The Real Banker Backlash
An interesting point from Gillian Tett who observes that the real populist backlash against the financial industry is likely to come when the bill genuinely comes due in the form of the need to massively reduce deficits in the 2011-13 period:
Perhaps that will occur when income taxes are hiked above 50 per cent. Or maybe when hospital budgets are cut, or military spending slashed. Either way, the potential list is long. While that might cause political instability (which, of course, would be bad for bond markets) it might trigger a renewed, vitriolic round of bank-bashing – particularly if voters in 2011 or 2012 know that 2010 was a year when banks paid out more, massive bonuses.
No wonder that some financial officials and politicians are frantically pleading with bankers behind closed doors to show more restraint in their current bonus round. “Don’t the bankers realise what could be coming?” I heard one senior western finance official tell a room full of bankers this week, as he argued – with passion and a sense of desperation – that it would be a mistake for banks to pay big bonuses.
But even if one firm’s management accepted the logic of this claim, there would be a collective action problem. People would want to go work at the firms that were still paying out the big bonuses. Under the circumstances “frantically pleading” couldn’t possibly work, you would need to actually force them to stop, perhaps through the kind of bonus windfall tax proposed by Martin Wolf.
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How Vindicated is Tim Geithner?
David Brooks has a good column today arguing that Timothy Geithner’s approach to the financial crisis has been vindicated and that actually one of the most roundly criticized aspects of the Obama administration’s approach has worked out well.
He makes strong points, but I would have tempered this a bit. Brooks writes that it “now seems clear that nationalization would have been an unnecessary mistake — potentially expensive and dangerously disruptive.” But he also notes:
In the next few months, Geithner will be confronted with a cross-cutting set of pressures. First, the need to reduce the deficits, which is uppermost on his mind. Second, the rising populism in Congress, which has to be battled sometimes and appeased sometimes by an administration that hopes to get things passed. Third, intense public cynicism about government, which means that every debate is washed in negativity.
Most important, there’s the jobs situation. If job growth returns, that will be a sign that the recovery is normal and Geithner and the administration can return to a more moderate path. If employment does not rebound or the economy double dips, that will be a sign of systemic problems. Geithner and his colleagues will probably adopt a much more activist posture and have to throw their lot in with the left.
I think these challenges underscore the fact that even though Geithner’s approach worked a lot better than his critics were inclined to say*, they also haven’t worked all that well. The unemployment rate is much better than people feared it would have been without a financial rescue, but it remains unacceptably high. And the problematic political situation seems to me to be largely a direct result of the government’s failure to capture a larger share of the financial upside associated with post-TARP large financial services firms. The way the Chrysler/GM bailouts were structured, if either firms becomes wildly successful in the future, the US taxpayer will get a very handsome payout. But the services rendered to Goldman Sachs and JP Morgan and the rest were not similarly oriented. The TARP money was “paid back” but the taxpayer hasn’t gotten anything resembling a fair share of the upside. This has created a situation in which it’s very difficult for the government to take further steps in really any direction.
The Appeal of Incoherence
Ross Douthat is back to blogging. Here he takes on the new conservative populism:
From Glenn Beck to the Tea Parties, much of the energy in the post-Bush G.O.P. is with people who have grasped, albeit sometimes in inchoate ways, that big government and big business are increasingly on one team, and the champions of free markets and limited government are on the other. But they don’t know what to do about it, and what they do seem to know — cutting taxes, and letting the rest take care of itself — is often non-responsive, not only to the problems the country faces, but to the problems they themselves have diagnosed.
Speaking as an Obama administration apologist, I’m glad to see the incoherence noted. But it’s also worth saying that incoherence strikes me as incredibly appealing. The main issue here is, I think, the incredibly unpopular TARP “bailout” bill. I believe that absent the bailout, we’d be looking at even higher unemployment today. But it was and remains incredibly unpopular and has done a lot to sour the public on the idea of activist government. It also raises, I believe, serious questions of moral hazard and social justice. These issues would best be addressed by more stringent regulation and higher taxes on high-income individuals that are used to fund more and better public services. And that’s what the administration is proposing.
But conservative populists, by insisting that the real answer is basically to go back in time and not do the bailout have created a win-win-win situation for themselves. In the congressional debate over financial regulation, conservatives have proven themselves to be slavishly loyal to the interests of large financial firms. And in the congressional debate over taxing the wealthy to expand access to health care, conservatives have proven themselves to be slavishly loyal to the interests of rich financiers. But via their meaningless denunciations of bailouts, they’ve positioned themselves as on the side of anti-banker public opinion. And yet precisely because this rhetoric is so non-credible, they continue to receive generous financial support from big finance and from big business in general. Meanwhile, the public largely holds Barack Obama responsible for public policy even though it’s possible for congressional minorities to thwart his agenda. Thus he so far bears the brunt of public distaste not only for the bailout, but also for congress’ unwillingness to enact his own regulatory agenda.
Moving to a less-incoherent posture would have some real benefits, but also disrupt the current sweet deal.
The AIG Counterparty Negotiations
A lot of the coverage of the new SIGTARP report on the handling of the AIG payouts—and, indeed, the report itself to an extent—seems a bit misleading.
