The Volokh Conspiracy

Two items in today’s Wall Street Journal (Tuesday, March 9, 2010) capture two different views of regulatory reform of credit default swaps.  The first is the emerging European view:

European leaders pushed for a ban on speculative bets against government debt following recent financial turmoil in Greece ...  German Chancellor Angela Merkel said Tuesday that her government is backing an initiative to curb the credit-default swaps market, together with France, Greece and Luxembourg, and she suggested Europe would forge ahead on its own even if the U.S. didn’t go along.

José Manuel Barroso, president of the European Commission, the European Union’s executive arm, said the commission would examine closely the possibility of banning outright “purely speculative” trading of the swaps ...

The ban now being discussed in Europe would allow investors to use the contracts to hedge against possible defaults by government borrowers, but prevent them from taking purely speculative positions. “It’s hard to justify why market players should purchase insurance against risks to which they are not themselves exposed,” Mr. Barroso said.

There are a number of responses one could make to the EU’s Barroso (below the fold, I put what appears to be the implied Obama administration view).  Contrast this, however, with the March 9, 2010 speech by CFTC Chair Gary Gensler on CDS regulatory reform. Gensler did not suggest attempting to ban “speculative” trading in CDS, but did endorse three general reforms to the CDS (and more generally the OTC derivatives) market:

The 2008 financial crisis demonstrated how over-the-counter derivatives – initially developed to help manage and lower risk – can actually concentrate and heighten risk in the economy.

A comprehensive regulatory framework governing over-the-counter derivatives should apply to all dealers and all derivatives, no matter where traded or marketed. It should include interest rate swaps, currency swaps, foreign exchange swaps, commodity swaps, equity swaps, credit default swaps and any new product that might be developed in the future. Effective reform of the marketplace requires three critical components:

First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, Wall Street and the Federal Government had no price reference for particular assets – assets that we began to call “toxic.” Financial reform will be incomplete if we do not achieve public market transparency.

Third, to lower risk further, standard OTC derivatives should be brought to clearinghouses. Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. With their use, transactions with counterparties can be moved off the books of financial institutions that may have become both “too big to fail” and “too interconnected to fail.” Centralized clearing has helped to lower risk in futures markets for more than a century.

Gensler’s speech is serious, plain-spoken and, even if one disagrees with particular policy prescriptions, a useful, well-organized walk through the issues.  I think that most participants in the regulatory reform process would accept these proposals as commonsense, at least in the US; going beyond them to the kinds of proposals being made in Europe currently is a different matter.  (There has been a lively debate going on in the Financial Times in the past few days over CDS and liquidity.)  (My own view is close to Gensler’s, FWIW, and where it differs, it certainly does not head down the EU path outlined above.) Continue reading ‘Two Views of Credit Default Swaps’ »

Not everyone is quite so fascinated as I with CDS spreads on Greek sovereign debt.  However, the issues raised by the Greek debt difficulties and the urgent discussions in the Eurozone over a possible bailout, attendant moral hazard, and the like are far more than merely fiscal or monetary questions.  Rather, this crisis is one of those instances in which the deep economic and financial problems directly reflect the questions of founding political design.  Political economy in its purest sense.  Regardless of what one thinks the right policy for the EU, Germany, Greece, and others, is at this moment, economist Otmar Issing’s Financial Times comment today (Tuesday, February 16, 2010) lays out a lucid statement of the foundational political issue of monetary union without political (or fiscal) union:

It seems that quite a number of observers have forgotten what Emu is, and what it is not. The monetary union is based on two pillars. One is the stability of the euro, guaranteed by an independent central bank with a clear mandate to maintain price stability. The other is fiscal solidity, which has to be delivered by individual member states. Member countries are still sovereign. Emu does not represent a state; it is an institutional arrangement unique in history.

In the 1990s, many economists — I was among them — warned that starting monetary union without having established a political union was putting the cart before the horse. Now the question is whether monetary union can survive without such a political union. The current crisis must be handled in such a way as to produce a positive answer. The viability of the whole framework — nothing less — is at stake.

By joining Emu, a country accepts its rules. Greece, moreover, also knew that adopting a stable currency that was not controlled by its own central bank implied a total break with the past. Devaluation of the national currency and an inflationary monetary policy were no longer options. A single monetary policy is implemented by the European Central Bank and it is the responsibility of each country to adjust its economic policies so that this one size fits all.

The fundamental political problem is a collective action problem — the “responsibility of each country” to adjust its fiscal policies to comport with a single monetary policy.  The collective benefits, including those enjoyed by Greece, of a single monetary union with a currency widely trusted are enormous, starting with a lowering of borrowing costs — lower costs of which, however, could have been used either to lower public debts to put/keep Greece in line with the levels of fiscal policy of the monetary union, or leverage the savings to borrow ever more.  Greece promised the former and went for the latter:

The benefits of joining a stable economic area are greatest for countries that were unable to deliver such conditions before. Thanks to the euro, Greece has enjoyed long-term interest rates at a record low. But instead of delivering on its commitment at the time of entry to reduce public debt levels, the country has wasted potential savings in a spending frenzy. The crisis with which it is now confronted is not the result of an “external shock” such as an earthquake, but the result of bad policies pursued over many years.

I myself believe that the sanitized language of economists on display here tends to hide, below a veneer of ‘sense’, a much more palpable ‘sensibility’ of “spend” that went with joining the monetary union.  It isn’t just that Greece and its public saw an opportunity to free-ride on the euro.  I’d say (from experience living in Spain and other poorer countries of the “old” EU) that joining monetary union was seen as joining the lifestyle of the richest countries in the EU.  It was a powerful behavioral signal toward living like northern Europe, not toward seeing virtues in lowering the borrowing costs of the public fisc.  My strong impression of what many Spaniards in traditionally poorer parts of Spain thought the EU meant, when I lived there on sabbatical in the mid 2000s was that to “be European” mean to have a “European” lifestyle, based on a Euro income.  And, moreover, that the reason why the EU showered particular regions of Spain with money for so many years was not simply in order to promote economic development or political stability — both of which it did — or to purchase regional loyalty to the EU even over national solidarity — it did that, too — but, from the inhabitants’ view, tomake them “European,” which meant, ultimately, to consume like Europeans were supposed to, and did, even if it was financed on debt-fuel.  This is another of those instances in which the sensibility — even though hard to document and measure — is hugely important and perhaps as important as the economic sense.

The EU is, from the standpoint of this sensibility, about equality, and it is unjust that there should be rich regions and poor regions.  Again, from the standpoint of this essentially EU citizenship=consumer sensibility, if you didn’t intend that the EU should be gradually moving not so much closer to political union as egalite, then why on earth did you create a euro, the point of which, from a consumer standpoint, is to put everyone on an equalized playing field?  I realize this sounds strange from the standpoint of economic sense, but that’s not what I’m talking about.  The great sociologist Zygmunt Bauman once remarked, in an essay in Telos in the late 1980s, that the fundamental condition of poverty in our age is not that it is a class as such.  It is that to be poor is to be a “flawed consumer.”

The euro, understood from this sensibility, took poor people who were poor because their countries were poor — a status that described whole national societies — and made them poor people within a unified social environment in which their poverty was no longer the condition of the country, but rather them as individuals who, within Europe, were now “flawed consumers.”  Small wonder, as a matter of sensibility if not sense, that they concluded that the point of the euro was to make them ... not poor.  Small wonder that their governments responded in kind.  Which is why the conclusion of this FT article, so economically sensible, lucid and compelling — it gets my complete agreement as a matter of policy — misses the fundamental point from the standpoint of euro-sensibility.

This moment is a turning point for Emu, and for the future of Europe. Most observers point to the high risks — which cannot be denied. However, any crisis also presents an opportunity. This is a big chance — probably the last for Greece, and others — to adapt fully to a regime of stable money and solid public finances.

For Emu, the crisis represents a final test of whether such an institutional arrangement — a monetary union without a political union — is viable for an extended period of time. Lax monitoring and compromises when it comes to observing implementation of rules have to stop. Emu is a club of states with firm rules accepted by entrants. These rules must not be changed ex-post. Governments should not forget what they promised their citizens when they gave up their national currencies.

From the point of view of the sensibility of citizens who define themselves as citizens of the EU — at the Union’s own urging — as consumers, identifying “with” the European Union on the basis of the solidarity of consumption, Greece has not forgotten in the least what it promised its citizens in joining the euro.  It promised to deliver them from the condition of merely “flawed consumers” among the wealthy of northern Europe.

The former General Counsel of Long Term Capital Management — it of the late 1990s near global financial meltdown — James Rickards, had a comment in the Financial Times a few days ago (Feb 11, 2010) on the credit default swap market and Greek sovereign debt.  Key section:

Greece’s travails are often measured by reference to the market in credit default swaps (CDS), a kind of insurance against default by Greece. As with any insurance, greater risks entail higher prices to buy the protection. But what happens if the price of insurance is no longer anchored to the underlying risk?

When we look behind CDS prices, we don’t see an objective measure of the public finances of Greece, but something very different. Sellers are typically pension funds looking to earn an “insurance” premium and buyers are often hedge funds looking to make a quick turn. In the middle you have Goldman Sachs or another large bank booking a fat spread.

