THE SHAPE OF US POPULISM
Part I: Legacy of Free Market Capitalism
Part II: Long-term Effects of the Civil War
Part III: The Progressive Era

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THE SHAPE OF US POPULISM, Part 4
A panic-stricken Federal Reserve
By Henry C K Liu

(Part 1: A rich free-market legacy - for some)
(Part 2: Long-term effects of the Civil War)
(Part 3: The progressive era)

The recent moves by the US Federal Reserve in the months following the credit market seizure of August 2007 to inject liquidity into a failed credit market and to bail out distressed banks and brokerage houses that had been caught holding securities of dubious market value are looking more like fixes for drug addicts in advanced stages of abuse.

So far, many of the Fed's actions taken to deal with the credit crisis have been self neutralizing, such as pushing down short-term interest rates to try to save wayward institutions addicted to fantastic returns from highly leveraged speculation, only to cause the dollar to free fall, thus causing dollar interest rates and commodity prices, including food and energy, to rise.

First, four months after the August 2007 credit market seizure, the Fed announced on December 12 the Term Auction Facility (TAF) program, under which the Fed will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window. By allowing the Fed to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility was intended to help promote the efficient dissemination of liquidity when the unsecured interbank markets came under stress.

Each TAF auction was to be for a fixed amount, with the rate determined by the auction process subject to a minimum bid rate. The first TAF auction of US$20 billion was scheduled for December 17, with settlement on December 20; this auction provided 28-day term funds, maturing January 17, 2008. The second auction of up to $20 billion was scheduled for December 20, with settlement on December 27; this auction provided 35-day funds, maturing January 31, 2008. The third and fourth auctions were held on Mondays, January 14 and 28, with settlement on the following Thursdays. The amounts of those auctions were determined in January. The Fed would conduct additional auctions in subsequent months, depending in part on evolving market conditions.

Experience gained under this temporary program was expected to be helpful in assessing the potential usefulness of augmenting the Fed's current monetary policy tools - open market operations and the primary credit facility - with a permanent facility for auctioning term discount window credit. The board anticipated that it would seek public comment on any proposal for a permanent term auction facility. In other words, the Fed had no idea how the market would react to its TAF program.

At the same time, the Fed Open Market Committee (FOMC) authorized temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements provided dollars in amounts of up to $20 billion and $4 billion to the ECB and the SNB, respectively, for use in their jurisdictions. The FOMC approved these swap lines for a period of up to six months.

On December 21, 2007, the Fed announced its intention to conduct biweekly TAF auctions for as long as necessary to address elevated pressures in short-term funding markets. The Board of Governors was to announce the sizes of the January 14 and January 28 TAF auctions at noon on January 4.

On January 4, 2008, the Fed announced it would conduct two auctions of 28-day credit through its TAF in January, increasing to $30 billion the auction to be held on January 14 and $30 billion in the auction to be held on January 28.

On February 1, 2008, the Fed announced it would conduct two auctions of 28-day credit through its TAF in February, offering $30 billion in an auction to be held on February 11 and $30 billion again in an auction to be held on February 25, making the total in February $60 billion. To facilitate participation by smaller institutions, the minimum bid size was to be reduced to $5 million, from $10 million in the previous auctions

On February 29, 2008, the Fed announced it would conduct two auctions of 28-day credit through its TAF in March. It would offer $30 billion in an auction to be held on March 10 and $30 billion in an auction to be held on March 24, making the total for March $60 billion.

But on March 7, 2008, the Fed announced two new initiatives to address continuing heightened liquidity pressures in term funding markets. First, the amounts outstanding in the TAF were to be increased to $100 billion from $30 billion. The auctions on March 10 and March 24 each would be increased to $50 billion - an increase of $20 billion from the amounts that were announced for these auctions on February 29. The Fed would increase these auction sizes further if conditions warrant.

To provide increased certainty to market participants, the Fed would continue to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary. The Fed was acknowledging that the credit market crisis was not a passing storm and that its previous TAF auctions did not produce the intended effect in the market.

Second, beginning immediately, the Fed initiated a series of term repurchase transactions that were expected to cumulate to $100 billion. These transactions would be conducted as 28-day term repurchase (repo) agreements in which primary dealers might elect to deliver as collateral any of the types of securities - Treasury, agency debt, or agency mortgage-backed securities - that are eligible as collateral in conventional open market operations. As with the TAF auction sizes, the Fed would further increase the sizes of these term repo operations if future conditions should warrant. The Fed announced that it was in close consultation with foreign central bank counterparts concerning liquidity conditions in markets. (See The Repo Time Bomb, Asia Times Online, September 29, 2005.)

On March 20, Bloomberg.com ran a report by Liz Capo McCormick - Treasuries' Scarcity Triggers Repo Market Failures:

Surging demand for US Treasuries is causing failures to deliver or receive government debt in the $6.3 trillion a day market for borrowing and lending to climb to the highest level in almost four years. Failures, an indication of scarcity, surged to $1.795 trillion in the week ended March 5, the highest since May 2004, and up from $374 billion the prior week. They have averaged $493.4 billion a week this year, compared with $359.6 billion over the last five years and $168.8 billion back through July 1990, according to data from the New York Fed.

Investors seeking the safety of government debt amid the loss of confidence in credit markets pushed rates on three-month bills today to 0.387%, the lowest level since 1954. Institutions worldwide have reported $195 billion in writedowns and losses related to subprime mortgages and collateralized debt obligations since the start of 2007, making firms reluctant to hold anything but Treasuries as collateral on loans.

"It shows you the kind of anxieties that are going on and the keen demand for Treasuries," said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co in New York. "The rise in fails tells us about the inability of dealers to obtain Treasury collateral." In a repurchase agreement, or repo, a customer provides cash to a dealer in exchange for a bill, note or bond. The exchange is reversed the next day, with the customer receiving interest on the overnight loan. A Treasury security is termed on 'special' when it is in such demand that owners can borrow cash against it at interest rates lower than the general collateral rate.

The Treasury Department cautioned dealers in January to guard against failing to settle in the Treasury repo market as interest rates fall. It cited periods of such failures to receive or deliver securities, known as "fails" in the repo market, earlier in the decade when rates dropped.

The difference between the rate for borrowing and lending non-specific Treasury securities, or the general collateral rate, has averaged 63 basis points below the central bank's target rate for overnight loans this year. The spread has averaged about 8 basis points the past 10 years.

Overnight general collateral repo rates have traded lower than the Fed's target rate for overnight lending every day this year. The rate on general collateral repo closed today [March 20] at 0.9%, according to data from GovPX Inc, a unit of ICAP Plc, the world's largest inter-dealer broker, compared with 1.25% yesterday. Today's rate is 135 basis points below the Fed's target rate for overnight lending of 2.25%. A spokesman for the New York Fed declined to comment on the fails data.

