This proposed settlement has no place in a capitalist economy.

First, a successful housing recovery is essential to the ultimate recovery of the economy. So the implications of any settlement that potentially hurts the housing market are extraordinarily significant for the health of the nation. Second, it is based on principles that are unrecognizable in a nation built on capitalism and hence accountability and the rule of law.

Bank officials have testified in investigations of the robo-mortgage scandal that they submitted up to  10,000 false affidavits per month. Such testimony is effectively an admission of criminal guilt. These people admitted that, on behalf of their firms, they broke numerous criminal laws, most likely including conspiracy, fraud, and misleading the Court.

The banks have attempted to deflect their misdeeds by suggesting that these illegal acts did not harm anyone. The laws were related to process only. The answer to such claims is that they are irrelevant. The banks are acknowledging that they perpetrated victimless crimes on a massive scale. And, each year, I suspect thousands of American citizens go to jail for perpetrating victimless crimes on a far lesser scale.

Moreover, these illegal acts demonstrate disrespect for the mortgage process. This same disrespect for appropriate processes, although not proven to be similarly criminal, is a large part of how our current mortgage mess was created in the first place. The banks ignored many basic underwriting rules in a rush to profit from extending as many mortgages as possible.

At this moment, I suspect the individual state attorney generals have the power, through civil suits and penalties combined with criminal prosecutions, to bankrupt the banking institutions that are guilty of this illegal behavior. This is, perhaps, the ultimate bargaining leverage, and it should only be given up in return for a settlement that will clearly heal the housing market.

Here are the several reasons why the proposed 46-state settlement is such disastrous policy-making:

1. There is no overriding public interest in a settlement of the type proposed at this time. No one believes this settlement will fix the housing market. The state attorneys general are giving up leverage (which exists only through the banks’ malfeasance) in return for what are minimal penalties to these giant financial institutions. As I previously pointed out, large monetary settlements have increasingly become a simple “cost of doing business” for financial institutions that break the rules.

To date, the Obama administration has attempted a seemingly endless number of programs designed to prevent foreclosures and heal the housing market. Each has been introduced with great fanfare and as an innovation that will not suffer from the failures of the previous program. Each has then failed.

I fervently hope that the latest program proposed by the administration will succeed. Unfortunately, I do not believe it will. My analysis, which is shared by professional housing economists, is that housing prices are headed substantially downward, by 20% or more, which will kick off a further weakening of the economy and a self-reinforcing system of foreclosures. This past Sunday, Joe Nocera’s column in The New York Times profiled the analysis of Laurie Goodman, which says we should anticipate that a “staggering” 10 million of the existing 55 million mortgages will ultimately default. The country could not be more ill served by a policy that weakens our ability to ultimately end this cycle of destruction.

2. Since the start of the crisis, my research has indicated that only a radical restructuring of homeowner debt, combined with innovations in housing finance, will end the crisis. Prior to the bailout, Obama had the opportunity to bring banks to the table to negotiate this necessarily extraordinary change. The opportunity was missed. We bailed out the banks, but not homeowners.

Now a second opportunity exists. The state attorneys general have the ultimate leverage to demand a restructuring of the housing market without legislation. Right now we don’t know what this should look like or what form it should take. But to give up this opportunity—until the statute of limitations is exhausted—would be inexcusable.

3. The banks (and even some government officials) assert that a settlement will spur a recovery of the housing market and the economy. This is absolute nonsense. In the words of MIT’s Simon Johnson (emphasis added):

With roughly a quarter of all U.S. households with mortgages owing more on their loans than their homes are worth, it’s no surprise that consumption, which accounts for 70 percent of gross domestic product, is restrained.

The consequent lack of demand discourages business investment, which means job creation remains weak. People are afraid of losing their homes and that fear keeps spending down and thus prevents them — and their neighbors — from getting jobs.

What can be done to break this vicious circle? One suggestion from some officials …– and of course many banks — is to accept a relatively small amount of money to settle the various robo-signing and other mortgage document cases that state attorneys general are pursuing. The claim is that this would put the banks back on their feet and spur lending. This is a complete illusion.