Stepping back, this all began when banks made various risky loans. In order to reduce the risks, they essentially bought insurance from AIG. But AIG itself didn’t manage its own risk-profile well. So when the loans started going bad, it turned out that AIG couldn’t cover its contracts. Consequently, AIG’s poor risk-management was going to undermine the risk-management at every firm that managed risk through contracts with AIG. That would have led to a wave of bank failures. So the government stepped in and took over AIG. At which point it paid out the contracts in full.
The accusation of the report is basically that the government could and should have gotten a better deal than that for taxpayers. Paying out 80 cents on the dollar or whatever. But one big question is how would that have worked. If AIG were a firm going bankrupt, what you would do is call everyone up and say “uh…we screwed up…we can pay everyone 80% of what we owe you or else we can declare bankruptcy and you guys can roll the dice and see what you get in the end.” That’s a good strategy. But once AIG had been taken over by the government, the government couldn’t really threaten to default on AIG’s contracts. The government could have threatened to use its regulatory authority in a punitive way unless AIG counterparties agreed to a quasi-voluntary haircut. I can see the case for doing that, but I can also see the case for not doing it.
The crux of the matter is that once AIG goes from being an on-the-verge-of-bankruptcy company to a government-owned company, there’s really no more leverage that’s 100 percent legitimate. You could have said, pre-takeover, “hey guys, we’ll take over AIG but only if you all promise to take a haircut on your obligations.” But then you’re setting up a game of chicken. Are you really going to cause an economy-killing wave of bank failures unless the banksters agree to take a haircut? Well, no you’re not. So even when you seem to have leverage you actually don’t.
What’s really wanted here is for the United States to be a different kind of country with a more public-spirited business class wherein the bank executives could be persuaded to “do the right thing” in light of all the crap that taxpayers were doing on their behalf. But we live in the United States of America.
Fundamentally, though, as with a lot of this stuff I think what’s being implicated is much less America’s financial crisis emergency response policies than our background conditions of social justice. The very rich people in the top 0.5 percent of the income distribution who’ve garnered such a large share of the economic gains of the past thirty years should pay higher taxes, and in return there should be more and better public services. The Federal Reserve shouldn’t be so complacent about ten percent unemployment.
Did Financial Innovation Cause Deng Xiaoping’s Economic Reforms?
Eugene Fama makes a curious claim on behalf of financial innovation since 1980:
But suppose we buy into the more common negative current view of finance. There is still a big open question. Beginning in the early 1980s, the developed world and some big players in the developing world experienced a period of extraordinary growth. It’s reasonable to argue that in facilitating the flow of world savings to productive uses around the world, financial markets and financial institutions played a big role in this growth. Despite any role of finance in the current recession, are the market naysayers really ready to argue that worldwide wealth would be higher today if financial markets and financial institutions didn’t develop as they did?
A banker in Frankfurt put this same point to me, apparently believing it’s a brilliant argumentative trump card. In reality, it’s a bit nuts—it’s relying on a post-1980 boom that didn’t happen. The United States didn’t start growing faster in 1980:
The claim you’re supposed to make on behalf of the post-1980 US economy isn’t that it’s grown faster (it hasn’t!) but that it’s been less variable than was growth in the early postwar decades. That’s why the term “Great Moderation” was termed. Except in the wake of the current bust, it’s clear that no such decrease in variation was actually achieved. Growth has been the same as it was before, and yet median income growth has been substantially slower. In Europe and Japan growth post-1980 has been much worse than growth was in the previous decades.
The place where growth really has been much better since 1980 than it was before is China. This is not a fact to be neglected. Chinese growth has been very rapid, and very consistently maintained. And a very large number of people live in China, people who started this process being very poor. The past 30 years’ worth of economic growth in China have done an enormous amount to improve human welfare.
But the cause of this turnaround pretty clearly wasn’t financial deregulation in the developed world. It was policy shifts in China—the process, commenced by Deng Xiaoping, of moving away from central planning and joining the global economy. This doesn’t strike me as even remotely debatable. When we look at impressive growth over the past 30 years were looking at policy shifts in China, the success of container shipping, and to an extent shifts in developed world trade policy.
Where Have All The Investment Opportunities Gone?
Kevin Drum offers an interesting perspective on the “savings glut”:
I'm putting my money into American real estate! (cc photo by chi king)
But why weren’t there enough good, traditional places to invest that money? And by “traditional” I mean people who want to build factories or expand call centers or start up biotech ventures. That is, businesses that provide goods and services to meet demand from consumers and corporations. The supply side of the economy may have been going great guns, but the demand side wasn’t keeping up. This is why some people think it’s better to talk about this phenomenon as an “investment drought.”
Kevin offers an explanation for this that relates to the maldistribution of income in the United States. But isn’t the real issue here that the good investment opportunities were all in China?
That’s what was screwy about the global economy of the 2000s. For each and every one of those years, everyone believed that the short- and medium-term growth prospects in China were better than the prospects in the United States. And yet on net investment funds were flowing from China to the United States. Similarly, Americans had much more consumer goods than Chinese people, yet it was Americans borrowing money to finance present consumption. Borrowing it from China! That’s why Bernanke called it a savings glut.