Nakedcapitalism.com observes that a lot of Treasuries are now held by counterparty risk-averse investors who are not interested in lending them, which could complicate the operation of the Fed's new facilities designed to unfreeze the mortgage market. The Fed may be running into its own liquidity constraints as it depletes its Treasury holdings and cannot add more non-inflationary "sterilized" liquidity.

The scarcity of Treasuries for repos means that demand for repo collaterals will push up Treasury prices and push down yields. Three month Treasury bills traded at 0.56% on March 19, a 50-year low, and a stunning 0.39% the following day, a rate last seen in 1954. Since bill prices are used as the input into other pricing models (most notably the widely used Black-Scholes option pricing model), the distortions in the Treasure market have the potential to feed into other markets, such as the credit default swaps market.

On March 11, 2008, the Fed announced that since the coordinated actions taken in December 2007, the G-10 central banks had continued to work together closely and to consult regularly on liquidity pressures in funding markets. Pressures in some of these markets had recently increased again. "We all continue to work together and will take appropriate steps to address those liquidity pressures. To that end, today the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing specific measures."

On the same day, the Fed announced an expansion of its securities lending program to include a new Term Securities Lending Facility (TSLF), under which the Fed would lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing lending program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally.

In addition, the Federal Open Market Committee has authorized increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will now provide dollars in amounts of up to $30 billion and $6 billion to the ECB and the SNB, respectively, representing increases of $10 billion and $2 billion. The FOMC extended the term of these swap lines through September 30, 2008. The actions announced would supplement the measures announced by the Federal Reserve on March 7 to boost the size of the Term Auction Facility to $100 billion and to undertake a series of term repurchase transactions that will cumulate to $100 billion.

This program allows primary dealers to exchange a total of $200 billion MBS of uncertain market value for Treasuries for 28 days instead of the traditional overnight lending. Why $200 billion?

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THE SHAPE OF US POPULISM, Part 4
A panic-stricken Federal Reserve
By Henry C K Liu

Because the Fed knows that primary dealers are holding $139.7 billion agency securities and $60.2 billion private label securities.

In The Wall Street Examiner, Lee Adler wrote in his article: Bandaid on a Ruptured Jugular:

Why do prime dealers (PDs) borrow securities from the Fed? To sell them short. The PDs are heavily short Treasuries at all times. They are heavily long all other debt securities simultaneously. The level of securities lending in recent months is unprecedented in all of human history, by an order of magnitude of 10.

The Fed is now responding to the pressure of theimminent collapse of the PDs and major banks worldwide, because not only are the PDs heavily short the stuff that is going up, Treasuries, they are heavily long the stuff that is going down, which is all other debt securities. This is the worst of all possible worlds and the Fed’s action is like putting a bandaid on a ruptured jugular vein.

Stealth nationalization of the financial sector
Adler quotes Steve Randy Waldman of Interfluidity (What Happens 28 Days later?): "Since the Fed cannot retire loans made via TAF and its repo program without adding to those 'elevated pressures', the loans should be considered an equity infusion, because they’ll be repaid at the convenience of the borrower rather than on a schedule agreed with the lender." What Waldman did not say was that the Fed had ventured into a broad nationalization of the prime dealers on Wall Street by being an equity investor.

Does the same argument apply to the new Term Securities Lending Facility (TSLF)? On the face of it, it's harder to view TSLF as an equity infusion, since the Fed is not handing out cash. But to firms holding illiquid securities that the Fed will accept as collateral, the program is equivalent to a not-so-efficient cash infusion, because the Treasuries the Fed lends are liquid and can be converted to cash easily in private markets, according to Waldman.

So, this new facility might well be a form of equity, if the Fed is willing to roll it over indefinitely and require payment only at the convenience of borrowers or when a normal market for them reappears. Waldman thinks what happens after 28 days is pretty clear. The swap will be rolled over and over and over until the mortgage-backed security market stabilizes. This could be a year from now, or perhaps 10. That may sound ridiculous but it is essentially what happened in Japan.

Waldman suggests that inquiring minds might ask what happens if the value of the MBS drops. Will the Fed issue a margin call or just look the other way? … One thing is for sure: The more liberal the Fed is in valuing the MBS the more likely a margin call situation arises. However Waldman strongly suspects the Fed will not disclose who is doing the swapping, in what size, or whether the swap ratio is 1:1 or not. So much for transparency.

"This may temporarily stop a further squeeze against dealers who are short treasuries and long MBS, but it is will not do much of anything to restore a bid in the MBS market. Nor will it cure the massive leverage problems at many of the primary dealers and banks," writes Waldman.

Adler cites an interesting paragraph from a MarketWatch article: "Counting the currency swaps with the foreign central banks, the Fed has now committed more than half of its combined securities and loan portfolio of $832 billion," Lou Crandall, chief economist for Wrightson ICAP noted. "The Fed won’t have run completely out of ammunition after these operations, but it is reaching deeper into its balance sheet than before."

"Bernanke's intent is to buy the primary dealers time, but it really can't work. Those securities will not be worth more tomorrow than they are today. For now, a MBS fire sale was averted, but it can't be put off forever," writes Adler.

On March 16, 2008, the Fed announced that the New York Fed has been granted the authority to establish a Primary Dealer Credit Facility (PDCF), intended to improve the ability of primary dealers to provide financing to participants in securitization markets and promote the orderly functioning of financial markets more generally.

The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available. The PDCF will remain in operation for a minimum period of six months and may be extended as conditions warrant to foster the functioning of financial markets.

The TAF program offers term funding to depository institutions via a bi-weekly auction, for fixed amounts of credit. The TSLF program is an auction for a fixed amount of lending of Treasury general collateral in exchange for Open-Market-Operation-eligible and AAA/Aaa rated private-label residential mortgage-backed securities. The PDCF program now allows eligible primary dealers to borrow at the existing Discount Rate for up to 120 days.

Down the slippery slope
The moves into new province suggest that the Fed has changed its traditional role in the economy with the support of the White House and the Treasury. Former Fed chairman Paul Volcker said in a public television interview the same evening that the Fed’s decision to lend money to Bear Stearns Cos. [via commercial bank JP Morgan Chase] to keep the investment house from collapsing is unprecedented and "raises some real questions" about whether that was the appropriate role for the Fed. The wisdom of the decision depends on "how severe this crisis was and the Fed’s judgment about the threat of demise of Bear Stearns," Volcker said. "That’s a judgment they had to make and an understandable judgment. It is absolutely not what you want for the longstanding regulatory support system."

The Fed's action then was an open admission that an ominous systemic crisis of total meltdown was a clear and present danger.