Now the piñata party begins. Banks grab their sticks and start pounding thinly traded Greek bonds and pushing out the spread between Greek and the benchmark German CDS price. Step two is a call on the pension funds to put up more margin, or security, as the price has moved in favour of the buyer. The margin money is shovelled to the hedge funds, which enjoy the cash and paper profits and the 20 per cent performance fees that follow. How convenient when this happens in December in time for the annual accounts, as was recently the case. This dynamic of pushing out spreads and calling in margin is the same one that played out at Long-Term Capital Management in 1998 and AIG in 2008 and it is happening again, this time in Europe.

Eventually the money flow will be reversed, when a bail-out is announced, but in the meantime pension funds earn premium, banks earn spreads, hedge funds earn fees and everyone’s a winner – except the hapless hedge fund investors, who suffer the fees on fleeting performance, and the unfortunate inhabitants of the piñata. What does any of this have to do with Greece? Very little. It is not much more than a floating craps game in an alley off Wall Street.

This is where the idea of CDS as insurance breaks down. For over 250 years, insurance markets have required buyers to have an insurable interest; another name for skin in the game. Your neighbour cannot buy insurance on your house because they have no insurable interest in it. Such insurance is considered unhealthy because it would cause the neighbour to want your house to burn down – and maybe even light the match.

When the CDS market started in the 1990s the whiz-kid inventors neglected the concept of insurable interest. Anyone could bet on anything, creating a perverse wish for the failure of companies and countries by those holding side bets but having no interest in the underlying bonds or enterprises. We have given Wall Street huge incentives to burn down your house.

I have general doubts about this being a complete, or accurate description, of the incentives in the CDS market.  In particular, I have two questions about this description of CDSs:

• First, is this a genuinely accurate description of the CDS market?  This presents it as being unmoored from the fundamentals, partly on account of the lack of an insurable interest (e.g., Goldman Sachs as an empty creditor at the time of the AIG meltdown) — but also because the parties have a massive agency failure problem in which the costs fall upon the hedge fund investors getting charged fees.  But is this really the case?  Are the parties on both sides, and the middle, in the CDS market really not checking against each other, quite apart from whether there is an insurable interest or not?
• Second, what is the argument for not requiring an insurable interest in the creation of an insurance market?  Liquidity and depth in the market?

Political scientist Jeffrey Friedman has an excellent article arguing that political ignorance by both regulators and voters played a key role in causing the financial crisis:

You are familiar by now with the role of the Federal Reserve in stimulating the housing boom; the role of Fannie Mae and Freddie Mac in encouraging low-equity mortgages; and the role of the Community Reinvestment Act in mandating loans to “subprime” borrowers, meaning those who were poor credit risks. So you may think that the government caused the financial crisis. But you don’t know the half of it. And neither does the government....

Given the large number of contributory factors — the Fed’s low interest rates, the Community Reinvestment Act, Fannie and Freddie’s actions, Basel I, the Recourse Rule, and Basel II — it has been said that the financial crisis was a perfect storm of regulatory error. But the factors I have just named do not even begin to complete the list. First, Peter Wallison has noted the prevalence of “no-recourse” laws in many states, which relieved mortgagors of financial liability if they simply walked away from a house on which they defaulted. This reassured people in financial straits that they could take on a possibly unaffordable mortgage with virtually no risk. Second, Richard Rahn has pointed out that the tax code discourages partnerships in banking (and other industries). Partnerships encourage prudence because each partner has a lot at stake if the firm goes under. Rahn’s point has wider implications, for scholars such as Amar Bhidé and Jonathan Macey have underscored aspects of tax and securities law that encourage publicly held corporations such as commercial banks — as opposed to partnerships or other privately held companies — to encourage their employees to generate the short-term profits adored by equities investors.....

This litany is not exhaustive. It is meant only to convey the welter of regulations that have grown up across different parts of the economy in such immense profusion that nobody can possibly predict how they will interact with each other. We are, all of us, ignorant of the vast bulk of what the government is doing for us, and what those actions might be doing to us. That is the best explanation for how this perfect regulatory storm happened, and for why it might well happen again.

For more of Jeff’s analysis of the ways in which ignorance contributed to the crisis, see here, and his much longer academic article on the subject in a special symposium issue of Critical Review (which also includes important contributions by many other scholars).

I don’t know enough about financial regulation to have any strong opinion on whether Jeff’s arguments are correct (though many of them strike me as persuasive). However, his analysis does overlap with my own work suggesting that the size and complexity of modern government greatly exacerbates the dangers of political ignorance (e.g. here and here). It is definitely a good and thought-provoking piece, even if there are parts that are hard for me to judge.

CONFLICT OF INTEREST WATCH: Jeff was one of the people who played a key role in getting me interested in the issue of political ignorance back in the 1990s. As editor of Critical Review, he published my very first article on the subject back in 1998. So I owe Jeff a great debt for, among other things, pointing me towards a subject that is one of the main parts of my research agenda, and promoting my work at a time when I wasn’t well-known at all. At the same time, we have disagreed in print over several major issues relating to political ignorance. So I’m hardly an uncritical cheerleader for Jeff’s arguments, or he for mine. In this series of articles, I think he makes a valuable contribution to the debate, even if we ultimately conclude that some other explanation of the crisis is more compelling. My guess is that the ignorance Jeff points to was at least an important contributing factor, even if other causes also played a major role.

UPDATE: Jeff has another interesting article about the causes of the financial crisis here (coauthored with Wladimir Kraus).

One theoretical way out of the Greece fiscal crisis for the Eurozone might be to apply standard Coase Theorem logic and find a way in which Germany could, under whatever face-saving language is necessary, bribe Greece to withdraw from the Euro.  The intent would be to get Greece off the Euro so that it could not cause more damage in the future (leaving aside, of course, all the Euro denominated bonds already out there) to the whole Euro as a currency, but giving Greece an incentive to do so, perhaps by providing some kind of mechanism to stave off bankruptcy or ensure that the debt can be turned over or otherwise have access to the capital markets.

Since, as Dutch scholar Martinned points out in the comments, the Euro is a one way ticket for all parties, getting someone out does not seem to be an option as such, the abilities to force Greece out appear to be perhaps even more remote than convincing it to reform its fiscal position, there is not where to go with this kind of analysis.  Put another way, the limit of getting Greece out of the Euro is an even further limit than the limit of Greek bankruptcy.

Still, a deal by which Berlin bribes Athens to get it out of its ability to poison the whole game does not appear crazy as a purely theoretical matter.  Practically ... it doesn’t seem like it.  Although talk of a “firewall” suggests something in these directions.  I have no evidence of any kind that such discussions are proceeding — zero.  It’s just a thought on my part and possibly a silly one.  Feel free to tell me either way in the comments.

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(Update 2:)  Let me add, based on the comments from Dutch scholar Martinned and others, it is starting to look as though Greece is not bribable because the rest of the EU doesn’t really have a legal option to force them out — meaning, quite apart from Greece’s internal coordination problems, its rational move is to threaten default and force the rest of the EU, ie Germany, to bail it out, under whatever suitable language and political cover can be found.  That does not seem like an irrelevant conclusion to investors.

How you frame that as an investment bet is not completely clear, however.  Betting against the euro is consistent with this hypothesis  - if it is true that Greece can’t be forced out, and it either defaults or gets bailed out, hard to see that this is not bad for the euro.  But now, betting against Greek bonds?  If you think Greece will get bailed out, then why bet against them?  But maybe you would prefer to see pressure put on Greek bonds in order to drive up the value of your euro-short?  The interaction of Greek bond strategies and short-euro strategies makes it hard to see a clear result simply from the surface of Greek bond spreads, looking back to the chart I posted yesterday.  Or am I missing something?  (End update.)

(Update 3:  Financial Times reports today (Wed, Feb 10, 2010) that the pressures downward on the Euro are forcing Berlin to have to fashion a rescue, but that it is trying to build some kind of firewall between it and Greece.)

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However, hunting around for Coase Theorem hypotheticals that didn’t involve the standard nuisance and pollution type cases for my 1L law and economics course — pure hypos without transaction costs, then gradually adding transactions costs back in — it occurred to me that I could structure a hypo around this kind of issue.

So ... as the WSJ and FT pointed out in my earlier posts on Greece and the problems of the southern Eurozone as against the northern Eurozone of Germany, the two main options for Greece are

• (i) withdraw from the Euro and devalue; or
• (ii) get a bailout from the Eurozone, which is particularly unpalatable to German voters (but which anyway would come with fiscal requirements that it seems hard to believe that Greece would ever persuade itself to meet).

Is there a way in which Germany and the still solvent part of the Eurozone of the north could bribe Greece to “temporarily” withdraw from the Euro?  Reaching an “efficient” solution in which Germany pays less than it otherwise would from a full euro-bailout, but pays something, essentially as a premium for getting Greece out of the euro with all the long term risks that presents. Continue reading ‘Should the Eurozone North Bribe the Eurozone South to “Temporarily” Leave?’ »

(Update.)  Thanks, Glenn, for the Instalanche!  Let’s add this front page article in the Financial Times today, Tuesday, February 9, 2010, “Traders in Record Bet Against the Euro.”

(You might also want to see my more general discussion in a post above on the directions of the EU regarding the unstable position of currency union without political/fiscal union.  Some people have raised some objections particularly to that post’s closing paragraphs regarding how the Obama administration views Western Europe — essentially losers in the globalized world, and no one worth paying attention to because anything of value that might have been learned from the internal European social democratic model has already been absorbed and priced into Obamism.  But I think it’s right — and I think that is the conclusion that European leaders have been drawing about what, not just Obama, but his senior cadre of intellectuals and elites think about Europe.