But in a larger sense, this reflects the failing of the international financial architecture. The IMF wasn’t just created as a stimulus program for the makers of giant puppets—the architects of the postwar economic order thought the globe would be wracked by periodic crises without something to play its role. Nevertheless after the way the IMF handled things in the 1990s, Asian countries resolved to never again rely on the IMF and to instead start stockpiling dollars. But this effort to develop a workaround created a ton of problems. Bypassing the organization turns out to be a poor substitute for actually addressing the problems with it.
Bankers Opposed Even to Resolution Authority
I pointed out yesterday that even conservatives like Ben Bernanke agree on the need for congress to pass some form of “resolution authority” regulation, empowering the government to deal with failing financial institutions that aren’t covered by the FDIC process. That’s clearly a necessary step to dealing with the “too big to fail” issue, and some people even think it’s sufficient.
And then there’s Edward Yingling, the banksters’ top lobbyist, who’s against the idea on the grounds that it “could make it unnecessarily more expensive for them to do business during less turbulent times.” As Pat Garofalo observes “as for ‘unnecessary’ expenditures, I’d like to ask Yingling what he thinks of the $700 billion spent to pull the banking system back from the brink.”
But, look, this is just zealous advocacy on Yingling’s part. It’s clearly preferable for large financial firms that they be allowed to exist in a way that ensures the taxpayers have no choice but to cover their losses in the case of screwups. Anyone with any sense would jump at the chance to privatize profits and socialize losses. It’d just be insane of congress to let them keep getting away with it. Y
Resolution Authority ASAP
Liberals will probably find a fair amount to disagree with in these remarks from Ben Bernanke, especially the lead elements that involve vague assertions about the “economic benefit of multi-function, international (financial) firms.” That said, there’s no reason whatsoever to disagree with this:
Both in answering the question and in his prepared text, Mr. Bernanke again beseeched Congress to act soon to give regulators “resolution authority” to cope with the imminent collapse of a big financial firm other than a bank, and to address other vulnerabilities in the regulatory regime exposed during the crisis.
There’s plenty of room for disagreement as to whether an approach to “too big to fail” that’s centered on this resolution authority point is sufficient. But I think everyone can agree that it’s necessary. And unlike other elements of regulatory reform, this is something that at least might come into play during the current crisis if things get worse. I see no reason why congress couldn’t or shouldn’t move quickly on this point irrespective of controversy over the rest.
Internationalizing Financial Regulation
Martin Wolf’s ideas for financial regulation:
First, create a set of laws and institutions that make it possible to bankrupt any and all institutions, even in a crisis. Second, make financial institutions safer, with much higher capital requirements, against all activities. Third, prevent off-balance-sheet activities. Fourth, impose dynamic provisioning. Fifth, require huge cushions of contingent capital. Finally, cease to favour debt-finance, throughout the economy.
Kevin Drum likes this a lot.
I’m not sure how much of this can stick in an industry where the product and the inputs (just money, really) can cross international borders so easily. Shut down some antics in London and they move to Zurich.
Relatedly, with a lot of regulatory ideas you need not only to write good rules down on a piece of paper in advance, you need to pull the trigger when the time comes. Say you resolve to “prevent off-balance-sheet activities” and write some rules. Then it’s 2017 and so-and-so at GiantBankCorp finds some kind of loophole. By 2019 everyone’s using this loophole. So some bureaucrat at Treasury says, “hey we should really rule that this amounts to an illegal off-balance-sheet activity and shut it down.” Next Tuesday there’s a story in Roll Call about how a group of GOP House members, joined by a bloc of moderate Democrats and even some liberals from the New York City area have written a letter to the Treasury Secretary warning that the proposed rule would reduce US financial services competitiveness. And you have to understand, this isn’t going to be a front page headline in Roll Call—this is 2019, not 2009, and the general public doesn’t care about banking regulation anymore—it’s buried in some backwater. The only people following the issue are financiers and lobbyist types. And, hey, the Secretary tells himself that the critics aren’t even wrong. Closing the loophole won’t shut the activity down, it’ll just ensure that the loopholes are being exploited out of the London office. Who does that help? What could go wrong?
Another Spin at the Wheel
Good news for investors who like to lose all their money, “John Meriwether, the hedge fund manager and arbitrageur behind Long-Term Capital Management, is in the process of setting up a new hedge fund – his third.” What’s that, you ask, didn’t his first fund lose all its money? Why, yes. And didn’t the second fund fold because it lost a ton of money? Yes, quite so. So how will this new one be different? It won’t! It’s “expected use the same strategy as both LTCM and JWM to make money: so-called relative value arbitrage, a quantitative investment strategy Mr Meriwether pioneered when he led the hugely successful bond arbitrage group at Salomon Brothers in the 1980s.”
The way this works is that you identify arbitrage opportunities such that you make trades you’re overwhelmingly likely to make money on. But those opportunities only exist because the opportunities are very small. So to make them worth pursuing, you need to lever-up with huge amounts of debt. Which means that on the rare moments when the trades do go bad, everything falls apart: “The strategy typically has a high ‘blow-up’ risk because of the large amounts of leverage it uses to profit from often tiny pricing anomalies.”
As a friend puts it, this strategy is “literally the equivalent of putting a chip on 35 of the 36 roulette numbers and hoping for no zero/36.” But you’re doing it with borrowed money. I’m not a huge believer in human rationality, so I totally understand how this scam worked once. That he was able to get a second fund off the ground is pretty amazing. If he finds investors for a third spin around the wheel I’m going to propose confiscating all the rich peoples’ money and giving it to capuchin monkeys.