Unlike the TAF, which swaps cash for MBS and therefore requires sterilization so as not to push the Fed Funds Rate below target, the TSLF is simply a swap of one instrument for another, albeit an inferior one. It is not printing, and it injects no cash into the system. To avoid the need to sterilize the liquidity injection, the Fed exchanged Treasuries in its procession for securities of dubious market value held by Bear Stearns.

Since Bear Stearns is not a banking holding company and does not own a bank, the Fed could only rescue it by providing the funds to JP Morgan Chase, a commercial bank that can access the Fed discount window for funds, to acquire Bear Stearns at a fire sale price of $2 a share, a ceiling dictated by the Fed to avoid the appearance of bailing out Bear Stearns shareholders, while other investors were bidding at $5.98. The shares had traded at $170 at its peak in January 2007 and at $67 two weeks before the rescue. The Fed will guarantee up to $30 billion of potential losses on Bear assets, later reduced to $29 billion with JP Morgan assuming the first $1 billion losses. It was the Fed’s first rescue of a prime dealer broker since the Great Depression and its latest effort to soothe financial markets roiled by fallout from rising mortgage defaults. Latest reports have JP Morgan renegotiating the sale price at $10 per share to ward off shareholder attempts to block the Fed-sponsored deal.

So far, the three special facilities introduced by the Fed in quick succession have failed to stabilize the credit market:
The TAF (Term Auction Facility) failed to restore liquidity.
The TSLF (Term Securities Lending Facility) failed to restore liquidity.
The PDCF (Primary Dealer Credit Facility) can be expected to fail to save a rising number of distressed primary dealers.


Clearly the bond market does not believe the TAF, the TSLF, or the PDCF, all liquidity actions, are going to solve the insolvency problem facing over-leveraged institutions.

Fed chairman Ben Bernanke is increasingly perceived by the market as running out of room to pump money into the financial markets and to cut interest rates to rescue the faltering economy. To providing liquidity to the market, the Fed has already committed as much as 60% of the $709 billion in Treasury securities on its balance sheet. It has opened the door of moral hazard to more bailouts with the decision to become a lender of last resort for Bear Stearns, one of the biggest Wall Street dealers.

The Fed is now forced to respond to the pressure of the imminent collapse of distressed primary dealers and major banks worldwide. Primary dealers have routinely heavily shorted Treasuries that are now going up in price, and heavily longed all sort of other debt instruments that are now going down in price. The normal formula for easy profit has become the worst of all possible worlds for primary dealers in times of market distress. Moreover, the high leverage will magnify the losses as it did profits during good times. Also structured finance has generated derivatives that are based on hundreds of trillions of dollars in notional value, causing every slight move in interest rate to produce payment obligations in hundred of billion of dollars among institutions whose capital structures are woefully inadequate.

Legal challenges
Inner City Press/Community on the Move, a housing and fair lending activist group, has challenged the legality of the Fed's quick approval of refinancing for Bear Stearns via JP Morgan Chase, questioning the Fed's authority to approve the deal involving a non-bank institution.

In a complaint filed with the Fed a day after the Fed action, Inner City Press labeled the central bank's brokering of the Bear Stearns deal as "entirely illegal" and anticompetitive, and questioned whether the required number of Fed Board governors had voted for it.

Bernanke took advantage of little-used parts of Fed law, added in the 1930s and last utilized in the 1960s, that allow it to lend to corporations and private partnerships with a special board vote. Such votes require approval from five Fed governors. The seven-member Fed board currently has two vacancies, and one governor, Randall Kroszner, is serving past the January 31 expiration of his term.

Inner City Press questioned the legality of the Fed approving the Bear Stearns deal without public notice, on the grounds Bear Stearns "is not a banking holding company and it does not own a bank."

The Federal Reserve bypassed its own normal emergency-lending policies to let securities firms borrow at the same interest rate at the discount window as commercial banks as the central bank sought to stave off a financial-market meltdown. Guidelines revised in 2002 say the Fed should charge non-banks more than the highest rate that

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THE SHAPE OF US POPULISM, Part 4
A panic-stricken Federal Reserve
By Henry C K Liu

commercial banks pay. Instead, Fed chairman Bernanke and his colleagues, in emergency votes on March 16, invoked broader authority in the Federal Reserve Act to give Wall Street prime dealers the same rate as banks. Backstopping securities firms, coupled with action to keep Bear Stearns afloat before its sale to JP Morgan Chase represent the central bank’s first lifelines to institutions other than banks since the Great Depression.

Under a regulatory regime dating back to the New Deal of the 1930s, the Fed oversees commercial banks, but investment banks are primarily regulated by the Securities and Exchange Commission, which in recent decades has become a captured regulator that resembles an asylum run by the inmates.

Senior Fed staffers said the arrangement allows JP Morgan Chase to borrow from the Fed's discount window and put up collateral of uncertain value from Bear Stearns to back up the loans. JP Morgan, a bank, has access to the discount window to obtain direct loans from the Fed, but Bear Stearns, an investment house, does not. While JP Morgan is serving as a conduit for the loans, the Fed and not JP Morgan will bear the risk if the loans are not repaid, officials said. When God sins, the entire theological structure rots.

Bernanke raced to unveil the new steps before the Tokyo Stock Exchange opened on March 17. The weekend action, timed to complement JP Morgan’s rescue of Bear Stearns, included a cut in the discount rate and the opening of borrowing to the primary dealers in Treasury securities, not all of which are banks. The changes were the Fed's most aggressive response to date to the eight-month-old credit crisis that has spread to the entire US economy and around the world. My article Why the Subprime Bust Will Spread (Asia Times Online, March 17, 2007) was written five months before the August credit crisis, at a time when establishment officials and gurus were assuring the public that the subprime mortgage problem was well contained.

The "temporary" facilities for 28 days have been extended on an increasingly larger scale. If they had a chance at being temporary the scale should be getting smaller and not larger. The Fed is putting in jeopardy its credibility by pretending that the "temporary facilities" might end or be phased out at the end of some future 28-day period when it knew in advance that was not possible. Each rollover increases stress in the precarious financial system as market participants become dependent on more Fed intervention to provide temporary adrenaline to unjustified market exuberance.

The Fed on March 16 cut the discount rate by 25 basis points to 3.25%. Two days later, on March 18, the Fed slashed its Fed funds rate target 75 basis points to 2.25% and the discount rate to 2.50%. US interest rate has now fallen to negative rate levels, meaning it is now below inflation rate.

Another day later, Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac received permission from regulators to pump as much as $200 billion of liquidity into the beleaguered US mortgage market without having to add compensatory capital. For weeks earlier, rumors had been rife about these two GSEs facing insolvency. Jonathan R Laing of Barron's characterized their shares as "worthless".