That’s quite apart from thinking that the Obama administration has so thoroughly absorbed the European lesson that a massive internal democratic socialist welfare state means geopolitical decline, that Obama is not just a weak leader in foreign policy — personally weak, as Sarkozy clearly thinks — but structurally weak as well, meaning that the foreign policy weakness is built into the structure of domestic policy shifts to a massive social democratic state.  These European leaders know better than anyone on the planet how the shift to their domestic social model implies geopolitical decline.  So they have no doubt as to where Obama is taking the US in foreign affairs.  As I said in the later post, we Atlanticists should have read Aron more recently.)

From the FT:

Traders and hedge funds have bet nearly $8bn (€5.9bn) against the euro, amassing the biggest ever short position in the single currency on fears of a eurozone debt crisis ...  The build-up in net short positions represents more than 40,000 contracts traded against the euro, equivalent to $7.6bn. It suggests investors are losing confidence in the single currency’s ability to withstand any contagion from Greece’s budget problems to other European countries.

The WSJ’s ‘Heard on the Street’ has an interesting item today comparing California and Greece from the standpoint of the bond markets.  Bottom line is that California fares far better than Greece in investors’ minds.  It’s a question, of course, how much of that is attributable to how investors see the underlying economies of each place and, instead, how investors are pricing the sugar daddi, er, the US government and EU-Eurozone institutions that might be called upon to offer a bailout.  But in terms of spreads, take a look at this chart from the story:

It is important to bear in mind that these kind of spreads can turn very quickly — indicators of short term sentiment concerning something that is basically a political and so, these days at least, a volatile issue.  These spreads for California could turn tomorrow, depending upon how investors read signals from Washington DC, or several other places.  Thus the WSJ article notes with respect to Greece’s dire situation:

Adoption of the euro, by removing the threat of currency fluctuations, encouraged yield-hungry investors to bid up Greek bonds. Leverage allowed Greece to run big current account deficits, despite low productivity growth. The result, once the credit bubble burst, is today’s crisis. There is no easy European fix.

Greece has two main options to restore competitiveness and narrow its current-account deficit: Withdraw from the euro and devalue, or win large and ongoing transfers from European states with surpluses like Germany.

Leaving the euro looks unpalatable. Bilateral transfers to Greece, even dressed up as loans, would be hard to sell to German voters. And such aid wouldn’t address Greece’s lack of competitiveness. Only grinding domestic deflation, with the risk of social unrest, or withdrawal from the euro could do that.

The imposition of EU “discipline” on Greece in return for transfers would represent creeping political union of an undesirable kind – one forced by Germany for fiscal reasons rather than one negotiated by member states. But Greece’s saving grace may be a default there would likely drag down Spain and Portugal. Such a risk will concentrate minds in Europe to find a solution, even if a bailout would not answer the question of the euro’s suitability for uncompetitive Mediterranean economies.

I’ll take up separately the question of California.  Likewise the question of political economy in the Eurozone — currency union without political or fiscal union?  But the article essentially thinks that California is saved not by a better internal structural economy, but instead because of its place deep in the heart of its guarantor.  California has better political hold-up.  It’s got better positioning to be able to force the US as a whole to internalize its difficulties, in ways (according to the article) that Greece will likely not be able to do with German voters.

One last quote from the FT quoted in the update:

Thomas Stolper, economist at Goldman Sachs, said: “ Behind this intense focus on Greece obviously is the long-standing unresolved issue of how to enforce fiscal discipline in a currency union of sovereign states.”

My class in private equity and venture capital doesn’t know it yet, but I think I might have them read Harvard Law School’s John Coates’ new empirical paper on the effects of ownership on M&A, or at least some important sections of it.  I’ve just been through it and think it’s terrific, with robust implications for differences between private and public targets.  (Plus, in the context of my class, it’s a good follow-on the some material from Larry Ribstein’s new book The Rise of the Uncorporation.)  You can find the full abstract and the paper at SSRN, but the one-sentence description is:  The paper “shows in a variety of ways how important M&A for private targets is to the economy, how different private target M&A is from public target M&A, and how important law is in creating those differences.”

(My class will have lots and lots of time to read, as class has been canceled and school closed — here in DC, the university hasn’t been open since last Thursday!  So I assume that my students are virtuously all snuggled up with texts on private equity, reading aloud with furrowed brows and cups of hot cocoa in one hand and yellow highlighter in the other.)

For those following financial regulatory reform debates, Paul Volcker’s NYT op-ed today is must-reading (NYT Op Ed, Paul Volcker, How to reform our financial system, January 31, 2010) (Thanks to Paul for pointing out misspelling.)

The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading — that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs. Those activities are actively engaged in by only a handful of American mega-commercial banks, perhaps four or five. Only 25 or 30 may be significant internationally.

Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called Chinese walls between different divisions of an institution. The further point is that the three activities at issue — which in themselves are legitimate and useful parts of our capital markets — are in no way dependent on commercial banks’ ownership. These days there are literally thousands of independent hedge funds and equity funds of widely varying size perfectly capable of maintaining innovative competitive markets. Individually, such independent capital market institutions, typically financed privately, are heavily dependent like other businesses upon commercial bank services, including in their case prime brokerage. Commercial bank ownership only tilts a “level playing field” without clear value added.

Very few of those capital market institutions, both because of their typically more limited size and more stable sources of finance, could present a credible claim to be “too big” or “too interconnected” to fail. In fact, sizable numbers of such institutions fail or voluntarily cease business in troubled times with no adverse consequences for the viability of markets.

What we do need is protection against the outliers. There are a limited number of investment banks (or perhaps insurance companies or other firms) the failure of which would be so disturbing as to raise concern about a broader market disruption. In such cases, authority by a relevant supervisory agency to limit their capital and leverage would be important, as the president has proposed ....   Continue reading ‘Volcker on Financial Reform’ »

(Update: I did not want to add my own reaction until I had a chance to read through the President’s speech.  In quick terms, I think it is conceptually the right approach, for the reasons laid out by Manzi, McArdle, today’s WSJ editorial, but above all by Paul Volker.  It is important to understand that this new Volkeresque proposal, as a regulatory matter, is altogether in a different world from the faux-populist banker bonus taxes under discussion; some aspect of them might well be politically necessary and well-justified, but no one can think that such theatrics constitute regulatory reform of too-big-to-fail and moral hazard.  Moreover, the WSJ editorial is correct to note that even if one accepts, as I do, that the idea of separating out proprietary risk taking from government-underwritten commercial banking, the devil is mostly in the details for how one separates those activities at the level of proprietary trading versus, for example, market-making on the behalf of clients.  Still, I have long thought Volker right in principle, and I congratulate the President and the administration for having the guts to go there.  I hope they see it through, and I hope Republicans see the virtue of this.  PS — the FT has excellent discussion of this today.)

I was interested to see that self-described center-right-libertarian Jim Manzi, over at NRO, has endorsed the broad concept behind President Obama’s recent banking regulatory reform proposals (here’s a description from the WSJ news pages; text of the President’s address is here at the WSJ’s Deal Journal; article at WSJ Real Time Economics blog describing mixed economist reaction is here).  Manzi says, of a proposal where the WSJ front page quite accurately headlined it as “New Bank Rules Sink Stocks: Obama Proposal Would Restrict Risk-Taking by Biggest Firms as Battle Looms”:

The first, and core, concept of the proposal is the re-segregation of commercial banking from proprietary trading (or roughly what used to be called commercial banking from investment banking). This is an excellent proposal ... I have been arguing for more than a year that this was the direction financial regulation needed to go, and that the logic of the situation would drive us here. The reason why is straightforward.

Finance professionals, like members of all occupational categories, attempt to build barriers that maintain their own income. One of the techniques used is to shroud what are often pretty basic ideas in pseudo-technical jargon. The reason that it is dysfunctional to have an insured banking system that is free to engage in speculative investing is simple and fundamental. We (i.e., the government, which is to say, ultimately, the taxpayers) provide a guarantee to depositors that when they put their savings in a regulated bank, then the money will be there even if the bank fails, because we believe that the chaos and uncertainty of a banking system operating without this guarantee is too unstable to maintain political viability. But if you let the operators of these banks take the deposits and, in effect, put them on a long-shot bet at the horse track, and then pay themselves a billion dollars in bonuses if the horse comes in, but turn to taxpayers to pay off depositors if the horse doesn’t, guess what is going to happen? Exactly what we saw in 2008 happens.

If you want to have a safe, secure banking system for small depositors, but don’t want to make risky investing illegal (which would be very damaging to the economy), the obvious solution is to not allow any one company to both take guaranteed deposits and also make speculative investments. This was the solution developed and implemented in the New Deal. We need a modernized version of this basic construct, and as far as I can see, this is what President Obama has proposed.

Megan McArdle broadly concurs.   Continue reading ‘President Obama’s Banking Proposal’ »

Over at Greg Mankiw’s blog, a discussion of whether the “surging monetary base” necessarily means inflation down the road:

Both reserves and T-bills are interest-paying obligations of the Federal government (including the Federal Reserve).  They are essentially perfect substitutes.  The monetary base, however, includes one of them but not the other, largely for historical reasons.

