1. The final version Dodd-Frank Bill fails to resolve the fundamental problems of the US financial system in two ways. First, it enshrines the policy of “too-big-to-fail” without limiting the behavior that led to the catastrophic collapse of 2008-9. Second, it does nothing to do shrink the excessive growth of the financial system itself, which has diverted the country’s capital, credit and managerial talent away from the competitive production of goods and services into debt-driven speculation.

The new financial “reform” fails to replace Glass-Steagall, which was repealed in 1999. Thus, the inherent conflict-of-interest that occurs when a bank is both lender and investor remains.

Dodd-Frank does establish rules for more transparency. But they tend to be in markets that were not major causes of the crisis, such as interest-rate derivatives and other traditional hedging securities. The higher risk (and therefore more profitable) derivatives, such as interest rate swaps, which were much more important in creating the financial collapse, will continue to be traded outside effective regulation. Another major contributor, the system of having rating agencies paid by bond issuers, was not reformed.

A new consumer financial protection agency was established. This represents some progress. But its effectiveness is likely to be limited since it will be administered by the Federal Reserve, whose priority is to keep banks and investment companies  profitable.

Many of the important issues, such as rules governing proprietary trading and minimum capital reserves will be left largely to the regulatory agencies. But little was done to restrain the revolving door of personnel moving between regulators and financial institutions that have made these agencies captives of the industry.

From the economic growth perspective, the core problem is not that some companies are too big to fail. It is that the entire sector is too big relative to the rest of the economy. Over the last 30 years, the finance industry has shifted away from providing credit to businesses producing goods and services that raise living standards to providing credit to itself for speculation, leveraged buy-outs and the trading of assets.

In 1979, the debt of financial corporations was roughly one-third of the debt of nonfinancial businesses in the US. By 2007, finance industry debt was over 150 percent of all corporate debt in America. This huge diversion of  credit into the financial markets encouraged a shift in investor expectation towards shorter term and riskier profits, the opposite of what the country and the world need.
The simplest and most effective way to restrain a sector in a market economy of course is to tax it. But the power of the financial lobby in both the Congress and inside the Obama administration prevented any serious consideration of a securities transfer type tax.

2. Calls for austerity are generally rationalized by the claim that the global bond markets, fearing inflation, demand it. But there is little evidence today that global investors are worried about inflation. Interest rates are low and there is an abundance of capital. In the US for example, bank reserves have risen from about $20 billion 2007 to over $800 billion today. Bankers and bond underwriters are not holding back because they think inflation is around the corner. They are holding back because there are not enough business opportunities because unemployment is high, incomes have flattened and worker/consumers are worried about their future.
In this context, the claim that we must starve the economy in order to encourage investment makes little sense.  As the recent financial crash indicates, no one knows what the bond markets will do.  If anything, the recent experience of Ireland suggests that austerity has the opposite effect. The Irish government tightened budgets in order demonstrate its “fiscal responsibility” to  global investors. The predictable result was a slowdown in growth, making Irish business prospects less attractive. So, today international investors are demanding a roughly 3 percentage point premium on their loans in that country.

Slow growth and high unemployment erode skills and work habits and technological progress. History shows us that such short term losses are rarely ever made up in the long-term. Moreover, for purposes of economic policy, the terms “short-term” and “long-term” really do not refer to time, but to economic conditions. Thus, for example, it is absurd to establish a goal of balancing government budgets by a certain year. We should not be balancing budgets before we return to full employment, no matter what they actual date.

3. President Obama’s fiscal stimulus policy in early 2009 clearly worked. The data show that it stopped the free-fall in both overall economic growth and in labor markets. The problem is that it was not enough. Inside the Administration, economists calculated that the economic conditions required a rise in the deficit of some $1.2 trillion. But fear of conservative criticism led them to limit the stimulus to $789 billion. So, while the stimulus prevented the economy from falling into a Depression, it was not enough to generate an actual robust recovery.

The US needs a new stimulus in the order of at least $400 billion, which would put roughly 4.5  million people back to work and jump-start private spending and investing. But at this moment it is politically impossible.

Inside the Administration, most economist understand the need for more stimulus now. But the political Right has used the fear of a rising deficit to stop Congress from acting. The Republicans are of course hypocrites – Reagan and the two Bushes both used deficit spending to fight downturns. But the public is confused; many even believe that the deficit is the cause of high unemployment! Democrats, including Obama, have contributed to this public confusion by failing to educate people on how the economy actually works.

Obama’s argument for not cutting back on government spending at the G-20 meeting was correct. But it was not credible because other leaders knew he had not been able to persuade his own Congress. In an effort to appeal to conservatives, he himself has ordered a freeze on Federal domestic discretionary spending Incidentally, Democrats have the power to change the dysfunctional rule that requires a 60 percent majority for bills to pass the Senate, which would probably give them the votes for a more expansive policy. But they are simply too timid to try.

4. Making balanced budgets a strict rule would doom the Eurozone. A more centralized and coordinated monetary and fiscal policy system is necessary. But if that policy leads to high and sustained unemployment and erosion of real incomes for the majority of working people,  it will simply exacerbate nationalist resentment, both in the stronger and weaker economies.

A few weaker countries might carefully withdraw from the Eurozone, leaving them free to pursue expansion through currency depreciation. But the withdrawal of the stronger economies would be both a political and economic disaster for Europe.

In order save the situation in both Europe and North America – and by extension the global economy itself – we need a general agreement among all of the leading nations for coordinated reflation.

Insight on-line Rome, Italy, September 2010.