At year-end 2007, the company owned in its portfolio or had packaged and guaranteed some $2.8 trillion of mortgages or 23% of all US residential mortgage debt outstanding. The company lost $2.6 billion in 2007 as a surge of red ink in the final two quarters more than wiped out a nicely profitable first half.

Shortage of borrowers
Still, even with all the liquidity the Fed has injected into the market, few are borrowing except to roll over maturing debts, as new profitable investments have become hard to find. Oil companies are flush with cash from windfall profits but they do not seem to be able to find worthwhile investments to put the cash to use. Exxon reported a record $39.5 billion annual windfall profits for 2007 from high oil prices, exceeding the gross domestic product of nearly two thirds of the 183 nations of the world, but the company failed to announce any plans for expansion.

The fear is that until prices in the $12 trillion US residential housing market stop falling and the pace of foreclosures ebbs instead of rises, the pain for banks and non-bank institutions, let alone home owners, will continue to get stronger to threaten a much deeper and broader economic recession.

The hope is that lower mortgage rates would enable home owners to cut their borrowing costs as they opt for better terms and help cushion the pain of falling home prices. But lower short-term rates cause the dollar to fall and long-term rates to rise. Moreover, mortgage defaults are no longer caused exclusively by high interest rate resets. Many borrowers have no incentive to keep making payments on mortgages on properties with market values lower than the outstanding value of the mortgage. Is the Fed in a position to pump $4 trillion into the housing market to stabilize inflated home prices?

Every few days, a new, stronger fix needs to be administered by the Fed to sustain a euphoric high in the market that will dissipate a few days later, with the inevitable result of a fatal overdose down the road. All that produces is a secular bear market, where every rebound is smaller than the previous fall, until the debt bubble fully deflates.

The bottom line in the current financial crisis is no longer one of credit crunch, but of massive insolvency in the financial market that will spread to the general economy, which no amount of Fed liquidity injection can cure short of hyperinflation. Further, there is no guarantee that even accepting hyperinflation will save the economy from protracted stagnation. The history of central banking shows that central bank policies can cause problems more easily than they can solve problems they created earlier. Economic distress from monetary dysfunction cannot be solved by merely printing money, which central banks consider its divine right.

Central banks of the G7 economies are reportedly actively engaged in discussions about the feasibility of using public funds for mass purchases of mortgage-backed securities as a possible solution to the credit crisis. This is essentially an option to nationalize the credit market after wholesale deregulation has turned free market capitalism into failed market capitalism.

The policy debate has shifted from one on fixing an appropriate interest rate policy to the need for aggressive intervention in a matter of weeks as the crisis spread from the subprime mortgage sector to engulf the entire financial system, as evidenced by the sudden collapse of Bear Stearns, a major investment bank, that threatens to touch off widespread counterparty defaults. Panic appears to have taken over at the highest levels in the inner sanctum of the central banking world.

Discord among central banks
The Bank of England reportedly is most enthusiastic to explore the idea, as it has a long history of nationalization, the latest example being its takeover the Northern Rock Bank, a big mortgage lender. The Federal Reserve is open in principle to the possibility that intervention in the MBS market might be justified in certain scenarios, but only as a last resort. The European Central Bank appears least enthusiastic, with the German central bank adamantly opposed to such a heretical proposition.

Jean-Claude Trichet, the ECB president, while avoiding immediate critical comment on the Bank of England's rescue of Northern Rock, said: "What is important is that we must not let the mistakes made by some impose a high cost on those who have made no mistakes."

Neo-liberal market fundamentalists continue to argue that new international bank capital rules requiring assets values to be marked to market rather than marked to models have exacerbated the credit squeeze, despite the now proven fact that flawed marked-to-model evaluation had been responsible for the current crisis.

US policymakers are more inclined to boost support for the mortgage markets indirectly through the expanding the role of the Federal Housing Administration, which provides mortgage insurance on loans made by FHA-approved lenders, and by easing regulatory restraints by the Office of Federal Housing Enterprise Oversight (OFHEO) on Fannie Mae and Freddie Mac. OFHEO stated that the required capital surplus for Fannie Mae and Freddie Mac will be reduced from 30% to 20%, immediately freeing up $200-$300 billion for the GSEs to buy mortgages.

This new initiative and the release of the portfolio caps announced in February, should allow the GSEs to purchase or guarantee about $2 trillion in mortgages this year. This capacity will permit them to do more in the jumbo temporary conforming market, subprime refinancing and loan modifications areas.

To support growth and further restore market liquidity, OFHEO announced that it would begin to permit a significant portion of the GSEs' 30% OFHEO-directed capital surplus to be invested in mortgages and MBS. As a key part of this initiative, both companies announced that they will begin the process to raise significant capital. Both companies also said they would maintain overall capital levels well in excess of requirements while the mortgage market recovers in order to ensure market confidence and fulfill their public mission.

OFHEO announced that Fannie Mae is in full compliance with its Consent Order and that Freddie Mac has one remaining requirement relating to the separation of the chairman and CEO positions. OFHEO expects to lift these Consent Orders in the near term. In view of this progress, the public purpose of the two companies and ongoing market conditions, OFHEO concludes that it is appropriate to reduce immediately the existing 30% OFHEO-directed capital requirement to a 20% level and will consider further reductions in the future.

However, like the Fed taking on more risk to bail out the mortgage market, the GSEs will do the same, increasing the amount of mortgages they will hold for each dollar of capital on its books.

Swinging back towards re-regulation
As Congress and the Bush administration struggle to contain the housing and credit crises and prevent more Wall Street firms from collapsing as Bear Stearns did, Edmund Andrews and Stephen Labaton of the New York Times report that a split is forming over how to strengthen oversight of financial institutions after decades of deregulation that had led to the meltdown in credit markets to expose weaknesses in the nation’s tangled web of federal and state regulators, which failed to anticipate the effect of so many new players in the industry.

In the Democrat controlled Congress, key committee chairmen, such as Massachusetts Representative Barry Frank of the House Financial Services Committee, New York Senator Charles Schumer of the Joint Economic Committee and Connecticut Senator Christopher Dodd of the Senate Banking Committee, are drafting separate bills that would create a powerful new regulator or simply confer new powers on the Federal Reserve to oversee practices across the entire array of commercial banks, Wall Street firms, hedge funds and nonbank financial companies.

Sheila C Bair, chairwoman of the Federal Deposit Insurance Corporation (FDIC), which insures deposits at banks and thrift institutions and is one of several federal bank regulatory agencies, said: "Capital levels are the most important tool we have at the FDIC, and investment banks have lower capital levels than commercial banks."

The Treasury Department of the outgoing Republican administration is rushing to complete its own blueprint for overhauling what is now an alphabet soup of federal and state regulators that often compete against each other and protect their particular slices of the industry as if they were constituents. It will unveil its own blueprint for regulatory overhaul in the next few weeks.