The bottom line is that when reserves pay interest, the monetary base is a pretty uninteresting economic statistic.

Does this mean that investors should stop worrying about inflation?  No.  Yet the worry should stem not from the monetary base but from the political economy and difficult tradeoffs facing monetary policymakers.  As the economy recovers, interest rates will likely need to rise.  Will the Bernanke Fed, feeling the political heat, get behind the curve and allow inflation to take off?  Will it decide that a little bit of inflation is not so bad compared with the alternative of risking an anemic recovery, a double dip recession, or (gasp!) congressional action to reduce Fed independence?   Maybe.  This is, I think, the right way to argue that higher future inflation is a plausible outcome.

I don’t know whether such inflation worries are justified.  But I am pretty sure that the exploding monetary base is not, by itself, a reason to fear a coming surge in inflation.

Mankiw remarks on a WSJ article a few days ago talking about some large investors betting on a rise in inflation and citing the the rise in the monetary base.  My own view is that these investors are perfectly aware of this, but are, in fact, making a political macro-bet that policy-makers will not have the political will to restrain inflation.  It would not surprise me in the least if it were the bet Soros ultimately makes — many, perhaps even most, of his biggest plays over the years have come by making political bets on the failure of immediate political will, starting with his bet twenty years ago against the pound.

Let me ask our readers a lightly different question.  How good are inflation-indexed USG debt as a hedge against inflation?  A prominent commentator — Martin Feldstein, I believe — suggested a few days ago that for many retail investors, they were a much better inflation hedge than gold.  (Someone might be good enough to send me the link.)  What is your view, both on the inflation outlook and on inflation hedges for the retail investor?

In the Financial Times today, Martin Dickson’s amusing admonition to bankers and their regulators.  If you happened to be the kind of parent who read your kid Hillaire Belloc’s Cautionary Tales for Children, this will all seem like familiar terrain.  Here is a bit from the opening:

There was a time when naughty boys
Would have to forfeit all their toys,
And go to bed without their food
To force a new, repentant mood
Upon the wretched little toads,
Who flouted our great social codes.

Nor was blind arrogance a trait
That parents liked to inculcate.
They had regard for social graces:
Not for their offsprings’ haughty faces.
A beastly child engaged in folly
Would surely have to say: “I’m sorry!”

But now we live in debased times,
Sans punishment to fit our crimes
Our moral compass has got lost,
Or on the rubbish heap been tossed.
As in this cautionary tale of bankers,
Who came to look like social cankers.

You will all know the basic story,
In all its venal details, gory.
Of how a bunch of peerless clowns
Despite degrees – from Yale to Brown –
Behaved like schoolboys in the lab,
When teacher’s gone to smoke a fag.

Exuberant beyond all reason
(For this or any other season)
Fired up by dreams of starter castles,
Sardinian yachts and vineyard parcels,
They built themselves a strange device –
A ticking bomb, to be precise.

The trouble was they did not know,
It was a bomb ’twas ticking so.
They thought it merely marked the beat
That called them to stay on their feet
And dance away – to really bop –
To music that would never stop.

The UK’s Prospect magazine — a genial, well-edited left-liberal take, by American standards, on politics — offers its list of the 25 leading public intellectuals offering commentary and sage advice in the financial crisis (in some cases action, too — Ben Bernanke is included).  The list is full of worthy commentators, and I wouldn’t disinvite anyone off the list — but it does seem to me a tad skewed to one direction, and not just with the natural weight given to UK people and, err, log-rolling in our time, i.e., Prospect contributors.

I was going to frame the question, “Who would you add to this list if you want to make it just as brainy but a bit more ideologically balanced?”  I’m not sure, however, looking back over it again, that I do think that everyone on this list should be here.  So let’s reframe it.  Twenty-five max.  For every name you nominate to go on, name who you vote off the island.

Interruption:  Changed my mind ... season of peace on earth, good will toward men, etc., etc.  No voting off the island.  Add up to ten names of your own to these and say why; no criticism of the existing list.

(In another post, but not this one, I’ll ask how you would set up a reality show involving economists and desert islands and, no, not where they all get eaten by hungry baboons — or each other.  Not this post.)

1. Simon Johnson. Professor at MIT, Peterson Institute fellow, former IMF chief economist, blogger, troublemaker and scourge of once-mighty banks—a worthy winner in 2009.

2. Avinash Persaud. Financial liquidity analyst, adviser to governments around the world, the man who has studied “herd” behaviour in finance, and now the man trying to stop it.

3. Adair Turner. An unusually bold regulator, Turner made headlines worldwide slamming “socially useless” finance (in Prospect) and suggesting a Tobin tax to put sand in the wheels of global finance.

The first three are the top choices, and everyone else in alphabetical order:

Ben Bernanke.  Cerebral Federal Reserve chairman, seen by many as saviour of the US economy while congress dithered.

Andrew Haldane. Bank of England director who warned of a “doom loop” of perpetual banking bailouts.

Philip Hildebrand. Swiss banker who boldly pushed cutting his country’s banks to size.

John Kay. Well-regarded British economist who wants a return to simple banking.

Mervyn King. Bank of England boss, initially wrong-footed by the crisis, but had a better, more aggressive 2009.

Richard Koo. Insider adviser to politicians and banks, an expert on the lessons from Japan, and deficit dove-in-chief.

Paul Krugman. Celebrated economist and author of a must-read New York Times essay on the failures of economics.

Christine Lagarde. French minister of economic affairs who got just the right mix of stick and carrot for French banks.

Donald Mackenzie. Edinburgh professor, author of many sharp LRB essays unpicking the anthropology of finance.

Lucy Prebble. 28-year-old British author of Enron, the best play yet on irrational exuberance.

Nouriel Roubini. Legendarily gloomy, normally correct finance analyst whose blogs alone can move markets.

Brad Setser. Young policy wonk, co-blogger with Simon Johnson and author of Bailouts or Bail-ins? with Roubini.

Robert Shiller. Credit-crunch US sage and behavioural economics pioneer.

Jon Stewart. Brainy American satirist whose Daily Show has made finance a laughing stock.

Joseph Stiglitz. Nobel laureate, chair of UN commission on financial reform and harsh critic of finance-as-usual.

Matt Taibbi. US journalist, wrote a celebrated scathing attack on Goldman Sachs.

Paul Volcker. Ex-Fed chair, pushing for splitting up investment and savings banks.

Elizabeth Warren. Harvard professor, consumer rights watchdog, leads the panel watching over Obama’s bailout money.

Martin Wolf. FT writer and the Anglosphere’s most influential finance journalist.

Paul Woolley. Innovative LSE thinker on “capital market dysfunctionality.”

Yu Yongding. Influential economist at the Chinese Academy of Social Sciences.

Zhou Xiaochuan. Bank of China head, architect of China’s response to the crisis.

Okay, I’ll bite on Fen’s comment in my previous post on opinion polls and climate change.

Suppose that you wanted, at the retail investor level, the cheapest and most efficient ways to go short on climate change policies, carbon regimes, whatever you think is relevant.  (In general, I’m a believer in sort-of efficient markets, despite all ... however, in matters political, I don’t think they are necessarily efficient even in the sense of predicting and pricing in political actions and policy.  I think there are exploitable inefficiencies arising from politicized markets.  Correct or not, go with the assumption.)  So, what’s your short strategy?  Not limited to stocks — tell me about bonds and credit instruments if you like, options and other strategies.  Or, for that matter, is it ultimately unshortable because it is driven, or eventually will be driven, by taxes across the board?

However, tell me how you would do it at the level of the small retail middle class investor, and in addition, what hedges you would include even in a generally short strategy?  Or is this kind of political risk — regulatory arbitrage bet too risky for small retail investors?  Get thee to thy index funds, etc.?

(I understand, by the way, if you think the question merely a provocation.  It is.  But not completely.  Speaking not politically, but as corporate finance professor, I would ordinarily advise someone that if you want to ensure that you truly understand your own financing strategy — at least if it involves public companies and instruments — you should be able to state clearly how you would go about shorting it and hedging it, and what the attendant costs and risks would be.)

Third installment in a five-part series on Silverglate’s book, Three Felonies a Day: How the Feds Target the Innocent.

“As a result of a burgeoning number of fraud investigations and prosecutions, I have become convinced that a concerted interagency effort is needed. We want to bring this additional firepower to bear on behalf of investors who might otherwise lose their confidence in the integrity of these markets.”

The Financial Fraud Enforcement Task Force, an interagency effort to investigate and prosecute those responsible for the current economic crisis, was established via executive order on November 17. But the above announcement was made twenty years prior. On January 31, 1989, then-Attorney General Dick Thornburgh touted the creation of a coordinated task force to bring to heel those responsible for the Wall Street scandals du jour.

Indeed, the present response to Wall Street failures seems straight out of a time-tested Washington playbook: Ratchet up enforcement, throw the miscreants in prison, and—voila—the public’s confidence in their markets and in their government is restored.