4. State attorneys general working in a coordinated action may sound positive. But in fact, it violates (at least in principle) the notion of federalism and state sovereignty that is a vital part of our Constitutional government. The federal government is the place for coordinated national action.

Many of the programs that ultimately formed successful aspects of the New Deal were first developed by FDR as Governor of New York. In effect, the states are laboratories for experiments, which can then be expanded in scope through the federal government. At a time when economic uncertainty is so high, we should not abandon the virtue of multiple experiments by individual states.

5. It is by no means clear that this settlement will have a meaningful impact banks’ behavior. This behavior has been so egregious that even The Wall Street Journal has been forced to acknowledge it.  The idea of entitlement is anathema to a capitalist system. Yet the more we punish massive rule-breaking with the equivalent of a slap on the wrist, the more we create the impression – among the general citizenry and the elite—that we no longer have a fair capitalist society.  As a consequence, the settlement has a strong chance of encouraging further misbehavior.

6 As economic inequality grows, political polarization increases and legislatures become paralyzed. This was a central conclusion of my book It Could Happen Here. Sadly, we are seeing this today.

In contrast, the robo-mortgage scandal provides an opportunity for action by courageous individuals (state prosecutors and attorneys general) that does not depend on a consensus, which almost certainly prevents innovation. These individuals can make a difference in the lives of millions who suffer today—even as our Congress fails to act. I hope they do not shrink from this awesome responsibility, one that they may not have sought but nonetheless possess.

The New York Times reports that “a handful of state attorneys general became so troubled by the direction this deal was taking that they dropped out of the talks. Officials from Delaware, New York, Massachusetts and Nevada feared that the settlement would preclude further investigations, and would wind up being a gift to the banks.” These attorneys general are to be commended, and the other states should follow their example. Hopefully, their stance will not weaken over time.

There is no reason to violate the capitalist ethos, which is built on accountability and the rule of law, by agreeing to a multi-state settlement. This ethos and the accompanying rules of behavior are what made us a great nation.  The far wiser policy is to develop an understanding of what actions will heal the housing market and work toward implementing a policy that realizes them.

Next in this series: Confusing Creating Profits with Creating Real Societal Wealth.

“Equal justice under the law” is a cornerstone of the American Republic. In statues, Lady Justice is blindfolded to symbolize that justice is blind to the differences between the powerful and the weak, the rich and the poor. Today, I fear that Justice’s blindfold is in tatters, and equal justice under the law has become a myth in the American economic system.

Capitalism is not an abstract ideal. It is a set of rules and principles that, over the past two centuries, has combined with democracy to create a great America. Yet without blind, impartial, and equal justice, capitalism simply does not work.

The life-blood of any capitalist economy is the idea that a fair bargain is binding. Indeed, this principal was enunciated in the early days of the Republic in the famous Dartmouth College case, when the Supreme Court ruled on the sanctity of contracts. A natural corollary of this principle is the notion that it will be enforced by our justice system with equal vigor for all of the parties to the contract.

There are four broad principles associated with criminal law that apply to a capitalist system:

First, stupidity — no matter how great or how extreme the consequences — is not a crime. Poor, high-risk decisions that led to the financial crisis are not, in themselves, criminal. Indeed, no economy can thrive if bad decisions carry criminal penalties. Crimes are violations of specific laws.

Second, there are at least two purposes in prosecuting an individual for criminal misconduct: punishment for misbehavior and changing behavior within the larger society. When a crime is prosecuted, it has a deterrent effect. The prosecutor is sending a message to the general public and anyone else contemplating such crimes in the future that this behavior will not be tolerated.

Third, prosecutors have discretion in pursuing a specific individual for an alleged criminal act. I have spoken with a host of prosecutors with regard to the financial crisis, and the most common answer is “these are hard cases to make” and “the budget to prosecute a complex financial crime is extraordinary.” As a result, civil settlements, where the banks pay large financial penalties, have come to rule the day. (However, as discussed below, in many instances egregious violations of the laws make these easy cases to make.)

Fourth, as should be obvious, no individual in our society has the right to decide whether a law is irrelevant. Laws are the rules that everyone is expected to follow. This applies to everyone citizen, no matter how high or how low they stand in our society.

