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Busch: Repeating The Mistakes Of The Past

As more and more Americans lose their jobs, the US government is following a path of policy decisions similar to those of FDR. As I wrote last fall, the government will attempt any and all possible actions to arrest the slide in the economy. Some will be perfectly legal, some will be ruled illegal later on just like the National Recovery Administration . This experiment in cartelization began in April 1933 and was ruled unconstitutional by the US Supreme Court in May of 1935.

Under the

Freedom of Information Act

, Judicial Watch (JW) has obtained copies of the minutes of the October 13th meeting between US Treasury Secretary Hank Paulson, NY Federal Reserve President Tim Geithner, and FDIC head Sheila Bair with the major banks. According to JW, the Treasury Department meeting

..."coerced major banks to allow the government to take $250 billion equity stakes. Among the other news, the documents confirm former Treasury Secretary Hank Paulson told the CEOs of nine major banks that they had no choice but to allow the government to take equity stakes in their institutions......"if a capital infusion is not appealing, you should be aware your regulator will require it in any circumstance."

In this vein, we're getting rumblings from the Obama administration to overhaul pay practices at financial companies. On the surface, no American voter would be against regulating pay that was tied to excessive risk taking that now has to be paid for by the same voter. However, the reach and direction this goes in is what is disturbing. The WSJ reports that the White House has begun serious talks on how it can change compensation practices across the financial-services industry, including at companies that did not receive federal bailout money. "Among ideas being discussed are Fed rules that would curb banks' ability to pay employees in a way that would threaten the "safety and soundness" of the bank -- such as paying loan officers for the volume of business they do, not the quality." No word yet on just exactly how that would be determined.

Lastly, Federal officials, including US Treasury Secretary Tim Geithner , said late yesterday said that they intend to regulate the giant market for derivatives. The plan is to force many standard over-the-counter contracts to go through clearinghouses that will guarantee trades and help cushion the impact from a collapse of a large financial institution. Clearly, regulators are targeting credit default swaps which was the weapon of choice that killed AIG. The repeal of Glass-Steagall contributed to creating an environment of risk taking by banks that lead to excessive pay and the use of arcane products like CDS.

Unfortunately, there are many more derivative products other than CDS like vanilla swaps and foreign exchange. The concern is that by forcing as many products as possible on to exchanges, the banks will lose their ability to provide tailored services to clients and to earn income from these services. This income, in turn, allows banks to lend to corporations to generate growth.

Not all aspects of what the government is attempting to do are wrong. But from the Paulson coercion experience, we can see the potential problems that may arise as Congress and the White House attempt to gain control over the financial services industry. My belief is that this sector will become much more like a utility such as electricity or nuclear power with heavy, heavy regulation. Typically when you regulate an industry, the prices are also regulated (think credit cards) and the amount supplied is reduced. These actions won't be just limited to the financial industry as the auto industry and newspaper industries are asking for help and possibly regulations as well.

Taking this back to the Great Depression, it wasn't until after WWII when prices for labor and goods were allowed to be set by the market that the US economy returned to growth. Ultimately should these actions go too far, they will elongate the recession rather than end it.

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Andrew Busch
Andrew Busch

Andrew B. Busch is Global FX Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece andreach him here and you can follow him on Twitter at http://twitter.com/abusch .