenspan would lower rates to boost lending.  (He used this tactic so reliably, in fact, that Wall Street bankers began calling it the “Greenspan put”–a caustic term that encapsulated their belief that the Fed would bail them out no matter what.)  But these policies never changed the underlying problems in the economy.  Rather, they served to cover up its deep structural cracks with a monetary blanket that made people feel more prosperous on paper, even as their jobs were being outsourced and their companies were being weakened by short-term market-driven decision making.   By the 2000s, underlying investment in the American economy was less as a percentage of GDP than in any other decade since World War II.  The casino, not the restaurant, was firmly in charge.”


LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog ( and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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