Improving the Administration’s Too Big to Fail Approach
Economics of Contempt has an excellent post up noting that the Obama administration’s proposed regulatory reforms actually do quite a bit more to deal with the “too big to fail” problem than is generally acknowledged. In particular, along with various regulatory steps, they’re asking for specific “resolution authority” over so-called “Tier-1 Financial Holding Companies. This would create a non-bankruptcy approach to dealing with insolvent big financial firms, much as the FDIC process exists for conventional banks.
But he also notes a substantial flaw in the proposal:
I think the administration makes a big mistake by requiring a separate “systemic risk” determination in order to use the proposed resolution authority for Tier 1 FHCs. This introduces needless uncertainty. Remember, a financial company is a Tier 1 FHC, by definition, if “material financial distress at the company could pose a threat to global or United States financial stability or the global or United States economy during times of economic stress.” An institution thus can’t even be a Tier 1 FHC in the first place if it doesn’t pose a systemic risk. Why require an additional, albeit slightly different, determination of “systemic risk” before the new resolution authority can be used? This will leave the market guessing as to which resolution regime — the Bankruptcy Code or the new resolution authority? — will be used to resolve a distressed Tier 1 FHC. Creditors, unsure which resolution regime will apply and thus how their claims will be treated, will be less likely extend credit at exactly the time we don’t want creditors to be pulling back from a Tier 1 FHC.
I would make the new resolution regime automatically applicable to Tier 1 FHCs. By requiring a second “systemic risk” determination, the administration is essentially saying that there are Tier 1 FHCs that can be resolved in an orderly fashion under the Bankruptcy Code as it’s currently written. You’d be hard-pressed to find any market participant who agrees with that statement (in fact, I don’t believe Tim Geithner honestly believes that statement). I continue to be confused by the insistence on a second “systemic risk” determination.
I think the real problem here isn’t that there’ll be uncertainty about whether or not the Bankruptcy Code will be used. The problem is that given policymakers clearly indicated (and correctly so) unwillingness to resolve big financial firms through bankruptcy, this seems to continue to hold the door open to future bailouts rather than actual use of the new resolution authority.
Either way, the proposal could be greatly improved by making this more automatic.
Bank Profits and Social Justice
JP MorganChase HQ
Jim Henley makes a good point in response to Kevin Drum:
It isn’t possible to get the banksters “off the federal teat immediately” or otherwise. There is simply no guarantee we make today that can bind the politicians of tomorrow. That’s not even necessarily a nebulous “tomorrow” either. Nor can we guarantee that, when the time comes, it would even make sense for tomorrow’s politicians to honor today’s future refusal. We have to figure out how to organize a political economy predicated on massive if implicit subsidies to the finance industry and its owners and executives so as to minimize the harm they can do and so it works tolerably for the rest of us. Am I optimistic that we can do this? Not so much. But since we can’t cut ‘em off, all we can hope to do is keep ‘em in line.
Right. Banks are profiting massively from ultra-low interest rates, but making such rates available serves the general interest. Banks are also profiting massively from implicit federal government guarantees. But you can’t “take away” those guarantees—they’re basically intangible—and it’s not at all clear that doing so would be wise. So you’re left with the difficult task of prudential regulation and trying to shrink the largest players over time with special fees and higher capital requirements.
That said, I think this is primarily an issue of social justice rather than an issue of technocratic regulation. And the answer is higher taxes on extremely high-earning individuals. The evidence suggests that big shot financiers make up a huge proportion of the highest-earning Americans, leaving CEOs of non-financial firms in the dust. You need to tax these guys and use the money to finance more and better social services and jobs for the people who provide the social services.
Having administration officials go whine to Wall Street honchos isn’t going to achieve anything.
Big Risks
This seems like a mighty strange choice of words:
A big reason for Goldman Sachs’s blowout profits this year has been the willingness of its traders to take big risks — they have put more money on the line while other banks that suffered last year have reined in such moves. Executives say there are big strategic gaps opening up between banks on Wall Street that are taking on more risks, and those that are treading a safer path.
It’s not really a “risk,” though, is it when you’re operating with an implicit government guarantee to pull your ass out of the fire if your bets blow up. The federal government is taking a risk on these Goldman trades, they’ve just given Goldman the bulk of the upside.
Government-Financed Gambling
Good piece by Graham Bowley in The New York Times:
It may come as a surprise that one of the most powerful forces driving the resurgence on Wall Street is not the banks but Washington. Many of the steps that policy makers took last year to stabilize the financial system — reducing interest rates to near zero, bolstering big banks with taxpayer money, guaranteeing billions of dollars of financial institutions’ debts — helped set the stage for this new era of Wall Street wealth.
Titans like Goldman Sachs and JPMorgan Chase are making fortunes in hot areas like trading stocks and bonds, rather than in the ho-hum business of lending people money. They also are profiting by taking risks that weaker rivals are unable or unwilling to shoulder — a benefit of less competition after the failure of some investment firms last year.