Now, let’s return to the financial crisis. In simple terms, three types of behavior have been documented: (1) “bad actors” who knew they were probably acting immorally but were not breaking the law, (2) activities that were most likely criminal, but without a trial no one has admitted to criminal behavior, (3) and admissions as testimony in open court of massive violations of the law (the robo-mortgage scandal is one example) with no prosecutions.

The consequences of the second and third type of behavior are inevitably calamitous for a capitalist economy. Business activity relies on the belief that, after the buyer and seller (or borrower and lender) have done all of their due diligence, our society will ensure that those who perpetrate false contracts will be punished. Fraudulent bargains will not be allowed. The alternative is massive uncertainty and a dysfunctional economy. For example, if a business person can’t rely on the law to protect his or her rights in a transaction, the individual is not going to enter into new contracts. The net result: Less investment, less economic activity, and far less innovation.

The SEC recently announced a $285 million dollar civil settlement with Citigroup. The firm had sold securities to investors and then turned around and shorted these same securities. The bank not only believed the securities would decline in value, but it actually spent its own money to make money off the terrible product it had sold to customers. Suppose I am in the jewelry business and I pretend that I am selling you a diamond that I know is really glass. I strongly suspect I would be guilty of some type of criminal fraud and would probably go to jail. At a fundamental level, I fail to see the difference between the jeweler and Citibank. Both have swindled the customer.

(Some readers may be thinking about the sophistication of the investors and the many agreements they probably signed disavowing representations by Citigroup. However, the fact of the settlement suggests that improper behavior absolutely occurred — if not, Citigroup would have fought the settlement. In addition, there is a strong argument that agreements that insulate any economic player from blatant misrepresentations should be void as against public policy.)

In a larger sense, the many financial institutions that have entered into settlements of hundreds of millions of dollars with the government are aware of all of the issues discussed above. My analysis is they have settled for two reasons: they don’t want to risk criminal prosecution and they don’t want the full details of their behavior to be discussed publicly in open court. And as noted in my earlier article, these settlements have become simply a “cost of doing business” for our increasingly monopolized financial sector and are unlikely to impact its behavior. In discussing the recent Citigroup settlement, The New York Times noted:

The settlement will refund investors with interest and include a $95 million fine — a relative pittance for a giant like Citigroup. On Monday, the company reported that in the third quarter alone it earned profits of $3.8 billion on revenue of $20.8 billion.

The message to people and entities, large and small, is that they cannot rely on a blind justice system to protect them from unscrupulous transactions. The idea of fair dealing — which is at the heart of our economy — is breaking down. This implicit message also erodes the underpinnings of a vibrant capitalist economy. The rich and powerful can violate the law and will receive a slap on the wrist. As a result, the rights of the less powerful entities, which were violated by these elites, will not be protected by our justice system.

Sadly, it gets worse.

It can be argued that it is not absolutely clear that the many civil settlements do in fact reflect violations of criminal law. With limited public records and no prosecution, financial institutions can assert that I lack all of the relevant facts in my discussion above and that the decision by the government to limit enforcement to civil action is proof that no laws were broken. I disagree, but it is arguable. In contrast, there are areas where there is no question the law was massively violated. Financiers have admitted it. The cases are open and shut. Yet no prosecutions have occurred.

Both cases reflect the ultimate destruction of a capitalist economy. They prove that some participants are above the law. The concept of fair dealing collapses.

Moreover, small businesses, which are repeatedly recognized as a key source of new jobs, are the hardest hit in an economy where a bargain is not a bargain and laws are not equally applied. These businesses have the fewest resources to ensure their rights are protected. A new calculus is added to all of their activities: Will they be treated in accordance with the rules that govern our society? If not, how can they possibly risk new activities where their rights and potential profits can evaporate because Justice no longer wears a blindfold?

The consequences of the prosecutorial failure to indict even the most egregious violators of laws associated with the financial crisis are high:

First, it encourages the belief among our financial elite that they are above the law. The dangerous sense of entitlement I referenced in my earlier article is reinforced. A vibrant capitalist economy depends on what an individual accomplishes, not who they are. Financiers can, perhaps rightly, assume that no matter how badly they corrupt our capitalist system they will be spared any meaningful penalties.

