Lifes Worth Knowing

The Rules of the Game

In Banks, Current events, Economics, Justin, Politics on November 23, 2011 at 4:03 pm

In Voltaire’s classic satire, Candide, there is a character named Pangloss who insists that everything is only is it could have been. Everything that happens in the world occurs because that is the only way that it could happen – everything was determined, so we could only take our lumps and move on.

Now, when it comes to the economy, most people, like Pangloss, just assume that things are just the way they are. National economies are such complex structures that there is no way to know exactly what is going on so it is best to assume that it is the way it is for a reason and move on.

Except, that’s not the case. Here’s a concept that took me literally years to fully understand:

Somebody wrote the rules of the game.

In this sense, I mean that Capitalism didn’t happen by accident. Our American economy didn’t happen just because. There were people throughout our history that made conscious decisions to shape our economy by altering the laws and regulations surrounding commerce – writing the rules of the game. These rules are mostly written by financial regulation and the tax code. And the basic outcomes of these rules, free market economics, upward mobility, income taxation – they are all accepted and integrated into the basic foundation of our system. So much so, that people hardly realize when the rules are being changed.

Indulge me for a second with a seemingly tangential, but apt metaphor:

The National Basketball Association was founded in 1949. The early years of the league were dominated by the big men of the game. Wilt Chamberlain, Bill Russell, and Kareem Abdul-Jabar were the pillars upon which the early decades of champions were built. Chamberlain holds the record for most points in a game, Kareem holds the record for most points in a career, and Russell holds the record for most titles won by a player. Clearly, the rules of the game of basketball were designed to favor the biggest men who could work in close to the basket.

Then, the rules of the game changed. The NBA added the three-point line in the 1979-1980 season. Now, the smaller guards who could shoot from long-range became much more valuable assets to a team. Larry Bird, Michael Jordan, Reggie Miller, Ray Allen, these guys  changed the game forever. Even though Jordan was never known as an amazing three-point shooter, the threat of the three pointer forced defenses to move out and open up the lanes that Jordan became so good at exploiting. Without the addition of the tree point line it’s a fair argument to say that Jordan may not have been as dominant as he was.

Now, what does this have to do with Voltaire and free market economics? I think it is pretty clear. The NBA changed the rules of their game, which led to the rise of a different type of dominant player. It allows a different player to exploit new opportunities to score.

In 1933, Congress passed the Glass-Steagall Act. It was financial reform legislation that addressed the issues in the banking system that perpetuated the crash of 1929 and the subsequent Great Depression. It limited the way that banks were able to speculate in the market.  When a bank is investing in securities, it risks enormous losses – and since the federal government guarantees our bank deposits (courtesy of the FDIC) the government decided that it didn’t wasn’t prudent to allow banks to take big risks if the government was just going to end up bailing them out.

This legislation effectively split banking into two categories, commercial banking (where we deposit our checks and use our debit cards) and investment banking (investment firms designed to play the stock market). This division of the banking sector ensured that the money people put in banks remained safe from the volatility of the markets.

Fast forward to 1999, when Congress passes the Graham-Leach-Bliley Act. This repealed the provisions in the Glass-Steagall Act that created the division between commerical and investment banks. The implementation of the new law meant that a company could act as a commercial bank, investment firm, insurance company, and securities trader. Once a bank had your money – it was free to use it as it pleased to try to generate a profit for the company. The argument was that by deregulating the banking industry, banks would be able to compete with each other and exploit new openings in the market. The rules of the game had changed.

It worked for a while, banks became enormously profitable business – second only to the oil industry. But then came 2008 and Lehman Brothers, then Washington Mutual, Merrill Lynch,  and AIG  followed. All of these companies had risked huge amounts of their portfolio on risky positions. A practice that would have been illegal under Glass-Steagall, and only made possible by the Graham-Leach-Bliley Act.  As a result, the federal government had to step in and bail out the flailing companies in order to preserve some of the value of people’s retirement funds and savings accounts that made up the big banks.

The rules of the game had changed, and they allowed the big banks to take on massive risk. If their bets paid off, they would be rewarded with huge profits. If their bets went wrong, they would be bailed out by the government and allowed to continue the practices that brought our economy to its knees. This is how our system is designed. It is designed to increase the profitability of banks (and the personal wealth of those who manage the banks) while placing the consequences of their actions upon the shoulders of the taxpayer and the middle class families whose pension funds, college savings accounts, retirement nest eggs make up the majority of the bank’s holdings.

I say this to illustrate the point that it didn’t have to be this way. Voltaire’s Pangloss was wrong. The financial crash of 2008 was not inevitable. The bankruptcies of Lehman Brothers and AIG were not inevitable. The bailouts were not inevitable.

Jordan’s spectacular career was aided by the addition of the three-point line. Without it, he may not have been able to do the things that he did. The financial collapse was aided by the repeal of the Glass-Steagall Act. Without it, the banks would not have been able to make the bets that they did, and would not have become insolvent and dragged the nation into the Great Recession.

Even to this day – the rules of the game that brought us to this point are still in effect. It was reported yesterday that banks are on track to have their most profitable quarter in over four years. Now the question is, is this a game that we want to be playing?

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