Treasury Secretary Henry Paulson has acknowledged that the problems exposed by the housing crisis were diffuse and complex and could not be solved with a single action. "There is no silver bullet," he said repeatedly last week. But he suggested that he did not want to take any drastic regulatory steps while the financial markets remained in turmoil. "The objective here is to get the balance right," Mr Paulson said. "Regulation needs to catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it." This attitude has been behind Alan Greenspan’s Fed policy on regulating financial innovations for the past two decades.

Ideological divide allows only cosmetic changes
But the two political parties strongly disagree along ideological lines about whether, after decades of freewheeling encouragement of exotic new instruments like derivatives and new players like hedge funds, the pendulum should swing back to tighter control. Wall Street firms have also been major contributors to both political parties, and they are certain to oppose tough new restrictions. Given the philosophical differences about the value of government regulations, it is unlikely that a Democratic Congress and the Republican Bush administration would agree on more than cosmetic changes.

Except for the Federal Reserve, all federal bank-regulating agencies receive funding from fees paid by member institutions. 

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THE SHAPE OF US POPULISM, Part 4
A panic-stricken Federal Reserve
By Henry C K Liu

These agencies have competed with each other to woo institutions with lighter regulation.

"If we don't tread very carefully on restructuring a very complex financial system, we might stifle the necessary animal instincts of a free market," said Mark A Bloomfield, president of the American Council for Capital Formation, a business advocacy group. "Every day, the cries of populism grow stronger and could trample good economic policy." This warning against populism has also come from the host of the Larry Kudlow Show in recent weeks as a threat against free market capitalism.

For neo-liberal market fundamentalists, the fear is not of an economic depression, but the populism that may follow it.

Rights of labor
The 1912 Democratic platform repeated the declarations of the platform of 1908:

Questions of judicial practice have arisen especially in connection with industrial disputes. We believe that the parties to all judicial proceedings should be treated with rigid impartiality, and that injunctions should not be issued in any case in which an injunction would not issue if no industrial dispute were involved.

The expanding organization of industry makes it essential that there should be no abridgement of the right of the wage earners and producers to organize for the protection of wages and the improvement of labor conditions, to the end that such labor organizations and their members should not be regarded as illegal combinations in restraint of trade.

The 1912 platform pledge the enactment of a law creating a department of labor, represented separately in the president's cabinet. In 1913, the Labor Department was created by president Wilson in his first year in office. The Clayton Act of 1913 exempted unions from the Sherman Anti-Trust Act. The Keating-Owen Act of 1916 banned child labor but was annulled by a conservative Supreme Court in 1918. The Federal Employees Compensation Act established the Office of Workers Compensation Programs in 1916. The International Labor Organization (ILO) held its first meeting in 1919 in Washington, chaired by Secretary William B Wilson, a second generation coal miner and a former child laborer.

After the 1917 October Revolution in Russia, more than four thousand alleged Communists were arrested in the US for deportation under the Anarchist Exclusion Act of 1918 in the first anti-communist witch hunt. The Department of Labor (DOL) refused to deport the bulk of those arrested and Secretary Wilson was threatened with impeachment for taking that position despite the fact that the DOL under his leadership helped indispensably in winning the war by mobilizing an effective workforce for defense production.

The present "war on terror" is also extracting a heavy toll on US domestic civil liberty.

Conservation
The 1912 Democratic platform declared:

... the Democrat belief in the conservation and the development, for the use of all the people, of the natural resources of the country. Our forests, our sources of water supply, our arable and our mineral lands, our navigable streams, and all the other material resources with which our country has been so lavishly endowed, constitute the foundation of our national wealth. Such additional legislation as may be necessary to prevent their being wasted or absorbed by special or privileged interests should be enacted and the policy of their conservation should be rigidly adhered to.

The platform called for immediate action by Congress to make available the vast and valuable coal deposits of Alaska under conditions that were intended to be a perfect guarantee against their falling into the hands of monopolizing corporations, associations or interests.

It pledged to the extension of the work of the bureau of mines in every way appropriate for national legislation with a view to safeguarding the lives of the miners, lessening the waste of essential resources, and promoting the economic development of mining, which, along with agriculture, "must in the future, even more than in the past, serve as the very foundation of our national prosperity and welfare, and our international commerce".

Agriculture
The 1912 Democratic platform supported the development of a modern system of agriculture and a systematic effort to improve the conditions of trade in farm products so as to benefit both consumer and producer. And as an efficient means to this end the platform called for the enactment by Congress of legislation that "will suppress the pernicious practice of gambling in agricultural products by organized exchanges or others."

In order words, future, options and derivatives of all sort that have landed the global economy in dire stress in 2008, with ruinously high food prices. On this issue, the 1912 Democratic platform failed spectacularly as structured finance spread beyond agricultural commodities to take full control of finance capitalism in the final quarter of the twentieth century and landed the global economy in a financial crisis in 2007.

The Philippines
The 1912 Democratic platform reaffirmed "the position thrice announced by the Democracy in national convention assembled against a policy of imperialism and colonial exploitation in the Philippines or elsewhere. We condemn the experiment in imperialism as an inexcusable blunder, which has involved us in enormous expense, brought us weakness instead of strength, and laid our nation open to the charge of abandonment of the fundamental doctrine of self-government. We favor an immediate declaration of the nation's purpose to recognize the independence of the Philippine Islands as soon as a stable government can be established, such independence to be guaranteed by us until the neutralization of the islands can be secured by treaty with other Powers."

Progressivism a middle-class movement
Reflecting the socioeconomic makeup of the nation, with the emergence of a prosperous middle class, US progressivism in the early 19th century was a movement with predominantly middle-class values and objectives, gaining support from small business owners, independent farmers, and professionals such as lawyers, doctors, teachers and journalists, as well as the intelligentsia. They subscribed to ethical, humanitarian and spiritual values rather than socialist concepts of class struggle.

Socialism never developed any popular base in US political culture despite strong communal roots among the early settlers. No socialist presidential candidate ever received substantial votes in US political history. Union leader Eugene V Debs, who ran as a Socialist Party candidate in 1908, received 420,793 votes against the 7,687,908 votes received by William H Taft; in 1912 Debs received 900,672 votes against the 6,293,454 voted received by Woodrow Wilson; and finally in 1920 Debs, running from prison serving a 10-year term for making an anti-war speech in violation of the Espionage Act of 1917, received 919,799 votes against 16,152,200 received by Warren G Harding. The last socialist presidential candidate was Norman Thomas, who in 1932 in the depth of the Great Depression received 881,951 votes against the 22,831,857 received by Franklin D Roosevelt.

