The Price of Inequality: How Today's Divided Society Endangers Our Future (27 page)

A major change occurred in markets around the turn of this century: most trading (some 61 percent in 2009, 53 percent in 2010) on the stock exchange was done by computers trading with other computers, using certain algorithms. Offers to buy and sell were based not on market research, on informed views about the prospects of, say, steel or the efficiency of a particular steel company, but rather on extracting information from the pattern of prices and trades, and on whatever other information a computer could absorb and process on the fly. Offers to buy and sell were held open for a nanosecond. The response to the suggestion that any firm making an offer to, say, buy a stock at a particular price hold open that offer for one second was: “Do you want to go back to the Middle Ages.” Of course, the prices that were determined in those nanoseconds were of no relevance to any
real
decision making. No steel firm would base its decision on whether to expand or contract on these microadjustments of stock prices. The algorithmic traders claimed that they were making markets more liquid (“deeper”), but it was a liquidity that disappeared when it was needed, when a
real
disturbance occurred to which the market needed to adjust. The result was that the market began to exhibit unprecedented volatility. On one day alone, May 6, 2010, stock market prices plummeted so much that the Dow Jones temporarily lost about 10 percent of its value, including a nearly 600-point drop in a five-minute period.
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Before the end of the day, the market regained much of its value nearly as fast as it had been lost. No one could claim that the real value of the country’s assets had diminished in that short period of time. Yet, constant reference to “price discovery” and “efficient markets” provided the halo that made this kind of flash trading seem not only acceptable but even desirable.

In fact, there are reasons to believe that flash trading actually makes markets not just more volatile but also less “informative.” Computers attempt to use complex mathematical algorithms to extract whatever information is in the market, in a modern and more sophisticated version of front running, the old-style illegal activities by which brokers try to use information they glean from those placing orders to enhance their own profits. Of course, market participants know this. If some market researcher discovered that some company was going to do well (had just made a valuable discovery), he might rush, placing a large order. But the computer traders would immediately sense this and try to use
his
information for their own purpose. Today, of course, the first trader knows the game he’s playing, so he would never place a large order, but would place a myriad of small orders. There’s been an arms race, where those doing the hard work of research try to keep their information away from the algorithmic traders, and the algorithmic traders try to break their code. One might say it’s just a waste of resources—a fight over the rents associated with early information. No decision gets made in the nanoseconds of the refined price discovery. But it’s worse than that. To the extent that the algorithmic traders succeed in outwitting those who do the real research, the returns to research fall; there will be less investment in information, and markets actually will convey less of the information that we care about.

T
HE
B
ATTLE OVER
P
OLICIES AS
A
B
ATTLE OVER
P
ERCEPTIONS

The extent to which the battle over policies is a battle over
perceptions
is particularly striking. The following paragraphs consider three big battles that occurred in recent years—over the repeal of the estate tax, the bank bailout, and mortgage restructuring. The latter two were, of course, front and center in discussions over the response to the 2007–08 financial crisis. All are critical to our understanding of how America has come to be so unequal. Without an estate tax, we create a new plutocracy, marked by dynasties that are self-perpetuating. The bailout provided money to the financial sector—one of the important sources of money at the top. And the failure to do enough about mortgage restructuring has contributed to economic stress at the bottom and in the middle.

Estate taxes
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As we’ve seen, the Right has been able to persuade many Americans to support policies that are
not
in their self-interest. The estate tax, which is imposed on those who have large estates passed on to heirs, provides the quintessential example. Critics of the estate tax call it a death duty and suggest that it is unfair to tax death. Under current law, the tax is levied only on the amount passed on that is
in excess of $5 million
(usually $10 million for a married couple),
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so that it is unlikely that most Americans would ever be touched by the tax, even with their overoptimistic view of mobility in American society.
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Yet, because of the concentration of wealth in our society, the tax can raise large amounts of money. Moreover, in theory a “fair” society would put everyone on a level playing field at the start. We know that that’s impossible; but the tax is designed to limit the extent of “inherited” inequality—to create a slightly more level playing field. It should be obvious that the tax is in the interests of most Americans, and yet the Right has persuaded large numbers to oppose it
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—against their own interests. For a brief moment, in 2010, it was totally repealed as a result of tax cuts passed in 2001 under the George W. Bush administration. The Right talks about how much the tax affects small businesses, yet the vast majority of small businesses are too small to be touched; and provisions within the estate tax allow for spreading the payment over fourteen years, precisely so that it will not be disruptive.
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Bank recapitalization

As the financial crisis unfolded, we saw how the banks managed perceptions. We were told that we had to save the banks to save the economy—to protect
our
jobs no matter how unsavory the bailouts felt at the time; that if we put conditions on the banks it would roil the markets, and we would all be the worse for it; and that we needed to save not only the banks but also the bankers, the bank’s shareholders, and the banks’ bondholders. There were, of course, countries like Sweden that had done otherwise, that had played by the rules of “capitalism” and put banks whose capital was inadequate into conservatorship, a process akin (for banks) to bankruptcy, focused on protecting depositors and “conserving” the banks assets; but those were “socialist” countries. To follow Sweden was not the “American way.” Obama not only bought into this line; by repeating it, he lent it an aura of authenticity.
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But this line had no factual basis and was designed to make the world’s most massive transfer of wealth acceptable: never in the history of the planet had so many given so much to so few who were so rich without asking anything in return.

