“Some people look at subprime lending and see evil. I look at subprime lending and I see the American Dream in action.”
– Former U.S. Sen. Phil Gramm, Nov. 16, 2008
The reason I bring up the former senator from Texas is that Gramm has been brought on as a senior economic adviser to Republican presidential candidate Ted Cruz.
This isn’t a promising development for Cruz, or the prospect that should he become president he will come up with sensible policies to address the United States’ economic challenges. Why do I say that? Because of what happened in the 1990s and early 2000s when the United States listened to Gramm.
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But first, a more recent trip down memory lane. Gramm, remember, was brought on as an adviser to the presidential campaign of John McCain in 2008. As the economy was stumbling that summer, Gramm said:
“You’ve heard of mental depression; this is a mental recession. We may have a recession; we haven’t had one yet. We have sort of become a nation of whiners. You just hear this constant whining, complaining about a loss of competitiveness, America in decline.”
At that point, the financial crisis was gathering headway: foreclosures had doubled in the span of a year, 1.6 million more people were unemployed than a year earlier, the stock market had plunged 25 percent and the nation was already eight months into the worst recession since the Great Depression. McCain, in a vain effort to rescue his campaign, had to immediately disavow the remarks. Gramm, meanwhile, refused to retract his comments. He was gone from the McCain campaign a few days later.
Not to put too fine a point on it, but I believe – as do many others – that Gramm was one of the major figures who helped set the stage for the crisis. My book “Bailout Nation” included a list of “Who is to Blame for the Crisis” that put Gramm at No. 3 after former Federal Reserve Chairman Alan Greenspan and the Fed itself. I’m not alone: Time magazine placed him at No. 2, while CNN ranked him No. 7.
Just to be clear, Gramm was but one player in the debacle, and blame for the financial crisis is spread far and wide, extending to major figures in both political parties.
But Gramm is the topic today, so let’s start with a list of particulars.
Gramm was a key sponsor of the Financial Services Modernization Act of 1999, also known as Gramm-Leach-Bliley Act, which effectively repealed the piece of the Glass-Steagall Act that had forced commercial banks to shed their investment banking operations during the Great Depression. The end of this separation didn’t so much lead to the financial crisis as remove a key firebreak, allowing the conflagration to rapidly spread throughout the banking system. Recall earlier events before the repeal: the shock caused by the 1987 stock market crash was confined to Wall Street, while the savings and loan crisis of the late 1980s did little harm to the broader economy.
The damage caused by rolling back Glass-Steagall pales compared with what resulted from the Commodity Futures Modernization Act of 2000. Gramm was a co-sponsor of the legislation, which exempted many derivatives and swaps from regulation. Not only was the law problematic, but it veered into potential conflict-of-interest territory.
At the time the legislation was under consideration, Gramm’s wife, Wendy, was on the board of Enron, which as we now know was one of the greatest accounting fiascos in history. Wendy Gramm served on the audit committee, overseeing the finances of the energy-trading giant. Enron, of course, in late 2001 filed the biggest corporate bankruptcy in U.S. history up until then. Before joining Enron, she had served as chairwoman of the Commodity Futures Trading Commission, from 1988 to 1993, where her tenure was the subject of some controversy.
Enron, a once-sleepy utility, was an early adopter of derivatives and swaps. Brooksley Born, chairwoman of the CFTC in the late 1990s, had recognized early on the potential danger these things posed. She rightly pressed for her agency to have regulatory oversight of derivatives.
It wasn’t to be so because of Gramm’s legislation. But there was more. At Wendy Gramm’s urging, then-Sen. Gramm inserted what became known as the Enron loophole into the Commodity Futures Modernization Act. That allowed Enron to avoid most regulation in its energy-trading business. Enron, coincidentally, was a major campaign contributor to the senator. We don’t know what impact the loophole would have had on the company; it collapsed in 2001 due to accounting fraud before it had a chance to collapse due to bad energy derivatives. However, the legislation Gramm pushed had other unintended consequences.
We got a chance to see those consequences a few years later when the American International Group failed, thanks in part to swaps – a form of insurance, really – on $441 billion of securities that turned out to be junk. AIG wasn’t required to put up much in the way of collateral, set aside capital or hedge its risk on the swaps. Why would it, when the law said it didn’t have to? The taxpayers were then called upon to bailout AIG to the tune of more than $180 billion.
Maybe it isn’t too surprising that Cruz would seek advice from Gramm. Cruz, after all, seems to want to hobble modern economic policy by returning to the gold standard. The Cruz-Gramm school of economics doesn’t seem very promising. We have seen these movies before, and they end in tragedy and tears.