Column: Obamas fury on banks is just politics

Written by Ajay Shah | Ajay Shah | Updated: Jan 23 2010, 07:32am hrs
When Barack Obama came to power, he handed the task of crafting intricate financial reform to the technocrats. Their work has been slowly finding its way through the US lawmaking process. On Tuesday, the Democratic Party lost a critical Senate seat in Massachusetts. Now, Republicans have the 41 votes required to block law. As a tactical response, Obama has embarked on a campaign to harness popular anger against banks. This could improve Democratic vote share, but it could do damage to confidence in the Obama administration and it could damage the prospects for recovery of the world economy.

Obama the candidate had fairly Left-of-Centre views on many things. Yet, when the Obama team came together, there was confidence in its staff quality. Timothy Geithner headed the ministry of finance, Larry Summers was put into a critical position in the administration and Bernanke was retained to run the central bank. All three individuals have impeccable reputations and the world trusted their policy consensus.

The team first focused on getting the economy back on its feet. In the aftermath of a systemic financial crisis, it makes sense to first rebuild confidence in the economy, and slowly move on financial reform. The reasons are two-fold. First, to have confidence about the new medicine that is proposed, one has to have confidence in an understanding of what went wrong in the crisis. And understanding crises is not easy. The passage of time, the full release of data, and the buildup of research papers help in arriving at a sound diagnosis of what went wrong. The second reason lies in the problem of macroeconomic stability. At a time when confidence is low, one does not want to rock the boat. Hence, it is sensible to do financial reform well after the environment of a crisis has subsided.

In the last year, the US Treasury had been slowly making progress on putting down a group of legislative priorities which would incrementally make progress on financial reform. While many of the details are contentious, these proposals reflect the mainstream consensus about what needs to be done.

In public, Obama focused on reform of US healthcare and not on finance which was left to his deputies. The whole story changed when Ted Kennedy, Democratic senator from the state of Massachusetts, died on August 25, 2009. From 1953 onwards, democrats have won this seat. But on January 19, 2010, the election took place, and the Democratic candidate lost.

This came as a shock to Obama. His window of opportunity of being able to do legislation without cooperation from the Republicans had ended. On January 21, he switched tracks drastically, coming out with a populist speech that tried to tap into public hostility against bankers.

The caricature that makes the public irate is that of bankers getting money from the government and paying it out to themselves as bonuses. This caricature is largely inaccurate, but it has aroused widespread anger anyway.

What is Obama proposing One key element is that when a bank benefits from deposit insurance, and access to emergency credit from the central bank, it would be prohibited from doing proprietary trading, and from owning or investing in private equity or hedge funds. (It is not a return to the Depression-era Glass-Steagall Act: they would continue to do investment banking for clients). In addition, Obama proposes to force a reduction in the size of the biggest banks.

Does this make sense Any economist will agree that the concentration of US banking in a few firms is a worrisome feature of the recent yearsbut few would support solving this through government diktat. Instead, it would make more sense to focus on the entry barriers and other regulatory mistakes through which the big banks have gotten bigger.

Banning proprietary trading sounds nice, but as every banker knows, it is hard to really draw the line between agency trading and proprietary trading. Regulators will find it difficult to enforce such a rule, in case it is enacted.

Perhaps the heart of the matter is that a weakened Obama administration knows that the gap between speeches and legislation is now bigger than it was. What is going on now is politics as theatre. Obama is attempting to consolidate his support from the Left and appeal to a middle that dislikes banks today. It is, hence, not surprising that most of the response to Obamas fire is a weary cynicism.

Could there be more at stake If a bigger shift towards populism and Left-wing politics is required, then Obama could choose to disrupt the policy team of Geithner, Summers and Bernanke. If this comes about, then it would be an important piece of bad news for the world economy.

The author is an economist with interests in finance, pensions and macroeconomics