The question could have been framed very differently. It could have been argued that the real American way is the rule of law. The law was clear: if a bank can’t pay what it owes and what depositors demand back, then it is restructured; shareholders lose everything. Bondholders are made the new shareholders. If there is still not enough money, the government steps in. Bondholders and unsecured creditors then lose everything, but insured depositors get back what they have been promised. The bank is saved, but the government, as the new owner of the bank, will eventually decide to wind it down, reprivatize it, or merge it with a healthier bank. It’s objective in part is to recover as much for the taxpayer as possible. We don’t wait, of course, until the bank has no money to take these drastic actions. When you go to the bank and put in your ATM card, if the light flashes, “insufficient funds,” we want it to be because your account, rather than the bank itself, had insufficient funds.
This is the way banking is supposed to work; but it wasn’t the way things worked in the United States during the Bush and Obama administrations. They saved not only the banks—there was a rationale for doing that—but also the shareholders, bondholders, and other unsecured creditors. This was a victory in the battle of perceptions.

There was an alternative way to frame the policy question. This narrative would have begun not with the suggestion that what Sweden did was not in our “tradition” but with an analysis of what economic theory and history had shown. That analysis would have demonstrated that we could have saved the banking sector, protected depositors, and maintained a flow of credit, all at less cost to the government, by following the ordinary rules of capitalism. This was, in fact, what Sweden and the United States had done in other situations when banks got into trouble.

Put simply, the economy’s interest could have been better protected and a sense of fairness in our system better preserved, if Obama and Bush had played by the rules of ordinary capitalism, rather than making up the rules as they went along—if they had, in a sense, abided by the rule of law. Instead, the bankers got their money without conditions. The money was
supposed to recapitalize the banks
, and
recapitalizing the banks was supposed to lead to more lending.
But money given to the banks that went to pay bonuses couldn’t simultaneously be used to recapitalize the banks. The bankers and their backers won the momentary battle—they got the money into the coffers of the banks and the bankers. But they lost the long-run battle of perceptions: virtually everyone sees what was done as
unfair—
and unjustified even by the unusual economic circumstances. It is this, as much as anything else, that has provided the impetus to the current backlash.
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Restructuring mortgages

When the housing bubble burst, many homeowners found themselves “underwater”: they owed more on their home than the home was worth. The bank bailout and the case for mortgage restructuring provide a clear contrast in the battle of perceptions: in one case, the perception that shaped government action was that a large bailout is
desirable
, while in the other, the perception that shaped government action was that a large restructuring is
undesirable
. Today the bailouts of the banks are widely seen as far from desirable. And ironically, there is increasing recognition that without doing more for the housing/mortgage market, our economy won’t recover.

What has happened in the mortgage market has been far from efficient. When foreclosure forces families out of their homes, everyone loses. The cost to the family—the disruption to their lives, the loss of their life savings—is obvious. Worse still, an empty home, uncared for, decreases the value of neighboring homes. More of them will go underwater. Communities with large numbers of foreclosures inevitably suffer. The bank loses too: the most important determinant of foreclosures is the extent to which the home is underwater. Foreclosures beget foreclosures: by making more houses go underwater, the banks increase foreclosures and their resulting losses; they lose still more from the substantial legal fees that accompany each foreclosure.

There are better ways of dealing with this unfortunate spiral: a write-down of the principal (what the homeowner owes), perhaps with a debt-to-equity conversion that gives the lender a share in the capital gain when the house is sold. Homeowners still have an incentive to maintain their homes; houses aren’t thrown onto the market, depressing housing prices; the costly foreclosure process is averted. Communities are protected. It’s to everyone’s advantage to give homeowners a fresh start. The lender gets as much or more than she would have otherwise. Executing this strategy would have required modifications to existing law, but the bankers—and the Obama administration—rejected this approach out of hand, at least until the 2012 election approached.
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The banks saw that restructuring mortgages would make them
recognize
their losses, an outcome they had successfully kept at bay with deceptive but legal accounting maneuvers that treated impaired mortgages—those in which the borrower was not keeping up with his payments—as if they eventually would be repaid. The true market value of these nonperforming mortgages was often a fraction of the face value. But recognizing the losses would have required the banks to come up with more capital, and they were struggling to get enough capital under the current regulations, let alone the new regulations (called Basel III) adopted in fall 2010.

Of course, the Obama administration and the bankers didn’t present their case this way.
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Two main arguments were advanced for not doing much for homeowners. It would be “unfair” to help those who were struggling with their mortgages when there were so many good and responsible citizens who had worked hard and paid off their mortgage, or were able to make their current payments. Furthermore, offering relief to homeowners would exacerbate the problem of moral hazard: if individuals were left off the hook, it would undermine incentives to repay.
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What was curious about these arguments was that they could have applied just as easily, and with greater force, to the banks. The banks had repeatedly been bailed out. The Mexican bailout of 1995, the Indonesian, Thai, and Korean bailouts of 1997–98, the Russian bailout of 1998, the Argentinean bailout of 2000, these and others were all really bank bailouts, though they carried the name of the country where banks had lent excessively. Then, in 2008–09, the U.S. government was engaged in yet another bailout, this one the most massive ever. The banks had proven the relevance of moral hazard—bank bailouts had repeatedly and predictably led to excessive risk taking by banks—and yet both the Bush and the Obama administrations ignored it and refused to discourage future bad behavior by, for instance, firing executives (as the UK did)
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or making shareholders and bondholders take a hit.
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Unlike the banks, most of the people losing their homes were not repeat offenders. Yet they were asked to lose all of the equity that they had put into their home, while bank shareholders and bondholders were given a massive gift.
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Moreover, few homeowners would have been willing to put themselves through the anguish that they have experienced—worries about losing their life savings as well as their home—had they known what was in store for them; their mistake was to trust the bankers, who seemed to understand markets and risk, and who had assured them that the risks they were undertaking were easily manageable.