Why has Washington adopted policies that tilt against the interests of traditional banks? Partly because of its own indiscriminate spending.

Government is now co-opting funds that would normally flow to private-sector markets. Moreover, policymakers may be manipulating the financial and banking systems to aid in funding the debt.

Federal Reserve flow-of-funds statistics show that in 1986 the U.S. government, its agencies, state and local governments, and sponsored mortgage pools took $401 billion out of the debt markets. This was 35% of the $1.149 trillion raised by all sectors of the economy in that year.

Public-sector demand declined to $284 billion by 1988, and this was 29% of the $987 billion raised in the debt markets that year. However, by 1991, government demand for debt rose to $459 billion - an incredible 74% of the $617 billion raised in that period.

Funds Shrink as Demand Grows

But the problem is more complex than those numbers show. And, the administration's little-acknowledged national financial policy, which I discussed April 30 in the commentary that began this series, would offer no solution.

Because of the government's regulation of depository institutions, banks and thrifts no longer may provide the funds they once did to make purchases in the financial markets. So as governments demand for funds has expanded, the supply of domestic funds has contracted.

Banks and thrifts went from being net providers of $302 billion to the markets in 1986 to being net withdrawers of $65 billion in 1991. This swing of $367 billion accounted for 69% of the $532 billion decline in the size of the domestic debt markets during those years.

Squeezing Others Out

If new sources of funds do not become available, other users of money will continue to be forced out of the debt markets as the federal government takes every available dollar for its own needs.

Foreigners, in the past, provided some of these funds. In 1986, foreign lenders provided $98 billion to U.S. domestic borrowers. By 1991, however, the foreigners were unwilling to lend more money.

Therefore, the federal Reserve had to print money to monetize the federal debt, a highly inflationary procedure. In 1991, for example, the Fed bought $31 billion of the government's new debt.

The need to fund government debt is the top priority of policymakers at the Treasury and the Federal Reserve. Funding the debt is critical to the survival of the U.S. financial system, the nation's economy, and perhaps even our form of government.

Manipulations to Fund Deficit

It is also evident that the Treasury and Federal Reserve control the key elements of financial policy in the United States, including those that determine the direction of the banking system.

In essence, these agencies can manipulate both overall policies and, more specifically, banking policies to help fund the debt.

It is not Machiavellian to assume that, sometimes, financial policymakers will use their power to help the government meet its debt obligations.

Congressional Emotions

It would be a mistake to underestimate Congress' frustration and rage at the savings and loan debacle and the Michael Milken stock and bond scandals.

Lawmakers' perception was that the system was out of control and that it was impossible to bring it back under rational supervision.

Difficulties with savings institutions first came to Congress' attention in 1966. Rates on short-term Treasury securities had risen above that was called at the time the "Magic 5's."

Regulation Q was being used to normalize savings rates nationwide, and some California institutions almost collapsed.

Government Activity Futile

For the next 15 years, regulators and legislators tried to solve the problem. Their efforts led to a number of bills, culminating in the deregulatory freedoms of the Garn-St Germain Depository Institutions Act of 1981.

By 1986-87, it was apparent that all the time and effort had accomplished nothing. Savings and loans were failing, and the eventual costs would be hundreds of billions of dollars.

It became conventional wisdom that no one had any concept of what actually was happening in the savings sector. Yet the debt-burdened U.S. government had to use hundreds of billions of tax dollars to neutralize the industry's money problems.

Extending Logic to Banks

If no one understood or could solve the thrift industry's problems, it was logical for Congress to believe that the same was true of banking's problems.

Trying to resolve the unresolvable, Congress panicked, sending regulators on a witchhunt that worsened banks' problems.

In 1991, Congress passed what William Isaac, former chairman of the Federal Deposit Insurance Corp. and now chief executive of the Secura Group, called one of the most regressive pieces of bank legislation ever.

Repeated examples of fraud and outright thievery apparently rampant among thrifts taking advantage of the more liberal provisions of the Garn-St Germain Act were among the more enraging aspects of the thrift debacle. Rep. Fernand St Germain himself left Congress under a cloud of suspicion.

Total Regulatory Breakdown?

The Wall Street scandals involving Dennis Levine, Ivan Boesky, Michael Milken, and others chronicled so well in James Stewart's book "Den Of Thieves" confirmed congressional belief that the regulatory structure had broken down.

Congress felt unable to assume that anyone in the regulatory agencies was uncorrupted or had the ability to assess what was happening in any part of the financial industry. The previously well-regarded system for detecting and preventing fraud in U.S. securities markets had seemingly ceased to exist.