Arrest rates for “white collar” fraud have surged in the wake of recent well-publicized financial scandals, according to data generated (PDF) from the FBI’s Uniform Crime Reports. Over a two-year period after the savings-and-loan scandal and the creation of the task force described above (1990–1992), the number of fraud arrests increased 53%; over the same period following the dot-com bust (2000–2002), arrests jumped 26%. Now, with regulatory agencies expanding their probes of alleged insider-trading violations and the Justice Department promising more convictions, a raft of indictments appears inevitable. But do these enforcement efforts reflect true criminal violations? Putting aside the long-term efficacy of such periodic orgies of prosecution, there remains the nagging question of whether the defendants are guilty of any crime.

One’s unease lies not in the seeming futility of enforcement per se, but in the very nature of the laws that regulate financial fraud. For one thing, the sheer volume of regulatory codes makes adherence to legal standards a high hurdle. When Congress was considering the Fraud Enforcement and Recovery Act earlier this year, the National Association of Criminal Defense Lawyers and the Federalist Society—organizations on opposite ends of the ideological spectrum but joined at the hip in battling unfair and excessive federal prosecutions—authored a joint letter (PDF) to the Senate Judiciary Committee, pointing out that virtually all criminal provisions then under consideration were already encompassed within the existing federal criminal code. Congress ignored this nonpartisan and eminently sensible plea, passed the legislation, and added to the Justice Department’s armamentarium of overlapping and vague criminal statutes.

More pernicious than the volume of federal laws, however, is their imprecise wording. Prosecutors are given too much latitude in pursuing perceived wrongdoers whose conduct isn’t explicitly proscribed by statutory language. In a society of laws, fair notice as to what conduct might land a citizen in prison is a vital component of due process.

This should not be confused with a plea for de-regulation, which is largely a political and not a legal debate. Nor is it a plea for leniency for those who knowingly violate clear rules, even if those rules are unwise. But providing average citizens with clarity of their legal obligations is a vital civil liberties matter having nothing to do with whether one believes in more regulation or less. Timothy Lynch, director of the Cato Institute’s Project on Criminal Justice, spells out the need for specifically defined legal boundaries in his timely treatise on modern criminal law, In the Name of Justice (to which I contributed a chapter):

There is precious little difference between a secret law and a published regulation that cannot be understood. History is filled with examples of oppressive governments that persecuted unpopular groups and innocent individuals by keeping the law’s requirements from the people.

Galleon Group hedge fund founder Raj Rajaratnam, indicted (PDF) yesterday on 11 counts of securities fraud and conspiracy, would likely fit into this “unpopular” category, especially as his unflattering, hand-cuffed image from an October 16 early-morning “perp walk” continues to grace broadsheets and blogs. Rajaratnam is accused of having foraged around for—and obtained—purportedly non-public information from corporate insiders. But serious questions exist as to the line between legitimate research and illegal trading, as well as the extent to which insider trading laws even cover such outsiders who seek inside information. (Unlike Rajaratnam, others involved in the case might be insiders, and their legal obligations would be considerably clearer.)

The law criminalizing insider trading, enacted with the Securities and Exchange Act of 1934, prohibits “any person, directly or indirectly,” to “use or employ, in connection with the purchase or sale of any security…any manipulative or deceptive device.” Lawmakers assumed the SEC, which the Act created, would issue regulations to flesh out the vague language and effectuate the statute’s intent. But the SEC’s regulations tend to mimic, rather than clarify, the statute’s oracular wording, and neither the SEC nor Congress has been particularly eager to spell out precisely the nature of “securities fraud” or “insider trading.”

In the 1980s, both Congress and the SEC had an opportunity to provide clarity to securities fraud law. The Insider Trading Sanctions Act of 1984 (“ITSA”) substantially increased the penalties for insider trading. The Insider Trading and Securities Fraud Enforcement Act of 1988 (“ITSFEA”) further upped the ante by providing sanctions against those who “recklessly…failed to take appropriate steps to prevent” violations by others. Remarkably, despite near-unanimous support in both chambers of Congress, neither statute did anything to define precisely what insider trading was and what kinds of “outsiders” were covered.

During the ITSFEA hearings, Chairman John Dingell of the House Committee on Energy and Commerce claimed that any definition of insider trading would provide criminals with a “roadmap for fraud.” (It appeared not to occur to him that legal clarity is actually meant to provide a roadmap for lawful conduct.) Dingell explained that his committee “did not believe that the lack of consensus over the proper delineation of an insider trading definition should impede progress on the needed enforcement reforms encompassed within this legislation.”

It is reasonable to ask the question—especially in light of the early morning arrests, perp walks, sensational trials, and gargantuan prison sentences—whether the current system for dealing with “insider trading” by corporate outsiders who pursue as much information as their research skills and personal contacts allow comports with basic notions of due process of law.

Similar due process questions arose in the case of two former Bear Stearns hedge fund managers. Prosecutors indicted (PDF) Ralph Cioffi and Matthew Tannin on securities fraud charges for, in effect, presenting an optimistic picture to investors while aware of the possibility of collapse. When Cioffi and Tannin were faced with questions as the subprime mortgage market—in which their funds were heavily invested—looked ominously shaky, they doubtless agreed with the prevailing wisdom: Sure, a total collapse could happen, but the markets could instead stabilize and suddenly present managers with a huge buying opportunity. The situation, after all, was unprecedented in modern times.

Were a fund manager to respond to questions by publicly indulging his pessimistic side— “I think our liquidity has dried up and we may be on the verge of collapse”—he surely would have caused precisely that which he was hoping to avoid: a fatal “run on the bank.” Such a statement could rightly be seen as professional malpractice, subjecting the manager to endless civil litigation by disgruntled investors who doubtless could demonstrate that, at the time, an optimistic outcome was still a distinct possibility and that the manager’s predictions of doom were a reckless self-fulfilling prophecy.

The case was yet another example of the Justice Department targeting “professionals who have engaged in seemingly routine requirements of their job,” I wrote in the Wall Street Journal when the criminal investigation commenced in April 2008. Fortunately, jurors recognized the Catch-22 in which the Bear managers found themselves and acquitted Cioffi and Tannin on November 10.

In light of the legacy of the federal government responding to market downturns with task forces and ramped up prosecutions and perp walks, former Attorney General Thornburgh’s testimony (PDF) at a July 2009 Congressional hearing on the phenomenon of “overcriminalization” was a gratifying departure from remarks past. Said Thornburgh:

Make no mistake, when individuals commit crimes they should be held responsible and punished accordingly. The line has become blurred, however, on what conduct constitutes a crime, particularly in corporate criminal cases, and this line needs to be redrawn and reclarified.

Amen!

Der Spiegel has an informative story on the possibility that a Eurozone country might default on its sovereign debt, with economic, political, and legal consequences that could be anything from serious to dire.  The country is Greece:

Greece has already accumulated a mountain of debt that will be difficult if not impossible to pay off. The government has borrowed more than 110 percent of the country’s economic output over the years, and if investors lose confidence in the bonds, a meltdown could happen as early as next year.

That’s when the government borrowers in Athens will be required to refinance €25 billion worth of debt — that is, repay what they owe using funds borrowed from the financial markets. But if no buyers can be found for its securities, Greece will have no choice but to declare insolvency — just as Mexico, Ecuador, Russia and Argentina have done in past decades.

This puts Brussels in a predicament. European Union rules preclude the 27-member bloc from lending money to member states to plug holes in their budgets or bridge deficits.

And even if there were a way to circumvent this prohibition, the consequences could be disastrous. The lack of concern over budget discipline in countries like Spain, Italy and Ireland would spread like wildfire across the entire continent. The message would be clear: Why save, if others will eventually foot the bill?

On the other hand, if Brussels left the Greeks to their own devices, the consequences would also be dire. Confidence in the euro would be shattered, and the union would face a crucial test. What good is a common currency, many would ask, if some of the member states pay their debts while others do not?

Furthermore, there is a threat of a domino effect. If one euro member falls, speculators will test the stability of other potential bankruptcy candidates. This could destroy the currency union. Because of this systemic risk, say the economists at the Swiss bank UBS, “we believe that if a country is facing a problem with debt repayment or issuance, it will be supported.

A default of a euro-group country doesn’t worry the monetary policy hawks at the Bundesbank, Germany’s central bank. “So what if Greece stops paying its debts?” one of the executive board members asked at a recent banquet in Frankfurt. “The euro is strong enough to take it.” The real threat, he says, is if Brussels comes to the Greeks’ aid. “Then the currency union will turn into an inflation union.”

Bankruptcy, of course, is not the precise word, because there isn’t a mechanism for bankruptcy in the case of states.  But the general point that “bankruptcy” drives home is clear; and I’d add the fact that Brussels would have to address this, one way or another, and this is oddly closer to bankruptcy (maybe) than simply the creditors trying to cobble together to schedule a workout with the insolvent sovereign.  There’s no code and there’s no legal structure as such, but there is an overarching legal and political structure that presumably can’t just ignore it and so would have to behave in some kind of quasi-governmental way.

Or am I dreaming?  What would Brussels do?  In any case, this article has circulated widely in the economic policy blogosphere.  Megan McArdle has an excellent discussion of the broader questions about the Euro, going back to her days at the Economist:

The euro zone, on the other hand, has tightfisted Germany spliced together with spendthrift Italy, which previously relied on serial devaluations of its currency to boost exports and ease the burden of its debt payments.  This is why I was more skeptical than most observers–including most of my colleagues–that the euro zone was going to survive long term.  If a few members are forced to exit, either because the central bank’s monetary policy is keeping them mired in recession, or because they need to inflate away a massive debt burden, then it’s hard to see how the zone survives.  If investors think the euro zone is fragile, they’ll demand higher interest rates to compensate for the currency risk they’re assuming.  Furthermore, a smaller currency zone means smaller gains from trade, and presumably less incentive to pay the price of turning your monetary policy over to the ECB.