Second, I would suggest that if prosecutors sent one banker to jail, they would cause a change in behavior throughout our financial institutions. If prosecutors looked for the person who most obviously violated the law, has already admitted it (so this is an easy case), and sent this perpetrator to jail — the deterrent effect would be high. Instead, the absence of prosecutions effectively validates ongoing criminal misbehavior throughout the financial sector.

Third, as these cases are publicized, the public loses faith in our judicial system. Vibrant capitalism depends on the belief that everyone is treated fairly — and bargains will be fairly enforced.

Finally, capitalism is, in part, based on the Horatio Alger ideal. If I play by the rules, the benefits of my work and innovations will accrue to me. When people lose faith in this ideal, they stop taking the type of risks that create great innovations. Now potential innovators must wonder whether law-breaking financiers will ultimately co-opt the societal wealth they may create. As their confidence in the fairness of the system erodes, so does their willingness to risk creating the new companies, and attendant jobs, the nation so badly needs.

Now let’s return to the protestors on Wall Street. Almost 3,000 people have been arrested for activities that caused minimal, if any, injury to our society. At the same time, no financiers have been arrested for blatant legal violations, probably including extensive fraud, which have led millions of people to suffer and have practically brought our great nation to its knees.

There is constant discussion in Washington of economic healing and economic recovery. These can only happen when we return to the primary principles that made us a great nation. One of these paramount principles is that our capitalist economy requires a new blindfold for Lady Justice.

Next article in this series: Creating profits does not necessarily create societal wealth.

This is the first in a s series of articles that explores the nature of a well-functioning capitalist system and how this system is now applied to the occupants of the buildings on Wall Street and those who are, quite literally, on The Street.

Capitalism is not an abstract ideal. It is as real as any market or currency. And it is the organizing principle that has, for over two centuries, powered the strength and resilience of America.

As we think about capitalism, it’s also useful to make an important distinction: It’s not what you say, it’s what you do. You may espouse capitalist ideals, but if you oppose responsibility, dishonor contracts, oppose competition, and embrace government subsidies, you are not a practicing capitalist.

For capitalism to work, there are several fundamental requirements: accountability, equal justice under the law, a clearly articulated purpose (and accompanying cost) for government subsidies of a specialized class of citizens, competition, and a relationship between the creation of profits and the creation of real wealth for the larger society.

Many of the protestors in New York City and around the country are jobless college graduates. The majority in all likelihood financed their education through federally subsidized student loans. A central characteristic of today’s generation of student loans is that, unlike most debts, they cannot automatically be discharged in bankruptcy. As a consequence, they are one of the few expenses in our society for which an individual is likely to be accountable throughout his life. As a nation, we teach our most promising youth, from the age of 18 on, the importance of accountability. We use the federal government to subsidize an investment in human capital. In return, the beneficiaries enter into a lifetime of responsibility and accountability. It is a sacred contract. It is arguably one of the best, and potentially harshest, lessons of accountability associated with capitalism in our society today.

Now, let’s contrast this high accountability with the behavior that occurred in our financial sector. When our largest financial firms created havoc in the U.S. economy through undisputed greed, mismanagement, and extreme risk, some important things happened. First, the government bailed the companies out without demanding any substantial change in behavior, and then the individuals responsible were not held accountable through civil or criminal law. As a result, the people who brought the nation close to the brink of economic collapse and caused untold pain and suffering — which continues to this day — returned after a brief hiatus to record levels of compensation. Individuals who earned tens of millions of dollars continue to earn these extraordinary sums. They have never been called to account for their deeds.

Can this be right? What about the many civil settlements negotiated by the federal government and the SEC? I would argue that, in light of the extraordinary profits these firms and individuals generate, such settlements are now viewed as a “cost of doing business.” They appear to have almost no impact on the behavior or attitude of the nation’s financiers.

Now let’s contrast the kids on the street with the employees of The Street. The kids are accountable for their debts. They know it, and they simply want jobs so they can fulfill their civic responsibilities. In contrast, the occupants of the building on Wall Street act as if the rules of accountability — which are central to a viable system of capitalism — apply to everyone except them. Instead, many of the Wall Street elite have developed a dangerous sense of entitlement.