The Obama administration felt that nationalizing and recapitalizing banks directly would require congress to appropriate far more money than was possible. After all, if you think “bailouts” are unpopular now, just ask what it would look like if Obama wanted hundreds of billions more. Instead, they’ve used regulatory forebearance and other techniques to put banks in a position to recapitalize themselves through trading profits. And that’s what we’re seeing here. It’s an ugly, ugly business. They’re basically gambling on the taxpayers’ dime and operating with an implicit taxpayer guarantee to cover their losses if they blow up.
Hulk Smash Banks (With Special Fees and Capital Requirements)
It really does seem like if even Alan Greenspan is coming around to the view that we shouldn’t allow financial institutions to grow to such enormous sizes that we really shouldn’t allow financial institutions to grow to such enormous sizes. What’s a lot less clear to me is what you can actually do, in practical terms, moving forward. Now if only someone like Alan Greenspan had been voicing these concerns back in the 1990s it would have been easy enough for regulators (like, you know, Alan Greenspan) to deny regulatory approval to the kind of mergers that gave us the superbanks of today. But while regulators can prevent big firms from merging and becoming super-big, I’m pretty sure they can’t just order Bank of America to unmerge itself.
This, I think, is one of the main reasons you hear more about breaking banks up from people talking to newspapers than you do from policymakers. What, exactly, are Ben Bernanke and Tim Geithner supposed to do at this point?
Which is why, I think, the idea of enhanced capital ratios and special fees is actually a pretty good idea. Greenspan says “I don’t think merely raising the fees or capital on large institutions or taxing them is enough.” He thinks we need to actually break them up. But raising fees and capital requirements can be a way of doing this. The point would be to make the fees and requirements onerous enough that the managers of large financial institutions find it worthwhile to start finding ways to spin things off and shrink. That would produce the goal of smaller firms without having the Treasury Secretary personally step in and reorganize the commanding heights of the economy. The test is that if the fees are imposed and banks don’t start doing this, you need to come back and raise the fees. The fees need to be high enough to generate substantial fee-avoiding behavior, you can’t just say “well, we’ve got some extra revenue so it’s all good.”
Our Goldman Sachs Problem
The striking thing about Goldman Sachs’ profits isn’t so much that Goldman is making so much money as it is that, as Kevin Drum observes, the money is basically all coming from trading. It’s not that they’re bringing in big bucks doing investment banking or giving financial advice. They’re just gambling. And winning.
But what if they lose? For all we know, they’re actually making really unsound bets. Imagine putting $1 down on a lottery where there are 100,000 possible outcomes. In 99,999 of those outcomes, you win $3. But if that 100th ball comes out, you lose $1 billion. That’s a terrible bet. But you could still put a nice long winning streak together making that bet. You could earn a lot of money. Now you’d never do it with your own money on the line. But suppose you could do it with your company’s money, and then pay yourself an annual bonus based on the profits, and know all along that if you ever wind up with the bad outcome that Uncle Sam is going to bail you out.
The Real Problem With High Wall Street Pay
Sometimes an interesting paper doesn’t do much more than provide empirical confirmation of what basic theory would predict. For example, Thomas Philippon and Ariell Reshef have a paper (PDF) illustrating the point that the relative wage in the financial sector tends to track the relative education level of the personnel:
We use detailed information about wages, education and occupations to shed light on the evolution of the U.S. financial sector over the past century. We uncover a set of new, interrelated stylized facts: financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period. We investigate the determinants of this evolution and find that financial deregulation and corporate activities linked to IPOs and credit risk increase the demand for skills in financial jobs. Computers and information technology play a more limited role. Our analysis also shows that wages in finance were excessively high around 1930 and from the mid 1990s until 2006. For the recent period we estimate that rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector.
As Ryan Avent points out, there’s a reasonable case to be made that this is actually the Wall Street compensation issue we should be worried about:
Officials in Washington scrutinising the pay packages of TARP recipients are primarily focused on the incentive effects of those pay structures—whether financial pay packages are inducing financial employees to take excessive risks. But the bigger incentive problem may be—almost certainly is—the drain of talent from other fields, into finance. If there were more evidence that this drain was producing significant net benefits for the economy, than there would be less cause to worry. To an increasing number of people, it looks as though the financial sector is recruiting the nation’s best brains and putting them to work endangering the global economy.
Imagine a world in which being the owner of one of these telephone psychic scam operations discovered that high-skill fake-psychics could produce more earnings than a low-skill fake-psychic. He might start recruiting more people from top schools. And other firms would notice that this one guy moving up the skill chain was producing benefits, and begin doing the same himself. Over time, competition between firms would drive compensation in the psychic sector up and a greater-and-greater share of the high-skill workforce would start draining out of other fields and into psychic work. This would, in turn, seem likely to create a less productive economy over time. Some people would be arguing that the high wages in the psychic sector are, as such, proof that the psychics are generating social value. But nobody looks at the actually existing psychic industry and infers from the fact that psychics are able to earn income that psychics possess real ability to forecast the future. Rather, we recall that as Larry Summers famously argued “there are idiots”.