As a pragmatic political force, progressivism found support among both conservatives and liberals and spread to all regions of the nation. Early 20th century progressivism turned 19th-century Hamiltonian preference for strong government to nurture a rich economic elite, towards government promotion of Jeffersonian popular democracy in defense of a large wage-earning working class dominated by big corporations. This movement created a prosperous middle class out of previously exploited workers and farmers, and resulted in a prosperous nation.

Love/hate towards government
All political ideologies realize that political control of governmental power is the route to shape the nation to its preference. As the nation and its economy grow, attitudes toward government change. Ideologies that have already gained dominance to the point of being accepted as natural order would resist big government, even if their very ascendance had been brought about by government policy. Ideologies that have remained unfulfilled would argue for strong government to right the wrongs.

When big business crusades against big government, it generally means it wants more freedom for big business to expand the private sector at the expense of the public sector. Big business opposes government interference to protect workers against corporate abuse. When big business is in distress either from foreign competition or from internal collapse from excesses, it calls for government assistance. When populists and progressive reformers crusade for government intervention, they generally mean to use political authority to correct ossified socio-economic injustice.

Anti-trust and monopolies
The problem of monopolies was the main contentious issue of the Progressive Era. Progressives were not of one mind on this complex, multi-faceted issue. One group, represented by Theodore Roosevelt, saw corporate consolidation as inevitable in modern economies and argued that the growth of big corporations should be regulated rather than forbidden. The Roosevelt faction leaned toward enlarging governmental power, as summarized by journalist Herbert Croly in his The Promise of American Life. Croly argued that economic injustice should be fought with governmental power and by the legitimization of a strong labor union movement to balance uneven market powers between corporations and workers.

Another group, represented by Woodrow Wilson, leaned toward prohibition of bigness in favor of small business to protect competition, arguing that bigness by its very nature eventually would make regulation on it ineffective without banning bigness. The Wilson faction leaned instead towards judicial enforcement of constitutional principles of individualism.

In 1916 Wilson appointed Louis D Brandeis to be Chief Justice of the Supreme Court to prevent the expansion of the "curse of bigness" by not permitting any one corporation to control more than 30% of any market. As a star litigator before the Supreme Court, Brandeis filed his famous "Brandeis Brief" to provide the court with sociological information on the issue of the impact of long working hours on women. The Brandeis Brief set a new direction for Supreme Court deliberation and for US law and became a model for future Supreme Court presentations.

Together with Brandeis, Roscoe Pound, Harvard Law School Dean, and Benjamin Cardozo, known as the Three Musketeers of the liberal faction of the court, argued that justice is more likely to be done if judges take into consideration the practical effect of general legal principles.

The progressive role of muckrakers
The rise of the investigative press played a crucial role in winning popular support for progressivism. Labeled by Teddy Roosevelt as Muckrakers, these pioneering reporters filed well documented exposes of fraud and graft and corruption. Henry Demarest Lloyd published an anti-trust report: Wealth against Commonwealth; Lincoln Steffens reported on political corruption in cities, and Ida Tarbell wrote History of the Standard Oil. Muckraking after 1914 often degenerated into unreliable sensational journalism and never quite rose again to the standards set by the likes of Lloyd, Steffens and Tarbell until the anti-Vietnam War era. The communication revolution brought about by the emergence of the Internet will facilitate a new wave of populism rising from collapse of the failure of unregulated free market capitalism.

Robert Marion La Follette, Republican governor of Wisconsin, introduced a series of progressive reforms that came to be known as the Wisconsin Idea. These reforms included taxation of the railroads, standardizing freight rates based on physical weight and size rather than commercial value, adoption of income and inheritance taxes, regulation of banks and insurance companies, limitation of working hours for women and children, passage of workman’s compensation and welfare laws, creation of a forest reserve and establishment of primary elections for nomination of candidate for state offices.

La Follette pioneered the use of nonpartisan experts in government commissions. A "new individualism" worked for a better chance for average citizens to own property to maintain the Jeffersonian ideal of popular democracy. The Wisconsin Idea brought about similar trends in many other states, including Iowa, Minnesota, Kansas, Nebraska and the Dakotas. Many progressive governors first attracted public attention by serving as counsel for commissions set up to investigate corruption in big business. Woodrow Wilson, a future president, served a Democratic governor of New Jersey with a progressive program.

Progressivism did not bring about any major transformation of the political and economic system partly because it was never its intention. It concentrated on a series of specific regulatory reforms, most of which had been achieved by 1914. In politics, the movement did much to revitalize democracy by making public

Page 5 of 5
THE SHAPE OF US POPULISM, Part 4
A panic-stricken Federal Reserve
By Henry C K Liu

officials and corporate management more responsive to public opinion. On economic issues, while progressivism failed to solve the problem of monopoly, it extended the power of the Federal and state governments to regulate big business through appointive commissions, such as Interstate Commerce Commission and the Federal Trade Commission to check the exploitation of labor and to conserve natural resources.

More fundamental than any specific reform was the emergence of a new attitude espoused by the progressive movement on political and business leaders to be more sensitive to popular approval beyond legal and regulatory bounds. The effect of the progressive movement, while it might not have altered the hardnosed mentality of big business, was manifested through the presentation of business activities in a favorable light by spending large sums on public relations. Effective progressive reform then, as with democracy itself, depended henceforth on the informed enlightenment of the voters and on their capacity for critically appraising establishment propaganda.

World War I ends US isolationism
World War I made the United State realize that despite pioneer era isolationism, the young nation was not disconnected to the affairs of Europe. There was awareness in the minds of the US elite that a Europe dominated by one single power would be geopolitically threatening to the national interest of the US, particularly if the victor should turn out to be Germany. The US leadership was primarily in sympathy with British and French ideological values and geo-economic interests predominant in the pre-war world order which was on the defensive from rising German threat.

The debate on the war was between supporting the Allies or neutrality. Support for Germany was never an option. Woodrow Wilson justified the rejection of isolationism on the ground of preserving democracy in Europe, yet the effect of the war on the US domestically was an unhappy growth of intolerance.

Wilson, the self-righteous democrat, told a close associate on the eve of his war message to Congress: "To fight you must be brutal and ruthless, and the very spirit of ruthless brutality will enter into the very fiber of our national life."

In June 1917, Congress passed the Espionage Act, imposing jail penalties for anti-war statements. A year later, the Sedition Act of 1918 was invoked to imprison 1,597 prominent anti-war activists, including Eugene Debs and Victor Berger, Socialist representative from Milwaukee, the first Socialist congressman in US history.

The government itself did much to whip up war hysteria through the Committee on Public Information headed by investigative journalist George Creel, which fabricated images and stories of German soldiers killing civilian babies and hoisting them on bayonets, and portraying anti-war activists as German spies, particularly among German Americans who were driven from their peacetime jobs and made to kiss the American flag in public.