I would argue that in a true, competitive capitalist society, the idea of entitlement is anathema to all participants. It suggests that rewards are disbursed because of who people are, as opposed to the tangible wealth they create for the nation.

It’s worth noting that old timers on Wall Street may still remember that until 1970 the New York Stock exchange mandated that investment banks be organized as some of the most accountable businesses in existence. Prior to going public, in the late 20th century Wall Street firms were organized as old-fashioned partnerships. The central idea of these partnerships was that every partner was fully liable for all of the debts incurred by the firm. If the partnership could not meet its obligations, the partners were required to meet these obligations with their own funds until they were personally bankrupt as well. It was a self-policing system that provided high incentives for investment banks to manage the risks they undertook. When every partner is liable, each has the highest possible incentive to ensure that the firm is not exposed to potential default. If they fail in this responsibility, both the firm and the individual partners can be wiped out. This rule was meant to avoid precisely what happened in the financial crisis.

Now these same publicly held financial institutions have been bailed out by the government and the high-paid executives are apparently immune — both with respect to their pay, their sources of employment, and their personal funds — from any day of reckoning.

The philosopher John Rawls is widely recognized for his theories of justice. In one exercise, his “veil of ignorance,” he suggests that if you are faced with a decision you should pretend you don’t know what kind of participant in the process you will be, so that “everyone is impartially situated as equals.” Since you are blind to your own interests, you are likely to develop the fairest answer. (I have found this to be the perfect exercise for sharing desserts. I cut the cake and then let each individual choose a piece. Since I don’t know what piece I will end up with, my cutting is far more likely to divide the pieces equally.)

Now let’s apply a variant of Rawls’s ideas to the situation on Wall Street today. You are a visitor from a foreign country or an alien world with no knowledge of Wall Street or capitalism. Then the principles of capitalism are explained to you and you are asked to identify the capitalists in this confrontation: the people in the buildings or the people congregating on the street. Which would you choose?

In a few days, President Obama will deliver his State of the Union Address. Right now, Martin Luther King Day is upon us. Both events suggest that it is a particularly appropriate moment for every American to stop and think about our society.

As a nation, have we made progress in realizing the vision articulated by Dr. King? Are we closer or further from living the virtues he described? In 1980, Ronald Reagan famously asked “Are you better off now than you were four years ago?” What percentage of Americans would answer that question affirmatively right now?

America today is characterized by excess, anger, mistrust, polarization, increasing pessimism, self-interest, and a lack of accountability. Of even greater concern, we are becoming a nation that is accepting the unacceptable.

In October 2008 when unemployment hovered between 6% and 7%, Barack Obama declared that we were in the middle of “an economic emergency:”

We face an immediate economic emergency that requires urgent action. We can’t wait to help workers and families and communities who are struggling right now – who don’t know if their job or their retirement will be there tomorrow; who don’t know if next week’s paycheck will cover this month’s bills.

With an unemployment rate now in double digits and at least 50% higher than the level in October 2008, President Obama says “there is only so much government can do.” Meanwhile, millions of people are suffering in a crisis of our own making. A crisis that is the result of what Paul Krugman recently called “the dysfunctional nature of our own financial system.” Yes, the President has proposed additional spending to create jobs, but few authorities expect that it will have a significant impact on our actual level of employment. But, few believe this program will have a meaningful impact. Robert Reich writes, “the chances of unemployment being 10 percent next November are overwhelmingly high.”

At the same time, the Administration’s housing program is a complete failure, and the nation faces massive foreclosures. As joblessness continues, one in eight mortgages is in default or foreclosure, and half of all mortgages may be underwater within a year. There do not appear to be any serious proposals to keep people in their homes as owners, so an even greater housing crisis may occur later this year or in 2011. It’s the elephant in the room that no one wants to discuss.

In the era of the New Deal, American ingenuity led to a series of job creation programs, social security, the FDIC (which eliminated the scourge of bank-runs), ultimately the GI Bill (perhaps the greatest investment in human capital the nation has ever made). The Roosevelt Administration was also committed to keeping people in their homes as owners, and the precursor to the modern-day 30 year mortgage was one of the central innovations of the era.