So far I’ve been proven wrong.  But Greece’s situation may provide an unhappy test of my hypothesis.  There seems to be some serious moral hazard in the market for the debt of troubled euro zone members:  as the quote above implies, investors are betting that other members will bail Greece out rather than risk damaging the euro.  As we saw right here in America, markets that believe in implicit government debt guarantees are extraordinarily fragile.  And as we saw in America, there may be no good solution:  bailing out Bear and letting Lehman fail were both extraordinarily costly.

A Greek bankruptcy thus has serious implications for Europe, and indirectly, for the rest of us.  European banks are heavily invested in Greek bonds, and if the country defaults, it’s probable that speculators will start eying other euro zone members.

But I wonder what, if any, are the questions for public international law, or public transnational law, or the constitutional order of the EU?  Does a Greek bankruptcy raise any issues for the political order of the EU?  Or can currency arrangements be kept separate from the EU, in the way that, for example, the UK stays out of currency union?  (I would point, by the way, to the work of my colleague Anna Gelpern, who is one of the leading scholars on sovereign debt restructuring — one of these days next semester, I’ll ask her to give us a guest post on what she thinks might transpire with Greece and other troubled small EU economies.) (Cross-posted from OJ.)

I am not an expert in consumer debt, so if this is incomplete or incorrect, I welcome comments on this.  However, here is an article from Yahoo Finance on how FICO scores are calculated, and specifically walking through the hits to your score taken for various credit events, ranging from maxing out a card to bankruptcy.  I was particularly interested to see that the better your starting credit score, the bigger the hit in points for each event.  Meaning, if your score started out at 680 and you had a late payment, the hit was 60–80 points.  But if you started out at 780, the same late payment was a 90–110 points hit.

PS.  My feelings about consumer debt are much the same as Megan McArdle’s, particularly as my daughter starts getting to those ages in which “consumption smoothing” looks like a possibly good idea ... I’m not about to sign onto the Dave Ramsey program (and I don’t sign onto his investment advice, except in the sense of the importance of savings), but I wouldn’t be unhappy if my child did ...  McArdle can retire now, if she likes, on her laurels for having written a post that I took Strong Measures to Persuade my kid to read, where McArdle talked about what it was like to be unemployed and not be able to afford Chinese food with friends, and how she practiced at home saying in the mirror the words, she said, that were about the hardest she’d ever had to say, “I can’t afford it.”

PPS.  Just in case anyone misunderstood, I was complimenting McArdle in talking about retiring now on her laurels, and high praise indeed.

I am a fan of Goldman Sachs.  It is one of the few individual stocks I own, running against all my standard corporate finance professor ‘buy index funds!!’ instincts.  Although we have had a surfeit of bankers and a surfeit of talent in financial engineering rather than, say, robotics, it is very scary to see the “silver linings” analyses talking about how it is such a good thing that smart Harvard or MIT students will no longer go to Wall Street, but will instead enrich elementary education or nursing or mountain-guiding.  While they might not be efficiently deployed in finance, it is a mistake to rejoice that the credit crash, deficit, tax rates, and other disincentives to innovation through risk-taking will push, through sheer lack of opportunity, smart people into things that do not take full advantage of their talents to the ultimate benefit of everyone.  I do a lot of development finance in the developing world, and the misallocation of talent simply from inability to supply opportunity is heartbreaking and worse.

The work of allocating capital in the capital markets, if not precisely God’s work, is so crucially important to men and women on earth that there is something wrong with these days having to defend it.  The little pieces of paper are vastly more efficient to steering rivers and seas of capital to and among enterprises — little gates and sluices in which small movements on paper can create immense movements in real life — than trying to do it by, what exactly?  Physical occupation of the premises as the sign of ownership?  Holding of hostages as collateral for a loan?  So I am untroubled by Goldman bankers getting rich, provided that their services serve efficient allocation; the problem is rules of a game that reward many wrong things and turn investment banking into a combination of crony capitalism and moral hazard.  Goldman’s current bonus pool is in large part a transfer, via yet more subsidized risk, from taxpayers to the firm; I trust in God and Blankfein that a goodly share of the booty will eventually wend to we shareholders.  But booty it is.

The problem here is not, and never has been, finding yet another little political fix to stick on top of the existing set of mis-allocation rules.  A “political offensiveness” tax, perhaps, under the socialist-sounding name of ‘excess profits’ or the capitalist-sounding name of ‘clawback’?  It’s neither, or both, of course.  The fixes-on-fixes eventually become flow-throughs to politicians like Chris Dodd; they permanently shift capital allocation into political allocation; and above all they don’t efficiently allocate capital.  Unless of course you’re Senator Dodd.  The answer has to lie at creating level playing fields at the base level, so that risk and return correlate for private parties, and they don’t have to apologize to anyone for the risks or the returns or the losses.

This is why Goldman Sachs’s cynical and tone-deaf small business program should serve as a wake up call for what business our capital allocators seem to think they are in.  At $500 million, the amount is paltry — 2.5% of the Goldman compensation pool or that ballpark.  And it does not even go to small business as such.  As the Wall Street Journal reports this morning (Deals and Deal Makers, Mike Specter, C5, November 19, 2009, I’ll post a link later), none of the small businesses emailing and telephoning in desperation for financing will “receive a check from Goldman Sachs.”  Instead:

“Goldman will spend $200 million on education and training programs, while funneling $300 million to so-called community-development financial institutions which largely serve historically disadvantaged communities that have had trouble accessing capital.“

One does not have to be a populist of the right or left to sniff that this is a ham-fisted PR program backed by miniscule funding.  Nor is this simply (as the quite interesting FT feature today on Goldman suggested) an ordinary case of Goldman corporate charity, of which it traditionally has done a great deal.  If it were, it would be much less problematic.

The much more important point is not what charity means — it is what high level business and finance have come to mean, when Goldman Sachs urgently decides that it needs to ”give back“ a sliver of what the taxpayers gave by giving it to ... community organizing.  It’s not corporate charity; it is protection money, clumsily done because unlike, say, Fannie and Freddie, Goldman is not used to doing it.  The message is that the future of the economy lies in crony capitalism and tending to the government relationships that happen, in this administration, to be community development institutions.  Even if the GSEs, Fannie and Freddie, showed what a splendid business model could be had tending to the care and feeding of Congress, its embrace by supposedly non-GSE Goldman Sachs shows us the way.  Apparently it will be a very efficient political capital market indeed.

(PS.  Note to journalists ... might any of the community-development institutions turn out to have ACORN ties?  I have zero idea whether this might be so.  Given the long-standing relationship of ACORN to the banking world via precisely these kinds of institutions, however, one should at least wonder.  And I at least would be curious to know whether Goldman thought vetting for this was a consideration.  Would Goldman consider this a bug or a feature in dealing with the current powers that be?)

I’ve been traveling recently, and so have been away from posting.  One of the enforced virtues of traveling — one of the few virtues of traveling for me these days — is the plane flight with no internet.  And if the big guy in front of me reclines his seat, as he always does, I can’t even get to my computer.  So I read  on flights.  I should have some reading gadget, Kindle or whatever, but I’m not that far along yet, and for that matter I should get an economy class friendly little word-processor to use on flights, but I’m cheap.  Here’s a selection across the varied reading on my flights.  No particular theme or order, I’m afraid (on account of the mixed-up topics here, I think I won’t open to comments; too jumbled to be productive). Continue reading ‘Reading While Traveling, Hard Copy and No Internet’ »

Michael Hersh describes a new $50 million George Soros initative to try and remake the economics profession so to reclaim it from “free market fundamentalists.”  The fund will be run by Robert Johnson, formerly a managing director of Soros Fund Management; it hopes to raise $200 million in matching funds.  (H/T Instapundit; also Mark N is right in the first comment to raise Cato as a better point of comparison in the (lengthy) discussion below the fold.)

Large swaths of economics are going to have to be rethought on the basis of what’s happened.” So said Larry Summers, President Obama’s chief economic adviser, in an interview in the weeks after the markets crashed a year ago. Yet to a remarkable degree, economic thinking hasn’t changed very much at all.

Now financier George Soros is announcing a $50 million effort to speed things along. This week Soros is gathering some of the leading practitioners of the market-skeptic school, who were marginalized during the era of “free-market fundamentalism,” among them Nobelists Joseph Stiglitz, George Akerlof, Michael Spence, and Sir James Mirrlees. He’s also creating an “Institute for New Economic Thinking” to make research grants, convene symposiums, and establish a journal, all in an effort to take back the economics profession from the champions of free-market zealotry who have dominated it for decades, and to correct the failures of decades of market deregulation. Soros hopes matching funds will bring the total endowment up to $200 million. “Economics has failed not only to predict and explain what happened but has also failed to protect society,” says Robert Johnson, a former managing director at Soros Fund Management, who will direct the new institute. “That’s what the crisis revealed. The paradigm has failed. There is no guidance.”