Christina Romer vs Political Reality
I’ve seen a fair amount of commentary on the part of Ryan Lizza’s profile of the Obama economic team where Christina Romer recommends a $1.2 trillion stimulus proposal and they wind up with just a bit more than half of that out of deference to the tender sensibilities of the United States Senate. I’ve seen less commentary on this other part, where basically the same thing happen on financial system policy:
Romer believed that the banks wouldn’t lend again until they were well capitalized. For banks in severe stress, she favored creating a government-backed “bad bank” to take the toxic assets off the banks’ books and then recapitalize them with government funds—essentially a version of nationalization, and what the Swedish government had done during that nation’s financial crisis of the early nineties. This argument was quickly rendered moot because of the cost. There wasn’t much money left in the TARP kitty, and any chance of getting more from Congress had ended with that morning’s news: A.I.G., which had received a hundred and seventy billion dollars in federal money, had handed out multimillion-dollar bonuses to the executives responsible for the company’s demise. Axelrod said, “The one thing that was absolutely clear was, we were not in a position to go back to Congress.”
Axelrod’s argument seems absolutely sound. And Rahm Emannuel’s argument on the stimulus that congress wouldn’t appropriate $1.2 trillion also seems absolutely sound. But of course Romer’s arguments weren’t arguments about feasible legislative strategies. Of all the senior members of the Obama administration, Romer has by far the least experience with practical legislative politics and also has the job that’s the least concerned with practical legislative politics. And I think that it was in a lot of ways a masterstroke to appoint a very policy-focused academic with no practical legislative experience to the CEA job. When people work too long in Washington, their notions of what would be good policy in principle tend to become unduly corrupted by their knowledge of what’s possible in practice.
But what Lizza is telling us is that on the two biggest pieces of macroeconomic management, the Obama administration is pursuing policies that its in-house expert on macroeconomic crisis management believed were far too timid. He’s also telling us that this was done primarily not because people disagreed with her analysis, but because they felt it wasn’t possible, legislatively speaking, to do what was objectively necessary. It’s a bit of a scary situation.
Hell Freezes Over Department
Well, waddaya know, I agree with Mark Penn about something:
The third decision the administration will be faced with is whether to launch a new stimulus package. Unemployment continues to creep up and is likely to soon hit the 10 percent tripwire. And while companies have reduced their payrolls, they are not growing on the top line, and the result is worsening job outlook. This is the most devastating result of the economic crisis that started with subprime mortgages and Wall Street arbitrage — persistently high unemployment.
From a strategic standpoint, it is that unemployment and how it is handled that will most likely determine the political fate of the administration. Joblessness is where economics and politics converge; while banking regulation and deficit reduction are certainly significant issues, no statistic is more vital in human or political terms than unemployment. And no decision is more critical for the president’s political future than how he moves to bring it back down — even if the fault rightly lies with the past administration’s neglect of the brewing financial storm.
Having chosen to spend what it takes to get us out of the recession, the president should not diverge from that basic direction at this point unless he wants to jeopardize essentially all the economic capital he has built up. In the polls, he’s losing steam as the one to handle the economy, but if he reasserts his positions and his policies, he can regain momentum, even in the face of higher unemployment.
I also agree with Ryan Avent that the theory that unemployment is caused by a boom/bust asymmetry seem to bolster rather than undermine the case for economic stimulus.
The question of policy design for a new stimulus package ought to be how do we design something that more directly targets the labor market rather than merely supporting GDP growth?
Quiggin on Tett
I have a review of Gilliam Tett’s Fool’s Gold forthcoming in The American Prospect, but John Quiggin has scooped me by also noticing something in Tett’s narrative that Tett herself seems to underplay or perhaps somehow miss. Namely the extent to which the financial instruments that she describes as having been misused or gone bad sometime after their invention were really rotten from the beginning. She lays the facts out quite clearly herself—the whole thing was always a house of cards, it just happens to be the case that the people at JP Morgan who invented the stuff didn’t build nearly as high a tower as some of their imitators.
Bank Nationalization
I think Felix Salmon and Tim Fernholz are both unduly impressed by the arguments presented in Ryan Lizza’s Larry Summers profile as to why the administration was right to reject bank nationalization as a financial crisis-management effort. Here’s what Lizza reconstructs:
The memo was divided into four sections. First, Summers explained that there was no legal authority to take over large bank-holding companies like Bank of America and Citigroup. Next, he pointed out that full nationalization of a financial institution might trigger systemic shocks, as investors retreated from other banks, creating exactly the kind of panic that nationalization was intended to prevent. (As [Obama economic official Gene] Sperling often argued, “You might come out and say, ‘I’m gonna take over Bank of America and Wells Fargo, but everybody else is safe!’ Maybe they believe you. And maybe they don’t. But if you get this wrong the Dow’s at thirty-five hundred! You’re the worst economic manager in the history of the United States!”)
Furthermore, Summers said, there was a medium-term risk that nationalized banks would lose value, in the same way that the act of foreclosure decreases the value of a home. Summers pointed to the example of Sweden, which was regularly cited by economists who favored nationalization. But Summers noted that Sweden didn’t nationalize for two and a half years, by which time the situation had become so severe—interest rates had reached a hundred per cent—that there were no other options. In addition, Nordbanken, the largest bank nationalized in Sweden, was already eighty per cent government-owned. Summers concluded by emphasizing that nationalization was a strategy that governments turn to only after it is very clear that nothing else can work.
The results of the stress tests showed that the banks were not in as dire shape as commonly believed. Most of the nineteen banks were able raise money privately. “It worked,” the Treasury official said. “People had money to put into banks. The nationalization crowd would have had the government putting all that money in.”