A number of appeals to the Supreme Court on lower court convictions under the Espionage and Sedition Acts were reaffirmed. The eloquent dissenting opinions written by Justice Oliver Wendell Homes on some of these cases enter the legal lexicon, such as the declaration that only a "clear and present danger" could justify any abridgement of free speech.

The important role of the US in securing victory for the Allies in World War l gave Wilson an exaggerated sense of US moral superiority, notwithstanding that the advantage the US enjoyed came entirely from its homeland being out of range from enemy attack. Prodded by Creel, without seeking Allied agreement, Wilson came up with his statement of Fourteen Points on January 8, 1918, as broad conditions for peace.

Six of the points concerned broad ideals that included open covenants of peace; freedom of the seas; removal of economic barriers between nations; reduction of armament; settlement of competitive claims on colonies by great powers but not decolonization; and a League of Nations. The other eight points dealt with territorial redistributions and self-determination for nationalities in fallen empires, except for nonwhites such as Africans, Asians and Arabs.

In October 1919, the German government indicated its willingness to accept a peace based on the Fourteen Points, but Britain and France insisted on modifications on freedom of the seas and the imposition of punitive war reparations. Revolution in Germany forced the Kaiser to flee to Holland and the Social Democrats set up the Weimar Republic.

The war incurred over 10 million deaths and burnt up $200 billion, or $3 trillion in current dollars. The US lost 50,000 soldiers with no civilian casualty on US soil. The US spent a total of $32 billion on the war, about $10 billion of which represented loans to allies. US GDP grew from $36 billion in 1914 to $78 billion in 1919. The war established the US as a leading world power, surpassing even the European victor nations.

Wilson’s League of Nations proposal met overwhelming opposition in a Republican controlled Congress over a range of reservations for various special interests, the most serious being one of national sovereignty.

The election of 1920 put Republican Warren G Harding of Ohio in the White House, whose campaign was couched in soothing generalities. "America’s present need," Harding explained, "is not heroics but healing; not nostrums but normalcy; not revolution but restoration."

The Roaring Twenties
The Roaring Twenties, an era dominated by Republican presidents: Warren Harding (1920-1923), Calvin Coolidge (1923-1929) and Herbert Hoover (1929-1933), saw the decline of progressivism and populism. Under the Republican conservative economic philosophy of laissez-faire, markets were allowed to operate without government interference.

Taxes were slashed and regulations lifted dramatically. Monopolies were allowed to reconstitute, and inequality of wealth and income reached record levels with government approval as needed by capitalism and with public acceptance of an illusion that any person, even those untrained in finance, could become a millionaire through rampant speculation. The nation’s monetary system was based on the gold standard, and the Federal Reserve was limited by the gold in its possession to significantly increase the money supply in times of financial stress. These excesses, fueled by an expansion of credit, moved the US economy toward the brink of disaster.

Calvin Coolidge, a quintessential New Englander from Vermont, served as the 29th vice president of the United States from 1921 until his succession to the presidency in 1923 upon the sudden death of Harding. Coolidge inherited a nation in the midst of an unprecedented economic boom built on debt-driven speculation and handed it over to fellow Republican Herbert Hoover just before it fell into the Great Depression.

A good Republican, Coolidge faithfully balanced the Federal budget, reduced the deficit and presided over the speculative rise of the stock market, which he mistook as the happy result of free markets. Coolidge ignored the needs of the poor and instituted a strict, discriminatory immigration policy based on race. "America," he said proudly, "must be kept American." The US political economy of the past two decades echoed closely the Harding-Coolidge decades.

The Coolidge administration unabashedly favored big business. He turned the Federal Trade Commission from a regulatory agency over corporate monopolistic abuse into one dominated by big business that facilitate corporate mergers and acquisition.

Western farmers did not benefit from the Coolidge prosperity. He twice vetoed (1927, 1928) the McNary-Haugen Farm Relief Bill, which proposed that the government buy surplus crops and sell them abroad in order to raise domestic agricultural prices. Coolidge argued that the government had no business fixing prices. Republican senators and representatives from the West formed a coalition with the Democrats against the president. This coalition also opposed the Coolidge tax cut for the higher income tax brackets, and the tax bills were greatly modified before they were passed.

In 1927 Coolidge vetoed a bill to provide extra payments to World War I veterans. The next year, he pocket-vetoed a bill for government operation of the Muscle Shoals hydroelectric plant in Alabama, on the Tennessee River to prevent competition for private utility companies. Coolidge’s attitude toward Muscle Shoals was consistent with his lifelong opposition to the expansion of government functions and the interference of the federal government in private enterprise.

The presence in his cabinet of Herbert C Hoover and Andrew W Mellon added to the pro-business tone of his administration. Coolidge supported the Mellon program of tax cuts and small government and encouraged stock market speculation as in tune with the American enterprising spirit. Coolidge’s policies left the nation unprepared for the inevitable economic collapse that followed. Coolidge declined to seek re-nomination in 1928.

The market crash in 1929 burst the speculative bubble of the late 1920s. Hundreds of thousands of uninformed people with no financial training were hoping to get rich by speculative with borrowed money collateralized by the market value of the shares in what appeared to be a perpetually rising stock market. By 1929, brokers were routinely lending small investors with 75% margin, which was outright conservative compared to the 99% margin granted to hedge funds and zero down payments for home mortgages in years before 2007. The amount of loans outstanding was about the amount of currency circulating in the US, again ultra-conservative by current standards.

A Brookings Institute study shows that in 1929 the top 0.1% of income recipients had a combined income equal to the bottom 42%. That same top 0.1% in 1929 controlled 34% of all savings, meaning a significant amount of their income was unearned from capital gain and dividends, while 80% of the working population had no savings at all.

Clinton, the populist?
By comparison, Bill Clinton and Al Gore in their 1991 populist campaign for the White House repeatedly pointed out the obscenity left by the Reagan administration, of the top 1% of Americans owning 40% of the country’s wealth. They also said that if home ownership is not counted and only counting businesses, factories and offices, then the top 1% owned 90% of all commercial wealth. Unfortunately, once in office, President Clinton did little to correct the situation. Clinton has been described as the best president the Republican would wish for. After eight years of George Bush, with home prices falling with no end in sight, the top 1% could end up with 99% of the nation’s wealth even when home ownership is counted.

Not all could be blamed on the Republicans. Jimmy Carter (1977-81) was the president who reversed many of the regulations put in place by Franklin D Roosevelt's New Deal. (See my reference to "Carter the Granddaddy of Deregulation" in Super capitalism, super imperialism, , Asia Times Online, October 12, 2007.) He deregulated airlines, railroads, trucking, long distance communication and banks regulation, particularly repealing Regulation Q, which prohibits banks from paying interest on demand deposit accounts.

