Fiscal Talks Only Offer Short-Term Solutions, Ignore the Tough Problems

Article excerpt

* The nation's economic future is still in limbo. The White House and congressional Republicans are seeking to avert the fiscal duff, including the automatic spending cuts mandated by the Budget Control Act of 2011.

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How this will end is unclear. As the old aphorism goes, "Those who say, don't know, and those who know, don't say."

But we do know how we got here. The "supercommittee" last year only had to find $1.2 trillion in a combination of tax increases and expenditure savings over 10 years to avoid this cliff That is $120 billion a year from a federal budget of $3.7 trillion--only 2.4 percent of the budget even if all the savings came from spending. The supercommittee failed. There was a time in this country when if the congressional leadership sent a select committee into a room to cut a deal, the leadership wouldn't let the committee out of the room until a deal was reached.

To be sure, the circumstances that led to the super committee have been a long time in the making.

The financial markets played a key role. Investment banking and commercial banking were for many years comfortably separated by the Glass-Steagall Act of 1932. Investment bankers were all partnerships, playing with their own money. Their focus was to provide the capital and deals that funded businesses. But that wasn't good enough, so Glass-Steagall was effectively repealed by Gramm- Leach-Bliley in 1999. This broke down the walls between securities and affiliated commercial banks. They could play with other people's money. Much more risk was injected into the system.

The Community Reinvestment Act of 1977 encouraged commercial banks and savings associations to meet the needs of all segments of communities. The pressure through the years forced banks to make risky loans. This, combined with Fannie Mae and Freddie Mac absorbing all these loans with an implicit guarantee from the federal government, kept fueling high-risk loans.

Fast forward to China and U.S. trade deficits. Chinese investors had lots of money and were looking for secure returns. A combination of large sums of cash looking for a home and the invention of mortgage-backed securities created an almost unlimited demand for these financial products. A demand for securities to fill up tranches of collateralized debt obligations (derivatives) contributed to the further decrease in lending standards. When the supply of mortgages began to dry, the industry created a non-traded security based not on actual mortgages, but on the insurance against default of the securities (synthetic collateralized debt obligations).

This house of cards began to fall when only about 15 percent of mortgage holders began to default.

The sad story of the financial system was occurring as U.S. debt obligations were soaring. The current federal budget is about $3.7 trillion. The cost of running the government is approximately $1.3 trillion. With a deficit of more than a trillion dollars, the cost of government is now totally borrowed. …