The key thing here is that the arguments as being relayed to Lizza seem not to know that the proposal to apply the Swedish model to the banking sector was a proposal to nationalize insolvent banks and explicitly guarantee the debts of the solvent ones. This is precisely designed to deal with the “nationalization sets off larger panic” worry. The fact that the stress tests showed that many banks were not in such bad shape is also irrelevant. Nobody ever proposed that we nationalize banks that weren’t in trouble. The proposal was to guarantee the obligations of banks that weren’t in trouble, a low-cost move since these are the banks that aren’t in trouble. The Obama administration wound up implicitly doing that anyway, which is precisely why most of the banks were able to raise money privately. The exact same thing would have played out with the exact same banks if the troubled banks had been nationalized.
The last resort argument seems frivolous to me. Yes, Sweden did this as a last resort. And it worked. Which is why it was being suggested that we not wait through a grinding two-and-half-year financial crisis before employing the remedy. I don’t think Summers took from the 1929-1940 experience that the correct thing to do is wait through 11 years of Depression before stimulating aggregate demand.
The legal authority question, by contrast, is obviously a real concern. If there’s no legal way to do something, then you can’t do it. But by the same token, if lack of explicit legal authority was really the objection to the policy, then you’d be writing a memo about (a) options to get the authority, (b) options to do it without explicit authority, and (c) alternatives to nationalization. Instead, we got a memo in which lack of explicit legal authority was thrown in as part of the kitchen sink.
To me the whole thing looks political. If you’re going to do something that’ll get you tagged as having undertaken an unpopular “bank bailout” then you might as well do it in a way that makes the bankers happy. Nationalization sounds at first glance like a sunny populist solution, but it would have still been hugely expensive and still characterized by many as a “bailout” (and, indeed, the whole point is in fact to bail out the creditors of major financial institutions) and also gotten Obama tagged as a Communist. You can’t take the politics out of politics, so on one level I say so be it. But on another level you still do have to worry if the handling of this crisis has paved the foundation for the next crisis.
Risk and Reward
An insightful comment from “Chris” at Felix Salmon’s blog:
The person most willing to take on risk is the one unaware he is doing so. He charges no risk premium…
The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.
As Salmon remarks:
This is possibly a very beautiful and elegant explanation for the extreme profitability of investment banks. They charge their clients a lot of money to take risk off their hands, and then they transformed that risk, using sophisticated financial engineering, into instruments which didn’t, on their face, look risky at all, and which could easily be sold to risk-averse investors. Bingo, massive profits.
Conclusion: “Financial complexity and innovation, on this view, are essentially tools of obfuscation.” I don’t think we should say that financial innovation is “essentially” one thing or another. A lot of the financial innovation of the past thirty years was aimed at regulatory arbitrage. A lot was basically aimed at hiding the ball so as to better be able to mislead people (and in some cases the financial institutions themselves) about where risk lay. And it’s also true that if you look at shifts in the global economy over the long run, innovation has led to more efficient financial markets. It’s much easier than it was 150 years ago to find reasonable ways to finance moderately risky projects in capital poor areas of the world.
But I think the upshot of this isn’t that we need to be “against” financial innovation but that we need to be skeptical of the claim that any measure to reduce the pace of innovation is likely to bring economic disaster. We should try to stifle innovation aimed at exploiting loopholes in regulations or ripping people off. It’s pretty basic to see that there are good business opportunities in those fields and thus we should expect a lot of innovative activity to be aimed at exploiting those opportunities.
Reform the Market for Ratings Agencies
Kevin Drum wonders what can be done about the ratings agencies:
Beyond that, I’m also a bit flummoxed about what the answer to the ratings agency problem might be. There’s probably a reasonable regulatory solution for fraud and negligence, but there seems to be wide agreement that the real problem is incentives: since issuers are the ones paying for ratings, it’s inevitable that agencies are going to lean into the wind to provide ratings the issuers like. I’ve read dozens of proposals for ratings agency reform, but the only one that really gets at this fundamental conflict-of-interest problem is to simply do away with them and turn debt rating into a government function. I’m a little skeptical of that, though, since it’s not at all clear to me that a government agency could hire the kind of talent it takes to keep up with Wall Street’s rocket scientists. What’s more, it’s not at all clear to me that anyone — Fed regulators included — would have rated SIVs much differently during the boom years than the ratings agencies did.
I’ve been told by people working in finance that in their opinion it would be feasible to use regulation to simply switch the payment scheme around and make it so that buyers of securities rather than issuers were the ones paying the ratings agencies. It’s not totally clear to me that that’s correct (for any given security you have one seller and many potential buyers so it seems it would be much more efficient to have the sellers pay) but that’s what I was told.
But I think the larger issue with the ratings agencies isn’t so much that they’re underregulated as it is that regulations we’ve put on other actors in the marketplace have created a ratings agency cartel. The underlying the premise of the idea that private ratings agencies can work is that agencies that fail to do a good job will fail as businesses. That can’t happen if there are only three ratings agencies and it’s impossible for new competitors to enter the market. As Mark Calabria explains in a paper whose general conclusions I wouldn’t embrace:
The modern regulation of credit rating agencies began with the SEC’s revision of its capital rules for broker-dealers in 1973. Under the SEC’s capital rules, a broker-dealer must write down the value of risky or speculative securities on its balance sheet to reflect the level of risk. In defining the risk of held securities, the SEC tied the measure of risk to the credit rating of the held security, with unrated securities considered the highest risk. Bank regulators later extended this practice of outsourcing their supervision of commercial bank risk to credit rating agencies under the implementation of the Basel capital standards.