The repeal of Regulation G eventually led to the Savings and Loan crisis. In 1980, the Interstate Commerce Commission still regulated both trucking and the railroads. AT&T (Ma Bell) had a nationwide monopoly in which long distance calls were carried via copper wires, each with the capacity of 15 calls. Technological innovation in fiber optic line allows 2 million calls per line. The most important long-term effect of transportation is the uneven development of the national economy favoring big population centers at the expense of rural small towns.

The Carter administration also gave greater power to the Federal Reserve System through the Depository Institutions and Monetary Control Act (DIDMCA) of 1980 which otherwise was a necessary first step in ending the harmful New Deal restrictions placed upon financial institutions. In fact, it would be safe to say that Ronald Reagan probably would have taken the necessary deregulatory steps had Carter kept all of the regulatory regimes in place.

Carter made it easier for Reagan to implement antigovernment actions. The deregulation movement started under Carter was continued by Reagan and Clinton. In 2008, calls for new regulation to rein in the excesses and abuse of market fundamentalism are heard from all quarters.

Wealth disparity causes depression
The Coolidge prosperity of the 1920s was not shared equitably among all citizens. The disparity of income between the financial elite and the average wage earner widened throughout the 1920s. While the disposable income per capita rose 9% from 1920 to 1929, those with income within the top 1% enjoyed a stupendous 75% increase from a much higher base in per capita disposable income.

In 2006, the chief executives of the 500 biggest US companies averaged $15.2 million in total annual compensation, according to Forbes business magazine’s annual executive pay survey. The top eight CEOs on the Forbes list each pocketed over $100 million. Larry Ellison, CEO of business software giant Oracle, was not in the top eight. But as the 11th richest man in the world, who ended 2006 being worth more than $16 billion, he should not complain on missing being among the top ten.

University of Chicago economist Austan Goolsbee points out that a CEO like Ellison literally cannot spend enough on personal consumption to stop his fortune from growing. Goolsbee calculates that Ellison would have to spend over "$183,000 an hour on things that can’t be resold for gain, like parties or meals, just to avoid increasing his wealth."

In 2006, Yahoo shares had sunk 35%, or about $20 billion in market capitalization value. Top talent, according to press reports, was jumping ship, not because of low pay but because of loss of confidence in the company’s future. A leaked internal Yahoo memo - known in tech sector circles as the "Peanut Butter Manifesto" - said that, like peanut butter on toast, Yahoo management was spreading dangerously thin.

Yet Yahoo CEO Terry Semel pocketed $71.7 million in 2006, over twice the take-home of any other chief executive in Silicon Valley. Since 2001, the year he left Hollywood to take Yahoo’s top slot, Semel has cashed out an additional $450 million in personal stock option profits.

On the 1920s, a major reason for the large and growing gap between the investing rich and wage earners was the increased manufacturing output throughout this period. From 1923-1929 the average output per worker increased 32% in manufacturing, but average wages for manufacturing jobs increased only 8%. From 1923-1929 corporate profits rose 62% and dividends rose 65%. The created wealth was going mostly to investors rather than workers.

In the 1920s, the Federal government also contributed to the growing gap between the investing rich and wage earners. The Revenue Act of 1926, similar to the 2000 Bush tax cuts, reduced federal income and inheritance taxes dramatically. Secretary of the Treasury Andrew Mellon lowered federal taxes to enable a taxpayer with a million-dollar annual income to reduce income tax from $600,000 to $200,000. Even the Supreme Court played a role in expanding the gap between the socioeconomic classes. In the 1923 case of Adkins v Children's Hospital, the Supreme Court ruled minimum-wage legislation unconstitutional.

A 2002 study released by Citizens for Tax Justice and the Children's Defense Fund reveals that under the Bush tax cut, over the next 10 years, the top 1% income recipients are slated to receive tax cuts totaling almost half a trillion dollars. The $477 billion in tax breaks the Bush administration has targeted to this elite group will average $342,000 each over the decade. By 2010, when (and if) the Bush tax reductions are fully in place, an astonishing 52% of the total tax cuts will go to the richest 1% whose average 2010 income will be $1.5 million. Their tax-cut windfall in that year alone will average $85,000 each. Put another way, of the estimated $234 billion in tax cuts scheduled for the year 2010, $121 billion will go just 1.4 million taxpayers.

In the 1920s, the wide disparity of wealth between the rich and the average wage earner increased the vulnerability of the economy. For an economy to function with stability on a macro scale, total demand needs to equal total supply. Disparity of income eventually will result in demand deficiency, causing over supply. The extension of credit to consumers can extend the supply/demand imbalance but if credit is extended beyond the ability of income to sustain, a debt bubble will result that will inevitably burst with economic pain that can only be relieved by inflation.

By the end of the 1920s, 60% of cars and 80% of radios were bought on installment credit. Between 1925 and 1929 the total amount of outstanding installment credit more than doubled from $1.38 billion to around $3 billion while the GDP rose from $91 billion to $104 billion. Today, outstanding consumer credit besides home mortgages adds up to about $14 trillion, about the same as the annual GDP.

The US economy was also reliant on luxury spending and investment from the rich to stay afloat during the 1920's. The problem with this reliance was that luxury spending and investment, unlike general consumption on basic needs, can fluctuate widely based on the wealthy's confidence in the US economy. More investment normally increases productivity. However, if the rewards of the increased productivity are not distributed fairly to workers, production will soon outpace demand. The search for high returns in a low demand market will lead to consumer debt bubbles with wide-spread speculation.

Mass speculation went on throughout the late 1920s. In 1929 alone, a record volume of 1,124,800,410 shares were traded on the New York Stock Exchange. From early 1928 to September 1929 the Dow Jones Industrial Average rose from 191 to 381. Company earnings became irrelevant as long as stock prices continued to rise to yield huge profits for investors. RCA corporation stock price leapt from 85 to 420 during 1928, even though it had not yet paid a single dividend. The wide spread buying of stocks on margin, investors could buy one share of RCA by putting up $10 of his own, and borrowing $75 from his broker. By selling the stock at $420 a year later, the investor would turn his original investment of $10 into $341.25, making a return of over 3,400%.

Populism receded in this frenzy era of speculation because the decline in wages had more than offset by speculative profits. The fantasy joy ride came to an abrupt end on Black Monday, October 29, 1929, and revived populism in the US. Populism in the New Deal had to do with reviving spending by the average citizen, shifting from spending by the rich.

This type of speculation was widespread all through the 1990 and early 2000s. The market meltdown that began in August 2007 has revived populism in the 2008 presidential election. The next administration will have to respond to a new populism to stimulate rising wages and full employment to shift from luxury spending to spending on and by the average citizen. A severe recession will come as surely as the sun will set, but it will not be the end of the world. It may, however, be the end of the world as we knew it.

Next: The Great Depression, the New Deal and the 2007 Financial Crisis

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.

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