The Securities and Exchange Commission, the New York Stock Exchange, the National Association of Securities Dealers, and other organizations had simply stopped meaningful monitoring of the markets for fraud.

Respected financiers were going to prison for fraud, but no victim was compensated. Fines levied by the SEC went into the Treasury and indirectly, some might argue, back to the SEC.

In 1990, Washington discovered it had a malfunctioning regulatory system, particularly in the depository-institution sector; a credit shortage; and a falling stock market. The economy was moving into recession, and unemployment was rising.

Meanwhile, the system of subsidized public borrowing has broken down, from the government's perspective, and the Federal National Mortgage Association is perhaps the best example. This is true even though no one can point to anything negative in Fannie Mae's operation - unlike thrifts, banks, and Wall Street.

Fannie Mae is unusually well managed and free of fraud. In many respects, it was a paradigm of a U.S. corporation.

Its profits have been growing at 30%-plus rates for years. Its stock price has multiplied, and its executives are among the highest-paid in U.S. industry.

Fannie Mae's Mission Failure

However, despite all those accolades, Fannie Mae did not prevent the decline of housing production in the United States to historically low levels.

While private entrepreneurs might respond, "So what? Fannie Mae's job is to produce profits for its stockholders," this is not the government's view.

A good part of Fannie Mae's profit comes from its borrowing at below-market interest rates. It can do this because buyers of its paper believe the federal government has guaranteed all of the agency's debt.

Baffling Move

The government wants Fannie Mae to be able to borrow money at low rates in order to stimulate housing production. Otherwise, there is no reason to let lenders believe in a government guarantee.

To add insult to injury, Fannie Mae made its money, in part, by shifting private unsubsidized debt on existing loans to implicitly guaranteed debt - a liability of the U.S. government.

Just as in the case of Fannie Mae, the government wants banks and thrifts to attract deposits at favorable rates under FDIC guarantees so that they will make good loans and stimulate economic growth.

It wants the stock market to function smoothly so that corporations will be able to fund capital expansion.

The government has demonstrated its willingness to pay for these outcomes with guarantees of financial-institution debt, tax abatement policies, and direct intervention. The problem, again, is that the government is not getting what it paid for.

Economic Goals Not Met

Entrepreneurs, stockholders, and market manipulators are all benefitting, but housing production is low, the economy went into recession or a slow-growth mode, and unemployment is relatively high.

What the government is getting is the right to share in the losses from every scandal, debacle, or failure. The government is the silent, unpaid partner in every successful venture and the only partner, it would appear, in every loss.

But it simply cannot afford the cost. The government needs every dime it can raise to cover its own deficit.

A simple solution to the government's problems would have been to eliminate debt guarantees. However, this was not politically acceptable and could have created financial chaos.

False Issue: Capital Ratios

Therefore, a less direct solution was devised. The government needed to create a false issue and, by resolving it effectively, deal with the real issue -- reducing the expanding liability implicit in debt guarantees.

The mechanism adopted was to force depository institutions to increase their capital ratios. More capital was demanded in relation to assets.

The capital issue is a false one because no one in government has devised a way to determine how much capital is in the banking and thrift industry.

No one can point to any instance of a bank failure's being prevented in the 20th century by high levels of capital in the banking system. Conversely, capital-rich banks have failed.

And no one at the Fed has ever completed a study to determine how much capital in the banking system helps the economy or how much hurts it.

Forcing capital ratios higher, however,is ideal for accomplishing the government's goal of reducing its liability for excesses in the private sector.

It sounds logical. Ratios are easy to establish, adjust, and monitor. And numerous tools exist to keep a bank's capital ratios from rising to levels that would be self-defeating. For example, reserve requirements can be altered to cut bank capital.

Most important, the technique of raising bank capital requirements works superbly if the goal is to reduce government exposure to FDIC insurance liabilities. Banks must slow the growth of, or actually cut, assets.

Directing Bank Loan Policies

Since fewer loans are made and since loans create the deposits that become the base of the FDIC's liability, their reduction eases the government burden.

Another important aspect of the capital-ratio approach is that it can be manipulated to direct bank lending policies.

For example, establishing lower capital ratios for funds invested in Treasury bills than for loan assets given banks incentives to lend into the Treasury market. And that reduces pressure on the Fed to print money and on the government to prop up the banking system.

In my next column, I will discuss the likely outcome of the current financial policy and the characteristics of the institutions that will emerge as winners.

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