The SEC, in designing its capital rules, was concerned that, in allowing outside credit rating agencies to define risk, some rating agencies would be tempted to simply sell favorable ratings, regardless of the true risk. To solve this perceived risk, the SEC decided that only Nationally Recognized Statistical Rating Organizations would have their ratings recognized by the SEC and used for complying with regulatory capital requirements. In defining the qualifications of an NRSRO, the SEC deliberately excluded new entrants and grandfathered existing firms, such as Moody’s and Standard and Poor’s.
In trying to address one imagined problem, a supposed race to the bottom, the SEC succeeded in creating a real problem, an entrenched oligopoly in the credit ratings industry. One result of this oligopoly is that beginning in the 1970s, rating agencies moved away from their historical practice of marketing and selling ratings largely to investors, toward selling the ratings to issuers of debt. Now that they had a captive clientele, debt issuers, the rating agencies quickly adapted their business model to this new reality.
The damage would have been large enough had the SEC stopped there. During the 1980s and 1990s, the SEC further entrenched the market control of the recognized rating agencies. For instance, in the 1980s the SEC limited money market funds to holding securities that were investment grade, as defined by the NRSROs. That requirement was later extended to money market fund holdings of commercial paper. Bank regulators and state insurance commissioners followed suit in basing their safety and soundness regulations on the use of NRSRO-approved securities.
This kind of situation could conceivably work if there were a large number of NRSROs but instead there are only three. And they essentially have the entire market in global finance captive. It’s a recipe for disaster.
The Investor Problem
Two quotes from Barney Frank talking to Ezra Klein:
What’s the most important part of financial regulation?
Limiting securitization. I believe the single biggest issue here is that people invented ways to lend money without worrying if they got paid back or not by securitizing the loan. When I was younger, the theory was if you had a high risk tolerance, you went into stocks. If you were safe and stodgy, you bought debt. But debt became the volatile aspect here.
[...]
One theory of the crisis is that the problem wasn’t traders and their high tolerance for risk. It was people fooling themselves into thinking this stuff was safe by slapping a triple-A rating on everything.
I agree; the theory has always been that people bought debt because it was safer. The basic problem was that 30 years ago when people lent other people money, they expected to be paid back by the people they lent money to. So they were very careful. Two years ago, most loans were being made by people who were going to sell those loans to other people and didn’t expect to be paid back.
This relates back to what I was saying about executive compensation. It’s true that the compensation schemes prevailing at many financial institutions seemed to involve bad incentives, but the real issue is why didn’t the market sort that out? Why don’t investors demand to be working with firms whose key employees don’t face those incentives? And similarly with securitization. The mysterious thing isn’t that people made bad loans that they were able to package and sell off, the mysterious thing is that they found buyers for the securities.
Ultimately this looks to me to go back to the ratings agencies, an issue Frank sort of dodged. But the ratings agencies are private for-profit companies that also enjoy a kind of government-sponsored monopoly status. In theory their behavior should be subject to market discipline, but in practice it’s not. They screwed up badly. But while lots of companies have gone bankrupt and lots of people have lost their jobs, the ratings agencies are all still in business. And no new competitors are coming to the fore and there’s no real way for anyone to break into the industry.
Compensation Reform
Having already noted the funny part of Paul Krugman’s case for banker compensation reform it’s worth turning to the serious part:
What’s wrong with financial-industry compensation? In a nutshell, bank executives are lavishly rewarded if they deliver big short-term profits — but aren’t correspondingly punished if they later suffer even bigger losses. This encourages excessive risk-taking: some of the men most responsible for the current crisis walked away immensely rich from the bonuses they earned in the good years, even though the high-risk strategies that led to those bonuses eventually decimated their companies, taking down a large part of the financial system in the process.
The Federal Reserve, now awakened from its Greenspan-era slumber, understands this problem — and proposes doing something about it. According to recent reports, the Fed’s board is considering imposing new rules on financial-firm compensation, requiring that banks “claw back” bonuses in the face of losses and link pay to long-term rather than short-term performance. The Fed argues that it has the authority to do this as part of its general mandate to oversee banks’ soundness.
This makes sense to me, though I’m moderately skeptical it can really be made to work in practice.
But I do think it’s worth dwelling on the fact that this really a pretty odd situation. Who doesn’t the market take care of this problem itself? It really seems like investors would be reluctant to deal with financial institutions that are organized this way. It seems like there was a reason the major investment banks were traditionally organized as partnerships—partnerships don’t have these incentives, and people should prefer to do business with institutions that don’t have these incentives. But the market’s not working like that. And it’s worth trying to understand why. If regulators start playing cat-and-mouse with compensation shenanigans, the mice are probably going to wind up winning. But if there’s some specific thing that’s preventing market discipline from adequately aligning incentives, we ought to be trying to find out what it is and what can be done about it.
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