I am curious what professional and academic economists make of this kind of initiative.  (Update:  Here’s a much better article from the FT.  And I’ve added ... still more to the post below.) Continue reading ‘A New Soros Initiative on the Economics Profession?’ »

The Lex column in the Financial Times reports that the rating agencies — Standard & Poor’s and Moody’s — are doing financially just fine and, well, even better than fine:

McGraw Hill this week showed the ratings business is on the increase ...  Its Standard & Poor’s credit ratings agency, which accounts for the vast majority of the publisher’s profits, produced its first quarterly rise in revenues in two years.

In a business with large fixed costs, any upturn makes a substantial impact on the bottom line. Profitability in McGraw Hill’s financial services division, which includes lower-margin data and research businesses as well as ratings, never hit the lofty peaks of rival Moody’s with an operating margin of some 55 per cent. Nevertheless, S&P still managed to reach a 40 per cent margin, having merely dipped to 34 per cent at the end of 2008.

I have found it remarkable how little scrutiny has been focused on the rating agencies, and how little has been done — sensibly or foolishly — to revamp their incentives and business models.  There was some discussion of cutting off the implicit regulatory monopoly created by regulations specifying their services; I am not sure even that has gone anywhere, though I haven’t checked recently.  However, Lex adds this cheerful thought:

In spite of widespread gnashing of teeth over rating agencies’ role in the crisis, both companies are even thought to have increased their fees this year. Furthermore, proposed regulation looks less onerous than first feared. McGraw Hill estimates that extra regulatory costs, such as more compliance personnel, will be half what it originally thought.

The New York Times reports that Congress and the administration might soon reach some kind of view on legislation for addressing “too big to fail” institutions.  Off the table is Paul Volker’s proposal to re-establish some line between commercial banking and proprietary trading — some updated Glass-Steagall demarcation.  On the table is the Treasury’s proposal to designate various institutions as “too big to fail” in various degrees and subject them to greater capital requirements, limits on risk-taking, and in addition require a so-called “living will” that would make clear how to disentangle these institutions from others in a crisis.  I think the “living will” idea is not a bad one on its own, as long as we all understand the limits of what it gets you.

Much, much more puzzling to me is this description in the Times, quoting Michael S. Barr, assistant Treasury secretary for financial institutions (italics added to show the quote):

The White House plan as outlined so far would already make it much more costly to be a large financial company whose failure would put the financial system and the economy at risk. It would force such institutions to hold more money in reserve and make it harder for them to borrow too heavily against their assets.

Setting up the equivalent of living wills for corporations, that plan would require that they come up with their own procedure to be disentangled in the event of a crisis, a plan that administration officials say ought to be made public in advance.

“These changes will impose market discipline on the largest and most interconnected companies,” said Michael S. Barr, assistant Treasury secretary for financial institutions. One of the biggest changes the plan would make, he said, is that instead of being controlled by creditors, the process is controlled by the government.

Some regulators and economists in recent weeks have suggested that the administration’s plan does not go far enough. They say that the government should consider breaking up the biggest banks and investment firms long before they fail, or at least impose strict limits on their trading activities — steps that the administration continues to reject.

The changes will “impose market discipline”?  How?  They all seem designed to make for better prudential regulation by government regulators — not a bad idea necessarily, in fact not a bad idea at all — but hardly market discipline.  As the Times says Barr says, if there is a big problem, instead of “being controlled by creditors,” the process will be “controlled by the government.” Continue reading ‘Market Discipline? What Market Discipline?’ »

One proposal for addressing too big to fail, or to systemically interconnected to fail, among financial institutions is to separate out the proprietary trading and other “casino” activities from the “utilities” business of commercial banking with the public.  In some ways (not all) it is a revival of the Glass-Steagall approach.  Paul Volker has urged such a policy, as have others.  The Obama administration has not so far shown any appetite for such it, preferring, in its Treasury blueprint for reform, to allow the functional interconnections within holding company structures, and identifying institutions that are regarded as too big or too systemically interconnected to fail and apply “regulation and last resort lending” to apply to them.

Something like the same debate is taking place in Britain, and the Financial Times’s Martin Wolf makes a comment on why one could see the functional separation desirable, but also why it is hard to do and hard to ensure that it actually reduces the systemic risk.  In response to a recent speech by Mervyn King of the Bank of England calling to separate out the “casinos” from the “utilities,” Wolf says:

it is evident why this distinction is appealing. If we define the utility parts of the financial system narrowly, as management of the payment system, it works like clockwork. It is in the management of risk (and the advice given to its clients) that the financial system fails. The limited liability businesses at the heart of our credit-based monetary system have a tendency to mismanage risk (and uncertainty), with devastating results.

However, he ultimately says that he is unpersuaded that a modernized form of Glass-Steagall can work as a structural solution to systemic risk:

Yet I remain unpersuaded that the structural solution – the separation of utility from casino finance – is workable, as I pointed out in a column on the “narrow banking” proposal of my colleague, John Kay. Indeed, Mr King himself is well aware of the difficulties.

First, the border between utility and casino banking is impossible to draw. For Mr Kay, the utility is the payment system and protection of deposits. This would leave all lending – including to households and businesses – inside the casino. For those in the US who hark back to the Glass-Steagall Act, the distinction is between commercial and riskier investment banking.

Mr Kay’s distinction is clear, but problematic. If we followed him, all risk management would become unregulated. It is inconceivable that governments would, or could, leave them so. If we moved back to a Glass-Steagall distinction (itself never accepted in continental Europe), we would need to draw a line. But where? Why would lending to households and business be good, but securitising those loans bad? Why would hedging be good, but speculating bad and how might one draw the line between them? Mr King counters that prudential regulation already draws such distinctions. I would respond that regulation has made a mess in doing so. Furthermore, these are not distinctions between businesses.

This is not to argue that there is no way of making finance safe. There is. But it would be far more radical: deposits would be 100 per cent reserve backed; and the liabilities of other investment vehicles would be adjusted for the market value of their assets at all times. Banking would disappear.

Short of such radicalism, we must approach the task in a more subtle manner. 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.

If we did all this, the world of finance would be duller and safer. It would still not have the reliability of jet engines. So long as we allow people to make leveraged bets on the future, breakdowns will occur. The division of finance into utility and casino cannot solve this problem. Only the end of leverage would do so. Do we want that? I doubt it.

I am still thinking through policy on this.  I am more or less persuaded that the Treasury view in the US represents a bad compromise that won’t  prevent the next crisis while stifling activities under regulation that might well turn out to have been both intrusive and yet mostly pointless.  Yet, while accepting Wolf’s criticisms of the casino-utility distinction, I question whether there is still not a role for a structural separation even if one recognizes that it does not solve all the problems of systemic interconnection of institutions via markets.  Constructive comments on the best approach to too big too fail and systemic risk welcomed.

In my last post I opened a discussion about my new paper, Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, which you can download here.  My thesis is that corporate law and theory goes haywire when the government, while enjoying sovereign immunity protection from corporate and securities law, takes control of a company by owning shares.  But does the government really control TARP companies?

When Treasury initially sold Congress on the bailout, the plan was to create all sorts of nifty market-oriented structures to reinvigorate the market for troubled assets.  But once Hank Paulson got the money, he used most of the first $300 Billion to buy stock in over 600 troubled banks (from Citigroup and Bank of America to your local First State bank).  Eric Posner warned us about this sort of surprise.  Some of the stock is non-voting preferred stock that gives Treasury the ability to appoint directors in certain circumstances, for other companies like Citigroup the stock is voting common equity.  The share purchase program was later extended to the automotive sector by Tim Geithner.  The question is whether the government is a controlling shareholder based on its percentage of share ownership, the fact that the government regulates banks, and the fact that it  loans them a lot of money.

Control is an elusive concept.  What does it mean to control something?  Is it the power to dictate demands, to encourage, to threaten, or maybe the power to destroy something if you wanted?  Some forms of control require force.  Then again, sometimes control can be exhibited more powerfully through a sublime and unspoken understanding, the Godfather-esque “I give him an offer, he don’t refuse.”  It is a question not lent to easy answers, and yet corporate and securities law is riddled with special provisions assigning liability, prohibiting transactions, or requiring additional disclosure based on whether a shareholder controls a company.

Analysis of control in business law is unfortunately muddled.  For an entirely novel method of determining control, keep an eye out for an article I’m doing with Terry Chorvat sometime next year.  For now, here are some basic rules: i) control is exclusive, a corporation may only have one control shareholder, ii) control is usually present for majority shareholders, unless the board has staggered terms (like the U.S. Senate) iii) holding a majority of shares is not required for control, owing to the collective action problems, rational apathy, and regulatory restrictions limiting dispersed shareholder exercise of their votes, and iv) factors indicating control for sub-majority shareholders could include percentage of holdings, special contractual rights, concurrent status as a powerful creditor, or actual exercise of control such as holding corporate office.

With that, let’s turn to the question of whether the federal government is a control shareholder for any of the 600+ companies accepting TARP bailout money.  We start with the obvious point that the government stands as both a powerful creditor and shareholder for most of these companies.  It also has a power that no other shareholder has, it regulates the companies.  For banking, Treasury and the Fed are regulators, for the automotive industry the DOTD, DOE, and other entities do the job.  At GM and AIG, Treasury and the Fed are majority shareholders (GM is not currently publicly traded, but soon will be).  Fannie and Freddie are not technically TARP bailout owing to their pre-bailout conservatorship (in much the same way that Marcia, Jan, and Cindy are not technically Brady) but in light of their starring roles in the financial crisis, let’s throw them in anyway as former Fortune 500 companies that are presently 100% government owned.