How does our response to the Great Recession compare to the age of FDR? To date, the most innovative response to the financial crisis, and the ensuing national misery, has been….TARP?

I refuse to believe that our current situation is the best that America can accomplish. I refuse to believe that we have truly harnessed the legendary ingenuity and resourcefulness of the American nation. I also believe there is a way to move forward and dramatically revitalize our suffering nation.

The president must recognize that more of the same is not good enough. He must stop accepting the idea that our nation is limited in what it can accomplish. He must also realize that difficult moments require strong leadership, not moderation or a search for consensus. Great leaders articulate an unwavering vision that causes people to believe they can accomplish more than they thought possible, and creates a sense that each of us has a responsibility that transcends our own well-being.

What if President Obama were to step up to the podium at his State of the Union message and challenge the nation to achieve 3% unemployment within 2 years? What if he committed the future of his Presidency to realizing this goal? What if he said that America is only America when we have jobs for people that want to work and opportunities for the generation of young Americans that is now threatened with a paucity of prospects? He could create a new sense of possibilities, and awaken a hunger inside almost everyone to ensure we remain a great nation.

Today, it’s easy to oppose any job creation efforts. There is no clear goal, and no stated vision. We are increasingly accepting a two-tier society: those with jobs and those who are forgotten. There is also no clear sense that creating private sector jobs is an act of patriotism. The president has the opportunity to shift these dynamics. By articulating a vision of a better nation, he can stimulate action and bring out the best in our society.

FDR brought hope to a miserable country when he promised, and delivered, “action and action now.” Roosevelt had no clear plan of how he would accomplish his agenda; but he was determined to relentlessly experiment until he succeeded.

Winston Churchill rejuvenated the British nation when he declared, “We shall never surrender,” despite what seemed like impossible odds. It’s worth noting the absolute resolve and determination in Chruchill’s words, which propelled the British people forward:

…we shall not flag or fail. We shall go on to the end, we shall fight in France, we shall fight on the seas and oceans, we shall fight with growing confidence and growing strength in the air, we shall defend our Island, whatever the cost may be, we shall fight on the beaches, we shall fight on the landing grounds, we shall fight in the fields and in the streets, we shall fight in the hills; we shall never surrender…

In a later era, John Kennedy did not know how America would land a man on the moon and return him safely “Before this decade is out” when he challenged the nation to accomplish this seemingly impossible task. But, in his speech before Congress, Kennedy did say:

I believe we possess all the resources and talents necessary. But the facts of the matter are that we have never made the national decisions or marshaled the national resources required for such leadership. We have never specified long-range goals on an urgent time schedule, or managed our resources and our time so as to insure their fulfillment.

We often forget that at the time of Kennedy’s speech, America was a nation shaken badly by Soviet advances in space. JFK responded with strength and determination to restore confidence. By stating a clear goal, President Kennedy created action and momentum.

Moreover, I believe that Kennedy’s description of our innate resources and talent applies, as well, to the nation today. We need Barak Obama to offer this same commitment to America, and to support his words with swift actions and righteous anger.

A few weeks ago I was a guest on WNYC’s Leonard Lopate show. At the end of the interview, I was asked why no political movement had grown up around reinventing our nation – if I believed it was so critical. I paused, leaned back in my chair, and said it had: America voted for change we can all believe in.

In October 2008, candidate Obama said:

This country and the dream it represents are being tested in a way that we haven’t seen in nearly a century. And future generations will judge ours by how we respond to this test. Will they say that this was a time when America lost its way and its purpose? …

Or will they say that this was another one of those moments when America overcame? When we battled back from adversity by recognizing that common stake that we have in each other’s success?

I have not forgotten these powerful words or what our nation sought on election day in 2008. After one year in office, I hope that President Obama remembers as well.

From my perspective, this reflects a growing public interest in the ideas discussed in the book, and how they are applicable to what is happening in our nation today.

From the WNYC home page on January 4, 2010:

Over the next week, I will distill, in writing, some of the meaningful discussion that took place. You can click the picture to hear the interview: