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I don’t often do book reviews, but having just finished Luigi Zingales’ book, A Capitalism for the People: Recapturing the Lost Genius of American Prosperity, I think it is worth writing about. For the last four years I have suggested that there might be common ground between liberals and libertarians. But every time I have tried to advance the notion, either the liberals have savaged the idea or the libertarians have complained of half steps and put forth their “anarcho-capitalist” solution, which is just plain stupid. Zingales offers a middle ground.

Zingales is a free market Professor at the University of Chicago’s Booth School of Business and his main fear is that Crony Capitalism is destroying the competitive nature of America’s economic system. He believes that government has an important role to play in society, but that as corporations become more dominant in financing politics, they “capture” the regulators who are supposed to control them. Similarly, the corporations lobby the congress to put through special subsidies for their industry, thus distorting competition. Zingales sees the cronyism on both sides of the political aisle, such as when Clinton Treasury Secretary Robert Rubin lobbied hard to get the Glass-Stegall Act repealed, in order to help Citigroup, which had already violated the law.

Rubin left the Treasury in July 1999, the day after the House passed its version of the bill by a bipartisan vote of 343 to 86. Three months later, on October 18, 1999, Rubin was hired at Citigroup at a salary of $15 million a year, without any operating responsibility. It is hard not to see the connection between these two events.

Zingales’ prescriptions for fixing this mess are pretty straight forward. Cut all government subsidies and special tax breaks to corporations. Eliminate all tax deductions for individuals, which “would reduce the marginal tax rate for all taxpayers by at least five percentage points, except for taxpayers making more than $500,000, who would see their marginal tax rate unchanged. Use Pigouvian taxes to correct distorted incentives and negative externalities. Examples of this are a progressive tax on payments to lobbyists by corporations; a tax on short term debt held by financial institutions (which he believed caused the 2008 crisis) and a tax on pollution flowing from industry.

It is on various social policies that liberals will find Zingales pushing them into uncomfortable areas. On K-12 education he advocates a progressive voucher system. All schools would have to compete for all children with schools getting paid more to take on under privileged kids. If schools hired bad teachers, they would face the possibility of going out of business. I for one think this idea is worth trying. The K-12 system is so screwed up in this country, we really need to shake it up and perhaps vouchers is the way. But it is in the area of healthcare that I find Zingales ignoring the obvious because of his attachment to the free market. He says that the reason American per capita healthcare costs are so out of control is that “healthcare, unlike most goods and services, is not purchased in a free market.” What this ignores is that the per capita healthcare costs that are so much lower in every other developed nation are directly accountable to their adoption of a single payer system that has the muscle to negotiate with doctors, hospitals and drug companies.

Ultimately taking on Crony Capitalism should be the main task of the next era of reform. Both political parties are so beholden to the corporation that this seems like an almost impossible task. Perhaps we have to start with getting the money out of politics as proposed by Larry Lessig’s Rootstrikers campaign. I know the Republicans are too in the bag to big business to take this on, but if Obama gets a second term, his first act should be to fire Tim Geithner and hire someone like Joe Stieglitz. That would send an unmistakeable message.

When a religious fundamentalist suffers a “crisis of faith” it is a mournful incident to witness. Such was the occasion when Alan Greenspan, former Chairman of the Federal Reserve appeared before Congress in the wake of the financial crisis of 2008. The man who had singlehandedly carried the faith of “the rational market” confessed that, “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in their firms.”

The revelations around the fraudulent LIBOR fix that are beginning to come forth have been greeted with half the outrage heaped on Bernard Madoff two years ago. Some would suggest that the reason Madoff seems to be the only corrupt financier behind bars is that he stole from the 1%, while the fixers at Barclays and the other banks that manipulated the $360 Trillion derivatives market got away with a mere dismissal and most of their bonuses intact. Eduardo Porter suggests the real reason for our non-chalance.

Perhaps the most surprising aspect of the Libor scandal is how familiar it seems. Sure, for some of the world’s leading banks to try to manipulate one of the most important interest rates in contemporary finance is clearly egregious. But is that worse than packaging billions of dollars worth of dubious mortgages into a bond and having it stamped with a Triple-A rating to sell to some dupe down the road while betting against it? Or how about forging documents on an industrial scale to foreclose fraudulently on countless homeowners?

What is so shocking is that most of what purports to be mainstream economic theory today is based on this notion of rational choice theory. The whole Potemkin Village of Libertarian Free Market theory is based on a concept that takes no account of the tendency of “rational actors” to cheat if they think they can get away with it. Porter again.

Company executives are paid to maximize profits, not to behave ethically. Evidence suggests that they behave as corruptly as they can, within whatever constraints are imposed by law and reputation. In 1977, the United States Congress passed the Foreign Corrupt Practices Act, to stop the rampant practice of bribing foreign officials. Business by American multinationals in the most corrupt countries dropped. But they didn’t stop bribing. And American companies have been lobbying against the law ever since.

Extrapolating from frauds that were uncovered during and after the dot-com bubble, the economists Luigi Zingales and Adair Morse of the University of Chicago and Alexander Dyck of the University of Toronto estimated conservatively that in any given year a fraud was being committed by 11 to 13 percent of the large companies in the country.

This is the basic flaw in the Republican argument that we need less regulation of the financial markets. As Simon Johnson wrote this morning, The Market Has Spoken and It is Rigged. This is the torch the Democrats must carry from now until the election. Mitt Romney is the poster child for Savage Capitalism. His election would signal the end of democracy and the beginning of Oligarchy.

The biggest political problem Obama has with both the Progressives and the Libertarians is that he pussied out on the Wall Street Bailout. No one went to jail, unlike the Savings and Loan Crisis of the 1980′s. We paid out the banks 100 cents on the dollar for billions of essentially worthless Credit Default Swaps and other forms of insurance written with no collateral behind it.

This week, Jamie Dimon gave Obama a do over. Obama needs to spend the next six months in a populist crusade to enact the Volker Rule is it’s strictest form. A form that would have banned the obviously phony “hedge” that JP Morgan is now going to loose $3 Billion on.

“The timing, prices and particular choice of index that people are saying that J. P. Morgan used seems to support the view that there was more to the trade than just a hedge,” said James Parascandola, a veteran credit-default-swaps trader formerly with MF Global Holdings Ltd. and Barclays PLC.

Already, Republicans like accused inside trader, Representative Spencer Bachus, the most powerful Republican on finance, are coming to Jamie Dimon’s defense.

“Even with this loss, I believe they’re one of the most profitable financial institutions in the country,” Mr. Bachus said at a House hearing on Wednesday morning. “There is no risk from this loss to depositors or to taxpayers.…They remain a very profitable, viable institution.”

Never mind.

For Obama, this is a Teddy Roosevelt moment. Roosevelt gave a speech in Provincetown, Massachusetts right after the Panic of 1907, which eerily mimicks the crash of 2008. He called out “the malefactors of great wealth” and went on to say,

“. . . [these men] combine to bring about as much financial stress as possible, in order to discredit the policy of the government and thereby secure a reversal of that policy, so that they may enjoy unmolested the fruits of their own evil-doing. . . I regard this contest as one to determine who shall rule this free country—the people through their governmental agents, or a few ruthless and domineering men whose wealth makes them peculiarly formidable because they hide behind the breastworks of corporate organization.”

For Barack’s whole administration he has followed his Harvard instincts and stuck with The Establishment. Thats why Geithner and Summers were his economic team and Gates was his defense team. Now, like Teddy he has to risk being called a class traitor and cast off his establishment team in the hopes that he could fulfill Tom Paine’s promise of our Revolution, “We have it in our power to begin the world over again.”

What is remarkable is that Obama essentially can fulfill this promise by doing nothing.

If he is able to defend the laws he already passed—the Affordable Care Act, the Women’s Equal Pay laws and the Sequester passed in the summer of 2011—we will have “begun anew”. Why?

Let’s start with the sequester.

Since 1955, Progressives have tried to cut the Military Budget, without success.But if nothing changes, starting in January the Defense Budget will take huge cuts.

For the Pentagon, that would mean about $50 billion a year in less defense spending from fiscal year 2013 to FY2021, according to the Congressional Budget Office. The CBO baseline already assumes roughly $450 billion in reduced defense outlays, coming from provisions of the Budget Control Act.

Lindsay Graham, Mr. Defense Pork is outraged at the very thought of the cuts.

“I have heard from people after every engagement: ‘why do you need this military?’ only to have to ramp up, go to war without the equipment, send the (National) Guard off with a shell of a force. What happens if China gets bolder, Iran gets a nuclear weapon, (or) we have to go into Yemen?”

I’m sure if Mitt Romney becomes President, Lindsay won’t have to worry.

So what about Bernanke’s notion that the Sequester will drive us off a “Fiscal Cliff” ? Well due to the brilliant negotiating by Barney Frank in the conference committee, there are no cuts to Medicare or Social Security in the Sequester. So does the “fiscal cliff” arrive because we are cutting the military industrial complex? Highly doubtful. The weapons systems now being built are on very long cycles and it is doubtful this employment would slow down. So what happens when the Bush Tax Cuts expire (the other part of Bernanke’s fiscal cliff)? Quite frankly, very little. The rich are not going to stop buying $100 million paintings, just because their income tax rate went up 4%.

So this is all Barack has to do. Push through the Volker Rule and threaten to veto any change to the Budget Control Act of 2011 or the Affordable Care Act.  An America with a radically reduced military budget, a decent and fair universal health care system and a financial sector under control would be able to face the future unburdened with Neoconservative fantasies of being the world’s cop and with an economy not built around speculation but around production and services sold world wide.

Now all Barack has to do is get reelected.

You owe it to yourself to watch the new Frontline two part special, Money, Power and Wall Street. It is as fine an understanding of where we are and how we got here as anything in our media system today. Part Two comes on next week, but already the major themes are becoming clear.

• Complexity-No one except the “Quants” (the mathematical geniuses in the Big Investment Banks) who designed the Credit Default Swaps that grew to a $50 Trillion market in 8 years, knew how the securities operated or how risky they really were.
• Transparency-The only reason the spreads were so big on the CDS market was that it was a totally Dark Market. There was no transparency. No one could tell the real values of the securities.
• The Committee to Save the World-Rubin, Summers, Paulson, Blankfein, Dimon and Geithner were all part of a club that was going to make sure that none of their members would have to take a haircut on all the crap they owned. The Democrats are just as guilty as the Republicans that this happened.

If Obama’s second term looks like Teddy Roosevelt’s second term and he turns into the trust buster populist President, then eventually this wrong doing will be punished. Until then, watch this show and get really pissed off.

Apple Store-Shanghai

I have been known to make occasional predictions about our economy, and this quiet time between Christmas and New Years leads me to venture once again into these waters.

In general I feel that the incessant Chicken Little “sky is falling” rhetoric coming out of the media is creating opportunities in the American stock market. When Apple is selling at a P/E of 14 and I can buy Chevron at a P/E of 8 with a 3% yield, good quality companies are selling cheaper than I can remember. Europe may have a financial crisis, but remember after 2008 the ECB did relatively little to shore up their banks. The stress tests were pathetic compared to the ones forced on the U.S. banks. Germany and France are rich enough to fix this problem and since they have both benefited from the Euro, I doubt they will let it crash. The temporary problems of European banks does however provide an opportunity for U.S. Multinationals to raise their game. Procter and Gamble competes with Unilever all over the world to sell shampoo and detergent. Unilever depends on European banks for lines of credit and my guess is that P & G’s cost of capital is cheap compared to Unilever.

Speaking of cost of capital. Despite the hand wringing from Republicans, the U.S. Treasury’s cost of capital is at an all time low. What does that tell you? That the rest of the world sees the U.S. as the best bet for the future. Part of this Republican meme about the “decline of America” is based on 19th Century notions of measuring trade. In David Ricardo’s time, the fact that England was a manufacturing powerhouse that exported to high value goods to Portugal and Portugal was a rural country that exported wine to England gave them each a comparative advantage in their sector. But when Apple assembles an I Pad in China and imports it into the United States it adds $500 to our trade deficit. But where is the great value captured in the product? By Apple shareholders, because the Chinese labor component is a tiny fraction of the selling cost? So traditional economics is totally distorting our real strength in the world economy.

This is not to say that there isn’t a job crisis in America as our less educated workers are caught in a global labor price arbitrage with Korean and Chinese workers. But this too will sort itself out in the next ten years as huge numbers of Baby Boomers retire. Even now, many companies are trying to hold on to Boomers with hard to replace skills past their retirement age. I’m well aware that there are a few Thirty-somethings who troll this blog that are totally frightened that they will never live as well as their parents. It is kind of pathetic because rather than adopting the obvious solutions to shore up their retirement prospects like removing the cap on Medicare and Social Security payroll deductions on high earners and drastically cutting back the defense budget, they are trying to start a generational war by scapegoating my generation and stealing their pensions.

I try to teach my students that one of America’s great understandings is the link between art and science. Hold up your I Phone and you intuitively get that. I’m pretty confident we can continue to excel as long as we somehow get our politics straightened out. That of course will be the task in front of us for 2012.

When you see a fork in the road, take it.-Yogi Berra

The events of the past week have clearly brought us to a fork in the road. At any important decision point it’s often useful to do a scenario planning exercise. What are the dynamics we are wrestling with and what are the possible outcomes of those forces? So the first force is that of deleverage. In ten years will we as a country (both individuals, businesses and governments) be more in debt or less in debt? And the second, countervailing force is that of devolution. Will the sources of leadership, innovation and change come from decentralized, networked, “bottom up” forces or from centralized, hierarchical, “top down” forces?

Anyone who doubted that we are living in a decentralized, networked world must have had their mind changed by this week’s events. On Thursday the Fed injected $105 billion into the U.S. Banking system and $200 billion to other central banks and still the global credit markets seized up. George Bush, Dick Cheney and John McCain are leaders for a centralized, top down world that no longer exists. Bush’s perplexed look at Paulson this morning tells the whole tale. He doesn’t have a clue as to what is happening on his watch. On the other hand, Barack Obama believes in the power of the decentralized, bottom up forces that powered his campaign and overthrew the top down hierarchy of the Clinton Machine. He is ready for this moment.

Then it seems to me the only question is are we going to be richer or poorer in ten years time? Will the boomers be leaving an unmanageable debt on our children and grandchildren? My belief is that the devolutionary forces that made it impossible for Paulson to control the downspiral on a de facto basis, can also help us figure out how to slowly rebuild our collective savings. Read more…

While the Congress ponders whether to cough up $300 billion to backstop Fannie Mae and Freddie Mac, the Fed has opened the discount window to these two crippled companies.

In a separate announcement, the Federal Reserve said it would make one of its short-term lending programs available to the two companies, Fannie Mae and Freddie Mac. The Fed said that it had made its decision “to promote the availability of home mortgage credit during a period of stress in financial markets.”

If you take just the mortgages they own you come to a total of $1.7 trillion supported by core capital of about $70 billion. That is a leverage ratio of 24 to 1. Throw in the guaranteed stuff and you balloon to 68 to 1. You can have a very good book of mortgages with a very low default rate and still be out of business quickly with that leverage. This is crazy.

So let me get this clear. You and I (the taxpayers) are going to loan these two companies $300 billion and the existing shareholders and bondholders are not going to have to take a haircut? If Henry Paulson was still running Goldman Sachs and a private company came to him for a rescue to stay out of bankruptcy, you can bet your bottom dollar that he would have “crammed down” the existing shareholders and bondholders. Fannie and Freddie have been run on the edge of criminal negligence by their executives who took millions out during the boom. In any sense of fairness, the equity holders should have been wided out and the bond holders asked to take a serious haircut.

But it looks like Uncle Sucker will step in with no such conditions. WTF. It sounds like Phil Gramm is already running the Treasury and corporate socialism is in the saddle.

Back in February, I warned that this economic slump was like a slow motion car crash. Today, as the Dow fell 358 points, it is dawning on investors that we are in for a long recovery. One of the big problems is that the Fed is very sensitive to the politics of an election year–the conventional wisdom being that an interest rate hike might make life for Republicans even more miserable than it already is. George Bush Sr. never forgave Greenspan for raising the Fed Funds rate in an election year. Doug Kass said in his morning note “the consumer would be more helped by reining in food and energy costs than he would be penalized by higher short term interest rates.”

The Republicans are in a pickle (to quote one of our correspondents). They represent the investor class, who probably make up 85% of the 16% of the voters who say the country is on the right track. When they look at their brokerage statements in early July, they are going to be just as pissed off as the rest of us.

As I write this, the Fed is just signing off on their interest rate move for this month. This has probably been one of the most contentious Fed Meetings in months. As you can see by the chart of Consumer Confidence above, we show all the signs of a recession. And yet, it’s clear that decisions like Dow Chemical’s to raise prices for the second time in a month, mean that the oil price surge is making its way into the plastics, chemicals and other parts of every product we buy. My guess is the Fed will stand pat on interest rates, but they ought to put out a firm statement about the worries of inflation. Last February, I worried about Stagflation.

I’m still worried.

As I write this, the Fed is just signing off on their interest rate move for this month. This has probably been one of the most contentious Fed Meetings in months. As you can see by the chart of Consumer Confidence above, we show all the signs of a recession. And yet, it’s clear that decisions like Dow Chemical’s to raise prices for the second time in a month, mean that the oil price surge is making its way into the plastics, chemicals and other parts of every product we buy. My guess is the Fed will stand pat on interest rates, but they ought to put out a firm statement about the worries of inflation. Last February, I worried about Stagflation.

I’m still worried.