At AIG, the Federal Reserve placed its shares with a trust that it created, the AIG Trust, managed by three trustees selected by the Federal Reserve.  The Fed’s position is that this helps to create a buffer between the Fed and AIG.  I don’t buy that argument.  I had an opportunity to testify about the AIG Trust, along with then AIG CEO Ed Liddy and the three trustees, at a hearing before House Oversight this summer where I urged that the AIG Trust Document actually requires the Trustees to manage the trust in the best interest of the Treasury Department.  To read the testimony, see here.  I’ve consulted for the Special Inspector General for TARP and the GAO TARP team on this issue for a Corporate Governance Audit requested by Senator Baucus, a very engaged and informed group of folks by the way, hopefully that report will bring this issue to light.

At Citigroup the government holds a 34% interest.  For any other shareholder 34% ownership, by itself, is a close call for determining control.  When we add the fact that banking is a deeply regulated industry, regulated by same two government entities that control the shares in question, and we also consider the fact that the government is also a substantial creditor of Citi through a number of guarantees it has also offered to Citi’s outstanding liabilities, I feel confident in asserting that the federal government is a control shareholder in Citi.  For real world indicia of control, consider that the government has chosen most of Citi’s current directors, and that Citi has been the first to accede to congressional demands on mortgage re-modifications, support for cramdown legislation, and worker visa limitations.

I won’t analyze every one of the 600 companies, but I think you get the point.  Treasury and the Federal Reserve are control shareholders of many TARP companies, the only real question is how many.

The Wall Street Journal has a new story from over the weekend on Democratic proposals, in Congress and the administration and from outside groups, to impose a tax on financial transactions (John D. McKinnon, Democrats Weigh Tax on Financial Transactions, WSJ, October 10, 2009):

Taxing financial transactions on Wall Street is gathering support in high places.

With federal budget deficits soaring, policy makers and other advocates are eyeing the huge sums that could be raised as a way to cover the costs of new initiatives.

Labor unions, in particular the AFL-CIO, have proposed a financial-transactions tax as a way to defray costs of a health-care overhaul. Lawmakers have discussed a similar fee as a way to cover the cost of future financial oversight. Liberal advocates are pushing the tax to pay for new stimulus spending.

Financial transactions taxes, whether on the US domestic level or the often-proposed international “Tobin tax,” are sometimes described simply as broad based revenue raisers, and sometimes described as ways of deliberately slowing down the movement and flow of capital.  As a revenue raiser, one current proposal operates this way:

This week, the left-leaning Economic Policy Institute floated the idea of a national transaction tax that would raise $100 billion to $150 billion a year. The tax, at a rate of 0.1% to 0.25% of the value of the trade, would be levied on all financial transactions such as stock trades, but not on consumer transactions such as with credit cards.

The money would be used initially to pay for temporary aid to states, hiring incentives for public– and private-sector employers and school construction money.

“We are in a difficult time right now, so people are looking at every opportunity to gain some revenue to fund” new initiatives, said Rep. Stephen Lynch (D., Mass.), a member of the House Financial Services Committee. “Because I was one of the first to suggest using this to fund [new] regulatory infrastructure, folks have come to me and said, ‘That’s a good idea; I’ve got a better one: Why don’t we use it for stimulus or especially health care?’”

One Democratic aide said the idea is under consideration among House leadership, though the discussions are preliminary.

It does sound like a dandy, relatively hidden revenue raiser — one that could generate vast sums of money relatively unnoticed, at least among ultimate ordinary consumers and taxpayers, who will not notice the long-term, collective hit to their pension funds and retirement funds which, anyway, they often do not directly manage.  However, taxing at the front end is generally considered more distorting than taxing at the back end, and a tax on simply engaging in transactions themselves is almost certainly more distorting, other things being equal, than a tax on the final net economic transaction.  Certainly less transparent to those who ultimately bear the tax.  And of course there are many questions of where the incidence of tax falls — after all, a huge percentage of these transactions involve people’s retirement funds, long term savings, pension plans, including those of the unions.  It is not just a bunch of plutocrats sitting around trading their stocks and bonds.

Hence a bit of bait and switch — when that point is raised, then the defense is offered that, well, after all, it is independently a good thing to slow down and make more expensive capital market transactions.  Capital flows too quickly and too fluidly as is, on this view; it needs to be slowed down, for its own sake, quite apart from the revenue raising.  The sand in the wheels of commerce is a good thing because the flow of funds is, if not precisely too efficient, then too volatile.  This was an argument heard particularly in the 1990s with respect to the global capital markets, around the various currency crises, the Mexican peso crisis of the early 1990s or the Asian crisis of the later 90s.  Of course, another bit of bait and switch was going on in those arguments as well — many of the Tobin tax supporters presented this as a desirable distortion of incentives, but actually were interested in the revenue, proposed as a way of funding international organizations starting with the UN.

Sometimes the transactions tax is coupled with the idea of exempting transactions that favor holding for some period of time — an anti-volatility, anti-rapid-turnover kind of rule; sometimes it is suggested that this will spare long-term retirement savings from the burden of the tax.  The problem is that the distortionary effects are not easily separated that way; the effects of economic distortion are not the same as the question of who pays the direct transaction tax.  The economic distortions are far less about whether I pay such taxes on my relatively infrequent trades in my retirement account and much more about whether the market as a whole is less efficient and so reduces the long run growth and value of my retirement account indirectly, irrespective of whether I, individually and directly, pay much in the way of the transactions taxes.

According to the article, leading Democrats such as Barney Frank are open to the idea.  The revenue needs, it seems, will be insatiable, and the distortions something like the indirect, hard to pin down, long-run effects of inflation.  But in the case of a domestic US transactions tax, of course there is something else to worry about.  There is no reason why financial transactions have to remain in American markets.  Other than efficiency, liquidity, depth, interconnectedness among financial markets, security, relatively good corporate and regulatory governance, transparency, low transaction costs, the neutral application of the rule of law to all comers.  Yes, the United States offers all those things, but it does not have a monopoly of them, obviously.  London offers all of that.  So do other places — mainland China does not, as yet, but Singapore does, and other places in the world.

Hard as it might be to imagine financial market transactions migrating from the US elsewhere, it has happened to many financial centers in the past and can happen to the US in the future.  The US has huge accumulated advantages in these areas, many of which are social, institutional, and political-legal cultural benefits that seem immutable and free-standing.   On the other hand, automotive Detroit seemed immutable and free-standing and the beneficiary of all those advantages for decades and decades — its political class decided to eat its seed corn, so to speak, and even once it was obvious where it was heading, decided to go with the flow and double-down the bet on ‘other taxpayers’ money’.  Maybe it will (continue to) work out for the best for the UAW and its labor allies, at the expense of the rest, but there are limits to even what the current administration can do for it.

This is not a declinist prediction.  It doesn’t have to be this way.  It is, rather, to observe that for the US now, actions to promote US decline are decisions taken today by the political class.  Decline-inducing decisions include making the US less attractive as a capital market center and leader, making transactions more expensive in order to favor current spending.

Does a complex welfare state need taxes?  Sure.  Transparent, widely shared, everybody pays something and everyone can see what they pay, so that everyone has a stake in the extent of taxing and spending, as visible and little distortionary as possible.  Thus almost the opposite direction to where the US tax code has drifted since the 1986 reform and even more so to where current proposals aim to go.  They tend to increase the rent-seeking possibilities of the political class and its ability to ‘get the juice’ from economic actors who must navigate the artificial shoals of regulations that aim to benefit particular constituencies and particular politicians.  VAT taxes flunk the transparency requirement, as do turnover taxes of this kind.  That is, of course, one reason why politicians love them.

I’m considering submitting two new course proposals to our curriculum committee at our law school here in DC.  I’d be grateful for your pedagogical advice.

One would be a reading-research seminar in law and economics on the current state of debate over the Efficient Market Hypothesis.  I imagine we would read some standard economics articles and material running back over the last few decades, including classics like A Random Walk Down Wall Street, but also a couple of recent books on the debate, including Justin Fox’s The Myth of the Rational Market, and perhaps Dick Posner’s book, among other things.   One specifically law school connection would be to help students understand how the theory underpins much regulation, how courts view cases, many parts of the law itself.

The second class would be on financial derivatives, considered as contracts.  We already have a class on derivative regulation at my school — this would be a class specifically on the contracts themselves, and the economic context in which the derivatives are used.

Would those seem like useful seminar courses for business law students in their third year of law school?  Or yet another example of professor doing what interests him without much attention as to pedagogical utility?  We are a solid mid tier school, in DC; many, many of our students go into government regulatory agencies dealing with the economy.

Via TaxProfBlog, I discovered the Davis Polk Financial Crisis Manual, in pdf.  I read it quickly while covering my wife’s classes at St. Alban’s today — all quizzes and tests, so I had time to read while the boys were struggling with conjugating the pluperfect in Spanish.  It’s really very good.  279 pages and available free online.  Congratulations to Davis Polk — so many of these law firm publications are just not readable; they tell you something about the limits of lawyers, not so much as writers but as editors.  This manual is genuinely useful.  I’ll certainly be using it, and I will be certain my students do as well.